Rethinking I.R.C. 2701 in the era of large gift tax exemptions.

• Author: Pegg, Christopher

Today's "permanently" increased transfer tax exemptions may provide new planning opportunities for individuals and couples with a net worth of between $5 and $10 million whose assets are likely to significantly appreciate during their lifetime. Techniques that incorporate the rules of I.R.C. [section] 2701 (all statutory references are to the Internal Revenue Code of 1986, as amended and the regulations promulgated thereunder) to "freeze" the value of assets now have increasing relevance for these taxpayers. While such techniques are nothing new, tax planners can reemploy what have been referred to as "freeze partnerships" to transfer appreciation out of a taxpayer's estate while retaining control and access to significant income for the rest of the taxpayer's life. Furthermore, this can be achieved without depleting the unified credit and will still allow for a step-up in basis at the taxpayer's death.

The concept of using a freeze partnership to shift wealth to younger generations while minimizing or avoiding a gift tax has existed since at least the 1970s. In very general terms, a freeze is accomplished as follows: Upon the creation or recapitalization of a partnership, the ownership interests are structured to consist of a preferred interest and a subordinated interest. (1) The preferred interest may have certain exchange rights as well as priority regarding annual distributions, which are noncumulative in nature. Upon appraisal, the vast majority of the partnership's value will be represented by these preferred interests and the subordinated interests can then be gifted (or sold) to a younger generation based on their reduced value. Once the subordinated interests are owned by the younger generation, the senior generation operates the entity in a way that transfers most of the partnership's value, along with all of the appreciation, to the subordinated interests.

The IRS and Congress viewed such strategies as tax avoidance schemes and consequently attempted to proscribe them through a series of legislative measures that resulted in the enactment of the special valuation rules of I.R.C. [section] 2701. While the application of these rules are sometimes complex and contain various exceptions, they essentially dictate that the value of the preferred interest retained by the senior generation be ignored when valuing the transfer for gift tax purposes. Therefore, the value of the gift of the subordinated interests is, for tax purposes, the full value of the freeze partnership.

Nevertheless, where these "zero-value" rules apply, the Treasury Regulations establish certain adjustments that mitigate their impact and the likelihood of double taxation by reducing the size of the taxable gift or estate when the preferred interests are later transferred. For this reason, it may often be advantageous for taxpayers to intentionally trigger [section] 2701 by creating and giving freeze partnership interests, because any increase in value for lifetime gift tax purposes will be removed from their taxable estates upon death.

As a simple example, imagine a married couple, Bill and Jane, who are in their late sixties, have adult children, and have made no previous taxable gifts. Bill and Jane have rental real estate worth $7 million, a home worth $1 million, and investable assets of $2 million. Bill and Jane live off of some of the income from the rental real estate and believe the value of the properties will appreciate substantially over time. They are glad to learn that their combined estate, if valued at a total of $10 million upon their deaths, would not be subject to an estate tax. They believe the escalation in property value, however, will significantly outpace the expected inflationary adjustments to their estate tax exemptions.

Like many taxpayers, Bill and Jane are looking to avoid estate taxes to the extent possible and to shift as much value to their adult children upon their deaths. Accordingly, this couple would like to transfer the appreciation on the rental real estate out of their taxable estates to minimize or eliminate any estate tax exposure in the future. However, they cannot afford the cash-flow implications of giving the real estate away now. They have heard of "freeze" techniques involving grantor-retained annuity trusts and sales to "defective" trusts, but Bill and Jane are uncomfortable defining exactly how much income they will need on an annual basis in the future and want to maintain flexibility. Further, the couple has a very low-cost basis in the real estate, and they are concerned about losing the step-up upon their deaths. They are also uncomfortable with the lack of clarity regarding the income tax implications upon the death of the grantor or a decision during life to "toggle off" the grantor status.

A freeze partnership, in this situation, can accomplish many of their goals without the uncertainty related to other, better-known freeze techniques. In this hypothetical, the couple would form a partnership or LLC with preferred and subordinated interests, and contribute the rental real estate valued at $7 million. (If the real estate is already in a partnership, it can be recapitalized for the same effect). The preferred interest would represent voting control, have a $7 million par value, and be entitled to any number of rights, including, for example, a preferred right to significant annual distributions that would be noncumulative. The preferred interest owner would also have an ability to force the partnership to redeem the preferred interest (a put option) for its par value. The subordinated interests would represent all other equity interests in the partnership or LLC and would, therefore, benefit exclusively from any appreciation of the real estate.

Bill and Jane would each gift 50 percent of the subordinated interests to their children or into a trust for their benefit. (2) Despite their retention of the preferred interests, the value of the gift for transfer tax purposes would be the value of the entire partnership ($3.5 million each for a total gift of $7 million) due to the application of the [section] 2701...