Rethinking I.R.C. §2701 in the Era of Large Gift Tax Exemptions

For individuals or couples with a net worth of $5-10 million, there are new opportunities to transfer assets and minimize taxes as the tax exemptions have increased. One way to do this is through a “freeze partnership,” which allows for transferring appreciation of assets to younger generations while keeping control and access to income. This also helps avoid gift taxes and allows for a step-up in basis at the taxpayer’s death. The concept of using a freeze partnership has been around since the 1970s and involves structuring ownership interests in a partnership to shift most of its value and appreciation to younger generations. The IRS and Congress didn’t like when people used certain strategies to avoid paying taxes. So they made rules to stop it. These rules say that if older people give away part of their property to their kids, the value of what they keep is ignored for tax purposes. This means that the gift for tax purposes is the full value of the property. But there are some adjustments to make sure people don’t get taxed twice. So, it might be a good idea for people to intentionally trigger these rules by giving away part of their property, because it could help them avoid taxes later on. As an example, imagine a couple, Bill and Jane, who own a lot of property. They could benefit from triggering these rules to avoid taxes on their property later. Bill and Jane want to avoid estate taxes and pass on the value of their rental property to their kids. They don’t want to give away the property now because they need the rental income. They’re concerned about income taxes and losing the property’s value when they die. They can set up a partnership where they have control and give the future value to their kids without paying gift taxes. In this case, Bill and Jane would get annual access to money for the rest of their lives. They could get as much as they need each year, and any leftover amount could be given to their children. When they die, their children would get a lot of money without having to pay a lot of taxes on it. This plan would need to be set up carefully by an expert to make sure it works correctly. IRC §2701 has rules about valuing interests in a partnership. To trigger these rules, the ownership of the partnership must include at least two different kinds of interests – preferred and subordinated. The preferred interest gets certain priority rights, but its earnings are capped at a certain rate. The subordinated interest gets any earnings that exceed this cap. The ownership must also be within a family, with the subordinated interests going to younger family members and the preferred interests staying with older family members. There are some exceptions to these rules that tax planners use to avoid them. These rules are meant to prevent people from manipulating the value of their partnership interests to avoid taxes. In some situations, it’s better for people to structure their transfers in a way that the zero-value rules intentionally apply. If they don’t, they could end up being taxed twice on the same assets. For example, if someone gives away some of their business interests and then dies, the value of the remaining interests could be taxed again in their estate. But there are rules that can help reduce the double taxation, so that the estate tax is only applied to the actual value of the remaining interests. There are rules in place to limit how much the value of a certain type of interest in a partnership can be reduced for tax purposes. This means that if the value of the interest goes down, the reduction in value for tax purposes is limited. This is important to consider when planning what happens to these interests after they are initially given as a gift. If someone gives a special type of gift to a family member in a lower generation, the amount of gift tax owed by the person giving the gift is reduced. This also applies if the person giving the gift dies and still owns the special gift. If the special gift was sold or exchanged, the value of the sale or exchange is used to reduce the gift tax owed. If spouses are sharing their gifts, they should be careful because it could affect how much gift tax they owe. If one spouse gives away part of their business while both are alive, they can split the gift with the other spouse to lower taxes. But if one of them dies before giving the gift, the rules change and the surviving spouse can only use the tax reduction if they actually paid gift tax on the gift. It’s important for both spouses to own part of the business and make their own gifts to avoid taxes. After the initial gift, they should plan carefully to make sure they can get a tax break when one of them dies. When creating preferred interests in a family partnership, it’s important to make sure that the rights associated with those interests don’t cause inclusion of other interests in the taxpayer’s estate. The senior generation should not have exclusive control over certain decisions, and the partnership should be operated carefully. It may also be helpful for the junior generation to buy the subordinated interests or make a capital contribution to the partnership in exchange for them. The senior generation should also have significant assets outside of the partnership and should not put personal assets inside the entity. It’s important to document and operate the structure correctly and have valid non-tax reasons for the arrangement. In order to get the most tax benefits from a freeze partnership, the preferred interest needs to be worth the same when it’s transferred as it is later. The IRS doesn’t value noncumulative distribution rights as much as cumulative dividend features, so it’s important to show value for the preferred interests in the put right. It’s also important to make sure the partnership has enough assets or can borrow money to fulfill the terms of the option contract. Freeze partnerships have other benefits too, like involving the family in investment decisions and providing guaranteed returns for the older generation while allowing the younger generation to invest for the future. When giving large gifts to grandchildren, it’s not clear if special tax rules apply. The rules for disclosing these gifts to the IRS are stricter than for regular gifts. Be careful to follow these rules when reporting the gifts on your tax return. Implementing a freeze partnership can save on taxes, but it also has some rules and restrictions. It’s important for tax planners and attorneys to understand these rules and be able to use the strategy when it’s the right fit for a client. There are specific regulations and guidelines that need to be followed when setting up a freeze partnership, and it’s important to be aware of them to avoid any potential pitfalls. This passage includes references to specific tax laws and regulations, as well as articles and rulings related to estate planning. It also includes information about the authors’ education and qualifications. The authors are members of The Florida Bar’s Tax Law Section.

Source: https://www.floridabar.org/the-florida-bar-journal/rethinking-i-r-c-2701-in-the-era-of-large-gift-tax-exemptions/