EFTA01145546.pdf

2011 Preferred Partnership Freeze CONFIDENTIAL [ This material is not intended for external distribution, nor is it intended as an offer or solicitation to purchase or sell any security, investment or service and anyone who distributes this material in such manner will be in violation of JPMorgan Private Bank policy and may be subject to disciplinary action up to and including possible termination. The sole purpose of this material is to inform internal personnel within the JPMorgan Private Bank J.P.Morgan 0 EFTA01145546  Please keep in mind This material is intended to help you understand the tax and financial consequences of the concepts and strategies discussed here in very general terms. However, the strategies found herein often involve complex tax and legal issues. Only your own attorney and other tax advisors can help you consider whether the ideas illustrated here are appropriate for your individual circumstances. JPMorgan Chase & Co. does not practice law, and does not give tax, accounting or legal advice. We will, however, be pleased to consult with you and your legal and tax advisors as you move forward with your own planning. CONFIDENTIAL J.P.Morgan 1 EFTA01145547  Preferred Partnership Freeze (PPF) is for investors interested in enhanced wealth transfer opportunities using a Delaware Statutory Trust Purpose: to "freeze" the value of assets that will be included in the senior generation's estate and shift the excess appreciation to the junior generation(s) without additional transfer tax. • It enables investors to transfer to beneficiaries anticipated appreciation in a tax-efficient manner while retaining a large portion of the investment and a fixed return • Investment is divided into Managing Units, Preferred Units and Residual Units • Preferred Units represent majority of initial asset value and carry a fixed (cumulative, non-compounding) rate of return • Residual Units represent balance of initial asset value plus anticipated appreciation in excess of the preferred return • Residual Units are gifted and/or sold to beneficiaries CONFIDENTIAL J.P.Morgan 2 EFTA01145548 Structure of Preferred Partnership Freeze 0 Senior family members transfer assets into a Delaware Statutory Trust (DST) 0 DST• issues multiple classes of units: Managing Units: general management control and collective 1% economic interest • Preferred Units and Residual Units: limited management rights and collective remaining 99% economic interest - Preferred Units provide a fixed, cumulative annual return to senior family members equal to the annual preferred payment on the Preferred Units (can be deferred for 4 years) and a fixed value on liquidation. Preferred Units provide greater security but limit participation in appreciation of the assets - Residual Units provide excess appreciation after satisfying Managing Units' 1% interest, and the Preferred Units preferred return. Residual Units provide less security but accrue the capital, income and appreciation beyond the fixed return to Preferred Units • J.P.Morgan Trust Company of Delaware acts as administrative trustee Senior family members initially receive all DST units for their contribution O Senior family members' 0 Assets Managing Units 0 Preferred Units Residual Units L. Managing Units: 1% 0 DST2 Preferred Units: 79% Residual Units: 20% J.P.Morgan Trust Company of Delaware (Trustee) ' Two members will initially capitalize DST to secure partnership tax treatment J.P.Morgan managing unit. 2 Member 1 receives 0.5% voting managing units plus all preferred units and residual; member 2 retains the other 0.5% voting 3 EFTA01145549  Structure of Preferred Partnership Freeze O To maximize the benefits of the PPF, senior family members may gift or sell the Residual Units at discounted value' to beneficiaries outright or to trust for their benefit; can also gift or sell Preferred Units over time • J.P.Morgan Trust Company of Delaware administers distribution and manages investments subject to Managing Unit holders. • Investment Manager directs Trustee as to