The freeze partnership is an often overlooked estate tax planning tool. Unlike more common estate tax planning vehicles, the freeze partnership is not a trust and, as the name implies, is a closely-held partnership, limited partnership or LLC (in this article, the term partnership will be used to refer to partnerships, limited partnerships and LLCs). If structured to meet the requirements of Section 2701 of the Internal Revenue Code ("Section 2701"), the freeze partnership allows the transfer of future appreciation of the partnership's assets to junior members of families or other transferees and leverages effective use of the transferor's lifetime estate and gift exemption.

Freeze Partnership (or LLC) Structure

The freeze partnership is a partnership with two classes of interest, a preferred class and a common class.¹ The family members or transferors with assets to transfer out of their estates (the "Senior Members") contribute assets, whether real estate, interests in other partnerships or LLCs, stock in operating companies, securities portfolios or other appreciating assets, into a newly formed freeze partnership in exchange for a preferred class of interest in the freeze partnership.² If another partnership owning the assets already exists, the Senior Members can contribute their interests in the existing partnership into the freeze partnership. Separately, the Senior Members can gift cash to their children, grandchildren or other transferee(s) (the "Junior Members"). The Junior Members then contribute the cash gifted to them and/or the Junior Members' own cash to the freeze partnership in exchange for common interests in the freeze partnership. The Senior Members may also gift the common interest in the freeze partnership to the Junior Members but for certain income tax reasons, gifts of contribution cash may be preferable over direct gifts of common interests.³

The preferred interest holders will be entitled to receive (i) a preferred return on its capital contribution (as further discussed below) and (ii) a liquidation preference (i.e., a priority over the common interest holders to receive a return of their invested capital contribution) in the event the freeze partnership is liquidated. On the other hand, the common interest holders are entitled to current distributions and any liquidating distributions that remain after the preferred interest holders are fully paid their accrued preferred return and their liquidating distribution, respectively.

Section 2701 Requirements

This freeze partnership structure allows the Senior Members to transfer all future appreciation or upside of the freeze partnership assets to the Junior Members with the leverage use of the Senior Members' lifetime estate and gift tax exemption, but only if certain requirements of Section 2701 are satisfied. If these requirements are not satisfied, the Senior Members' preferred interests are deemed to have a zero value and the entire freeze partnership value is attributed to the common interests, thereby imposing a much greater gift tax value on the transfer or issuance of the common interests to the Junior Members. To avoid a zero valuation of the preferred class, the preferred interest holders must receive a preferred return that is cumulative and payable at least annually.⁴ This preferred return must be a market rate of return, which is determined by a qualified appraiser.⁵ Section 2701 also requires the total value of common interests to equal at least 10% of the sum of the total value of the entire freeze partnership and the value of any partnership debt owed to the transferors or Senior Members.⁶

Optimal Situations for Freeze Partnerships

Whether in combination with other wealth transfer techniques or on its own, the freeze partnership can be ideal for certain circumstances including the following:

Families with Appreciating Assets and High Cash Flow Needs

The freeze partnership may be ideal for families who have highly appreciating assets but whose net worth has not reached the estate tax thresholds. Currently, estates with values under the lifetime exemption amounts of $11.7 million per person and $23.4 million per couple are not subject to Federal estate tax. For these families, their main priority is to maintain sufficient cash flow to fund their growing businesses and family living expenses. With time, however, their net worth could grow and exceed the lifetime exemption amounts. Under the current laws starting January 1, 2026, the current lifetime exemption amount is scheduled to decrease to approximately $6 million per person and $12 million per couple.⁷ With the scheduled decrease in the lifetime exemption, the possibility that the estate values of these families will reach the taxable limits become a real concern.

Real Estate Investments and other Assets with Highly Depreciated Tax Bases

Real estate investments are often encumbered by either recourse or non-recourse financing. After taking years of depreciation deductions on their tax returns and multiple refinancing on appreciated real estate values, owners of real estate often have investments where their share of liabilities exceeds their tax basis in the property and/or have negative capital accounts (if the real estate investment is held through a partnership). The liabilities and negative capital accounts may prevent a gift transfer during the transferor's lifetime to the succeeding generation for a couple of reasons. First, transferring property encumbered with liabilities that exceed the transferor's basis could trigger a taxable gain. Second, by transferring the property during the transferor's lifetime, the transferor foregoes the basis step-up that would occur if the transfer occurs at death (provided that the basis step-up is not eliminated by proposed legislation).

