By: Randall A. Denha, JD, LL.M.
With the outcome of the estate tax laws up in the air, it leaves tax planning a little unsettling. With the federal estate tax exemption now at $5 million per person, we don’t know what Congress will do. In fact, one cannot even predict what our faithful politicos will do.
Suppose Alan and Stella Gates have an $11 million estate. They can currently pass $10 million of it onto their children without being taxed. That leaves $1 million. With the lifetime gift tax exemption of $5 million, they are in great shape. But suppose the estate tax exemption is reduced to $1 million per person. They now have a $4.5 million tax liability. With the gift tax rates as high as 35%, giving the money away may not be the answer. What should they do?
One solution that is growing in popularity is the Preferred Family Limited Partnership (“PFLP”). In a PFLP there are two classes of interest: preferred and common. The preferred is considered “preferred” because it is entitled to preferred dissolution rights. The dissolution rights are fixed at a value of the property initially contributed to the partnership. In addition, there are usually preferred income rights as well. This means that the preferred interest holder is entitled to receive preferred distributions of net cash flow from the partnership, equal to a set percentage of the value of the dissolution value.
The preferred interests are much like preferred stock in a corporation, where the “common” interests are subordinate to the preferred interests — however, with an interesting twist. The common interests are subordinate to the preferred interests with regard to dissolution and income rights, but the common interest holders tend to have voting and managerial control over the partnership. The common interest holders share proportionately in the partnership’s income distributions, but only to the extent that the preferred interest holders have received the preferred income or dissolution payments.
Suppose Alan and Stella transfer $2 million of their assets into a partnership in exchange for a preferred partnership interest with an interest rate determined by the partnership, say 6%. This rate is established by comparing the distributions to similar investments with comparable levels of risk. Setting the rate too high, like 12%, could be considered excessive and a gift tax could be levied, unless treated as increases in value of the common interests. Therefore, it is important to seek professional counsel to determine a realistic interest rate. These distributions are cumulative, accruing at a fixed rate interest until paid. They are entitled to $120,000 a year ($2,000,000 x 6% = $120,000). With their preferred status, they receive preference over the other partners when the returns fall short. The preferred partners are paid first before the other partners are paid their shares. These preferred distributions can be paid monthly, quarterly, or annually from the partnership as long as they are alive. Upon their death, the yearly payouts will be included in their estate and a value will be determined based on current interest rates at that time.
However, there is a small catch with the PFLP. The non-preferred or common interests must make contributions to the partnership that are equal to or greater than ten (10%) of the original contributions by the preferred partners otherwise they will be deemed to have received a gift equal to ten percent of the value of the total equity interests in the PFLP. This can really throw a wrench in the deal, unless you plan ahead. If you know your intention is to create a PFLP then the preferred partners may want to make gifts to the non-preferred partners (children) in advance in the amount necessary to capitalize the partnership. Suppose in Alan and Stella’s case, they know they want to contribute $2 million to the partnership to be safe with those assets that may be subject to tax. Consequently, their four married children would have to collectively contribute at least $222,500 to have a valid PFLP.
This is determined by calculating what 10% would be of all the original contributions ($2,000,000 + $222,500 = $2,222,500 x 10% = $222,500). Given that Stella and Alan can gift $24,000 per year to each child and their respective spouses, they can gift $192,000 per year. Therefore, it would take Alan and Stella at least two years of gifting to their children (without a gift tax) to establish a fund large enough for the non-preferred partners to capitalize the PFLP.
Now here is where it gets exciting. Similar in concept to the growth in value of common stock of a corporation, the partnership should have an objective to earn more than the 6% preferred distribution rate. If the partnership can achieve excess earnings of 5% or higher (achieving a 10% return or better), the PFLP will be worth over $4 million in 14 years! The net result is that the non-preferred partners will benefit from an appreciation of their contribution of $222,500 to an appreciated value of nearly $2.5 million. Isn’t that what the Gates wanted in the beginning? While the estate is still subject to the $1,714,285, nearly $2.5 million dollars of real estate has been removed from Alan and Stella’s estate, free of gift or estate tax. The children are in a much better place, too, when, and if, an estate tax imposes a tax on the $1,714,285.
The PFLP can be a very effective device when it is reasonably anticipated the assets contributed to the PFLP will grow in value in excess of the rate of return paid to the preferred interest holder. Whether the PFLP is capitalized with real estate, an operating business, permanent life insurance tied to an equity index, or any other type of asset, the key to its success is being able to grow in value at a rate which exceeds the payment to the preferred interest holder.
However, like all intricately designed estate planning tools, the IRS loves to challenge those that could be considered as tax avoidance strategies. Therefore, it is extremely important that you seek competent legal counsel when you consider using this win-win exit strategy.
In accordance with Treasury Department Circular 230, please be advised the advice contained herein was not intended or written by the practitioner to be used, and that it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer; the advice was written to support the promotion or marketing of the transaction(s) or matter(s) addressed by the written advice; and the taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.