investment of assets. • Managing Unit holders control important voting decisions. Preferred and Residual Unit holders have limited voting rights. Senior family members Managing Preferred I Preferred Units Payments Units DST Managing Residual Preferred Units: 79% Units: 1% Units: 20% Appoints Investment J.P.Morgan Trust Company of Delaware (Trustee) Managers and O Residual Trustee 0 Directs Units trustee Investment Beneficiaries' Manager Trust z LL z J.P.Morgan J.P. Morgan can provide names for a professional appraisal 4 EFTA01145550 PPF capitalizes on Delaware's favorable laws and continuity of asset management across generations... • Limited liability for all Unit holders, even if they participate in management • Confidentiality of all Unit holders is preserved as only the name of the trust and the name and address of the Delaware trustee need to be disclosed • Dissolution does not necessarily occur upon the death, incapacity or bankruptcy of a unit holder • Flexibility to react to changes in regulatory or tax laws to facilitate the changing needs of trust participants • Trustee is allowed broad investment authority to employ Modern Portfolio Theory and flexibility of delegating investment decisions to other advisors J.P.Morgan 5 EFTA01145551  ...and J.P.Morgan's ability to offer bundled delivery makes the PPF a cost-efficient solution • The formation of a preferred partnership freeze is simple and economical — established by filing a Certificate of Trust with the Delaware Secretary of State • Investment management costs can be reduced through economies of scale • J.P.Morgan's fiduciary system provides the following: — documentation of the value of units transferred among family members - attendance to tax compliance - maintenance of the records of the preferred partnership freeze strategy to preserve its integrity for tax purposes as a separate legal entity CONFIDENTIAL J.P.Morgan 6 EFTA01145552  Delaware administration responsibilities • Account set-up • Ongoing communication - Administrative matters including record keeping and market value statements - Fiduciary oversight for regulatory and planning considerations • Account administration - Investment maintenance (i.e. subscription agreements and offering memoranda) • Ongoing communication with Managing Unit holders and investment manager - Custody including safekeeping, income collection, and optional trading platform • Responsibility for liquidations, distributions, and withdrawals - Preferred payments, tax distributions, redemptions • Executing distribution transactions including deferral of preferred payments • Evaluating distribution/redemption requests from Unit holders • Determining amounts and timing of all distributions • Obtaining valuations to support distributions, as necessary • Complying with Internal Revenue Code Section 2701 rules and provisions of estate freeze strategy documents • Cash-flow analysis for preferred payments • Maintaining required income/principal ledgers • Delegated responsibility for tax compliance - Compilation of partnership return work papers — Review and execution of partnership returns and K-1s — Evaluation of filing positions including Section 754 elections CONFIDENTIAL J.P.Morgan 7 EFTA01145553  Transfer tax considerations • Internal Revenue Code Section 2701 describes and sanctions the estate freeze strategy • Gift tax value of Residual Units must be ≥ 10% of the capital account funding value of estate freeze strategy • Discounts may apply to funding, calculation of the effective preferred rate and valuation of Residual Units • Appreciation in estate freeze assets exceeding effective preferred payment rate accrues to benefit of Residual Unit holders without causing additional gift or estate tax • Preferred Payments: - Based on prevailing "Market Rate" of return, typically determined by valuation professional's appraisal and may be deferred for 4 years on a rolling basis - Nominal preferred rate may be reduced by discounted funding, deferral of preferred payments and benefit of all capital (including common units) at