The freeze partnership allows the Senior Members to postpone the transfer of the preferred interest and its associated liabilities until death, thereby preserving a potential basis step-up to offset the associated liabilities and negative capital accounts. At the same time, future appreciation of the real estate investment can be transferred to the Junior Members through the common interest during the Senior Member's lifetime, thereby avoiding the inclusion of the appreciation in the Senior Member's taxable estate.

Commercial and Business Constraints

In some cases, commercial and operational constraints may dictate the Senior Members' ability to transfer assets to irrevocable trusts for estate tax planning. For instance, lenders often require the Senior Members to demonstrate creditworthiness by disclosing their personal balance sheets and to evidence the Senior Members' managing control over their business interests and assets. Lenders are often uncomfortable financing arrangements that involve irrevocable trusts. Under these circumstances, the freeze partnership allows the Senior Members to effectuate estate tax planning with a vehicle—a partnership or LLC—with which third-party commercial parties have greater familiarity and comfort transacting business. While careful drafting of the partnership agreement provisions relating to the Senior Members' rights and powers is required to avoid incomplete gifts, freeze partnerships provide greater leeway to the Senior Members to continue operating and managing business assets.

Example

To illustrate the freeze partnership technique, assume Jim is the sponsor of real estate funds. He forms limited partnerships or LLCs (each a "fund") to acquire and develop real estate projects. Third-party investors invest in the funds and, in exchange for sponsoring the fund, Jim receives various fees and a 30% carried or promote interest (i.e., future appreciation in the fund asset after the investors receive a certain return on their investment). To date, Jim has sponsored five (5) funds. While Jim has significant stake in the funds, the full value of his net worth has yet to be realized and is not subject to estate tax. Assume also that Jim's spouse Lisa has invested their savings and built a substantial portfolio of marketability securities. Their assets are summarized as follows:

Assets	Today's FMV	Projected FMV in 10 Years
Interest in Fund 1 – $8,000,000 Industrial Property	0	720,000
Interest in Fund 2 – $5,000,000 Industrial Property	0	450,000
Interest in Fund 3 – $7,000,000 Apartment Complex	0	630,000
Interest in Fund 4 – $8,000,000 Industrial Property	0	720,000
Interest in Fund 5 – $5,000,000 Industrial Complex	0	450,000
Other Commercial Real Property	6,000,000	8,400,000
Marketable Securities	400,000	1,450,000
Family Home	2,000,000	3,200,000
Total Net Worth	8,400,000	16,020,000

Assume Jim and Lisa contribute all of their assets except their family home to a freeze partnership (a total value of $6,400,000). Jim and Lisa receive preferred interests for their contribution. Jim and Lisa gift to their one daughter, whether outright or in trust, common interests in the freeze partnership or contribution cash. If cash is gifted to their daughter, their daughter would then contribute the cash to the freeze partnership in exchange for common interests. The following table illustrates the wealth transferred through the freeze partnership technique. The illustration assumes the asset composition in the preferred interest in the freeze partnership has a 5.5% market yield (as determined by a qualified appraisal). It also assumes that Jim and Lisa gift to their daughter common interest equivalent to 10% of the total fair market value of the freeze partnership.

Contribution of Assets (Other Than Family Home) to Freeze Partnership:
Aggregate current FMV of contributed assets	6,400,000
Projected FMV of contributed assets in 10 years (excluding home)	12,820,000
Jim and Lisa's annual fixed income from preferred interest (at 5.5% yield)	316,800
Daughter's income from common interest	0
In 10 Years, Assume All Assets Have Been Sold at Projected FMV:
Jim and Lisa's aggregate income (10 years × $316,800)	3,168,000
Jim and Lisa's equity values/sales proceeds (90% × $6,400,000)	5,760,000
Daughter's aggregate income from partnership	0
Daughter's share of equity values/sales proceeds ($12.82 million - $5.76 million)	7,060,000
Equity Value Transferred to Daughter in 10 Years	7,060,000

By implementing this freeze partnership structure, Jim and Lisa reserved for themselves fixed annual cash flow of $316,800 from the freeze partnership and the full return of their invested capital up to $5,760,000 in the freeze partnership. At the same time, Jim and Lisa transferred current equity value and future appreciation with an estimated value of $7,060,000 (realized in 10 years) to their daughter through the transfer of common interest.

