Preferred limited partnerships - Now the FLPs of choice?

Journal of Taxation

Volumn 89, Issue 6, 1998, Pages 325-342

  Hatcher Jr , Milford B ^a,b   Kniesel, Gregory E ^a,c,d,e  

^a Atlanta Office   (United States)

^b State Bar of Georgia ^*  (United States)

^c FMV Opinions Inc

^d ESOP Association

^e American Society of Appraiser   (United States)

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EID: 33749140555     PISSN: 00224863     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (57)

1. This article will assume that all partners are family members. Slightly different rules would apply if nonfamily members were partners. This article also assumes that the preferred interests are limited as to distributions (i.e., nonparticipating).
2. The preferred rates will vary weekly, or even daily. In general, preferred rates will fluctuate in the same direction as interest rates, but preferred rates tend to be fairly volatile and from time to time will go up or go down while interest rates are headed in the other direction.
3. If the accrued but unpaid net-cash-flow preference is not satisfied in full by the end of the fourth year following the year of accrual, the unpaid balance will compound retroactively to the end of the year of accrual at the stated net-cash-flow preference rate. See Section 2701(d) and Reg. 25.2701-4.
4. Sections 2701(a)(3)(A) and (c)(3); Reg. 25.2701-1(a)(2)(ii). But see Section 2701 (c)(3)(C)(ii), which permits certain distribution rights not otherwise meeting the definition of "qualified payments" to be treated as such.
5. See Reg. 25.2701-1(a)(2) and Rev. Rul. 83-120, 1983-2 CB 170.
6. Sections 2701(a)(1) and (3)(A), (b)(1)(B), and (c)(2); Reg. 25.2701-1(a)(2)(i).
7. Section 2701(a)(4); Reg. 25.2701-3(c).
8. Regs. 25.2701-1(a)(2) and 25.2701-3.
9. See note 7, supra.
10. see Section 2704(b) and Regs. 25.2704-2(a) and (c).
11. Section 2704(b)(3)(B) and Reg. 25.2704-2(b).
12. See Section 2704(b)(2)(B)(ii) and Reg. 25.2704-2(b).
13. See Section 2703.
14. Reg. 20.2031-3.
15. See H. Rep't 101-964, 101st Cong., 2d Sess. 157 (Statement of the Managers, 10/26/90), 1991-2 CB 606 (RRA '90 Conference Report), which states that minority and other "fragmentation discounts" still may be taken into account. See also Reg. 25.2701-3(b)(4).
16. Id.
17. Id.
18. The 35%-to-45% discount is substantially influenced by the 80%-preferred/20%-nonpreferred capital structure. Lesser discounts probably would be in order for materially lesser weightings of preferred interests, such as 50%-preferred/50%-nonpreferred.
19. The reduction in the net-cash-flow preference from 8% to 7.5% should not cause the value of the preferred interests to drop below the $80 dissolution preference. The better matching of the net-cash-flow preference to the PLP's projected cash flow, without having to rely on capital gains or in-kind distributions, should justify the net-cash-flow preference reduction without adversely affecting the value of the preferred interests.
20. See note 8, supra.
21. Reg. 25.2701-1(b)(2). See Section 2701(e)(5).
22. See Reg. 25.2701-3(a).
23. Reg. 25.2701-1(a)(2).
24. Rev. Rul. 83-120, 1983-2 CB 170, goes on to state that actual payment of dividends, and not just the ability to pay, will be taken into account in evaluating dividend coverage.
25. See Reg. 25.2701-3. Although Reg. 25.2701-3(b) expressly adopts a four-step approach, two other steps are effectively required by Regs. 25.2701-3(b)(4)(iv) and-3(c).
26. See Reg. 25.2701-3(b). See also note 1, supra.
27. See Section 2701(a)(4) and Regs. 25.2701-3(b)(4)(ii) and -3(c).
28. See Reg. 25.2701-3(b)(4)(iv). The Regulations literally may call for a gift to be constructively received if the value of the respective partner's nonpreferred interests, calculated through the first five steps, exceeds the actual value of those nonpreferred interests, calculated without regard to Section 2701. It is difficult, however, to conceive of a gift having occurred in an economic loss situation where the consideration exchanged for the nonpreferred interests, as opposed to the value of the nonpreferred interests received therefor, exceeds the value of these nonpreferred interests, as determined under the first five steps of the subtraction method.
29. See Section 2701(a)(2)(C) and Reg. 25.2701-1(c)(4).
