Many strategies exist for transferring wealth from one generation to the next without running afoul of the estate tax. Most of these, however, are still subject to the generation-skipping tax and other measures instituted by Congress to ensure that no wealth transfer goes untaxed. The author details a novel strategy that bears no such consequences: granting family members partnership interests in a family business.
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Estate tax planning usually attempts to reduce current asset values to be included in an estate or to shift future appreciation to the next generation. Qualified personal residence trusts (QPRT), grantor retained annuity trusts (GRAT), sales to intentionally defective grantor trusts (IDGT), gifting, and other strategies are designed to accomplish one or both of these goals by creating either an immediate transfer or an estate tax freeze. Each planning opportunity has its own advantages and disadvantages, and must be designed with an individual or family’s needs in mind.
Moving value from a senior generation to children often does not fully accomplish a family’s desired estate tax savings, as the value shifted is included in the next generation’s estate. For high-net-worth families, there is often a desire to move the value to heirs removed more than one generation in order to avoid estate tax in multiple generations of estates. This planning can become problematic due to the generation-skipping tax (GST), which attempts to prevent individuals from leaving sizeable estates to generations more than once removed. Prior to the GST, it was common for wealthy families to leave their assets to grandchildren as opposed to their own children, skipping a generation and allowing the children to avoid paying estate taxes on the transferred assets.
Once the SMLLC is an operating business, 100% owned by the family corporation, it can grant either profits or capital interests to its employees, specifically the children, grandchildren, or other heirs of the senior generation.
Family businesses that are taxed as partnerships for income tax purposes, including LLCs taxed as partnerships, can use partnership income tax law provisions to accomplish traditional estate planning goals. This is accomplished by granting children or grandchildren (or even great-grandchildren) ownership interests in the partnership as compensation. Using partnership income tax law, significant reallocations of income and transfer of current value or appreciation to subsequent generations is possible without using any annual or lifetime exclusions, with no impact from the special valuation rules contained in Chapter 14 (IRC section 2701, et al.), and with no generation-skipping tax consequences.
Partnership Interest as Compensation
In order to discuss granting ownership interests in a partnership as compensation, it is necessary to define the two types of partnership interests: capital interests and profits interests. Revenue Procedure 93-27 provides that a “profits interest is a partnership interest other than a capital interest.” And it defines a capital interest as “an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.”
If a taxpayer receives a profits interest in a partnership in return for services rendered, Revenue Procedure 93-27 states that the initial receipt of such an interest is generally not taxable to the recipient nor deductible to the partnership. In other words, the granting of this interest as compensation is a completely tax-neutral transaction. A profits interest is not exempt from current taxation, however, if—
- the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease;
- within two years of receipt, the partner disposes of the profits interest; or
- the profits interest is a limited partnership interest in a publicly traded partnership.
It is critical to understand that the granting of a profits interest has no impact on any current partner’s capital account. The recipient of the profits interest has, by definition, no capital account balance at the date the interest is granted.
Because the transaction has no tax impact, none of the current partners have a change in their tax basis, and the new profits interest partner receives the interest with zero basis. Therefore, while current value is not transferred to the junior generations, they do receive a share of all future profits of the entity with no gift or income tax consequences, shifting significant future income and capital account value growth to the next generation.
In contrast, capital interests received as compensation are taxed on the fair market value of the interest, and the partnership is also allowed a deduction in the same amount. This does impact each partner’s capital account, as each recipient receives a percentage of the partnership’s fair market value and tax capital value upon the grant of the interest. The outside basis is equal to the amount of income reported. The income recognized by the receiving partner is taxed as a guaranteed payment pursuant to Internal Revenue Code (IRC) section 707(c).
The grant of a capital interest does accomplish the goal of transferring current value to the recipient; as such, the junior-generation partners will now receive a share of all future profits of the entity, with no gift tax consequences. There will be income tax consequences, which may or may not be beneficial to the entire family group. Each particular transaction should be reviewed to determine the self-employment and income tax savings from the partnership’s deduction, and compare those savings to the increased self-employment and income tax of the guaranteed payment for the recipient.
The above strategies will only work in an operating business taxed as a partnership. A corporate family business must first transfer the business to an LLC taxed as a partnership in order to follow this strategy. This can be accomplished by forming a single-member LLC (SMLLC), which will be a disregarded entity for income tax purposes, and transferring some or all of the corporation’s operating assets to the SMLLC. Once the SMLLC is an operating business, 100% owned by the family corporation, it can grant either profits or capital interests to its employees, specifically the children, grandchildren, or other heirs of the senior generation. Upon the grant of an interest, the LLC becomes a partnership for tax purposes by default, and therefore allows use of the strategies described above.
