A New Decade Dawns Bright for Multigenerational Estate Planning
With the economy recovered, privately-held companies and family firms with significant holdings should consider taking advantage of historic low interest rates now before the window of opportunity closes.
It’s been almost ten years since the bankruptcy of Lehman Brothers, the failure of Bear Stearns and the Madoff Ponzi scheme rocked the financial markets. Back then, generations of fortunes were wiped out overnight and the future looked terrifyingly bleak. Valuations in most asset classes diminished and recoveries were uncertain. Government was encouraged — or forced —depending how you look at it, to become an investor and lender to support the economy and bail out fragile industries and firms deemed too-big-to-fail.
As dire as those circumstances were, however, they also presented a “best of times” scenario for the estate planning community. The low valuation of assets coupled with low interest rates enabled some privately-held companies and family businesses with meaningful real estate holdings to execute transactions that will be sustainable over time and generations.
Not all these entities were poised to benefit, however. Some had to hunker down to survive the recession and left transfer tax planning to a later day. Others, including non-family controlled firms and those entrepreneurial in spirit, felt they hadn’t created values to justify complex planning.
For those businesses who missed their chance, it’s not too late to get on board. In fact, with valuations recovered in many sectors, and with the uncertainty surrounding future tax policy, the wise move is to act now.
Family Firms: Don’t Be Scared Off by Trump Talk
Back in 2008 the looming end of Bush era tax cuts and potential elimination of the estate tax focused the attention of family planners and their clients. Many saw the opportunity to transition ownership of assets they rightly believed were at a low point. With the added incentive to charge near-zero interest on intra-family sales, a near perfect storm arose that resulted in countless transactions.
Fast forward to 2017 and the hypothetical investor, John. Years after joining his family firm, he has assumed control of its real estate portfolio from his ailing father and is considering ways to restructure the holdings to manage his siblings’ ownership. He also wants to transfer some ownership to his teenage son and daughter to bring them on as rightful heirs to the family heirloom. But President Trump’s mixed signals on regulations is making him hesitant.
Last August then-candidate Trump pledged to undo Obama-era proposals for stricter enforcement of estate and gift taxes. If finalized in their present form, the regulations would severely restrict discounts to the valuation of interests in many family-controlled entities for estate, gift and generation-skipping transfer purposes.
After careful consideration, John decides to wait to see if the Treasury Department will be able to modify or rescind the proposed legislation. Should he? The logical answer would seem to be yes. But more practical advice is to go forward with his intention to restructure, while keeping his eyes and ears open to maneuvers in Congress that may affect his planning. With the US on one of the longest runs of low interest rates in its history, it makes sense to move now. Although valuations have recovered in many sectors from the lows of the financial crisis, many experts have been predicting that interest rates will rise. In fact, the Applicable Federal Rates (AFR) issued by Treasury that govern intra-family transfers have gone up. (Though they are still in the historic low range.)
John has multiple options for restructuring ownership with his siblings (or cousins as would be the case in a broader ownership group typical in the third generation and beyond). Those include possible buyouts, split ups and other sophisticated estate planning techniques. Typically, gifts and/or sales to grantor trusts are a part of such planning.
Of these, one increasingly popular option is the freeze partnership. This enables a senior or leadership generation to “freeze” the value of its economic interests in the business assets, with future appreciation and risks of ownership typically held, often in trust, for the next generation. That can allow the bulk of future capital appreciation of those assets to be exempted from estate tax for one or several generations.
Closely-held Firms: Inexpensive Alternatives Exist
Firms that are owned and managed by unrelated individuals have additional considerations. Unlike family firms that can be guided by statutorily prescribed low interest rates (AFRs), the same incentives do not necessarily apply.
Consider this hypothetical: A regional real estate firm founded 15 years ago by two unrelated partners has grown substantially with property management and oversight of development projects. Their 40 employees are committed and well compensated but they have no clear sense of their professional futures.
To restructure, the founders not only have to consider the monetization of their real estate (much of it locked into illiquid carried interests), but they also have two other priorities. First, they need to develop the next generation of leadership. Second, they must value the operating platform.
While family firms often choose to remain private, those owned and managed by unrelated partners commonly go for deals that bring the best returns. Low interest rates make the cost of reinvesting in existing businesses relatively inexpensive. Accordingly, a sale to REITs, pension funds, family offices and foreign buyers are worthwhile transactions for non-family firms to consider.
The past decade has created significant value creation for privately owned real estate enterprises. Now is the time — while the window of opportunity is still open — for both family firms and closely-held businesses to look at their options both for tax savings and for sustainability.