One of the primary objectives of estate planning is to pay the least amount of tax possible on the transfer of wealth to the next generation. This may be accomplished by transferring the future growth of an asset so that your remaining interest is frozen in value. Through the use of a partnership freeze, you can maintain current control of an underlying asset while transferring its future growth to the next generation.

For example, a partnership freeze may be an ideal vehicle to transfer nonvoting, closely held securities that in the future could be subject to an initial public offering. Control may be maintained by the donor through either a limited partnership or a limited liability company. Whichever entity is chosen, the basic structure of the transaction remains the same. For purposes of this discussion, a limited partnership will be used as an example.

One Step at a Time

The first step is for you to establish a limited partnership by transferring assets to a partnership. The partnership may retain these original assets until your death (and thereafter), which means that appreciating assets are more likely to be retained in the partnership.

In exchange, you receive a general partner interest, preferred interests and residual interests. Preferred interests are similar to preferred stock and have a fixed annual return and liquidation value. The residual interests are similar to common stock and have the potential to grow in value. The general partner interest controls the partnership and may be as small as a 1% interest.

You make a gift of the residual interests to the next generation while retaining the preferred interests and the general interests. The value of the residual interests may be subject to minority discounts and must be at least 10% of the partnership’s value. In valuing the preferred interests, the law now ignores liquidation, call, put and conversion rights and similar bells and whistles.

The preferred payments must be determined at a fixed rate (either as a percentage or dollar amount), be required to be made on a periodic basis and be cumulative. The preferred payments can be deferred for up to four years, which provides the partnership with an opportunity to grow without being stymied by initial cash flow requirements.

The rate of the preferred payments may generally be higher (6% to 10%, for example) than payments under a grantor retained annuity trust (GRAT) or installment sale (two other popular freeze techniques), but the dollar amount of the preferred payments may be much lower and may continue for much longer than under those methods. For example, rather than using a 10- or 15-year term for a GRAT or installment note, the partnership may make payments for your lifetime that are 50% or less than the payments under the other options.

In addition, a properly structured partnership may be able to make the preferred payments in kind without triggering gain. The preferred payments will not be considered income except to the extent that the partnership has taxable income.

The partnership freeze will offer the greatest benefit if the assets in the partnership grow at a rate faster than the market rate of return that is used to set the preferred payments. If the partnership assets fail to grow at a rate that is faster than the underlying rate, then the partnership freeze will not be successful, except that the residual interests passing to the children will have been transferred using a minority valuation discount.

Timing Is Everything