work to produce amount necessary to pay this lower effective rate • PPF may be less likely to be subject to IRS scrutiny than standard family limited partnerships. - Reinforced by the independent Trustee's control over distributions z 0 LL z V J.P.Morgan 8 EFTA01145554 Income tax considerations • PPF: Delaware Statutory Trust classified as partnership for income tax purposes • Contributions: generally in-kind contributions do not cause immediate gain recognition - Exceptions may apply, such as: • Investment company rules - diversification • Property contribution subject to liabilities assumed by partnership - Built-in gains: subsequent partnership sale allocations of pre-contribution gain to contributor • Basis (if tax free contribution): — Partnership's basis in assets same as contributor's basis — Partner's basis equals cash plus adjusted basis of contributed assets • Allocations: - Profits: First to Common Managing Units and Residual Units allocable for prior aggregate losses, second to Preferred Units for prior aggregate losses, third to Managing Units percentage interest and Preferred Units' cumulative return, and fourth to Residual Units - Losses: First to Common Managing Units percentage interest and Common Residual Units until reduced to zero then second to Preferred Units until reduced to zero • Preferred payments: made only from net cumulative tax profits from inception, so Preferred Units have taxable income up to nominal return when partnership has taxable income - Not guaranteed payments which are required regardless of income and which are taxed as ordinary income with partnership realized events when satisfied in-kind - Non-taxable in-kind distributions or borrowed cash can be used to satisfy timely preferred payments • Distributions: — Cash: distribution taxable typically as capital gains only if exceeds basis - Security: distribution generally not taxable event • Exception - Built-in gains within 7 years of contribution unless contributor reacquires back originally contributed property — Non-liquidating distribution: partnership inside basis allocation — Liquidating distribution: partner's outside basis allocation; generally non taxable event unless cash exceeds outside basis — Disguised sale presumption: taxable event presumption for distributions within two years of contribution • Mergers with Family Limited Partnerships J.P.Morgan 9 EFTA01145555  Assumptions for PPF analysis • $16,000,000 in funding • 15% valuation discount on asset due to illiquidity and lack of marketability • 1 %/79%/20% Managing/Preferred/Residual Unit split • 15% estimated total returns • Estimated 7.5% mandatory fixed annual payments attributable to Preferred Units2 • Residual Units gifted3 to beneficiaries' trust at discounted value: — 10% illiquidity discount on overall value of DST - 30% additional discount on value of Residual Units • Undiscounted value of gift: $3,200,000; discounted value: $2,720,000 • Client has already utilized lifetime gift exemption • Gift tax rate (2011): 35% • Estate tax rate (2021): 55% • 4 year deferral of mandatory fixed annual payments to Preferred Units • Grantor retains income tax liability due to grantor trust status in beneficiaries' trust3 CONFIDENTIAL Note: Numbers are for illustrative purposes only. 'Return does not consider yield versus appreciation since income tax is not considered. Return estimate is for illustrative purposes only. Actual return will vary. =Effective hurdle rate: 2.2%; 7.5% preferred coupon rate reduced by 15% discount on underlying asset, plus benefit of additional residual and managing value to fund coupon payments, benefit of deferral periods, less effect of cost of gift tax. J.P.Morgan 3Units can be gifted or sold. GST exemption can be allocated in gifting. Please read "Important Information" in Appendix. 