Don't overlook the credit for tax on prior transfers.

However, what is surprising is that the proposed regulations take the unprecedented view that a covenant not to compete entered into contemporaneously with a stock redemption is entered into "in connection with" the redemption for purposes of Sec. 162(k), which disallows a deduction "for any amount paid or incurred by a corporation in connection with the reacquisition of its stock...." In addition, Prop. Regs. Sec. 1.197-2(a)(4) states that "Section 197 does not apply to any amount paid or incurred for a section 197 intangible if a deduction for the amount would be disallowed under any provision of the Internal Revenue Code other than section 263. (See, for example, section 162(k).)"

Therefore, although the covenant not to compete would constitute a Sec. 197 intangible, any amount paid or incurred under the covenant would not be deductible under Sec. 162(k). Thus, the proposed regulations apply the "in connection with" language of Sec. 197(d)(1)(E) to Sec. 162(k).

This position is illustrated in Prop. Regs. Sec. 1.197-2 (k), Example (4). However, this example suggests that amounts paid or incurred pursuant to a covenant not to compete, entered into at the time of a stock redemption, may not always be nondeductible under Sec. 162(k). In the example, the corporation and the shareholder have no business relationship with each other except for the corporate-shareholder relationship. This appears to indicate that, if the shareholder was also an employee or had some other active involvement in the corporation's business (factors often present in many closely held or family-owned corporations), perhaps the noncompete agreement would not be viewed as being entered into in connection with a stock redemption (and, therefore, not subject to Sec. 162(k)).

If the proposed regulations are finalized, amounts paid or incurred under a covenant not to compete entered into contemporaneously with a stock redemption will be scrutinized as being:

--additional consideration for the redeemed stock, nondeductible to the corporation and generally capital gain to the shareholder;

--in connection with the stock redemption, nondeductible to the corporation and ordinary income to the shareholder under the covenant's terms; or

--not in connection with the stock redemption, amortizable by the corporation over 15 years and ordinary income to the shareholder under the covenant's terms.

Consequently, under these proposed regulations, factual controversies can be anticipated if noncompete agreements are entered into contemporaneously with stock redemptions.

Example 1: B inherits $1,000,000 worth of property from A, which is the amount remaining after estate taxes on A's $2,000,000 estate (assuming a 50% marginal estate tax rate). B dies within two years of A; C is B's sole beneficiary. Using the same 50% estate tax rate, and absent any other provisions, C would be left with an inheritance of $500,000 after the second set of estate taxes, or the equivalent of 25% of the original $2,000,000 from A's estate.

An often overlooked section of the Code will mitigate the diminution of property by successive estate taxes. Sec. 2013 provides a credit against the Federal estate tax imposed on the present decedent's estate for Federal estate tax paid on the transfer of property from a transferor who died within 10 years before or two years after the present decedent's death. The maximum credit is the lesser of the Federal estate tax attributable to the transferred property in (1) the transferor's estate (the "first limitation") or (2) the present decedent's estate (the "second limitation"). Accordingly, if by reason of deductions and/or the unified credit, no estate tax is due from either of the two estates, no credit is available. Separate computations are required for property received from two or more transferors.

Although a detailed explanation of the mechanics involved in determining the "first" and"second limitation" is beyond the scope of this discussion, it is sufficient to say that the "first limitation" equals:

Value of transferred property/Transferor's adjusted taxable estate x Transferor's adjusted Federal estate tax

Hence, the "first limitation" is computed using the average tax rate of the transferor's estate. The "second limitation" equals the difference in the estate tax payable before the credit and the estate tax payable if the net value of the transferred property is excluded from the transferee's gross estate. The "second limitation," therefore, is computed using the marginal estate tax rate of the transferee's estate. (For a detailed discussion of the calculation, see Streer and Strobel, "Credit for Prior Transfers Can Produce a Significant Reduction in estate Tax," TTA, Aug. 96, p. 495.)

The interval between the dates of death of the present and prior decedents determines the portion of the maximum credit allowed on the second decedent's estate tax return. The credit decreases in 20% increments for each two-year interval between deaths. If the interval between deaths is within two years, the entire credit is allowed, 80% if the interval is within the third or fourth year, etc.

The regulations provide that the word "within" means "during." For example, if the transferee's death occurs exactly two years from the transferor's death, the first death is considered to have occurred within two years of the second death and 100% of the credit will be allowed.

