Family Investment Partnerships: Beyond the Valuation Discount

May 2013

Family Investment Partnerships: Beyond the Valuation Discount

Paul S. Lee, J.D., LL.M.

National Managing Director

This presentation is provided by AllianceBernstein L.P. Bernstein Global Wealth Management is a unit of AllianceBernstein L.P. This presentation booklet has been provided to you for use in a private and confidential meeting to discuss a potential or existing investment advisory relationship. This presentation is not an advertisement and is not intended for public use or distribution beyond our private meeting. Bernstein does not provide tax, legal or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.

FIPs: Beyond the Valuation Discount Bernstein.com 1

Bernstein does not provide tax, legal or accounting

advice. In considering this material, you should discuss

your individual circumstances with professionals in

those areas before making any decisions.


Family Investment Partnerships

Not just about the valuation discount

Cases mandate lower discount than illiquid assets

“Disregarded restrictions” (Obama Administration “Green Book”)

“Nonbusiness/passive assets” (H.R. 436)

Alternative Design Structures

Chapter 14 (groan)

Investment Implications

Income Tax and Partnership Accounting Issues

Estate Planning Applications

Securities Law Issues and New Legislation


Non-Tax Reasons for Forming a Family Investment Partnership

Control

Centralized (and hopefully competent) management of investments

Reduction of expenses

Expanded investment opportunities

Creditor protection

Platform for resolution of family disputes

Facilitate or enhance other estate planning techniques


Choice of Entity

Limited Partnerships

S Corporations

Regulated Investment Companies

“Multi-Series LLCs”

Taxation Flexibility Limited Liability

Limited Liability Companies


Chapter 14: Section 2036(c) Repealed

[10%] per annum

x

Fixed Liquidation Amount

+

Voting Rights

+

Put & Call Rights

+

Conversion Right

Class A (Preferred) Class B (Common)

Preferred FLP

Excess Return

Over

Preferred Stock

100% = Value = 0%


Replaced by Section 2701

Transfer of Partnership Interest

Member of the Transferor’s Family

Applicable Retained Interest

Zero Valuation

• Contribution to capital • Redemption • Recapitalization • Change in capital structure

• Spouse • Lineal Descendant • Spouse of Lineal Descendant

• Distribution Right with “Control” Entity • Liquidation, Put, Call or Conversion Right

Subtraction Method


Exceptions to 2701 or Zero Valuation

Exceptions to Section 2701

Market Quotation

Same Class and Proportional Class

Vertical Slice

Guaranteed Payment

Mandatory Payment right

Junior or Subordinate Interest

Exceptions to Zero Valuation

Qualified Payment Right

Deemed Qualified Payment Right

Subtraction Method Does Not

Apply

(Normal Gift Tax

Rules)

Subtraction Method Applies


Subtraction Method

Step 1: Determine

Step 2: Subtract

Step 3: Allocate

Step 4: Apply

10% Minimum Value Rule

Fair Market Value of All Family Held Interests

Value of Senior Equity Interests

Balance Among the Transferred Interests

Certain Discounts & Other Appropriate Deductions

Not Liquidation Value but No Discount for

Minority Interest

Zero Value Or

Qualified Payment Interest

Discounts for: Minority Interest

Lack of Marketability Subordination

Not Necessarily a “Phantom” Gift


Qualified Payment Interest

Step 1: Determine

Step 2: Subtract

Step 3: Allocate

Step 4: Apply

Fair Market Value of All Family Held Interests

Value of Senior Equity Interests

Qualified Payment • Payable At Least Annually • 4 Yr. Deferral Allowed • Fixed Rate at a “Discount Rate” • Cumulative • Lower of Rule for Extraordinary Payment Rights

Deemed Qualified Payment • Election to treat a distribution right as a QP • Payments in specified amounts and times


Single Class Share FLPs

Gen. 1

Family

Members Gen. 2

Family

Members

Gen. 3

Family

Members

Single Class Share

50%

30%

20%

Tax Items Distributions

Typical Terms Distributions and beneficial interests pro rata according to relative capital accounts Income Tax All tax items shared pro rata according to relative capital accounts Chapter 14 Implications Same Class and Proportional Class Exceptions apply