10 EFTA01145556 Compared to doing nothing, PPF can increase wealth to beneficiaries with little upfront cost Cash flow example: $16,000,000 assets, 15% return on assets Scenario 1 Scenario 2: Preferred Partnership rreexe Senior Family Members Beneficiaries 79% 1% 20% Fixed annual Voting Year Hold asset Cost of gift tax payments Preferred Managing Residual 0 Discounted assets $13,600,000 $10,744,000 $136,000 $2,720,000 Gift tax incurred upon gift ($599,760) 10 Value of assets upon liquidation 64,728,924 (2,426,364) 10,380,770 10,744,000 543,482 43,060,672 Estate tax (35,600,908) 1,334,500 (5,709,424) (5,909,200) (298,915) Net wealth to beneficiaries 29,128,016 (1,091,864) 4,671,347 4,834,800 244,567 43,060,672 8,658,850 43,060,672 Total value to beneficiaries $29,128,016 $51,719,522 Assumptions Pre-funding economic value. 516,000,000; Discount on DST 10%; Discount on residual. 30%; Discount on assets contributed . 15%; Preferred . 79%; Residual . 20%; Managing . 1%. Fixed annual payments. 7.5%; Return on assets & fixed annual payments. 15%; Years of payout deferral 4; 2011 Gift tax rate. 35%; 2021 Estate tax rate. 55% Note: Above example is for illustrative purposes only. These materials should not be construed as providing legal, tax, or accounting advice. Numbers have been rounded for convenience, are only estimates for illustrative purposes and should not be relied upon. Actual return will vary. J.P. Morgan 11 EFTA01145557  Economic flows of PPF Example Pre-funding economic value 16,000,000 Discounted FMV of capital accounts 13,600,000 Discount on assets contributed 15% Preferred units percentage 79% Managing units percentage 1% Residual units percentage 20% Term of strategy 10 Fixed annual payment 7.5% Annual payout amount 805,800 Years of payment deferral 4 Total return of asset 15.00% Beginning Appredation Distributions End of Year Grantor fixed of year annual Total Accrued 79% 1% 20% payments Year Total Managing Preferred payments Preferred Managing Residual DST Total 0 10,744,000 136,000 2,720,000 13,600,000 13,600,000 1 13,600,000 2,400,000 805,800 10,744,000 160,000 4,290,200 16,000,000 16,000,000 2 16,000,000 2,760,000 1,611,600 10,744,000 187,600 6,216,800 18,760,000 18,760,000 3 18,760,000 3,174,000 2,417,400 10,744,000 219,340 8,553,260 21,934,000 21,934,000 4 21,934,000 3,650,100 3,223,200 10,744,000 255,841 11,361,059 25,584,100 25,584,100 5 25,584,100 4,197,615 (8,139) (805,800) 3,223,200 10,744,000 289,678 14,710,898 28,967,776 813,939 29,781,715 6 28,967,776 4,705,166 (8,139) (805,800) 3,223,200 10,744,000 328,590 18,563,213 32,859,003 1,749,970 34,608,972 7 32,859,003 5,288,850 (8,139) (805,800) 3,223,200 10,744,000 373,339 22,993,374 37,333,914 2,826,405 40,160,318 8 37,333,914 5,960,087 (8,139) (805,800) 3,223,200 10,744,000 424,801 28,088,061 42,480,061 4,064,305 46,544,366 9 42,480,061 6,732,009 (8,139) (805,800) 3,223,200 10,744,000 483,981 33,946,950 48,398,131 5,487,890 53,886,021 10 48,398,131 7,619,720 (40,697) (4,029,000) 10,744,000 543,482 43,060,672 54,348,154 10,380,770 64,728,924 CONFIDENTIA Note: Preferred paymentscan be deferred for 4 years J.P.Morgan Assumes assets are liquidated in year 10 12 EFTA01145558  Compared to a FLP/LLC, PPF can increase wealth to beneficiaries with little upfront cost Cash flow example: $16,000,000 assets, 15% return on assets Scenario 1 Scenario 2: FLP/LLC Senior Family Members Beneficiaries 80% 20% Voting managing Year Hold asset Cost of gift tax / Non-voting Non-voting 0 Discounted assets $13,600,000 $10,880,000 $2,720,000 Gift tax incurred upon gift ($599,760) 10 Value of assets upon liquidation 64,728,924 (2,426,364) 51,783,139 12,945,785 Estate tax (35,600,908) 1,334,500 (28,480,726) Net wealth to beneficiaries 29,128,016 (1,091,864) 23,302,413 12,945,785 22,210%,„5,49 12,945,785 Total value to beneficiaries 529,128,016 $35,156,334 Value added by FLP/LLC $6,028,318 Value added by PPF $22,591,506 Difference $16,563,188 Assumptions: Pre-funding economic value = S16,000,000; Discount on FLP/LLC = 10%; Discount on non-voting units = 30%; Discount on assets contributed = 15%; Non-voting to beneficiaries = 20%; Non-voting remaining with senior generation = 79%; Voting managing = 1%; Return on assets = 15%; 2011 Gift tax rate = 35%; 2021 Estate tax rate = SS% Note: Above example is for