As a general proposition, all estate freeze transactions share some common characteristics. These transactions generally involve a senior generation family member (sometimes referred to as "Senior Family Member") making some form of a transfer of an asset and receiving back some form of cash-flow interest (e.g., a promissory note, a fixed annuity interest, or a preferred payment).  These transactions can be very advantageous from an estate-planning standpoint in that they can provide a means to provide a more stable priority cash-flow interest to the Senior Family Member while shifting potential future growth above that cash-flow interest to or for the benefit of junior generation family members (sometimes referred to as "Junior Family Member(s)"), or perhaps trusts for their benefit.  Thus, all of these freeze transactions involve some balancing of risk versus reward, which might fit nicely with the relative risk appetite and investment horizon of different family members. 

These transactions are broadly referred to as "estate freezes" because the Senior Family Member's "cash-flow" interest will be limited to the specific type of interest received, but those interests will not participate in future growth potential above a fixed hurdle.  The other interests, typically held by the Junior Family Members, will participate in the upside growth potential of the transferred asset. Thus, the Senior Family Member's interest is "frozen" for estate tax valuation purposes. Beyond this broad theme, the different techniques often implemented by planners will vary and shave relative pros and cons. There are different "flavors" of freeze transactions that are employed to achieve this trade-off of interests in different ways, and there are relative pros and cons that are associated with different types of freezes.  In the authors’ opinion, there is not necessarily one superior freeze technique. Rather, the most appropriate technique in a certain situation will be dependent upon a balancing of a number of factors, including cash-flow needs, investment horizon, appetite for risk and certainty versus uncertainty and complexity, desired rate of return, and multigenerational considerations.    

The most common freeze techniques include the Grantor Retained Annuity Trusts (or “GRATs”), Sales to Intentionally Defective Grantor Trusts (“IDGTs”), and Preferred Partnerships.  Each of the techniques provide alternatives to outright gifting to effectively transfer wealth to the next generations while also providing some cash-flow to the current generation, but they do have characteristics that make them unique.

Grantor Retained Annuity Trusts (GRATs)

A GRAT is a statutorily blessed vehicle under IRC section 2702, which can provide a means to essentially make a gift tax-free transfer of the future appreciation (above the IRC section 7520 interest rate) of a gifted asset without triggering any gift tax.  This is accomplished by the transfer of assets by the grantor into an irrevocable trust, called a Grantor Retained Annuity Trust, or GRAT, which provides a mandatory stream of annuity payments to the grantor for a selected term of years, with any remaining balance passing typically to or for the benefit of the remainder beneficiaries of the trust (usually the grantor’s children or trusts for their benefit). 

The value of the gift is determined upon the GRAT’s creation by calculating the present value of the remainder interest gift by subtracting the present value of the annuity stream payable to the grantor using the IRC section 7520 interest rate applicable for the month of the funding of the GRAT.  If the GRAT is “Zeroed-out” (a “Zeroed-out GRAT”), which is typical, the present value of the annuity stream is structured to roughly equal the value of the assets transferred into the GRAT.  This results in a gift of “zero” or, more accurately, near zero for gift tax purposes. If the assets in the GRAT, however, are invested to grow in excess of the annuity stream required to be paid to the grantor/annuitant, and if the grantor outlives the selected trust term, the GRAT’s assets are removed from the grantor’s estate, and the excess assets pass to the remainder beneficiaries (typically the grantor's children or trusts for their benefit) free of additional gift taxes. Essentially, this provides for a gift-tax-free transfer of the future appreciation (if any) in the assets.

The numerous technical requirements for a GRAT must be strictly adhered to in order for it to be effective.  The failure to satisfy any of these requirements, either at creation or in the subsequent administration of the GRAT, can have potentially harsh consequences.  The violation of any of these requirements could potentially cause the initial transfer into the GRAT to fail the requirements of a Qualified Interest under IRC section 2702 and accordingly trigger the zero valuation rule with respect to the grantor's retained annuity interest.  In such event, rather than the taxable gift equaling the actuarial value of the remainder interest (which, in the case of GRATs that are "zeroed out," is very close to zero), the taxable gift could instead be the entire value of the asset transferred into the GRAT from inception. 

