Deep Freeze: How S Corporation Owners Can Use Partnerships to Accomplish Estate Tax and Income Tax Planning Goals

Taxpayers have long searched for techniques to pass wealth to the next generation in a tax-efficient manner. This can be particularly challenging for taxpayers who have investments in appreciated real estate. Further complications exist for many property owners who hold their interests in an S corporation.  

Real estate ownership has distinctive tax attributes, such as accumulated depreciation and debt on the property, that can cause unintended tax consequences when the property is sold or transferred. Due to characteristics related to real estate, passing property to the future generation may be more complicated than the wealth transfer strategies deployed for more liquid assets. A freeze partnership technique may be a solution for these unique issues.  

Phantom Gain in Real Estate 

With respect to transferring real estate to younger family members, there is an additional income tax trap if that real estate is encumbered by debt that exceeds the property’s tax basis. “Phantom” gain to the extent of that excess may result in generating a potentially large income tax bill.  

Example 

Laura owns 100% of Laura Inc., an S corporation, which owns a rental property that was purchased in 2000 for $18 million. Over 24 years, Laura Inc. has deducted approximately $12 million of depreciation related to the building. Net of depreciation, there is a remaining basis of around $6 million. Over the years, Laura Inc. has taken mortgages and other loans out on the building, which now total $34 million. In 2025, the building is worth $50 million.  

Tax issue resulting from a third-party sale - If Laura Inc. sells the property in 2025 for $50 million, Laura, as the sole shareholder, will recognize and pay taxes on a gain of $44 million ($6 million of the purchase is non-taxable as a return of basis). However, the net proceeds from the sale will be $16 million ($50 million value less the $34 million mortgage debt). Sometimes, the tax bill may be higher than the resulting proceeds.  

Tax issue related to gifting the property - If Laura instead transferred the property by gift, she would recognize and pay income tax on a “phantom” gain of $28 million ($34 million of mortgage debt less her $6 million basis). The debt relief would be considered the same as receiving cash in this transaction.  

What is a “Freeze” Partnership? 

Among other estate planning options, a “freeze” partnership can mitigate the phantom income tax gain problem described above while also effectively transferring real estate to accomplish estate and gift tax objectives. 

The mechanics of setting up a freeze partnership are relatively simple. The owners (Senior Members) of appreciated real estate contribute the property to a new LLC or partnership in return for preferred units. The Junior Members, typically the Senior Members’ children, contribute assets (capital) in return for common units. If the children do not have sufficient funds, the senior members can loan or give a gift to the junior members, who then contribute such assets to the new LLC for the common interests. This can also be done in the S corporation setting with a partnership being created as originally 100% owned by the corporation, and the Junior Members receiving 10% of the underlying partnership from the S corporation (through either a purchase or gift from the S corporation owner).  

Section 2701 of the Internal Revenue Code provides a roadmap for how to structure the preferred interest to maximize its value. Under this section, the preferred interest must bear a fixed percentage return on capital (typically determined by a qualified appraiser), be cumulative, and be payable at least annually. (However, section 2701(d)(2)(C) allows for payments to be made up to four years after the original due date and still be considered as timely made.) In addition, the total value of the common interests must be equal to at least 10% of the sum of the total value of the entire partnership plus the value of any partnership debt owed to the Senior Members.   

Returning to the previous example, assume that instead of selling the property, Laura Inc. creates a freeze partnership. The preferred interest holds 90% of the capital and retains the debt of the company. The preferred interest remains with the S corporation. The common interest holding the remaining 10% will be transferred to the Junior members. Laura’s preferred interest (held through the S corporation), as determined by a qualified appraiser, will be included in her estate upon her death. Still, any future appreciation will pass to her children free of gift and estate tax.  

The freeze partnership technique is complicated, and we encourage you to contact our experts below to discuss whether a freeze partnership solution could improve your entity or family situation.