illustrative purposes only. These materials should not be construed as providing legal, tax, or accounting advice. Numbers have been rounded for convenience, are only estimates for illustrative purposes and should not be relied upon. Actual return will vary. CONFIDENTIAL J.P.Morgan 13 EFTA01145559 Direct gift vs. gift of non-voting FLP/LLC units vs. gift of residual units Residual Units capture not only the growth on the Residual Units, but also the appreciation of the entire entity above the required fixed annual payments - equivalent to an additional 16.6% return above the 15% return Value to beneficiaries in year 10: Direct gift of S3.2MM vs. Gift of $3.2MM FLP/LLC units vs. Gift of $3.2MM residual units Value to beneficiaries in 000's 45,000 40,000 35,000 41,969 30,000 25,000 20,000 15,000 10,000 11,854 5,000 0 Direct Gift ■ Gift of non-voting FLP/LLC units ■ Gift of Residual Units Year 10 Direct gift: 53.2MM growing to 512.9MM less appreciated cost of gift tax of 52.0MM FLP/LLC: 53.2MM growing to 512.9MM less appreciated cost of gift tax of 51.1MM Gift of residual: 53.2MM growing to S43.1MM less appreciated cost of gift tax of 51.1MM J.P.Morgan Assumes 15% return. Return estimate is for illustrative purposes only. Actual return will vary. 14 EFTA01145560  PPF shifts capital account appreciation to residual units over time Managing Managing 1% 10/0 Residual $O.1Mm Preferred 20% 20% $2.7Mm $10.7MM Preferred Residual 790/0 79% Total value of entity: Liquidation Value: $13.6MM $54.3MM • Year 0 Year 10 CONFIDENTIAL Assumptions: S16MM funding; 15% valuation discount on asset due to illiquidity and lack of marketability; 1%/79%/20% Managing/Preferred/Residual Unit split; 15% estimated total return; Estimated 7.5% mandatory fixed annual payments attributable to Preferred Units; Residual Units gifted to beneficiaries' trust at discounted value: 10% illiquidity discount on overall value of DST, 30% additional discount on value of Residual Units; 4 year deferral of mandatory fixed annual payments to Preferred Units J.P.Morgan Return estimates are for illustrative purposes only. Actual return will vary. 15 EFTA01145561  What will the assets have to return to ensure that wealth transfer goals are achieved? Not the preferred rate of return 8.00% 7.50% Why? 7.00% • • Discount on asset 6.00% - • Discount on DST and Residual Units 5.00% • 4-year deferral • Benefit of growth from 100% of 4.00% value of the entity 3.00% 2.20% 2.00% 1.00% - 0.00% Fixed preferred Effective return payment rate required for PPF to be effective) CONFIDENTIAL 7.5% preferred coupon rate reduced by benefit of residual units value (in addition to preferred and managing units) to fund J.P.Morgan coupon payments, payment deferral periods, and 15% discount on assets contributed. Therefore, effective hurdle rate is the return required to produce ending residual value of $2.72MM (breakeven) + $599,760 (gift tax). 16 EFTA01145562  PPF exponentially benefits from incremental investment performance over time The value at death1 of PPF versus holding the assets. Assumes various return rates: 5%, 8%, 11%, 150/02 Value to beneficiaries in O00's IN Freeze 55,000 ;1 9::, , No Freeze 15% 50,000 45,000 40,000 35,000 15% 11% 30,000 25,000 11% 8% 5% 15% 20,000 8% 11% 5% 15,000 8% 5% 8% 11% 15% 5% I I 10,000 5,000 I O r 1 4 7 10 Time (years) CONFIDENTIAL ' Assumes assets are liquidated. J.P.Morgan 2 Return estimates are for illustrative purposes only. Actual return will vary. 17 EFTA01145563  Key Benefits Non-economic • Single upfront transfer eliminating need for annual transfers in the future (i.e. cascading GRATs that continually "re-GRAT" • Consolidated management in Delaware • Strong legal certainty • Beneficial definition of security law "Qualified Purchaser" vs. GRAT • Leverage other strategies with additional discount afforded structure Economic • No leakage first 4 years, minimal leakage thereafter • May benefit from valuation discounts • GST allocation with gift of residual • If appreciation not as expected, can redeem preferred, locking in value or dissolve