The Capital Shift Partnership
| Publication year | 1984 |
| Pages | 787 |
| Citation | Vol. 13 No. 5 Pg. 787 |
1984, May, Pg. 787. The Capital Shift Partnership
A partnership of family members can be used to "freeze" the value of one generation's interest in property and shift future growth to a younger generation. Although the Internal Revenue Service ("Service") has taken a noruling position on partnership freezes,(fn1) pending study of the area, partnership freezes have gained in popularity. A special kind of partnership freeze has developed, referred to herein as a "capital shift partnership" because the technique is based on shifts in capital through special allocations of profits, losses and distributions. In fact, such partnerships may shift not only future appreciation (a pure "freeze"), but also current values, to the younger generation.
Assume that a wealthy parent, P, owns commercial real estate. P has a large estate and desires to shift value from his estate to his child, C. However, P wants to retain control of the real estate and wants to retain cash flow and tax losses.
P and C form the PC partnership. P contributes the real estate, which has a fair market value of $500, is subject to a debt of $410 (providing for payments of interest only) and has a basis to P (including the debt) of $450. P's initial capital account is equal to the property's net fair market value of $90. C contributes $10 of his own money in cash and receives an initial capital account of $10.(fn2)
Although P has contributed 90 percent of the capital and C only 10 percent, the partnership agreement assigns P a 10 percent "percentage interest" and C a 90 percent "percentage interest." The partnership agreement contains an IRC § 704(c)(2) allocation of gain,(fn3) but otherwise provides that distributions and net profits or losses will be allocated so as to bring the capital accounts into proportion with the percentage interests. Once the capital accounts are in proportion to the percentage interests, distributions and allocations of profits and losses follow the percentage interests. On liquidation, proceeds are distributed in accordance with capital accounts.
Table I shows the partners' capital accounts, assuming that the property generates $50 of annual cash flow from rents and that the interest carried on the loan is $45 per year, so there is $5 of annual net cash flow. The property generates rental income of $50 per year, interest expense of $45 per year and depreciation deductions of $19 per year, or a net tax loss of $14 per year. (For purposes of simplicity, other items of partnership cash flow, profit or loss are ignored, and it is assumed that the partnership simply retains C's $10 capital contribution.) At the beginning of the fourth year, the property is sold for $750, and the partnership is liquidated. Table I shows a liquidation to illustrate the effect of the allocations. However, the partnership could, and most likely would, be continued and the sale proceeds reinvested.
As Table I shows, because P's capital account is "too high" in relation to his percentage interest, all net cash flow and losses are allocated to P during the first three years. When the property is sold, the bulk of the gain is allocated to C, because his capital account is proportionately lower than his percentage interest. Liquidation proceeds are then distributed in accordance with capital accounts. The result is that P has retained all net losses and net cash flow during the period of operations, but on sale receives only 10 percent of the net sale proceeds. The rest of the proceeds, and the bulk of the gain, have been shifted to C. The value of P's interest immediately before the liquidation is $35.
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