IRC section 704(c)(1)(A) requires that the partnership specially allocate any pre-contribution gain on the sale of contributed property to the corporation. Furthermore, section 704(c)(1)(B) requires the corporation to recognize gain if the contributed property is transferred to another partner within seven years of the date it was contributed to the LLC. Finally, section 737(a) requires recognition of gain if the corporation is distributed any other property. These provisions are designed to prevent shifting pre-contribution gain income among partners; as this present strategy is not intended to shift pre-contribution gain, there is no impact.
These strategies are also not appropriate for a passive investment partnership, as the younger generation will not be performing services sufficient to justify the compensation required by this strategy.
Vesting Schedule/Possible Forfeitures
For both capital and profits interests, an interest that may be forfeited may be taxed at either the date of receipt or the date the forfeiture lapses. The recipient must choose the time of taxation, and will involve the consideration of an IRC section 83(b) election. For a profits interest, it is suggested that the recipient elect immediate taxation, as there will be no taxable income.
Choosing to Transfer Profits Interest or Capital Interest
Profits interest transfers generally work better in partnerships in which the owners have lower taxable income, while capital interests work better in higher-income entities. This is because the guaranteed payment income recognized by the recipient in a capital interest transfer becomes tax inefficient if there is not enough taxable income for the senior generation owners to benefit from the corresponding deduction.
Chapter 14 Special Valuation Provisions
When discussing the granting of partnership interests as compensation, it is appropriate to determine whether the granting of an interest will cause an issue under Chapter 14 (IRC section 2701), resulting in a deemed gift of the interest retained by senior generation partners. A partnership interest transfer will not trigger section 2701 because all parties in the transaction will have identical liquidation rights. Section 2701 is designed to tax as a gift the entire value of an entity when the transferor retains a preferred right to liquidation or other payment rights by deeming that the remaining interest has a value of zero. Specifically, it was designed to avoid a preferred stock recapitalization, in which a senior generation owner would create a preferred stock class and give that preferred stock a liquidation right equal to 100% of the company value, then give the common stock, with no value, to the next generation. As the company’s value increased, all appreciation would go to the next generation, as the preferred stock was frozen at a set value.
IRC section 2701 states that it only applies if the transferor retains an “applicable retained interest,” which is defined in section 2701(b) as “any interest in an entity with respect to which there is (A) a distribution right, but only if, immediately before the transfer … the transferor and applicable family partners hold … control of the entity, or (B) a liquidation, put, call, or conversion right.” Unless there is some additional agreement, granting a partnership interest does not involve a put, call, or conversion right. There is a liquidation right, and there may be distribution rights if guaranteed payments are made for the use of capital, but these rights should be the same for all partners. The liquidation provisions in a partnership are statutorily established; all partners receive liquidation proceeds equal to their capital accounts. Because the liquidation rights are made in the same manner to all partners, they are not deemed to cause an interest to be an applicable retained interest.
Treasury Regulations section 25.2701-2(b) defines an applicable retained interest as “any equity interest in a corporation or partnership with respect to which there is either (i) an extraordinary payment right … or (ii) in the case of a controlled entity … a distribution right. “Extraordinary payment right” is defined as “any put, call, or conversion right, any right to compel liquidation, or any similar right, the exercise or nonexercise of which affects the value of the transferred interest.” “Distribution right” is defined as “the right to receive distributions with respect to an equity interest,” but explicitly does not include “any right to receive distributions with respect to an interest that is of the same class as, or a class that is subordinate to, the transferred interest” (emphasis added). Also excluded are extraordinary payment rights, mandatory payment rights, liquidation participation rights, rights to guaranteed payments of a fixed amount under IRC section 707(c), and nonlapsing conversion rights.
Based on analysis of these provisions, the granting of a partnership interest, absent some special distribution right or put/call, will not trigger IRC section 2701.
The following summarizes the tax impact of a hypothetical business entity taxed as a partnership, under three different cases. As of December 31, Father owns 94% of the entity, and Daughter owns 6%. Case A shows a tax computation that assumes no changes are made to the ownership structure. Case B assumes a 24% profits interest is awarded to Daughter as compensation, bringing her ownership of future income and appreciation to 30%. Case C assumes that a 24% capital interest is granted as compensation. It has been determined that the compensation is reasonable. No special allocations are included. Assume that the transfer is made on the first day of the year.
Starting capital 141,000
Another provision of partnership income tax law that can accomplish estate-planning goals is found in IRC section 704, which allows special allocations. Under section 704(a), partners’ distributive shares of the partnership’s income, gain, loss, deductions, and credits generally are determined by reference to allocations of various items under the partnership or operating agreement. This can be done by ownership percentages or in some other format. The partners can therefore choose to allocate certain items to the younger generation partners that will cause their interests to increase in value to a greater extent than those of the senior generation. For example, the agreement could state that the first $100,000 of income is allocated to the younger generation partners, or that while the younger generation partners only own 10% of the entity, they are allocated 50% of future gains, and therefore appreciation.
