A freeze transaction is an estate planning technique that uses the interplay of the differing financial and valuation characteristics of preferred equity and common equity securities to transfer assets from one generation to another while minimizing estate and gift taxes. A reverse freeze is a wealth transfer strategy that uses a limited partnership (“LP”) or a limited liability company that is structured to have both preferred and common interests (we will assume the use of an LP structure). In a reverse freeze transaction, the transferred partnership interest is the preferred interest. The preferred partnership (“PP”) interest is structured to receive a preference return that is senior to any distributions made to the common partnership (“CP”) interest. As discussed later, the preference rate is tied to the risk profile of the partnership. The preferred LP interest is generally structured to be cumulative and compounding, so that the preference rate will compound for any arrearages of preference payments not paid within a four-year grace period. The common LP interest of the partnership only shares in partnership income after the preferred payments have been made to the preferred interest holder.
A leveraged reverse freeze, which is a modification of the traditional reverse freeze, involves the sale of the PP interest to a family member in return for a note or a transfer of the PP interest to a grantor retained annuity trust (“GRAT”) or other estate planning vehicle (both with interest paid at the applicable federal rate (the “AFR”) or the Internal Revenue Code Section 7520 rate). Generally, the seller or transferor of the PP interest retains the CP interest in the partnership. Thus, the family member or GRAT will receive a significant portion of the appreciation and cash flow generated by the partnership in excess of the installment payments or GRAT annuity payments, which is the ultimate goal of a leveraged reverse freeze. For the reverse freeze strategy to be effective, the preference rate for the PP interest necessary to sustain a value equal to its face value should be significantly higher than the AFR or the Section 7520 rate.
Appraisers have several important roles in leveraged reverse freezes. These include: 1) acting as a consultant to the estate planner regarding the structure of the partnership; 2) determining the appropriate preference rate; 3) determining the percentage of PP interests in the partnership; and 4) calculating the Fair Market Value (“FMV”) of the CP interest, if required. Ideally, the family should consult with the appraiser prior to forming the partnership, rather than having to amend its agreement at a later date.
We will discuss these items later using a hypothetical example that assumes that a husband and wife who own a portfolio of assets consisting of corporate bonds, domestic stocks, and government bonds are interested in a leveraged reverse freeze.
The freeze transaction has been around for many years. Initially, these transactions involved operating companies that recapitalized their capital structures into preferred and common stock. The founders transferred the common stock and retained the preferred stock. The preferred stock typically had voting rights but was generally noncumulative and often did not pay its dividend. The preferred stock represented a significant percentage of the capital structure and the possibility of a dividend to the preferred shareholders’ depressed expected earnings allocable to the common stock. Of course, no dividends could be paid to the common shareholders unless the preferred shareholders were paid their dividends first.
In subsequent years, taxpayers could transfer passive assets through transactions using either holding companies or partnership interests. The 1987 Tax Court case, Estate of Harrison v. Commissioner1, was a prime example of this technique. The spectacular success of the taxpayers in that case led to provisions of the Tax Reform Act of 1986, which prohibited transactions of this type. The “anti-Harrison” provisions effectively ended planning using interests that might be perceived as preferred securities. For several years, the Internal Revenue Service failed to issue any guidance on the definition of a “preferred interest.” In late 1990, tax legislation authorized Chapter 14, Sections 2701 through 2704 of the Internal Revenue Code (the “IRC”), which sought to clarify various aspects of preferred interests, retained interests, buy-sell agreements, and applicable restrictions.
In essence, Chapter 14 set standards that must be met for a preferred interest to be appraised at face value for valuation purposes. They include paying a fixed rate of income after a safe harbor and having market terms and rates. If these standards are not met, the preferred interest will be valued at its FMV with that amount being subtracted from the total value of the company. Since the freeze involved the senior generation retaining the preferred security and gifting or selling the common security to the next generation, unintentional gift taxes could result based on these new standards.
Structuring the Partnership
During the formation of the partnership, appraisers should work with the estate planner to determine the optimal terms of the partnership. Although most appraisers are not attorneys (and cannot provide legal advice or legal opinions), there are several important issues that can affect the ultimate efficacy of a leveraged reverse freeze. These issues include:
- the proportion of PP interests that can be issued
- which asset types are most suitable for the maximum benefit of a leveraged reverse freeze
- whether other provisions should be considered (for example, payment-in-kind (“PIK”) interest)
Generally, planners use a fixed preference rate due to its simplicity. Fixed rate comparables are more plentiful and are easier to study than other, more complex, securities. It may be best, however, to employ a floating preference rate or a participation PIK structure when income is inadequate to allow for a market rate to achieve the objective of a fairly valued PP interest. In addition, the PP interest is generally cumulative and compounding.
Probably the greatest contributions an appraiser can make during this portion of the planning are recommending the asset mix of the partnership, the percentage of preferred securities in the capital structure, and the preference rate. It is critical that the underlying assets be able to support the required GRAT payments. Generally, we advise our clients that a combination of risky and cash-flowing assets (such as dividend paying stocks and corporate bonds) are best for a leveraged reverse freeze strategy – they provide a healthy yield, but are still risky investments that may enable high returns for the partnership and warrant a high preference rate. The chart “Reverse Freeze” presents the initial ownership of the partnership and a diagram of the flow of funds between the GRAT and the partnership in our hypothetical example involving a husband and wife.
In our example on the next page, we have assumed that the husband and wife decide to form a partnership with a fixed preference rate that is cumulative. In addition, they elect to contribute $50 million in investment grade corporate bonds (trading at par and yielding 6 percent) and $50 million of dividend-paying stocks (with an expected appreciation rate of 8 percent and a dividend yield of 2 percent) to the partnership. We typically would not advise the couple to include their government bond portfolio, as these assets are often too conservative for a leveraged reverse freeze. Upon formation of the partnership, the couple will transfer the PP interest to a five-year GRAT. Assume that the five-year Section 7520 rate is 3.2 percent.
