Planning Opportunities Using Preferred Partnerships

Transcription

1 Planning Opportunities Using Preferred Partnerships N. Todd Angkatavanich Edward A. Renn Withers Bergman LLP 660 Steamboat Road 157 Church Street, 19 th FL Greenwich, CT New Haven, CT T T F F Park Avenue, 10 th FL New York, NY T F IRS required statement This document (and any attachments) was not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.

2 Preferred Partnerships to Shift Value Division of partnership or LLC interests into preferred and non-preferred interests Preferred interests have priority to income and liquidation proceeds, but cap on upside potential Non-preferred ( common ) interests are subordinate to income and liquidation rights of preferred interests, but capture all residual growth of partnership or LLC If older generation/parent owns preferred interests and younger generation (or, better, GST exempt trust) owns common interests, there is a potential to freeze the growth in value of parent s preferred partnership interests and shift growth (in excess of preferred coupon) to common interests. 2

3 IRC Section 2701 Overview Perceived Abuse Different generations work in concert to artificially minimize the value of assets transferred to younger generation. How Older generation transfers interests in an entity (corporation or partnership) to members of younger generation while at the same time retaining certain types of interests in the same entity that soak up most of the value of the entity thus making the gifted interest worth very little. What It Can Do Cause the value of the gift to members of the younger generation to include the value of the interest retained by the older generation and in certain cases treat the value of the retained interest to be zero. When it Applies Any transfer, which includes recapitalizations, capital contributions and changes in capital structure, if the older generation then has senior distribution rights in a family controlled entity or discretionary liquidation, put, call or conversion rights in any entity. (Retained rights that are mandatory and quantifiable typically are excluded.) 3

4 Historical Background Pre-2701 Perceived Abuse Parent recapitalizes family company into preferred interest and common growth interest Parent s preferred interest was loaded with discretionary rights to artificially boost gift tax value: Non-cumulative rights to payments Liquidation rights Puts/calls Under subtraction valuation method artificially high preferred value depressed common value - resulting in minimal gift of common (but with all upside potential). E.g. value of entire Company - $10M Value of preferred stock with bells and whistles $9.5M Value of gift of common stock $0.5M. Parent gifts or sells common interest at depressed value and keeps preferred parent s discretionary rights never exercised, so value stays in company f/b/o common interest holders. 4

5 Pre-2701 Preferred Partnership Perceived Abuse 5

6 Pre-2701 Preferred Partnership Perceived Abuse Valuation Before Gift Parent Retained Preferred Common Gifted to Kids (at depressed value) Preferred (Discretionary Rights Inflated Value) Common (Deflated Value) Partnership Agreement Provisions 6

7 Pre-2701 Preferred Partnership Perceived Abuse Valuation After Gift Parent Kids Preferred (Deflated Value) Common (Inflated Value) Value shifted to Common when discretionary rights not exercised 7

8 Pre-2701 Preferred Partnership Perceived Abuse After October 9, 1990: 2701 *Values Parent s Retained Interest at Zero, causing deemed gift 8

9 Basics of Section 2701 Congressional response to perceived abuse Zero valuation rule applied to Preferred Interests: Distribution right or extraordinary payment right Parent Preferred Common (Growth) Gift of Common Kids Family Company $10M Pre-2701: Value of Family Company $10M Less: Artificially high value of preferred ($ 9.5M) Gift Value of Common $500k Post-2701: Value of Family Company $10M Less: Zero value of preferred (0) Gift Value of Common $10M 9

10 Basics of Section Definitions Section 2701 applies when an Applicable Family Member holds an Applicable Retained Interest after making a Transfer to a Member of the Transferor s Family. Applicable Family Member Transferor s spouse, ancestor of Transferor or his/her spouse, or spouse of ancestor. (Basically family members in Transferor s generation or older) Member of the Transferor s Family Transferor s spouse (even though not a younger family member), lineal descendant of Transferor or his/her spouse, or spouse of descendant. (Basically younger family members) Transfer Includes traditional transfers, capital contribution to a new or existing entity, recapitalization, or change in the capital structure of an entity. Sometimes can be tricky to spot the transfer (e.g., kids make a capital contribution to an entity already in existence that is owned by parent). 10

11 Basics of Section 2701 Applicable Retained Interests Two types of Applicable Retained Interests the retention of either by the transferor or other Applicable Family Member (i.e., an older family member) will trigger the zero valuation rule if certain other conditions satisfied: Distribution Right UNLESS has same or subordinate distribution rights as the transferred interest Extraordinary Payment Right 11

12 Basics of 2701 Distribution Right Right to receive distributions with respect to an equity interest. Family control pre-requisite for this Partnership At least 50% of capital or profit interest; or any equity interest as a general partner of an LP (question in a general partner ). Corporation At least 50% of the total voting power or total FMV of the equity interest of the corporation. Valued at zero for purposes of the Subtraction Method of valuation Assumption is that a family controlled entity would not make discretionary distributions to older family members, as this would deplete amount that could be transferred to younger generation Note A distribution right that is the same as or subordinate to the distribution right of the transferred interest is not an applicable retained interest for purposes of Section