30. The same result would follow by applying the six steps of the subtraction method pursuant to Regs. 25.2701-3(b) and (c).
31. See Section 2701(e)(5); Regs. 25.2701-1(a)(3), -1(b)(2)(B), and-3.
32. Compare Reg. 25.2701-1(a)(3) with Reg. 25.2701-3(b)(1)(i).
33. Step 2, as set forth in Reg. 25.2701-3(b)(2)(i), does not apply to any preferred interests received by the transferor as consideration for the transfer. Nevertheless, the last sentence of Reg. 25.2701-3(b)(4)(iv) requires the value of the preferred interests received in the recapitalization to be subtracted, and Step 2 would seem to be the logical place for such subtraction.
34. See note 27, supra.
35. See Reg. 25.2701-3(b)(4)(iv). The position taken by the Regulations is probably more supportable in a recapitalization context than in an initial contributions context, although there is still some possibility that a true economic loss will questionably be transformed into a taxable gift under the Regulations' approach. See the text and example following note 26, supra.
36. See Reg. 25.2701-3(a).
37. See Regs. 25.2701-1(a)(1) and (2).
38. See note 27, supra.
39. See Reg. 25.2701-3(b)(4)(iv). The position taken by the Regulations is probably more supportable in a transfer context, where the value of what is given up is expected to equal the value of what is received; otherwise, a gift is a distinct possibility.
40. See Reg. 25.2701-3(b)(4)(ii).
41. See Rev. Rul. 93-12, 1993-1 CB 202.
42. This 7% annually compounded appreciation is the same as would result, in all probability, under Section 2701(d) if no dividends are paid. In fact, substantial distributions with respect to the preferred interests are anticipated. If these distributions are likely to be consumed for living expenses, this 7% annually compounded appreciation assumption would overstate the value that is includable for ultimate estate tax purposes and is attributable to the retained preferred interests. If these distributions are reinvested in a manner that generates a 10% annually compounded return, the value includable for ultimate estate tax purposes and attributable to the retained preferred interests would be understated.
43. See Section 2704(a). See also TAM 9804001.
44. See Mulligan, "Sale to an Intentionally Defective Irrevocable Trust for a Balloon Note - An End Run Around Chapter 14?," 32 U. Miami/Heckerling Inst. on Est. Plan. 15-1 through 15-41 (1998), for a reasonably detailed analysis of installment sales to a grantor trust.
45. See Ltr. Rul. 9535026, which at least implicitly raises the specter of any number of transfer tax risks, including Sections 2036, 2701, and 2702, if it is anticipated or reasonably foreseeable at the time of the sale that the installment note would not be paid according to its terms or if the trust's ability to pay the installment note is in doubt. Generally, assets other than those being sold for the installment note must be available to help pay the debt service. Those additional assets may be in the form of "old and cold" prior gifts or personal guarantees. In the absence of such other assets, the Section 2036 risk in regard to the grantor trust would be quite substantial. See Mulligan, supra note 44, pages 15-6 through 15-11 and 15-21 through 15-26.
46. If the accrued but unpaid net-cash-flow preference is not satisfied in full by the end of the fourth year following the year of accrual, the unpaid balance will compound retroactively to the end of the year of accrual at the stated net-cash-flow preference rate. See Section 2701(d) and Reg. 25.2701-4. If the PLP's cash flow is not initially expected to be sufficient to satisfy the net-cash-flow preference (except possibly with long-term capital gains or an in-kind contribution), a protective election under Section 2701(c)(3)(C)(ii) may be advisable, although it is probably not required.
47. Section 7872; see Frazee, 98 TC 554 (1992), and Ltr. Rul. 9535026.
48. Id.
49. See Rev. Rul. 98-43, 1998-36 IRB 9.
50. See the discussion in the text, above, under "Valuation of Preferred Stock."
51. See Madorin, 84 TC 667 (1985), Reg. 1.1001-2(c), Example (5), and Rev. Rul. 77-402, 1977-2 CB 222. See also Mulligan, supra note 44, pages 15-36 through 15-38.
52. Section 1014.
53. See Sections 1014(c) and 691.
54. See Sections 754 and 743(b).
55. See Sections 671 et seq. and Rev. Rul. 85-13, 1985-1 CB 184.
56. Section 1361(b)(1)(B).
57. Section 1361(c)(2)(A)(i).