I've been a CPA for nearly 20 years - serving private small business and real estate the entire time. I take the lessons learned in serving and now running a small business and share them here. For business owners, investors, and advisors looking to lower their cost of capital, subscribe for delivery straight to your inbox π Also on YouTube at PlugAccountingandTax!
Storytime - Dangerous DIY Estate Planning in a Partnership
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Years ago, one of the largest owners of real estate in Houston came to our firm with a new-fangled tax structure they were about a week away from executing. Looked great on paper and hit their pain points. But in reality it would have handed the IRS a gift tax bill in the millions, and nobody in the room had any idea. Here is what they were trying to do - something not uncommon: The parents were in their sixties. They owned all this commercial real estate, and for historical reasons it sat inside C-Corps. The buildings have appreciated for decades and are going to keep appreciating. The parents wanted to "freeze" their own value at today's number and let all of the future growth land in their kids' hands, so that growth would not be taxed in their estate when they pass. That goal is exactly right. Freezing the senior generation's value and shifting appreciation down to the next generation is the whole point of good estate planning for a family that owns something as valuable as this prime real estate. The problem was a tax code section written to address just this. The plan that looked freeA long-time family friend attorney had suggested this clever workaround. Form a new partnership. Contribute the C-corp stock into it. Then grant "profits interests" in the partnership to the kids. For those not in the know - a "profits interest" gives the holder a share of the future profits and appreciation of a partnership, but no share of the value that already exists on the day it is granted. Its liquidation value at grant is zero. In the compensation world, when you give a key employee a profits interest for their services, that grant is generally not a taxable event precisely because it is worth nothing the moment it is handed over. So the family's logic was: the kids' profits interests are worth zero today, therefore this is a zero gift, therefore no gift tax and no gift tax return. Freeze accomplished, for free. But in tax, if it sounds too good to be true you can bet there's a rule against it. Chapter 14 was built for thisBack in 1990, Congress got tired of families freezing their estates with clever equity structures and added Chapter 14 to the code. The relevant piece here is Section 2701, and it does not care what you call the interest you gave your kids. It cares about the interest you kept. When a senior family member transfers a growth interest to the next generation and holds onto a "preferred" or senior interest, Section 2701 does not let you value the gift the intuitive way. It uses what is called the subtraction method. You start with the value of the entire entity, and you subtract the value of the interest the parents kept. Whatever is left is the gift. Here is the trap. Section 2701 says that the interest the parents kept is valued at zero unless it carries a very specific feature called a qualified payment. A qualified payment is a fixed, cumulative distribution, a real coupon, paid at least annually at a market rate that a qualified appraiser signs off on. A plain capital interest with no fixed coupon does not qualify. And in the family's proposed structure, the parents' retained interest had no such coupon. So run the subtraction. Entire partnership value of one building, call it $15 million. Minus the parents' retained interest, valued by law at zero. The gift to the kids is not zero. It is $15 million. That is a gift large enough to blow completely through the parents' lifetime exemption and drop them straight into 40 percent gift tax territory, on a transaction they thought was free. And because it was never reported, it would have sat there as a live problem until an examiner or a future estate return surfaced it, with interest and penalties compounding the whole time. How it is supposed to be doneThe frustrating part is that a freeze like this can absolutely work. It just has to be built correctly. Done right, the parents keep a preferred interest that pays a real, cumulative coupon at an appraised market rate, something in the range of five to six percent, paid at least once a year. The kids take the growth interest, valued at no less than 10 percent of the whole, and everything above that flows to them going forward. When the retained interest actually carries that coupon, it is no longer valued at zero. It carries real value, the subtracted number is large, and the gift shrinks to something small and intentional. The freeze does what the family wanted. Alternatively, engaging in a full estate planning exercise would have likely presented additional opportunities to use trust structures like GRATs or IDGT sales. This was the end result in this instance - referring them to the right estate planner to address the complexity that was at hand. The takeawayIf you own something that has appreciated and you are thinking about moving the growth to your kids, that instinct is correct and worth acting on. But the words "freeze" and "profits interest" are exactly where families get hurt, because the structures that sound simplest are the ones Chapter 14 was written to catch. We caught this one with about a week to spare. π«‘ Group Chat Worthy Posts π₯π²
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I've been a CPA for nearly 20 years - serving private small business and real estate the entire time. I take the lessons learned in serving and now running a small business and share them here. For business owners, investors, and advisors looking to lower their cost of capital, subscribe for delivery straight to your inbox π Also on YouTube at PlugAccountingandTax!
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