The general inability to allocate generation skipping transfer (“GST”) tax exemption to a GRAT is one of this technique’s limitations, as it effectively prevents practitioners from structuring GRATs as multi-generational, GST-Exempt trusts.  This is because of the “estate tax inclusion period” rule (the “ETIP Rule”), which basically provides that GST-Exemption cannot be allocated to a trust during its trust term if the assets would otherwise be included in the grantor’s estate under IRC section 2036 if he or she died during that term.  If the grantor were to die during the annuity term, a portion or perhaps all of the GRAT assets would be included in his or her estate.  As a result, the ETIP Rule would preclude the grantor from allocating GST-Exemption to a GRAT until the end of the ETIP (i.e., the end of the annuity term).  Because of this limitation, there would be little if any ability to leverage the grantor’s GST-Exemption with a GRAT.  As a consequence, such assets will typically be subject to estate tax at the death of the second generation beneficiaries or will be subject to a GST tax upon a GST event at the second generation’s death.

Sale to Intentionally Defective Grantor Trust

A Sale to Intentionally Defective Grantor Trust (IDGT) is another popular type of estate freeze transaction utilized by planners.  This technique generally involves the grantor selling an asset, such as an interest in a closely held business or perhaps a family limited partnership, to a grantor trust (typically for the benefit of grantor’s children and possibly spouse) in exchange for a promissory note. The grantor typically “seeds” the trust by making a taxable gift, ideally well before any sale occurs, with an amount equal to a minimum of 10% of the total value of the assets to be transferred. Because this transaction involves a sale to the IDGT, presumably for fair market value, in exchange for a promissory note in the amount of the fair market value sale price, no taxable gift should result in theory, as the transaction is presumably a fair market value exchange rather than a gift. 

Because the grantor is selling an asset to a trust that is a grantor trust to him or her, the transaction should also not result in a gain recognition event for income tax purposes because grantor trusts are ignored for income tax purposes. It should be noted, however, that a deemed sale will occur in the event that the grantor "turns off" grantor trust status while the promissory note has an unpaid balance. 

The cash flow component of the IDGT transaction going back to the grantor consists of the promissory note plus interest imposed based upon the appropriate AFR in effect for the month and year of the sale; however, any growth in the assets held by the IDGT above the repayment of the note and AFR interest occurs in the trust and is outside of the grantor's taxable estate. The ability to shift post-sale appreciation out of the grantor's estate and into the IDGT can be quite powerful.  Furthermore, because of the grantor trust status, the grantor is obligated to pay the income taxes associated with the assets in the trust, which enables the trust’s assets to essentially grow on an income tax-free basis. The grantor pays income taxes out of his or her own assets, which would otherwise be subject to estate or gift tax at some point in the future.

One of the advantages of an IDGT transaction over a GRAT is the ability to effectuate the sale transfer of assets into a multi-generational GST-Exempt structure, thereby achieving a longer term wealth transfer structure than a GRAT, which is generally considered to be only "two generation" in nature.

The conventional wisdom is that estate tax exposure in the case of an IDGT transaction should be limited to the value of the promissory note owned by the grantor at his or her death.  It is possible, however, that the IRS might raise an argument that the promissory note itself constituted a retained interest in the sold assets, thus causing those assets to be included in the grantor’s estate under IRC section 2036. In Estate of Donald Woelbing v. Commissioner, the IRS raised the argument that the sold stock was included in the grantor's gross estate under IRC section 2036(a)(1) under the theory that the promissory note was a retained income interest in the sold stock. It would seem that such an argument would be highly facts- and circumstances-based.  Practitioners are well advised to resist the urge to simply back into the amount of the note payments based upon the anticipated income generated off of the sold assets. The IRS has also attempted to recharacterize the promissory note as a transfer with a retained interest, thus causing a deemed gift under IRC section 2702.

When planning for the lifetime transfer of hard-to-value assets, there is uncertainty as to the value that will be ultimately determined for gift tax purposes.  Consequently, there is inherent risk that a transfer of assets that is intended to fall within the grantor’s available gift tax exemption might ultimately be determined for gift tax purposes to exceed that available exemption and might cause gift tax liability with respect to the overage.  In the case of a sale to an IDGT, there is also the risk that the sale price might ultimately be determined to be for less than fair market value (as the IRS also argued in Woelbing), which could lead to additional gift tax exposure to the extent of the shortfall in the purchase price. Of course, this is not an issue that is new but rather one that estate planning practitioners have been grappling with for over 70 years, going all the way back to the Procter decision.

