By Stephen M. Breitstone and Jerome M. Hesch
This article was ﬁrst presented at the 47th Annual Notre Dame Tax & Estate Planning Institute. For individuals who desire to receive income from an income producing asset during their lives, traditional estate planning techniques such as gifts, grantor retained annuity trusts (GRATs) and installment sales to grantor trusts cannot provide for income payments that continue until death. The preferred partnership can provide lifetime income payments and shift the increase in the value of the income-producing assets to individuals or trusts that are not exposed to estate tax when the individual dies. Because the only asset exposed to the estate tax is a retained preferred partnership interest that does not participate in the in-crease in value of the partnership’s assets, the amount exposed to estate tax is frozen at the value of the preferred partnership interest, hence the term ‘‘preferred partnership freeze.’’
The freeze partnership has two ownership interests, a preferred interest entitled annually to a ﬁxed amount and a common interest that is allocated all partnership income and value of the partnership’s assets in excess of the guaranteed preferred payments. Typically, the individual contributes the income producing asset to a partnership in exchange for a preferred interest and a common interest. The individual then transfers the common interest by a gift or sells the common interest to a trust, typically a grantor trust, for a promissory note. Because the frozen preferred partnership interest is owned by the individual, the ﬁnancial objective, the retention of guaranteed income payments during life, while dividing the economics of the partnership into ﬁxed income preferred and common growth equity interests is achieved. By disposing of the common interest that is allocated all appreciation in value, the estate planning objective is also achieved.
By including a frozen preferred partnership interest in the decedent’s estate, the income tax-free step-up in basis that is not available with estate planning techniques that shift appreciated assets out of the decedent’s estate included can be used. And, if the partner-ship’s asset is encumbered real estate, the income tax basis for the preferred partnership interest includes the value of the preferred interest and the amount of the mortgage liability. The income tax advantage can eliminate the phantom gain that would be reported when the mortgage liability exceeds the income tax basis for the real estate. On the practical side, it is important to consider how one should draft a preferred partnership agreement so as to take into account considerations under §2036(a).1 After the freeze partner-ship had been implemented, one needs to consider how to maintain its income tax and estate tax beneﬁts if the partnership has years when the cash ﬂow is not sufficient to make the annual payments for the preferred interest and other ﬁnancial considerations that may occur such as the partnership’s assets decline in value.
Read more here.