Treasury Regulations section 1.704-1(b)(2)(ii)(h) states that in making this determination, it is necessary to look at all agreements among the partners or between the partnership and any partner, regardless of whether the agreements are oral or written, or whether they are included in an official operating agreement document. If a partnership agreement is modified, a determination will be made as to whether the modification was part of the original agreement. If the modification was part of the original agreement, prior allocations may be re-allocated to conform with the new agreement, and future allocations may be reallocated in accordance with the new agreement under Treasury Regulations section 1.704-1(b)(4)(vi).
Substantial Economic Effect
It is critical that any such partnership agreement have “substantial economic effect” to be respected; any allocations that do not will instead be allocated by the IRS according to the various partners’ interests in the partnership pursuant to IRC section 704(b). The “substantial economic effect” test is intended to ensure that allocations reflect the economic consequences of the partnership’s receipt or incurrence of these items. In addition, the test is intended to prevent special allocations whose tax consequences overshadow their economic effects, such as special allocations of different classes of income to different partners, where the allocations as a whole do not change the economic positions of the partners.
As explained in Treasury Regulations section 1.704-1(b)(2)(ii)(a), in order for an allocation to have economic effect, it must be consistent with the partner’s underlying economic arrangement. This means that if there is an economic benefit or burden that corresponds to an allocation, the partner to whom the allocation is made must receive the related benefit or cost. An allocation has economic effect if it either 1) has economic effect under the general rule or 2) meets the alternate test for economic effect.
Under the general rule, an allocation must meet the following three tests in order to have the requisite economic effect:
- The partner’s capital accounts must be “properly” maintained in accordance with the accounting rules in Treasury Regulations section 1.704-1(b)(2)(iv);
- Liquidating distributions must be made in accordance with capital accounts that have been properly maintained; and
- Partners with a deficit in their capital accounts must be required to restore such amount to the partnership upon liquidation of their interest, and such amount must be paid to creditors or distributed to other partners in accordance with their positive capital account balances.
An allocation will have substantial economic effect under the alternate economic effect test where a partner to whom an allocation is made is not required to restore his deficit capital account balance pursuant to Treasury Regulations section 1.704-1(b)(2)(ii)(d)(2) if—
- the operating agreement requires that the partners’ capital accounts be properly maintained and liquidating distributions be made in accordance with the capital accounts; and
- the operating agreement contains a “qualified income offset” provision.
A qualified income offset provision generally requires that a partner who unexpectedly receives an adjustment, allocation, or distribution that results in a deficit (or increased deficit) capital account must be allocated items of gross income and gain in an amount and manner sufficient to eliminate such deficit as quickly as possible.
As defined in Treasury Regulations section 1.704-1(b)(2)(iii)(a), the economic effect of an allocation is not substantial if—
- the after-tax consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation were not contained in the operating agreement; and
- there is a strong likelihood that the after-tax consequences of no partner would, in present value terms, be substantially diminished compared to such consequences if the allocation were not in the operating agreement.
In short, an allocation shifts tax consequences when there is a strong likelihood that the net increases and decreases that will be recorded in the partners’ capital accounts will not differ substantially from the net increases and decreases that would be recorded without the allocations and the total tax liability of the partners will be less than if the allocations were not made.
Examples from Treasury Regulations Section 1.704-1 The AB equal partnership is an investment partnership whose portfolio is expected to earn $10,000 of dividend income and $10,000 of tax-exempt income. The partners agree to allocate the first $5,000 of dividend income to Partner A, who has a large net operating loss carryover from prior years, and the first $5,000 of tax-exempt income to B, who is in a high tax bracket. Although the allocation has economic effect, the economic effect is not substantial because the allocation reduces B’s tax liability and there is a strong likelihood that the after-tax consequences to A and B will not be diminished substantially as a result.
A and B form a general partnership, to which each contributes $40,000. Their partnership agreement requires that their capital accounts be maintained according to the capital account maintenance rules. The agreement provides that upon liquidation, partnership property will be distributed equally to the two partners.
The agreement does not require either partner to restore capital account deficits. The agreement grants A and B equal shares of all partnership income and loss, computed without regard to cost recovery deductions, and equal shares of partnership cash flow. It allocates to A, however, all partnership cost recovery deductions.
The allocation of all cost recovery deductions to A lacks economic effect because the partnership agreement providing for this allocation fails to satisfy the requirements described above. In addition, A’s and B’s actual economic arrangements indicate that A will not bear the entire risk of a decline in the value of the partnership’s depreciable property corresponding to the cost recovery deductions allocated to him. At the beginning of its first tax year, the partnership purchases depreciable property for $80,000 (its only asset). The cost recovery deduction for that year is $10,000, which is allocated entirely to A.