13 Basics of 2701 Extraordinary Payment Right Liquidation, put, call and conversion rights No control requirement as the extraordinary payment right is held by the older family member, not by the entity. Valued at zero for purposes of Subtraction Method of valuation Assumption is that older family member would not exercise the extraordinary payment right, as this would deplete amount that could be transferred to younger generation 13

14 Rights That Are Not Extraordinary Payment Rights or Distribution Rights Under Section 2701 Mandatory Payment Rights Right to receive a payment required to be made at a specific time for a specific amount. Liquidation Participation Rights Right to participate in a liquidating distribution (not this is different than right to cause the liquidation of the entity). Right to Guaranteed Payment Right to a fixed amount under Section 707(c) of the Code. Non-Lapsing Conversion Right Corporations Non-lapsing right to convert an equity interest in a corporation into a fixed number or fixed percentage of shares of the same class as the transferred interest Partnerships Non-lapsing right to convert an equity interest into a specified interest of the same class as the transferred interest. 14

15 Qualified Payment Right ( QPR ) (exception to a Distribution Right) Statutory basis for 2701 compliant preferred partnerships. QPR Cumulative payment Payable at least annually At a fixed rate or at a rate bearing a fixed relationship to a specified market interest rate A preferred interest that is a QPR is valued under traditional valuation principals (not subject to Zero Valuation ). Lower of Rule If QPR as well as liquidation, etc., rights (Extraordinary Payment Rights), value of all such rights determined as if liquidation rights exercised in the manner resulting in the lowest value determined for all such rights held by senior family member. 15

16 Lower of Value Rule If Applicable Retained Interest has both a Qualified Payment Right and an Extraordinary Payment Right, must value the Applicable Retained Interest by assuming that each Extraordinary Payment Right is exercised in a manner resulting in the lowest total value being determined for all the rights. 16

17 Lower of Value Rule (cont d) Example Dad, the 100% stockholder of a corporation, transfers common stock to Child and retains preferred stock which provides (1) a Qualified Payment Right having a value of $1,000,000; and (2) a right to put all the preferred stock to the corporation at any time for $900,000 (an Extraordinary Payment Right). At the time of the transfer, the corporation's value is $1,500,000. Under the "Lower Of" rule, the value of Dad's retained interest is $900,000, even though he retains a Qualified Payment Right worth $1,000,000. This is because his retained interests are valued under the assumption that Dad exercises his Extraordinary Payment Right (the put right) in a manner resulting in the lowest value being determined for all of his retained rights (i.e., in a manner that would yield him $900,000). As a result, Dad has made a gift of $600,000 ($1,500,000 - $900,000), rather than $500,000 if the value of his preferred interest was based upon the $1,000,000 value of the Qualified Payment Right. 17

18 Circumstances When Section 2701 Does Not Apply Marketable Securities market quotations on an established securities market readily available for the value of either the transferred interests or the Applicable Retained Interest. Same class exception Applicable Retained Interest is of the same class as the transferred interest (difference in voting and non-voting can still be same class ). Vertical Slice Proportionality Rule transfer results in a proportionate reduction of each class of equity interest held by transferor and Applicable Family Members. 18

19 Pro-Active Planning With Section 2701 Compliant Entities Division of partnership or LLC interests into preferred and nonpreferred interests Preferred interests have priority to income and liquidation proceeds, but cap on upside potential Non-preferred ( common ) interests are subordinate to income and liquidation rights of preferred interests, but capture all residual growth of partnership or LLC If older generation/parent owns preferred interests and younger generation (or, better, GST exempt trust) owns common interests, there is a potential to freeze the growth in value of parent s preferred partnership interests and shift growth (in excess of preferred coupon) to common interests. 19

20 Basic Preferred Partnership Parent Child (or GST Exempt Trust) Capital Contribution Preferred Coupon Common Capital Contribution * Value of Parent s interest frozen at value of initial contribution * Parent retains predictable cash flow Preferred Partnership 20

21 Valuing The Preferred Interest QPR avoids Zero Valuation rule; but still must be valued Value of preferred interest should equal par to avoid partial deemed gift under traditional indirect gift theory. Rev. Rul factors: Yield as compared to risk-adjusted market comparables Coverage of coupon Dissolution protection Voting rights Lack of Marketability De minimus Rule - junior equity interest (i.e., common interest) deemed to have a minimum value equal to at least 10% of the gross assets of the entity under the subtraction method of valuation. 21

22 GST Non- Exempt Trust Distribute $10M to Children (G-2) Child 1 Child 2 $10M gift* $10M gift* Preferred frozen shares get: - Fixed preferred coupon - Liquidation preference Dynasty Trust fbo Child #1 s descendants Dynasty Trust fbo Child #2 s descendants Preferred Partnership Common Growth shares get all appreciation over preferred coupon Investments *Assuming split gifting with spouse 22

23 Preferred Partnership with QTIP Freeze Spouse Income QTIP Child Preferred Coupon Common Capital Contribution Capital Contribution Preferred Partnership * Caveat Consider potential Section 2519 argument on contribution. 23

