A common estate planning technique is for a client to contribute property to a limited partnership, and for the client then to sell the limited partnership interest he or she owns to a grantor trust (1) in exchange for a promissory note. This kind of planning is often referred to as an intrafamily installment sale. (2) Under current law, the limited partnership interest being sold could be subject to an appraised aggregate discount ranging from 10 to 40 percent for lack of marketability and minority interest. If the fair market value of the assets owned by the partnership were $1 million, a 35 percent discount would result in the limited partnership interest having a $650,000 fair market value. The principal amount of the promissory note is equal to the discounted sale amount of the limited partnership interest with an interest rate equal to the applicable federal rate (the AFR) for the month of sale promulgated under I.R.C. [section] 1274(d) (1986), as amended. The interest accruing on the promissory note is typically lower than the anticipated earnings of the partnership's assets. With this technique, the discounted portion of the partnership interest and the earnings and appreciation that exceed the interest payable on the promissory note pass to younger generations free of transfer taxes (i.e., estate, gift, and generation skipping transfer taxes). With the recent decline in the value of real estate and marketable securities and the decline in the AFR, what should a client do when the unpaid principal amount of the promissory note exceeds the current value of the limited partnership interest that was sold, or if the current AFR is less than the stated interest rate on the note? For example, assume that your client created a family limited partnership and contributed $1 million worth of marketable securities to the partnership. Assume that a third-party appraiser determined that the value of the limited partnership interest owned by the client was $650,000. The client created a grantor trust and transferred $65,000 to the trust as a gift. (3) In November 2007, the client sold the limited partnership interest to the grantor trust in exchange for a nine-year balloon promissory note with interest payable annually. The promissory note bears interest at the mid-term AFR for November 2007 (which was 4.39 percent), resulting in annual interest payments by the trust to the client of $28,535. The promissory note is collateralized by a pledge of the limited partnership interest. In March 2009, the assets owned by the partnership are valued at $500,000. (4) The client wants to decrease the principal amount of the note either to $325,000 or $390,000 (5) and decrease the interest rate payable on the note to 1.94 percent, (6) which would reduce the annual interest payable to $6,305.