Gen. 1

Family

Members Gen. 2

Family

Members

Gen. 3

Family

Members

Single Class Share

? % Stocks

? % Taxables

40% Stocks

60% Munis 70% Stocks

30% Munis

90% Stocks

10% Taxables

50%

30%

20%

Tax Items Distributions Investment Implications • Investment strategy (asset allocation) shared by all family members • Allows for unified, rebalanced portfolio


Multi-Series LLC

Gen. 1

Family

Members Gen. 2

Family

Members

Gen. 3

Family

Members

Multi-Series

Family, LLC

40% Stocks


30% Munis

90% Stocks

10% Taxables

U.S.

Stocks

Municipal

Bonds

Taxable

Bonds

Foreign

Stocks

Hedge

Funds

Venture

Capital

REITs


Multi-Series LLC: Customizing Asset Allocation

Gen. 1

Family

Members Gen. 2

Family

Members

Gen. 3

Family

Members

Multi-Series

Family, LLC

40% Stocks


30% Munis

90% Stocks

10% Taxables

U.S.

Stocks

Municipal

Bonds

Taxable

Bonds

Foreign

Stocks

Hedge

Funds

Venture

Capital

REITs

28% 12%

60%


Multi-Series LLC: Customizing Asset Allocation

Gen. 2

Family

Members

Gen. 3

Family

Members

Multi-Series

Family, LLC

70% Stocks

30% Munis

90% Stocks

10% Taxables

Global

Stocks

Municipal

Bonds

Taxable

Bonds

Foreign

Stocks

Hedge

Funds

Venture

Capital

REITs

Gen. 1

Family

Members

40% Stocks

60% Munis


Multi-Series LLC: Consider Fully Diversified “Classes”

Gen. 2

Family

Members

Gen. 3

Family

Members

Multi-Series

Family, LLC

70% Stocks

30% Munis

90% Stocks

10% Taxables

Fully

Diversified

(20/80)

Taxable

Bonds

Fully

Diversified

(80/20)

Gen. 1

Family

Members

40% Stocks

60% Munis

Municipal

Bonds

REITs

Hedge

Funds

Venture

Capital


Preferred FLPs: Typical Terms (Simplified)

_____% per annum

x

Fixed Liquidation Amount


Preferred FLP Excess Return

Over

Preference

PREFERRED SHARES

Preferred Return:

Annual Distribution Payable at Fixed Rate

Cumulative

Liquidation Preference:

Fixed Amount + Unpaid Preference

Valuation:

Fixed Liquidation Amount (No Discount)

COMMON SHARES

Return:

No Distributions Until Preferred Return Paid

Excess Return Above Cumulative Preferred Return

Liquidation:

All Assets After Liquidation Preference to Preferred

Valuation:

Minority, Lack of Marketability & Subordination Discount


Preferred FLPs: Investment Implications


Preferred FLP

Preferred Return

And Distributions

Excess Return

Investment Implications • Preferred holder has fixed return (like a bond) • Common holder has excess return (like equity) • Allows for unified, rebalanced portfolio

? % Stocks

? % Taxables

Gen. 1

Family

Members

Gen. 3

Family

Members

40% Stocks

60% Munis

90% Stocks

10% Taxables


Qualified Payment Preferred FLPs

Class A

(Preferred)

Preferred FLP

Income Tax Depends on allocations of profit & loss Chapter 14 Implications • Valued in Step 2 of the Subtraction Method • Depends on Methodology or “Discount Rate”

PREFERRED CHARACTERISTICS

Preferred Return:

• Annual Distribution Payable

• Yield at Fixed Rate

• Not Dependent on Profits

• Cumulative

• 4 Year Deferral

• Voting Rights if Traditional Freeze

Liquidation Preference:

• Fixed Amount + Unpaid Preference

• Callable at death (Mandatory Payment)

Valuation:

• Fixed Liquidation Amount (No Discount)


Rev. Rul. 83-120, 1983-2 C.B. 170

Major factors

Yield

Dividend Coverage

Dissolution Protection

Minor Factors

Voting rights

Lack of marketability

“high-grade, publicly traded preferred stocks”

Preferred Stock Yields

6% to 14%

Financial Services

Oil & Gas

Real Estate

Preferred Stock Sectors


Qualified Payment Preferred FLPs: Private Annuity?