24 Preferred Partnership GRAT Parent GST Trust Preferred GRAT Contribution of Preferred Interest Annuity (Funded by Preferred Coupon) Capital Contribution Common Capital Contribution Long Term GRAT Preferred Partnership 24

25 Reverse Preferred Partnership GST Trust Parent Preferred Common Capital Contribution Capital Contribution Preferred Partnership * Section 2701 not applicable since parent holds subordinate common interest. 25

26 Section 2036 Concerns 2701 Compliant Preferred Partnership is statutory for gift tax purposes only. Potential 2036(a)(1) retained interest argument for estate tax purposes. Bonafide Sale exception. Need proper valuation of preferred coupon at par. If less than par is it for adequate and full consideration? Negotiation of separate and distinct economic interests. Potential 2036(a)(2) control Strangi, Turner 26

27 2701 Issues in Fund Carried Interest Transfers Principal Appreciation Potential GP LLC Outside Investors Management Co. LLC 20% carry Management Agreement GP LP LP 2% fee Fund LP Investments 27

28 What is the Vertical Slice Rule and why do we care? The most elegant solution to a draconian deemed gift tax rule under IRC Section 2701 The rule is really just one (of several) safe harbor exceptions to Section 2701 The proportionality exception Broadly requires a parent who wishes to transfer a percentage of his GP carried interest to children (or their trust) to also transfer a proportional interest of fund LP interest (e.g., 25% carry + 25% LP interest) 28

29 The Vertical Slice Management Company? GP Carried Interests XXXXXXXXXXXXXXXXXXXXXXXX NO Fund LP Interests YES 29

30 Limitations on Vertical Slice Planning Example GP Carry $1M LP Capital $20M If Parent makes a Vertical Slice gift of 50% of his $1M GP interest (= $500,000), he must also make a proportional gift of 50% of his $20M LP capital (= $10M). Total gift of $10.5M x 35% gift tax rate = $3.675M gift tax liability. This can be too restrictive when a partner has significant LP capital invested in the Fund. 30

31 Carried Interest Transfer Preferred Partnership Common and Preferred (with Mandatory Payment Right, Qualified Payment Right or guaranteed payment) LLC Interests Step 1 Parent Contribute GP and LP Fund Interests Step 2 Parent Preferred Gift of Common Growth Interests in LLC Common Dynasty Trust LLC LLC GP LP FUND 31

32 Speaker Biography N. Todd Angkatavanich, Esq., Withers Bergman LLP N. Todd Angkatavanich is a principal at Withers Bergman, LLP. His practice is focused on tax, trusts and estates, and business succession matters for affluent individuals and their families. He regularly advises domestic and international families and family offices with respect to creating trusts and related business structures to preserve, protect and grow family wealth for multiple generations in a tax efficient manner. A frequent speaker, Todd has given presentations and webinars/teleconferences for various organizations including the Heckerling Estate Planning Institute, the American Bar Association Real Property, Trusts & Estates Law Section, Trusts & Estates magazine, BNA/Tax Management, as well as numerous Estate Planning Councils, CPA societies, Family Office associations and other organizations. Todd has authored numerous articles in publications such as Trusts & Estates, Estate Planning, ACTEC Journal, BNA/Tax Management Estates, Gifts and Trusts Journal, Private Wealth, Private Asset Management, FFI Practitioner and other publications. Todd is a member of the Editorial Advisory Board of Trusts & Estates magazine (Estate Planning and Taxation Committee). He is also a member of the Advisory Board for BNA/Tax Management Estates, Gifts and Trusts Journal. Todd is the 2012 recipient of the Best Private Client Lawyer Award by Family Office Review North America. Todd is the Vice Chair of the Business Planning Group Business Investment Entities Committee of the American Bar Association, Real Property, Trusts & Estate Law Section for Todd received his B.A., in Economics, magna cum laude from Fairleigh Dickinson University, his J.D., Tax Law Honors, from Rutgers School of Law, his M.B.A. from Rutgers Graduate School of Management, and his LL.M, in Taxation, from New York University School of Law. Todd may be contacted at todd.angkatavanich@withers.us.com. 32

33 Speaker Biography Edward A. Renn, Esq., Withers Bergman LLP Edward A. Renn is a principal in the international law firm, Withers Bergman LLP. Ed focuses on domestic and international private client matters. He provides legal advice on U.S. and international estate planning, income maximization strategies, FLP and LLC planning, wealth preservation, business succession planning, international tax planning for entities and individuals, planning for same-sex couples, trust structures and estate administration. Ed frequently utilizes sophisticated life insurance strategies in both income and transfer tax planning. Ed is a frequent speaker and writer, and has coauthored several books on estate planning: Protecting the Family Fortune: Advanced Planning for Ultra-High-Net-Worth Family Businesses and Their Owners; Fortune s Fortress A Primer on Wealth Preservation for Hedge Fund Principals; and Advanced Estate Planning Wealth Preservation for Physicians. You can contact Ed at edward.renn@withers.us.com. 33