The determination of the preference rate and the percentage of the preferred class in the partnership are intertwined. The greater the percentage of the partnership that is preferred, the greater the preference rate must be, due to interest coverage issues. Appraisers should advise the estate planner of the most economically reasonable proportion of the partnership that may be accounted for by PP interests. The limit to the proportion of PP interests occurs when there is a reasonable probability that the partnership will default on its preference payments. It is important that appraisers run sensitivity analyses to determine this threshold.
The relationship between the preference rate and the percentage of the preferred class can be modeled by calculating the pro forma cash flow of the partnership and applying a minimum coverage ratio based on the riskiness and volatility of the assets. The coverage ratio depends, in part, on the stability of the underlying assets of the partnership. The resulting cash flow is then divided by a range of yields derived from an analysis of the bond and/or preferred stock markets that will result in a range of preferred interest values.
The chart “How Much Preferred Interest Can the Partnership Support?” indicates the general relationship between the characteristics of the assets held by the partnership and the amount of preferred interest the partnership can support.
In determining the preference rate, appraisers should consider factors relating to the credit quality of the PP interest, as indicated by distribution, total return, and asset coverage ratios, the terms and provisions of the PP interest, and an analysis of the assets of the partnership and its risk profile. Revenue Ruling 83-120 provides guidance for determining the preference rate. Rev. Rul. 83-120 was issued to
…amplify Rev. Rul. 59-60, 1959-1 C.B. 237, by specifying additional factors to be considered in valuing common and preferred stock of a closely held corporation for gift tax and other purposes in a recapitalization of closely held businesses.
Although a PP interest is not exactly the same as preferred stock in a corporation, its structure is very similar – the PP interest is generally structured to have a liquidation preference and preferred return that may only be paid from cash flow and asset appreciation.
Some of the issues that the appraiser should consider in setting the preference rate are:
- current market conditions
- the underlying risk profile of the assets of the partnership
- the percentage of partnership interests that are preferred versus common
- the lack of marketability of the PP interest
Marketable securities portfolios tend to have low dividends but high appreciation potential. At first glance, they might not appear to satisfy the cash-flow requirement to pay preferred distributions. However, the safe harbor allows for a four-year grace period in making distributions.2 The yield can be satisfied through capital gains as well as ordinary income. This approach is based on total return rather than current cash flow. Distributions can be made by selling securities, equity participation, or a PIK.
To select an appropriate preference rate, we must first understand the factors that impact the credit analysis of securities similar to the PP interest. We will then assign the PP interest a credit rating and analyze the yields of publicly traded securities with a similar credit rating. To determine the applicable credit rating for the PP interest, we conduct an analysis of various ratios (such as interest coverage, return on capital, and debt ratio) of the partnership and compare such ratios to publicly traded debt and preferred equity securities. Ideally, we will locate publicly traded securities that have features similar to the PP interest such as maturity, issuance date, PIK feature, and conversion.
Given the factors discussed in Rev, Rul. 83-120 and based on the expected profile of the partnership, the PP interest frequently will be considered non-investment grade (although, it is possible to have a lower yield than non-investment grade securities depending on the partnership’s underlying assets).
However, the reasonableness of the leveraged reverse freeze structure can become questionable if the credit rating of the PP interest is too low. Generally, we advise planners to structure the partnership so that the proportion of preferred interests in the partnership equates to a below investment grade credit rating of BB or B. The combination of the preference rate and the associated interest coverage ratio corresponding to a BB or B credit rating should provide the appraiser with the proper percentage of total PP interests.
In addition to the specific risk factors of a PP interest quantified by credit analysis, other specific risk factors impact the preference rate. These primarily relate to the PP interest’s lack of marketability, lack of an indenture, potential for subordination (if the partnership were to incur any debt), and lack of industry or governmental regulation. These specific risk factors serve to increase the preference rate beyond that of publicly traded non-investment grade securities. Typically, we apply a risk adjustment to the preference rate indicated by comparable publicly trade securities in the range of 50 to 300 basis points (in other words, a yield of 8 percent for a similar publicly traded security would be adjusted upward by 0.5 percent to 3 percent to account for these factors).
Assume that in our hypothetical example, we determined that 40 percent of the partnership interests should be PP interests having a preference rate of 11 percent. If the partnership earns 5 percent before income taxes, there will be enough income to satisfy the preferred payment to the PP interest. At the end of the GRAT’s term, the remainderman will receive the cumulative value of the PP interest, tax-free (following a return of capital to the donor).
FMV of CP Interest
Appraisers may also be asked to calculate the FMV of the partnership’s common partnership interests. This analysis is generally the same as that applied for traditional family limited partnerships (“FLPs”). In selecting the appropriate discounts for lack of control and lack of marketability, appraisers should consider:
- the risk profile of the partnership
- the subordinated nature of the CP interest
- the projected distribution stream to the common partnership interest
- the term of the partnership
- any voting rights afforded to the CP interest
The primary difference between our hypothetical CP interest and a standard LP interest in a partnership without a PP interest is the subordinated nature of the CP interest. The CP interest is subordinate to the PP interest in that it receives distributions only after the preference return payments have been made.
Further, upon liquidation, the CP interest will receive its liquidation proceeds after the PP interest. All else equal, this subordination will require discounts that are greater than for a traditional LP interest in an FLP.
1 Estate of Harrison v. Commissioner, T.C. Memo 1987-8.
2 Internal Revenue Code Section 2701(d)(2)(c).