The economic conditions accompanying COVID-19 have created many avenues of change. As a law firm specializing in comprehensive estate and income tax planning for affluent investors, our imperative is to identify planning opportunities when they occur, even under these current conditions.
The effects of the pandemic have caused a decrease in the valuation of a significant number of closely held businesses, investment portfolios and real estate properties. To that end, there is a once-in-a-generation estate and tax-planning opportunity called the Preferred Partnership Freeze (PPF) for those who wish to seize the opportunity brought on by the current crisis. The Great Recession of 2008 created similar opportunities, and many of our valued clients seized the opportunity when presented.
This PPF uniquely provides both the estate tax savings while taking advantage of income tax laws. The overriding essence of the PPF captures natural discounts associated with the current low interest rates combined with declining asset values created by the pandemic. Rarely does an estate tax planning technique allow both.
The assets you expect to appreciate in the long run can be frozen at today’s lower valuations while shifting the future appreciation into a dynastic trust for future generations spanning 365 years. For depreciable property, like rental real estate, the PPF combines the best of the estate tax deferral of the “freeze” with the income-tax free “step up in basis” for capital gains elimination and increased depreciation and amortization for depreciable real estate.
How Does the PPF Work?
You identify assets expected to appreciate in value over time, which might include closely held businesses, investment portfolios and especially for real estate with mortgages and then contribute those assets to one or more limited partnerships (“LP”) that are established with two classes of LP interests: 1) a class of Preferred LP shares; and 2) a class of Common LP shares.
You keep the Preferred LP shares and then you gift or sell some or all of the Common LP shares to a newly formed dynasty trust, such as our HYCET Trust (opens in new tab)™ (which stands for Have Your Cake and Eat It Too). This action freezes the current value (by the Preferred LP shares) while shifting the future appreciation to the Common LP shares you transferred to the dynasty trust, which is how estate taxes can be avoided for generations to come.
An Example to Show the Strategy in Action
To help further bring this strategy in focus, let’s look at an example of how one family may put it into practice. A couple in their 70’s owns several commercial real estate properties from which they receive rental income. They have engaged in a number of tax deferred Sec 1031 exchanges over the years so the mortgages on the properties far exceeds their “income tax” bases. They expect the properties to continue to appreciate and would like to defer the estate taxation on the appreciation as long as permitted by “freezing the value” of the properties in the current estate. Finally, when they die, they do not want to lose the income-tax free “step up in tax basis” so their heirs may receive a higher tax basis for calculating the depreciation of the rental properties thereby reducing the income tax on the future rental income. In short, they want to have their cake and eat it to.
Is this possible? It sure is. Under current tax law, combining the benefits of the partnership tax rules with the generous estate and gift tax exemptions allows this couple to achieve both income and estate tax savings.
The Bottom Line
It’s important to remember the big picture in the midst of this day-to-day crisis. You may be aware that the generous lifetime federal estate tax exemption of $11.58 million will be cut in half on Jan. 1, 2026, and if there is a change in the White House this November, estate and gift tax exemptions could be repealed altogether or rolled back while tax rates increase. Moreover, to help pay for the recent $2 trillion stimulus package, look for these generous gift and estate tax exemptions to be rolled back well before 2026.
The bottom line is this once-in-a-generation planning opportunity will not likely be available once we recover from this current crisis – so now is the time for an action plan, especially while you are hunkering down indoors perhaps with the time and attention to devote to this. And recover we will! Stay safe and stay healthy.
Jeffrey M. Verdon, Esq. is the managing partner of the Jeffrey M. Verdon Law Group, LLP (opens in new tab), a Trusts & Estates boutique law firm located in Newport Beach, Calif. With more than 30 years of experience in designing and implementing comprehensive estate planning and asset protection structures, the law firm serves affluent families and successful business owners in solving their most complex and vexing estate tax, income tax, and asset protection goals and objectives.
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