Class A

(Preferred)

Preferred FLP

Private Annuity • Section 7520 • Mortality Tables and Valuation Factors in 20.2031-7(d) • IRS Publication 1457 • 110 Year Exhaustion Test • PLR 9324018 (Section 7520 not appropriate if in perpetuity and closely-held)


Qualified Payment Preferred FLPs: Others

Class A

(Preferred)

Preferred FLP

Deemed Qualified Payment • Not an exception to Section 2701 • Valued in Step 2 of Subtraction Method • Depends on the Discount Rate Mandatory Payment Right • Exception to Section 2701. • Valued according to regular gift tax rules. • Right to a required payment at a specified time. • Includes right to receive specified amount at death. • Includes right to receive amount upon certain date or change of control.


Guaranteed Payment Preferred FLPs

Class A

(Preferred)

Preferred FLP

Chapter 14 Implications • Exception to Section 2701 • Valued according to regular gift tax rules • Fixed rate and not contingent as to amount or time Income Tax • Ordinary income to preferred holder • Deductible by partnership • Does not effect capital accounts other than to reflect payment and deduction

Guaranteed Payment • Payments to a partner for the use of capital • Not dependent or contingent on profits • Reasonable guaranteed payment is 150% of the AFR (for disguised sale purposes)


Profits Preferred FLPs

Lee Wendell & Mil Hatcher Richard Dees

Jonathan Rikoon


Capital Account Maintenance

“Substantial Economic Effect”

Economic equivalence or targeted capital accounts

Capital accounts adjusted so a liquidation would produce same economic effect

Revaluation Events

Contributions

Admission of new partners

Liquidation or distributions

Periodic revaluations if substantially all assets publicly-traded


Possible Capital Shifts?


AB Preferred FLP 7% per annum

x

$5 Mil.

$5 Mil.

Common

Year 1: No Profits or Losses

Initial Capital Account

$5,000,000

Initial Capital Account

$5,000,000

Resulting Capital Account

$5,350,000

Resulting Capital Account

$4,650,000


Contribution of Assets In-Kind

Family Member

Investment FLP

704(c) Allocations

Differences in book value

& tax basis under 704(c)

Must be made

property-by-property (no aggregation)

Rev. Proc. 2001-36

PLR 200438029 PLR 200633019

Assets-in-kind

Non-taxable event

Unless FLP is “Investment Company”

721(b) and 351(e)

Exception for

“Diversified portfolio”

“Insignificant amount”

All section ( ) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.


Allocation of Profit and Loss


All tax items allocating according to net capital appreciation or depreciation

of the capital accounts for the year

If none, according to relative capital accounts

Qualified Payment Preferred FLPs

Layer Cake

First, to all partners to offset prior losses

Second, to preferred partners until capital accounts equal unreturned

contributions

Third, to preferred partners up to preferred return

Fourth, to common partners

Target/Relative Capital Accounts

Targeted capital account

Tax items shared according to relative capital accounts

Who gets the losses first?

What if there are insufficient

profits?

Special allocations afterwards?


Reverse 704(c) Allocations with Securities Partnerships

Stock 1

$100

(bought)

Stock 2

$200

(bought)

Stock 1

$400

(Value)

Stock 2

$1,000

(Value)

Year 1 AB Partnership Purchases Stock

Year 2 Admits Equal Partner C

Year 3 ABC Partnership Sells Stock 1

Stock 1

$700

(Sold)

Stock 2

$1,000

(Value)

“Detailed” Reverse 704(c)

Partner A: $250

Partner B: $250

Partner C: $100

$300 Unrealized

Gain Year 2

A & B

$300 Unrealized

Gain Year 3

A, B & C

“Aggregate” Reverse 704(c)

Partner A: $278

Partner B: $278

Partner C: $44


“Mixing Bowl” Transactions & Distributions In-Kind

Contributing

Partner

Investment FLP

Capital accounts unaffected

Outside basis of contributing partner and inside basis of property automatically

adjusted (no 754 election)