The credit is computed on Schedule Q and the accompanying worksheets of Form 706, Federal Estate Tax Return. Although the schedule may be somewhat cumbersome to complete, it may be well worth the effort.

As an added benefit, Regs. Sec. 20.2013-1 provides:

There is no requirement that the transferred property be identified in the estate of the present decedent or that the property be in existence at the time of the decedent's death. It is sufficient that the transfer of the property was subjected to Federal estate tax in the estate of the transferor....

Simply stated, there are no tracing requirements to qualify for the credit. For example, if B inherits X stock from A, it is not necessary that B own the stock at her death to qualify for the credit. The mere fact that the X stock was subject to estate tax in A's estate is sufficient. Sec. 2013(d) provides that the transferred property be valued at the same amount at which such property was valued in the transferor's estate, subject to certain reductions. Therefore, the net value of transfers used in arriving at the "first limitation" will also be the value for arriving at the "second limitation," regardless of whether B disposed of the stock or the stock has appreciated in value.

Caution: The transferred property must be able to be valued at the time of the transferor's death; otherwise, no credit will be allowed. A common example of a situation in which this problem is encountered is an income interest in trust in which the trustee is granted the power to accumulate or "sprinkle" income among various beneficiaries. Since it is not guaranteed that the trustee will make annual distributions to a specific beneficiary, the life interest is not susceptible of valuation.

Sec. 2013(d) directs that in arriving at the value of the property transferred to the present decedent, the value at which the property was included in the transferor's gross estate is reduced by (1) the amount of the transferor's Federal estate tax and any other death taxes payable out of the transferred property, (2) the amount of any marital deduction allowed the transferor's estate if the present decedent is the transferor's spouse and (3) the amount of any encumbrance or obligation incurred by the second decedent with respect to the transferred property.

An illustration of the above rules is provided in Regs. Sec. 20.20134(b)(3)(iii), Example (2):

The transferor bequeathed certain property to the decedent with a direction that the decedent pay $1,000 to X The value of the property transferred to the decedent is the value of the property reduced by $1,000.

In addition to outright transfers of property, other types of "property" also qualify for the credit. Regs. Sec. 20.2013-5 provides examples of "property," including ". . . annuities, life estates, estates for terms of years, vested or contingent remainders and other future interests."

Accordingly, a life income interest in a trust will constitute property under Sec. 2013, notwithstanding that such interest will not be included in the transferee's estate tax return (since, by definition, a life estate terminates at death). (Of course, the compounded value of the income received during life may comprise an asset of the estate.) In these instances, the actuarial value of the life estate on the date of the transferor's death will be used to determine the amount of the credit.

Example 2: H's will provided that income from a testamentary trust for which no marital deduction was claimed was to be distributed to his surviving spouse, W, during her life. At the time of H's death, W was 80 years old. For purposes of the credit, the value of the property is contingent on W's life expectancy at the time of H's death. H died in March 1997; the applicable Federal rate was 7.8%. Actuarial tables provide that a life estate for an individual aged 80 is $0.40710 for each $1.00 of property transferred. If the property transferred to the trust valued at Federal estate tax values in H's estate was $1,000,000, this would mean that for purposes of the "first" and "second" limitations, the value of the transferred property is $407,100, before any of the adjustments required under Sec. 201 3(d).

Tip: If a qualified terminable interest property (QTIP) election is available to an executor under the will of the first-to-die of a married couple, the potential tax savings resulting from the credit for prior transfers should be compared with the results obtained by making a 100% QTIP election. Since the life estate is to be valued actuarially (and in most cases, regardless of the surviving spouse's physical health at the time of the decedent's death), this strategy may be effective when the surviving spouse is not expected to live for the entire length of her life expectancy and the life expectancy is less than 10 years. If the decedent was terminally ill, however, this strategy should not be used.

Considering the credit for tax on prior transfers, Example 1 will reach different results: On the death of B, who inherited $1 million from A, the estate tax imposed on such property in B's estate was $500,000, assuming a 50% marginal estate tax rate. However, a credit will be available for prior transfers, limited to the lesser of the estate tax paid in A's estate attributable to such property (assuming it is also $500,000 or the estate tax paid in B's estate attributable to such property. If B's death is within two years of A's, 100% of the credit, or $500,000, will be allowed. As a result, C would stand to inherit the entire $1 million of property.