The following table demonstrates the estate tax savings resulting from the freeze partnership technique in Jim and Lisa's example:

	Without Freeze Partnership	With Freeze Partnership
Jim and Lisa's estate value in 10 years	16,020,000	8,960,000
Estimated lifetime gift/estate tax exemption in 10 years ($5 million indexed for inflation)	12,5000,000	12,5000,000
Assumed gift value of common interest gifted to daughter (to be determined by qualified appraiser) with 30% combined lack of marketability and control discounts	0	448,000
Jim and Lisa's unused lifetime gift/estate exemption	12,500,000	12,052,000
Total estate subject estate tax in 10 years	3,520,000	0
Estate tax rate after 12/31/2025	45%	45%
Jim and Lisa's estimated estate tax in 10 years (assuming no further appreciation)	1,584,000	0
Estimated Estate Tax Savings	0	1,584,000

Conclusion

The freeze partnership can be an entry level estate tax strategy for families who are currently below the estate tax threshold. The freeze partnership can also be employed with other estate tax planning vehicles to leverage transfer strategies. For instance, common interests in the freeze partnership could be sold or gifted to grantor trusts and dynasty trusts.⁸

The freeze partnership could also serve as an alternative to other estate planning strategies. If certain proposed legislation pass, grantor retained annuity trusts (GRATs) and sales to intentionally defective grantor trusts (IDGTs) may become less advantageous as estate planning strategies.⁹ Even assuming no applicable legislation is passed and GRATs and IDGTs remain wholly viable estate tax strategies (which will most likely be the case), the freeze partnership still offers a planning alternative for Senior Members requiring greater flexibility and control of partnership assets for business reasons, fixed cash flow and/or the eventual basis step-up.¹⁰

 

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¹ Like corporations, partnerships and LLCs can have multiple classes of interests with various economic and voting rights depending on how the partnership or LLC operating agreements are structured.

² There should be careful planning and analysis as to which assets are suitable for contribution to a freeze partnership. For instance, if S corporation stock is transferred into a partnership, its S corporation election will be terminated.

³ If the Senior Member's share of partnership liability exceeds his or her basis in the partnership, or the Senior Member has a negative capital account in the partnership, gifting cash to Junior Members is preferred over gifting common interest in the partnership to avoid triggering gain recognition or the transfer of a negative capital account to the Junior Member.

⁴ If there is insufficient cash flow to distribute the preferred return to the Senior Members on an annual basis, there is an initial four (4) year grace period for the freeze partnership to pay the accrued preferred return followed by an additional four (4) year grace period in which the freeze partnership can pay the accrued preferred return if the freeze partnership issues to the preferred interest holder a promissory note bearing compounding interest at the applicable discount rate. Int. Rev. Code Section 2701(d)(2)(C); Treas. Reg. 25.2701-(c)(5).

⁵ Int. Rev. Code §2701(c)(3). Rev. Rul. 83-120 predates the effective date of Section 2701 but it provides guidance on the considerations used to value preferred stock and common stock in family transfer situations.

The qualified appraiser will and should consider factors including the preferred return paid by public companies with comparable pre-tax and pre-interest earnings, comparable ability to timely pay dividends and comparable protection to pay the liquidation preference to the preferred interest holder (determined by the company's net worth).

⁶ Int. Rev. Code §2701(a)(4).

⁷ The lifetime estate and gift tax exemption is scheduled to sunset in 2026 to pre-2018 amounts of $5.49 million per person and $10.98 million per couple, adjusted for inflation. Int. Rev. Code §2010(c). Accounting for inflation, the lifetime exemption is estimated to be approximately $6 million per person and $12 million per couple in 2026.

⁸ If common interest is transferred to a grantor trust, the transferor and the grantor trust will be deemed the same person for income tax purposes. Therefore, it will be necessary that another taxpayer hold some interest, whether preferred or common, in the freeze partnership so that the freeze partnership is not treated as a disregarded entity.

⁹ For the 99.5 Percent Act, S. 994, 117th Congress (proposed March 25, 2021)]. GRATs and installment sales to the IDGTs are more efficient freeze techniques because the Section 7520 interest rate, as opposed to the higher market rate of return, is used to determine the annuity or installment payments to the grantor or transferor. However, the freeze partnership is a helpful alternative if the grantor prefers greater cash flow and there are income tax reasons to use the freeze partnership.

¹⁰ Basis step-up can be accomplished for assets transferred to GRATs and IDGTs by giving the grantor the right to buy back the transferred asset with cash, a promissory note or other higher-basis assets in order to include the transferred asset in the grantor's estate. However, the grantor or Senior Member may not have requisite cash or assets to buy back the transferred asset. In the case where a promissory note is used to buy back the transferred asset, there is an unsettled question whether there is taxable gain to the GRAT and IDGT when the promissory note installments are received after the grantor's death.