Recognition of Gain/Loss

Contributed property

Distributed to any other partner

or Receive other property

Within 7 years

Other

Partner


Remember: Distributions of securities

will not be considered distributions of cash if

“investment partnership” under 731(c)(3)(C)


Withdrawing Partners with No Section 754 Election

75%

Remaining

Partners B,C & D

25%

Withdrawing

Partner A


ABCD Investment FLP

Partnership Sells $200 Basis $300 Value

A’s Partnership Interest

$200 Basis

$300 Value

$75 Gain $25 Gain Allocation under 704(b)

$225 Basis

$300 Value

$75 Gain Redemption under 731

$225 Basis

$300 Value


The “Stuffing” Solution

75%

Remaining

Partners B,C & D

25%

Withdrawing

Partner A

ABCD Investment FLP

A’s Partnership Interest

$200 Basis

$300 Value

$0 Gain $100 Gain “Stuffing” under 704(b)

$300 Basis

$300 Value

$0 Gain Redemption under 731

$300 Basis

$300 Value


Partnership Sells $200 Basis $300 Value


Constructive Sales

Section 1259

Recognition of gain

Appreciated financial position

Shorts or other hedges that transfer substantially

all of the asset’s risk and return

Activities of related persons are attributed to

taxpayer


Family Member

Investment FLP

“Long/Short” Hedge Fund Investment


Straddle Rules

Section 1092

Deferral of loss upon disposition of straddle

Straddles:

Positions that are valued on an established market,

That can be sold, exchanged or otherwise liquidated,

and

The value change in one position will result in an

inverse change in value in the offsetting position.

Includes:

Short sales while holding a long position in the stock

Any short position in “substantially similar” property

Applies to outside holdings if pass-thru entity

establishes position


Family Member

Investment FLP

“Long/Short” Hedge Fund Investment


The “Permanent” Fix to the Wealth Transfer Tax System

“American Tax Relief Act of 2012*”

Reunification of Gift, Estate and Generation-Skipping Transfer Tax

$5.25 million Applicable Exclusion Amount for 2013 (indexed from 2011)

40% maximum rate

Portability of “Deceased Spousal Unused Exclusion Amount”

No Sunset Provision

*P.L. 112-240, enacted January 2, 2013

Don’t forget about the income tax rates…


Gift of the Common: The Perfect Applicable Exclusion Gift?


Preferred FLP

Estate Tax Exclusion

GST Tax Exclusion

Transfer Tax Rate

Gift of Common Interest

$5.25 Mil.

Paradigm Shift: The ATRA-Math Bernstein.com 36

Splitting Income with Investment Partnerships and LLCs

STCG/Ordinary Rate Single Joint

10% $0-$8,925 $0-$17,850

15% $8,926-$36,250 $17,851-$72,500

25% $36,251-$87,850 $72,501-$146,400

28% $87,851-$183,250 $146,401-$223,050

33% $183,251-$398,350 $223,051-$398,350

35% $398,351-$400,000 $398,351-$450,000

39.6% $400,001+ $450,001+

LTCG/QD Rate Single Joint

0% $0-36,250 $0-$72,500

15% $36,251-$200,000 AGI $72,501-$250,000 AGI

18.8% $200,001 AGI-$400,000 $250,001 AGI -$450,000

23.8% $400,001+ $450,001+

$52,354 tax savings $42,236 tax savings

Non-Grantor Trusts

hit highest tax bracket

@ $11,950 taxable income

31.8% with surcharge




Running the Brackets

Split the income, not necessarily the cash flow: S corporation, LLC and LP shares

FIPs: Beyond the Valuation Discount Bernstein.com

0

2

4

6

8

10

12

89 91 93 95 97 99 01 03 05 07 09 11 13

37

Still Extremely Low AFR and Section 7520 Rates

Section 7520 Rate (%)**

Average: 6.0%

May 2013 (1.2%)

6.60% 6.80% 6.77%

2.54%

3.84%

4.80%

0.20% 1.00%

2.60%

0.16% 0.84%

2.18%

Short-Term Mid-Term Long-Term

May 2013

(Annual)

Max.

