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Tax News
CCA 201442053 – Partnership Freeze Gone Awry
October 23, 2014
Administrative Actions
The IRS released a few days ago the above-mentioned CCA, which illustrates the gory pitfalls of Sec. 2701. In this ruling, the IRS had to opine whether the recapitalization of a family partnership would be subject to Sec. 2701. The parties here attempted a partnership freeze. This is an estate planning technique whereby the older generation retains a fixed interest in the partnership and transfers future profits to the younger generation. Thereafter, the older generation could gift portions of the retained interest annually within the limits of the annual gift exclusion. Alternatively, the transferor could gift portions of the retained interest to charity and take a deduction.  The idea is that a portion of the partnership interest is removed from the transferor’s estate.  In this particular ruling the parties agreed that in exchange for services provided by Child A and Child B to LLC, future profit and loss, including all gain or loss attributable to Company’s assets, would be allocated equally to Child A and Child B. After the recapitalization, the parent’s sole equity interest in the LLC was the right to distributions based on his capital account balance as it existed immediately prior to the recapitalization.

Section 2701 and the partnership freeze should be familiar to investment fund principals who typically transfer a portion of their carry to their children or to a trust for the benefit of their children. Section 2701 is designed to curtail “freeze” abuses with the draconian effect of valuing the retained transferor interest at zero and thus causing a gift transfer of the same amount to the transferee.  This is a harsh result.  Tax lawyers would usually structure the freeze so that Sec. 2701 does not apply. This could be done by drafting for a single class of interest, meeting the proportionality rule, the vertical slice exception, or providing for a “qualified payment right.”  The section usually applies only if there is a family control over the entity in which the interest is being transferred. In the investment fund context, the issue arises when the fund’s GP is controlled by one person and its family.  The most common approach of dealing with Sec. 2701 is to transfer something known in the industry as a “vertical slice,” or in other words a proportionate transfer of the GP’s entire interest (capital, carry and capital commitment). Thus, GPs would fall within one of the express exceptions of Sec. 2701. When a “vertical slice” is not practical (for e.g. the GP may have a significant capital account which would result in a material gift tax liability), the GP could use a holding company where it would contribute its GP and LP fund interests. Then it “freezes” the holding company by creating a preferred interest with a “qualified payment right” and a common interest that is transferred to a dynasty trust, for example. Generally, the GP would not just transfer the carry (i.e. the profits interest). The concern again is Sec. 2701. Practitioners are concerned that the “carry” is usually a “complex” profits interest because it is subject to various subordinations, clawbacks and so on.  Being “subordinate” to the capital interest that the GP usually holds in the fund under its capital commitment obligation, a “carry” transfer could squarely fall under Sec. 2701.  This is contrary to a simple profits interest which is a straight-up share in company profits which is “subordinate” only in a sense that it gets paid if there are future profits. Thus, practitioners pontificate that a complex profits interest could be viewed as a separate class of subordinate equity for purposes of Sec. 2701 but a simple interest likely would not be.

In this CCA, the taxpayer did not implement a vertical slice or a qualified payment right preferred. It seems that the taxpayer relied on the same class or proportionality exceptions (not to be confused with the proportionate/vertical slice exception). The IRS, however, disagreed with the taxpayer’s planning.  It basically said that the recapitalization, which resulted de facto in the grant of a profits interest, triggered Sec. 2701. The reason was that the capital interest retained by the transferor and the profits interest given to the transferee were different classes of interest, namely, the retained capital interest was “senior” to the “subordinate” profits interest. This is essential for the application of Sec. 2701 which generally captures situations where the transferor retains a senior interest and transfers a subordinate interest (e.g. preferred v common scenario).   Now, the facts of the rulings were somewhat egregious because parent did not retain any interest in the profits, but as we alluded to above, we are not entirely clear why a simple profits interest as the one in the ruling would be subordinate to the capital interest. These particular interests were granted in an LLC whereby no member had priority over any other member as to participation in profits, losses and distributions or the return of capital contributions. The IRS did not provide much rationale why these interests should be viewed as different classes and why one is subordinate to the other. The only reason was that the profits interest carried a right to distribution based only on future profit and gain.  To us, subordination means that one interest gets paid before another interest. This agreement liquidated in accordance with capital accounts. If children had accumulated a capital account of X from profits and parent’s capital account was Y, nothing gave preference of father’s account Y over X if there was insufficient money in the LLC.

Ironically, this CCA seems to come as an answer to a rhetorical question Richard Dees (a Mc Dermott attorney who was involved with drafting Sec. 2701) raised in a 2009 article regarding these issues. He pointedly said:

“How do we decide whether section 2701 applies and, if it does, which units are the applicable retained interests? Do we assume that section 2701 does apply and that the IRS can simply argue that either class of units is the senior interest depending on which one results in the worst possible gift tax consequences? If so, why would Treasury and the IRS go to great lengths in the regulations to avoid the harsh results that the statute could have produced, only to reinstate those results by stretching the regulations beyond their apparent meaning? Delving into the interstices of the regulations seems unlikely to help us apply section 2701 to our partnership equity interests.”

This musing says a lot about Sec. 2701 and the regulations thereto.  We highly recommend his article “Profits Interests Gifts Under Section 2701: ‘I Am Not a Monster’” if you can get your hands on it. This CCA reiterates that a simple profits interest is a separate equity class subordinate to a capital interest. This, coupled with the fact that there is scant guidance on this “subordinate” profits interest issue, makes the CCA notable. The bottom line is, if you are a GP who is considering a freeze, ask your adviser about the CCA.  The CCA may not be an issue for variety of reasons – for example, you are not in control of the GP, you are OK with a vertical slice (i.e. transferring both carry and capital) or you are doing the freeze in the early stages of the fund whereby the value of the gift will be low even if Sec. 2701 were to apply.  It is worth it, however, to look closely at these issues because in the case of a mishap, the tax cost could be great.  If you are an adviser, please drop us a line about this ruling or write a comment. We are curious what you make of it.

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Tags: GP estate planning, partnership freeze, profits interest, Sec. 2701, subordinate interest