Preferred “Freeze” Partnerships

In its most basic form, a preferred “freeze” partnership (referred to as a “Freeze Partnership”) is a type of entity that provides one partner, typically a Senior Family Member, with an annual fixed stream of cash flow in the form of a preferred interest, while providing another partner with the future growth in the form of common interests in a transfer tax‑efficient manner. Preferred Partnerships are often referred to as “Freeze Partnerships” because they effectively contain or “freeze” the future growth of the preferred interest to the fixed rate preferred return plus its right to receive back its preferred capital upon liquidation (known as the "liquidation preference") before the common partners are entitled to anything. The preferred interests do not, however, participate in the upside growth of the partnership in excess of the preferred coupon and liquidation preference, and all that additional future appreciation inures to the benefit of the  common “growth” class of partnership interests, typically held by the younger generation or trusts for their benefit.  Over time, assuming that the Freeze Partnership’s assets are invested in such a way so as to outperform the required coupon on the preferred interest, the common interest will appreciate in value, thereby enabling future growth of the partnership (above the preferred coupon) to be shifted to the Junior Family Members that hold the common interests.

In the family context, a Freeze Partnership can provide a very useful vehicle to match the respective needs of different generational family members, in much the same way as those family members might orient their investments more heavily into equities or fixed income based upon their respective ages, cash-flow needs, risk tolerance, and investment horizon.

There are various issues that must be considered in connection with the formation of a newly created entity or the restructuring of an existing entity into a Freeze Partnership.  The most notable issue is IRC section 2701, which generally can result in a deemed gift upon a “transfer” by a Senior Family Member’s in connection with a Freeze Partnership in which he or she retains senior equity interests, unless very specific requirements are satisfied with respect to the Senior Family Member’s preferred interest.  A “transfer” that can potentially trigger a deemed gift under IRC section 2701 is broadly defined and includes not only traditional gift transfers but also capital contributions to new or existing entities, redemptions, recapitalizations, or other changes in the capital structure of an entity.

A Senior Family Member’s preferred partnership interest is most typically, but not always, structured as a “qualified payment right” under IRC section 2701 to safeguard against the Senior Family Member’s contribution of assets to the Freeze Partnership being considered a deemed gift under the IRC section 2701 “zero valuation” rule.  The use of this “qualified payment right” structure will result in the Senior Family Member’s retained preferred interest being valued under traditional valuation principles for gift tax purposes and not under the unfavorable “zero valuation rule” of IRC section 2701. This generally requires that the Senior Family Member’s preferred interest be structured as a fixed percentage return on capital, that is payable at least annually and on a cumulative basis.  Even if the preferred interest is structured as a qualified payment right, it is critical that no “extraordinary payment rights” be retained by the Senior Family Member in order to avoid the “lower of” rule.

Even if the Senior Family Member’s preferred interest is properly structured to avoid the "zero value” deemed gift rule under IRC section 2701, there are still other gift tax issues to consider under traditional gift tax principles. Properly structuring the frozen preferred interest merely avoids the distribution right component of the Senior Family Member’s preferred interest being valued at zero under the Subtraction Method of valuation for purposes of determining whether and to what extent a deemed gift has been made to Junior Family Members in connection with the transfer. There might still, however, be a partial gift under traditional valuation principles if the Senior Family Member’s retained preferred coupon is less than what it should be when measured against an arm’s length transaction.  Vital to arriving at the proper coupon rate is the retention of a qualified appraiser to prepare a valuation appraisal to determine the preferred coupon required for the Senior Family Member to receive value equal to par for his or her capital contribution.  In preparation of the appraisal, the appraiser will typically take into account the factors set forth by the IRS in Revenue Ruling 83-120.

Unfortunately, there is no black and white test as to what will constitute sufficient evidence that a preferred interest in a partnership is an equity interest. To address this uncertainty, the planner might consider "stapling" a participation feature to the preferred interest, thereby creating a hybrid interest to further support the position that the preferred interest is an equity interest in the Freeze Partnership.