Min.

Applicable Federal Rates*

Jan. 1998–May 2013

*Section 1274(d) of the Internal Revenue Code of 1986, as amended (Code), compounded annually.

**Code Section 7520. As of May 2013.

Source: Internal Revenue Service (IRS) and AllianceBernstein

Installment Sales to IDGTs

&

Intra-Family Loans

GRATs

&

CLATs

Qualified Payment

(Rev. Rul. 83-120) 8-10%

Guaranteed Payment

4.91% (150% of AFR)

Bernstein.com Paradigm Shift: The ATRA-Math 38

What about a 100 Year GRAT? … 360 Year GRAT?

0%

50%

100%

Today 10 Yrs. 20 Yrs. 30 Yrs. 40 Yrs. 50 Yrs

Mortality Risk*

80 Yr. Old

70 Yr. Old

60 Yr. Old

50 Yr. Old

0%

2%

4%

6%

8%

10%

12%

14%

16%

Today 2023 2033 2043 2053 2063

Projected 7520 Rate**

10th Percentile

Median

90th Percentile

*Based on 2000-RP mortality tables, single life, male.

**”Today” is 7/1/12. Based on Bernstein estimates of the range of returns for the applicable capital markets over the periods analyzed. Source: AllianceBernstein

Historical Average

Bernstein.com Paradigm Shift: The ATRA-Math

12.0%10.4%

2.0% 2.5%

6.2% 6.7%

1.2% 1.72%

Section 7520 Rate Global Equity Return

39

What about a 100 Year GRAT? … 360 Year GRAT?

Year 20: Projected 7520 Rate & Annualized Returns

96.1% Probability

7520 Rate is ≥ 1.2% Return Needed for

$172,254 Annuity

*See 20.2036-1(c)(2)(iii), examples 1 and 2. **Based on Bernstein’s estimates of the range of returns for the applicable capital markets over the periods analyzed. Source: AllianceBernstein

50%

90%

10%

95%

5%

Probability

$10 Mil. Contribution

“Zeroed-Out” GRAT

§ 20.2036-1(c)(2): Maximum Amount Includible*

7520 100 Year GRAT 360 Year GRAT

Rate ($172,254 Annuity) ($121,660 Annuity)

1.2% 14,354,479$ 10,138,351$

2.0% 8,612,687$ 6,083,011$

3.0% 5,741,792$ 4,055,340$

4.0% 4,306,344$ 3,041,505$

5.0% 3,445,075$ 2,433,204$

6.0% 2,870,896$ 2,027,670$

7.0% 2,460,768$ 1,738,003$

Bernstein.com Paradigm Shift: The ATRA-Math 40

GRAT Does Not Need to Be 100 Years

Source: AllianceBernstein

50 Year GRAT 7520 Rate at Death § 20.2036-1(c)(2): Amt. Incl.

Annuity 267,126.84$ 1.2% 22,260,569.64$

Interest Rate 1.2% 2.0% 13,356,341.78$

Years 50 3.0% 8,904,227.85$

PV of Grantor's Retained Interest 10,000,000$ 4.0% 6,678,170.89$

Annuity Factor 37.43540022 5.0% 5,342,536.71$

Life Factor 0.449224803 6.0% 4,452,113.93$

Remainder Factor 0.550775197 7.0% 3,816,097.65$


Annuity 234,761.45$ 1.2% 19,563,454.43$

Interest Rate 1.2% 2.0% 11,738,072.66$

Years 60 3.0% 7,825,381.77$


Annuity Factor 42.59643082 5.0% 4,695,229.06$

Life Factor 0.51115717 6.0% 3,912,690.89$



Annuity 211,967.13$ 1.2% 17,663,927.83$

Interest Rate 1.2% 2.0% 10,598,356.70$

Years 70 3.0% 7,065,571.13$


Annuity Factor 47.17712512 5.0% 4,239,342.68$

Life Factor 0.566125501 6.0% 3,532,785.57$


The Most Compelling Planning Opportunities Today Bernstein.com 41

“Intentionally Defective” Grantor Charitable Lead Trusts

GRANTOR

CHARITABLE

LEAD ANNUITY

TRUST

GRANTOR

BENEFICIARIES

Remainder

Contribution

Annuity

CHARITY

170(a)

Deduction

Charitable Lead Trusts, as defined under Sections 170, 170A, 2055 and 2522 of the Internal Revenue Code of 1986, as amended from time to time (the “Code”), and the Treasury Regulations thereunder.