and recapitalize • Hurdle rate may be lower than AFR and 7520 rates per valuation discount and benefit of preferred payments deferral Key Risks • IRS may arrive at different valuation conclusions • Underlying asset could experience losses or earn less than the preferred coupon • Tax law changes may affect potential benefits of structure CONFIDENTIAL J.P.Morgan 18 EFTA01145564  Creative gifts of Residual Units may further enhance the PPF • Gifts to grantor trusts — investor remains responsible for income taxes of trust, allowing the trust principal to grow tax-free — trust provisions may provide for asset substitution, allowing investor to transfer high basis property/cash to trust in exchange for the low basis property in order to receive benefit of stepped up estate tax basis • Gifts to generation-skipping trusts — value passes beyond children's generation without second level transfer taxes — Perpetual Delaware Trust compounds estate tax free for successive generations • Other wealth transfer strategies may be integrated with the PPF CONFIDENTIAL J.P.Morgan 19 EFTA01145565  Assumptions for integration of other wealth transfer strategies with PPF Hold PPF with GRAT PPF with Cascading PPF with Sale to IDGT GRAT $16,000,000 in funding; 10 year $3,200,000 FMV residual units in $3,200,000 FMV residual units in $1,557,818 note; 10 year term term funding; 10 year term funding; 10 year term Taxable value: $1,071,000 Taxable value: $1,071,000 FMV of sale: $2,909,094 Assume same underlying GRAT is zeroed out GRATs are zeroed out Gift made of discounted assets to asset trust for coverage: $155,782; FMV: $290,909. 15% return on asset* 15% return on asset* 15% return on asset* 15% return on asset* Estate tax rate: 55% Estate tax rate: 55 % Estate tax rate: 55 % Gift tax rate: 35%; Estate tax rate: 55 % No income tax is considered. No income tax is considered. No income tax is considered. No income tax is considered. Grantor retains income tax Grantor retains income tax Grantor retains income tax Grantor retains income tax liability. liability. liability. liability. Assume 15% discount on Assume 15% discount on Assume 15% discount on Assume 15% discount on underlying asset underlying asset underlying asset underlying asset Structure 7520 rate: 3.0% 7520 rate: 3.0% Long-term AFR rate: 4.3% specific assumptions 20% Annuity escalation 20% Annuity escalation 1%/79%/20% managing/preferred/ 1%/79%/20% managing/preferred/ 1%/79%/20% managing/preferred/ residual unit split residual unit split residual unit split 7.5% fixed annual payments to 7.5% fixed annual payments to 7.5% fixed annual payments to preferred units (based on 79% of preferred units (based on 79% of preferred units (based on 79% of PPF discounted funding) discounted funding) discounted funding) assumptions 10% illiquidity discount on total 10% illiquidity discount on total 10% illiquidity discount on total holdings; 30% additional discount holdings; 30% additional discount holdings; 30% additional discount on residual on residual on residual 4 year deferral of payments on 4 year deferral of payments on 4 year deferral of payments on preferred units preferred units preferred units J P Morgan Return estimates are for illustrative purposes only. Actual return will vary. 20 EFTA01145566 Value to beneficiaries Value to beneficiaries with different strategies assuming 15% return Value to beneficiaries in 000•s 55,000 50,000 49,815 50,132 45,000 40,000 35,000 30,000 29,128 25,000 20,000 ■ Hold ■ PPFIGRAT* ■ PPFICascading GRAP PPF/Sale to IDGT* Year 10 J .P.Morgan *Annual payments inkind. 21 EFTA01145567  Residual units fund a GRAT Cash flow example: $16,000,000 assets, 15% return on assets Scenario 1 Scenario 2: Estate Freeze Senior Family Members Beneficiaries 79% 1% 20% Fixed annual payments and Voting Year Hold asset GRAT payments Preferred Managing Residual 0 Discounted assets $13,600,000 $10,744,000 $136,000 $2,720,000 Gift tax incurred upon gift 10 Value of assets upon liquidation 64,728,924 15,883,009 10,744,000 488,459 37,613,455 Estate tax (35,600,908) (8,735,6