Structuring a Freeze Partnership requires balancing competing factors from an income tax and transfer tax perspective.  In drafting the provisions relevant to the preferred coupon, it is necessary to balance the following income tax and transfer tax concepts, which do not necessarily overlap smoothly. In addition to the IRC section 2701 gift tax issues and the estate tax issues mentioned above, partnership income tax issues must be considered in connection with the formation of the partnership to protect against the recognition of gain as a result of the contribution of assets into the Freeze Partnership.

In the case of partnership assets consisting of securities, there should be no recognition of gain as a result of the capitalization of the partnership if no “diversification” occurs under IRC section 721(b) as a result of a partner’s capital contribution.  Accordingly, if both partners already have diversified portfolios, then the contribution by them of their portfolios into the Freeze Partnership should not result in gain under the IRC section 721(b) diversification rule. 

In addition, it is critical that the contribution of assets into the Freeze Partnership is not considered to be a disguised sale. To address this issue, one could structure the preferred coupon to fall within the reasonable payment safe harbor by ensuring that the preferred payment does not exceed 150% of the highest applicable federal rate, but this might present difficulties given the low interest rates and the higher required preferred coupon that would typically be determined under Revenue Ruling 83-120.  An alternative safe harbor to the reasonable payment is available for operating cash flow distributions, which are not presumed to be disguised sales unless the facts and circumstances clearly suggest otherwise.  An operating cash flow distribution is a transfer of money by a partnership to a partner that does not exceed the partnership's net cash flow from operations, multiplied by the lesser of (i) the partner's percentage interest in partnership profits for the tax year in question,] or (ii) the partner's percentage interest in overall partnership profits for the life of the partnership.  Care should be taken if adopting a safe harbor approach to confirm that the partnership complies with the technical requirements of both the operating cash flow safe harbor and the Qualified Payment Right under IRC section 2701, including possibly making a protective Qualified Payment Right election.

Failure to satisfy the disguised sale regulatory safe harbor does not necessarily mean that a preferred payment is not "reasonable;" rather, it simply means that the safe harbor cannot be relied upon.  Given that the rate of return is being determined by an independent appraisal to reflect a market rate of return, presumably based upon the IRS’ articulated valuation factors as set forth in Revenue Ruling 83-120, a good argument should exist that the preferred payment should be reasonable and thus the facts do not "clearly establish" that the payment of the preferred return is part of a disguised sale.

N. Todd Angkatavanich, JD, LLM (taxation) is a principal in Ernst & Young’s National Tax Department, Private Client Services Group. Todd previously co-headed the U.S Private Client & Tax Group at the private client law firm Withers Bergman LLP. He focuses on representing domestic and international families and family offices in structuring multigenerational wealth transfer, preservation and business succession vehicles, with an emphasis on navigating the transfer tax pitfalls that often arise under Chapter 14 of the Code. At the same time, he assists families with introducing the next generation(s) to the non-tax concepts of engagement and flexible stewardship so as to achieve effective long-term wealth preservation coupled with beneficial enjoyment. He has experience structuring GRATs, sales to grantor trusts, family limited partnerships and preferred partnerships, succession structures and dynasty trusts. He also has had experience with international planning including foreign grantor and non-grantor trusts, preexpatriation and related projects. Todd is also an ACTEC Fellow and frequent speaker at conferences including the Heckerling Estate Planning Institute, serves on the Editorial Boards of Trusts & Estates and BNA Tax Management and is co-author of a BNA Portfolio on Wealth Transfer Planning with Carried Interests. He enjoys collaborating on client, industry and business development initiatives.

Jonathan Mayer, CPA, is a senior manager with Ernst and Young's private client services practice. He passionately serves dynamic privately held businesses, their owners, and their families with tax planning and succession planning matters. He also serves ultra-high net-worth families and their related family offices, investment partnerships, and complex trust structures.  Jonathan has over 11 years of tax compliance and tax consulting experience, responsible for service delivery covering individuals, partnerships, S corporations, private foundations, estates and trusts.  He was recently honored by the AICPA with the Personal Financial Planning Standing Ovation award for exceptional professional achievement and his contributions to personal financial planning. He can be reached at jonathan.mayer2@ey.com.