3 Month Rule for Charitable Trusts

7520(a) election

May 2013 rate of 1.2%

Effective thru July 2013


Rev. Proc. 2007–45, 2007–29 IRB 89

Guaranteed Annuity

Determinable amount

Paid periodically

Not less than annually

Payment Requirements

Not subject to any minimum or maximum payout

May provide for an annuity amount that is:

Fixed dollar

But increases during the annuity period

Provided that the value of the annuity is ascertainable at the time the trust is funded


1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Level 120% 150%

Value ($ Mil.)

Possible Guaranteed Annuities ($10 Mil. CLAT for 20 Years)

6.0

4.0

2.0

$565 K

$64 K $1.9 K

Cumulative to Charity Fixed: $11.3 Mil. 120%: $12.0 Mil. 150%: $12.4 Mil.

$565 K

$2.1 Mil.

$4.1 Mil.

Initial Annuity

Final Annuity


1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Level 120% 150% Shark-Fin

$563 K

$2.1 Mil.

$12.7 Mil.

Final Annuity

4.0

12.0

Value ($ Mil.)

Cumulative to Charity Fixed: $11.3 Mil. 120%: $12.0 Mil. 150%: $12.4 Mil.

Shark-Fin: $12.7 Mil.

$1,000

Initial Annuity

$4.1 Mil.

16.0

Possible Guaranteed Annuities?

8.0


Preferred + 6% Shark-Fin

Preferred Investment FLP or LLC in a Defective Shark-Fin CLAT

What about excess business holdings under § 4943?

Preferred Investment

LP or LLC Interest

(Junior Equity Exception

to 2701)

$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

Preferred Payments


Securities Laws Implications: Dodd-Frank Act

Securities Act of 1933

Investment Company Act of 1940

Investment Advisers Act of 1940

Regulation D • 35 “non-accredited” investors • Unlimited “accredited investors”

Section 3(c)(1) • 100 beneficial owners Section 3(c)(7) • “Qualified Purchaser”

Section 203(b)(3) • “Private adviser” exception • 15 clients

Eliminate “Private Adviser” Exemption • “Private funds” defined • “Family offices” exempted • SEC Release IA-3220 (6/22/11) • Final Rule 202(a)(11)(G)-1 (8/29/11)

Dodd-Frank Act (Effective July 21, 2011)


Family Office Exemption

“Family Client” includes:

Spouses

Former Spouses

Spousal equivalents

Adopted children

Foster children

Former family members

Trust solely for family clients

Family owned companies

G1

G2 G2

G3 G3 G3

G4 G4 G4

G5 G5 G5

G6 G6 G6 G6 G6 G6

G7

G8

G9

G10 G10 G10 G10 G10

G11

G12

G13

G14 G14 G14 G14 G14 G14 G14

ancestor of original

family office re-designated ancestor

of new family office


“Qualified Purchasers”

FLP is a “Qualified Purchaser”

FLP with $25 million in investments

All FLP partners are “qualified purchasers”

Individuals with $5 mil. in investments (incl. spouse)

Trust with $25 mil. in investments

Trust with $5 mil. in investments and all trustees and

grantors have $5 mil. in investments

FLP with $5 million in investments, owned by

2 or more persons who are related as siblings or spouse

(incl. former spouses), or direct lineal descendants (by birth

or adoption)

Spouses of such persons

Estates of such persons

Trusts established by or for the benefit of such persons

Foundations or charitable organizations

Family Member

Investment FLP

Hedge Fund Investment

Family Investment Partnerships: Beyond the Valuation Discount

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Transcript of Family Investment Partnerships: Beyond the Valuation Discount