The freeze partnership technique (the “technique”) to shift wealth to the next generation while saving estate, gift, generation skipping, and income taxes has been in use for decades, although you wouldn’t know it. Even though this technique is expressly sanctioned under Internal Revenue Code (“I.R.C.”) §2701, in practice it is probably the least utilized estate freeze option. Alternative freeze methods such as the grantor retained annuity trusts (“GRATs”), and the installment sales to intentionally defective grantor trusts (“IDGTs”) have become popular because they are simpler or may be more flexible. But those methods have severe limitations when dealing with negative capital account assets and where mortality risk of the grantor is a very real concern. When properly structured, the freeze partnership technique can avoid the unintended adverse income tax consequences triggered by other freeze alternatives securing a step-up in basis for the business assets and eliminate the negative income tax consequences for the succeeding generation. Because various estate and income tax-planning objectives can be achieved where other techniques fail, planners should not be reluctant to add the partnership freeze to their repertoire and implement this technique when appropriate circumstances call for it.
In general terms, the technique is in many respects similar to a corporate recapitalization. A freeze partnership could be a limited partnership or a limited liability company (referred as “preferred partnership”) with at least two classes of interests, a preferred interest and a subordinate interest, which is akin to a common interest to which most of the appreciation will accrue. The preferred interest may be issued in exchange for capital contributions at the inception of the entity, or they may be issued as part of the recapitalization of an existing entity.
The preferred interest will be entitled to a preferred return and a liquidation preference, whereas the subordinate interest will be entitled to growth and appreciation of the assets. With a family controlled entity, strict requirements of I.R.C. §2701 must be satisfied to avoid a zero valuation for the preferred interest. The preferred interest can avoid the zero valuation if it has a right to receive a qualified payment and a liquidation preference stating that before dissolution of the company the stated dissolution preference will be paid to the members holding the preferred interest. The rules require that the subordinate interest have a value of not less than 10% of the value of the company, plus the value of any debt of the entity held by the transferor.
The Implementation of the Technique
As a hypothetical of how this technique could work, let us imagine a taxpayer who is a successful real estate entrepreneur, in his sixties, has children, and made minimal previous taxable gifts. The taxpayer owns several real estate properties under a holding company. It is a partnership for tax purposes and the taxpayer owns nearly all of the interests in the entity. Because he held the real estate assets long term, the taxpayer took advantage of the depreciation deductions and distributed proceeds of nonrecourse financings causing him to have a significant negative capital account even though the properties have appreciated significantly in value. The deferred income tax liability may exceed the value of the real estate causing a problem for the taxpayer. How do we facilitate the taxpayer getting value to his children thereby taking advantage of the temporarily increased lifetime exemption without causing income tax issues? Dying while still owning the properties will erase the income tax but holding the properties until death will cause a significant estate tax. Moreover trying to control the estate tax through the use of GRATs or sales to grantor trusts creates an extreme risk of failure because of the income tax liability.
Consequently, in this set of circumstances, a freeze partnership can achieve many of the taxpayer’s goals. Correctly done, creating the partnership with two classes of units has no income tax consequence on formation, the value of the preferred interest retained by the parent is frozen but for changes in interest rates and other indicators of value for preferred interests, and upon death, the negative capital account attributable to the preferred interests is erased (barring the enactment again of carryover basis).
One way to implement this technique involves the following steps: First, taxpayer forms a new limited liability company (“LLC”). Second, taxpayer contributes 100% of his interest in the holding company in exchange for a preferred interest that is entitled to a fixed qualified payment and a liquidation preference in the new LLC. Third, to comply with the complex partnership income tax rules and maintain the allocation of non-recourse debt to the preferred interest, taxpayer will gift enough cash to his children to contribute to the new LLC in exchange for a subordinated interest worth 10% of the value of the entity, which will be entitled to growth and appreciation over and above the preferred return. A variation on this would be for the taxpayer to gift the cash to irrevocable grantor trusts for the benefit of his children so that their interests are outside of their estates on their deaths. However, if all of the interest in the new LLC is owned either by grantor trusts or the grantor, the new entity will not qualify as a partnership and not get the benefit of the freeze technique. In that case, make sure that a small interest in the entity is held by the children outright so as to avoid this pitfall. Fifth, through proper design of the allocation of rights, preference and distributions under the operating agreement and taking advantage of the discounted value of the preferred interest, taxpayer will be able to allocate the cash flow first to the qualified payment and shift the surplus of the remaining cash flow to the next generation. Finally, taxpayer will receive the cash flow needed for life, will obtain the step-up in basis at death for the preferred interest, and will ensure to the extent possible that regardless of the appreciation of the underlying assets, no estate tax will be owed.
Drafting Consideration for the Partnership/Operating Agreement
In order to accomplish all the goals detailed in the above hypothetical, special attention should be given to the written operating agreement. The operating agreement should provide for a fixed annual cash distribution payable to the member holding the preferred interest before any distributions are made to the members holding the subordinate interests. The amount distributed as a qualified payment cannot be contingent on the entity earnings. Ultimately, if the four-year grace period, as described in I.R.C §2701(d)(2)(C), expires, it must be paid from capital if earnings are insufficient, or, alternatively, could be delayed to be paid not later than the eight years after the due date if the operating agreement provides that interest accrues on the unpaid distribution compounded annually at the rate prescribed under I.R.C §7520. A provision providing flexibility for the manager to issue additional units for the subordinate interest in case a different valuation of the preferred interest is finally determined by the Internal Revenue Service (“IRS”) is necessary to ensure that the subordinate interest will have a minimum of 10% equity in entity regardless of the IRS determination of value. Also, the dissolution provision should limit the participation of the members holding the preferred interest beyond the principal and preferred rate of return to avoid a higher valuation of the preferred interest.
Effective implementation of the freeze partnership technique requires working knowledge of the partnership rules, experience with the intricacies of drafting an operating agreement, and careful evaluation of the estate, gift and income tax-planning considerations. Even though, at first glance, this technique may be intimidating because of the significant complexities governed by I.R.C. §2701, when it comes to planning for holdings with negative capital, the partnership freeze technique has certain distinct advantages over a GRAT or IDGT by providing certainty as to the ability to obtain a step-up in basis upon death and transferring the appreciation in value to the next generation.
*This article was also published in the December 2020 edition of the Cleveland Bar Journal.
 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended.
 A comprehensive presentation of the special valuation rules of I.R.C §2701 is beyond the scope of this article.
 See Treas. Reg. §25.2701-2(b)(6) (a distribution right in a family controlled entity has value under I.R.C. §2701 only if it is a qualified payment right cumulative in nature and paid at least annually).
 As part of the Tax Cuts and Jobs Act of 2017, the gift and estate tax exemption amount was doubled, with the inflation-adjusted amount in 2020 being $11.58 million. The increase is set to expire December 31, 2025, but political climate may alter the expiration date.
 There is uncertainty whether the grantor’s death will give rise to a step-up in basis. For specific rules regarding property acquired from a decedent, see Treas. Reg. §1.1014-2.
 A comprehensive list of elements needed to be included in an operating agreement to accomplish the partnership freeze technique is beyond the scope of this article. The elements provided are some of the key provisions needed to accomplish the freeze and avoid the negative impact of I.R.C. §2701.