The Partnership Freeze: The End Game For A Sale of Business/Estate Planning
The ultimate end game for a business owner is the sale of one business to a third party and finally cashing out. A problem that I have seen in my practice, particularly relating to C corporations, is that there is often no planning prior to the sale of that business by the owner. As a business owner, you want to pay the least amount of tax, and certainly not a double tax. Unfortunately, the buyer does not want to inherit hidden liabilities and therefore only wants to purchase the assets of the business and not your stock.
The other side of the coin, is where the business owner, for estate planning purposes, wants to transfer real property currently owned by a C or S corporation to either a partnership or limited liability company, in order to achieve a stepped up in basis on the real property on the business owner’s death. In this situation, the real property (or its value through a 1031 exchange) is to remain in the family, but if not done correctly, will be subject to an income tax trap on the transfer.
Planning for the sale of a business or the transfer of real property owned by a corporation is similar to trying to put the pieces of the puzzle together in order to achieve only one level of tax. For the sale of a business, I will assume that the S corporation election is not practical for whatever reason(s). Just because you cannot do the S corporation election, it does not mean that there are not other planning opportunities. This article will focus in on the “partnership freeze” planning as another method for you to explore.
Before I discuss the partnership freeze and the various types, I would like to remind you that if there are appreciated assets within your C corporation, a simple sale to a favorable flow through taxable entity, such as a partnership or limited liability company, may be something to explore. For example, if your C corporation has losses and owes you money for past services or loans, it might be possible to do a sale to you with you contributing the appreciating assets to a limited liability company. Remember, there will be a tax on the sale of your business. You are trying to reduce as much of it as you can.
The Concept and Types of Freezes For a Sale of Business.
Certain types of partnership freeze transactions, sometimes known as “roll-out” partnership freezes, have evolved from the estate freeze to become a common means of “separating” incorporated appreciated business assets from the closely held C corporation and transferring them to affiliated or unrelated parties at no current tax cost but subject to potential deferred income recognition, possibly many years later, thus reducing taxes on a present value basis (or, in one variation described below, possibly permanently eliminating them).
1. Partnership Partial Freeze.
A partnership partial freeze transaction is structured basically as follows: a closely held C corporation with two or more businesses (“transferor” transfers tax-free, a business and related appreciated assets to a new limited partnership or limited liability company (LLC) in exchange for (i) a preferred interest entitling it to a non-voting preferred yield and the preferred return of capital prior to liquidation at the option of the transferor or of the LLC, and (ii) a common interest entitling it to a fixed percentage (say, 20 percent) of the residual profits, losses, cash flow and liquidation proceeds remaining after satisfaction of the preferred interest. A “buyer” for the transferred assets, that may or may not be related, transfers, tax-free, business assets (or cash to purchase business assets) to the partnership in exchange (at fair market value) for the remaining common interests (say, 80 percent).
Thus, the value of the transferor’s interest in the business (to the extent captured in the preferred interest) is essentially frozen at the value of the preferred interest which value should approximate the current fair market value of the transferred business assets, because all the future growth will be captured entirely by the common interests. The desired tax treatment should be available to the transferor because gain on the frozen portion is effectively fixed and deferred until the preferred units are redeemed or sold for cash. Thus, the transferor has reduced its tax liability on the built-in gain on a present value basis (compared to the immediate tax liability that would obtain in a direct sale to the “buyer”) The transferor could then also achieve post-transactional liquidity by “monetizing” its preferred LLC interest (by borrowing against it on a recourse basis).
2. Leveraged Partnership.
A so-called “leveraged” partnership can achieve the same long-term tax deferral result of the freeze partnership, but it adds to the deal the “up-front” distribution of partnership-borrowed funds to achieve immediate tax-free liquidity for the transferor. A leveraged partnership transaction is structured basically as follows. A closely held C corporation contributes appreciated business assets to an LLC in exchange for a distribution of cash and a common percentage interest (say, 20 percent). The cash comes from the LLC’s borrowing from an unrelated third-party lender. The LLC loan is guaranteed by the transferor corporation to the extent the LLC assets are insufficient to repay it but is otherwise nonrecourse to the LLC members. The “buyer” contributes other business assets (or cash used to purchase business assets) to the LLC in exchange for a common interest (say, 80 percent).
The LLC makes the remedial allocation election. Cash flow from the business and the contributed assets which have been subjected to the entrepreneurial risks of the LLC’s business activities) will be employed to pay down the loan and to make distributions. Because the transferor has guaranteed the third-party loan to the LLC, the loan will be allocated to the transferor under Section 752, so that its basis in the LLC will increase by that amount upon the borrowing, and the distribution of all the cash loan proceeds to it will therefore be non-taxable. As the loan principal is paid down, the transferor recognizes taxable income to the extent the deemed distributions of cash exceed its basis in the common interest (and thus the deferred gain is amortized over the life of the loan). The transferor will also recognize gain to the extent of the buyer’s depreciation of the built-in gain under the remedial allocation method. All unrecognized gain is recognized when the preferred interest is ultimately redeemed for cash. As stated, the leveraged partnership structure is similar to the freeze partnership in that the tax result for the transferor is a deferral of the built-in gain on the appreciated asset and future appreciation is transferred to the common interest holders. For the buyer, the effect of the remedial allocation election can be the same as a steeped-up basis in the transferor’s appreciated assets.
3. “Mixing Bowl” Partnership.
Yet another means of deferring tax on appreciated C corporation assets is the “mixing bowl” partnership if the transferor wishes to “sell” the appreciated assets and use the proceeds to ‘buy” assets of a completely different (other) business without recognizing gain on the appreciation. In the mixing bowl, both buyer and seller contribute their respective business assets to the same LLC, where they remain indefinitely, subject to the vicissitudes of the LLC’s business activities. Each member, pursuant to the operating agreement, manages the other’s assets in the LLC and takes, by means of special allocations (having substantial economic effect), a disproportionate share (say, 80 percent) of the other business’s income, deductions and cash flow. Flowing a lapse of at least seven years, the transferor’s LLC interest may be liquidated tax-free in exchange for the other business and its assets.
Concept of Freeze with S Corporations and Estate Planning.
In this type of planning the real property that is owned by the S corporation is one that is to remain with the family. Again, the goal is to have the value of the real property to be stepped up to its FMV on the death of the family owner for estate planning purposes. This will not occur, if the real property is owned by an S corporation. The shares of stock (outside basis) will be stepped up, while the real property (inside basis) will not.
Typically, the planning is as follows: A new LLC or LP is created. The S corporation contributes land to the LLC in exchange for a preferred return based upon a value determined by an appraiser. The family contributes cash or property worth 10% to the LLC for a common interest. In exchange preferred interest income, the S corporation receives a 20% gain on future appreciation of the real property, while the family receives an 80% gain on appreciation.
A qualified appraisal is the key to determine the preferred return amount and the contributions by the parties. The reason for this is to avoid constructive dividends and other adverse income tax consequences. Compared to the sale of a business where the value has been set by the parties, the appraisal is the insurance policy for being successful, if there were an IRS audit.
Conclusion.
Under certain circumstances, given the time line available to the business owner, some form of partnership freeze may be a viable option. The same is true for estate planning purposes. In either situation, a valid business purpose must be established and the avoidance of well defined IRS rules is a must.