At the beginning of the partnership’s second tax year, it sells the property for $70,000, its adjusted basis. The sale results in no gain or loss. Subsequently, the partnership liquidates and A and B each receive $35,000; they therefore share equally the economic loss resulting from the property’s depreciation. A, however, has received the entire tax loss in the form of the $10,000 first-year cost recovery deduction. The allocation of the cost recovery deduction is not consistent with the partners’ economic arrangements. Therefore, it lacks economic effect and must be reallocated equally between the partners in accordance with their interests in the partnership.
In each case, substantial value is transferred out of the senior generation’s estate with no gift or estate tax impact, and little or no income tax cost.
In another example, G and H form a general partnership, to which G contributes $75,000 and H contributes $25,000. Their partnership agreement requires that their capital accounts be maintained according to the capital account maintenance rules and provides that all partnership distributions must be made 75% to G and 25% to H, regardless of their capital account balances. The agreement does not require either partner to restore capital account deficits, and grants to G and H equal distributive shares of all partnership income, gains, losses, and deductions. This allocation lacks economic effect because the partnership agreement fails to satisfy the requirements described above. In addition, G and H’s economic arrangements show that they do not share the partnership’s economic profits and losses equally, but in a 75/25 ratio. Therefore, the agreement’s equal allocations of partnership items lack economic effect, and the partnership’s income, gains, losses, and deductions In each case, substantial value is transferred out of the senior generation’s estate with no gift or estate tax impact, and little or no income tax cost.
Finally, K and W form a limited partnership for the purpose of investing in improved real estate. K, the general partner, contributes $10,000 and W, the limited partner, contributes $990,000. The $1,000,000 is used to purchase an apartment building on leased land. The partnership agreement provides that 1) the partners’ capital accounts will be determined and maintained in accordance with the capital account maintenance rules; 2) cash will be distributed first to W until he has received the amount of his original capital contribution, next to K until he has received the amount of his original capital contribution, and thereafter equally between them; 3) partnership net taxable income will be allocated 99% to W and 1% to K until the cumulative net taxable income allocated for all taxable years is equal to the cumulative net taxable loss previously allocated to the partners, and thereafter equally between them; 4) partnership net taxable loss will be allocated 99% to W and 1% to K, unless net taxable income has previously been allocated equally between the partners, in which case the net taxable loss will first be allocated equally until the cumulative net taxable loss allocated for all tax years is equal to the cumulative net taxable income previously allocated to the partners; and 5) upon liquidation, W is not required to restore any deficit balance in his capital account, but K is. These allocations lack economic effect because the partnership agreement does not require that distributions in liquidation be made in accordance with the partners’ positive capital account balances, and it does not require W to restore the deficit balance in his capital account upon liquidation. Therefore, the partnership’s income, gains, losses, and deductions must be reallocated in accordance with the partners’ interests.
There are additional planning steps that can be taken to attempt to reduce self-employment taxes, including using limited partnerships.
Nonrecourse Debt Exception
A second exception to IRC section 704(a) is the allocation of items based on nonrecourse debt. Pursuant to Treasury Regulations section 1.704-2(e), allocations of losses and deductions attributable to partnership nonrecourse liabilities do not have economic effect because the creditor alone bears any economic burden that corresponds to those allocations. Nonrecourse liability is a partnership liability to the extent that no partner or related person bears economic risk of loss for that liability. Thus, nonrecourse deductions must be allocated in accordance with the partners’ interests. If an individual partner has guaranteed, or is the creditor, of the nonrecourse debt, the debt will be treated as recourse debt to that individual partner.
There is a lengthy test in Treasury Regulations section 1.704-2(c) used to determine whether deductions are nonrecourse deductions, but normally it is depreciation that brings a partnership loss below basis without including nonrecourse debt in the basis calculation. The test involves the computation of partnership minimum gain chargeback and other complex matters and is beyond the scope of this article.
Example of Benefits Provided by Planning
The Sidebar, Case Study, provides a detailed summary of the potential benefits of the provisions discussed in this article. In this example, transferring a 24% profits interest results in a tax savings of $12,000 to the family and shifts $192,000 of value to the next generation. With the transfer of a 24% capital interest, the family’s income tax cost is $6,040, and the value shifted is $868,800. In each case, substantial value is transferred out of the senior generation’s estate with no gift or estate tax impact, and little or no income tax cost.
Additional Planning Not Covered
Self-employment tax is not covered in the example, but should be analyzed in each particular fact pattern. There are additional planning steps that can be taken to attempt to reduce self-employment taxes, including using limited partnerships or following the provisions of the proposed Treasury Regulations section 1.1402(a)(2)(h)(2)(i). These planning strategies are beyond the scope of this article.
The author thanks Daniel E. Galusha and the entire team at Farm Credit East for their partnership over the years in developing and refining the material in this article.