Estate freeze transactions not covered by Chapter 14.

A direct estate freeze can be accomplished with a lifetime gift to children or grandchildren of stock or a partnership interest in a family enterprise. Post-gift appreciation and earnings on the stock or partnership interest are shifted from the donor's estate to the donees. Any gift tax paid by the parent donor is excluded from the donor's estate, unless death occurs within three years of the gift, in which case the gift tax is added back to the estate under Sec. 2035(c). The overall benefit of removing the gift tax itself from the taxable estate is offset to some extent by the time value of money on the estate tax "prepayment."

Other freeze transactions that might have been reached by repealed Sec. 2036(c) may now be appropriate. For example, after recapitalizing his stock in the family corporation, a parent might choose to retain the common stock and give the preferred stock to his children. The special valuation rules of Sec. 2701 do not apply to this type of transfer.

In such a "reverse freeze," the objective is to minimize the gift tax value of the preferred stock given to the children. Therefore, the parent would usually select noncumulative preferred stock without value supporting features (such as a conversion privilege into the common stock or a liquidation right). As circumstances permit, the corporation then declares and pays dividends on the preferred stock. These dividends reduce the book value and presumably the fair market value of the parent's common stock. Furthermore, the dividends should not be treated as gifts because the gift-taxable event was the initial transfer of the preferred stock. The principal disadvantage to such a transfer is the double taxation of the preferred stock dividend, first at the corporate level and then to the preferred stock shareholder. (Of course, this type of transfer is unavailable for S corporations, since two classes of stock would be involved.)

Sec. 2701 is aimed at preventing undervaluation of common stock given by a parent to his children, based on an excessive value ascribed to the preferred stock retained by the parent. This provision does not appear to prevent the parent from selling common stock in the family corporation in exchange for a private annuity or a self-canceling installment note (SCIN). The value of the common stock previously held by the parent is then replaced by the funds received as payments on the annuity or SCIN before the parent's death. The health and projected life expectancy of the parent are critical considerations in deciding to attempt one of these transactions. Note, however, that the client cannot be suffering from a terminal illness at the time the transaction is done. Otherwise, the Service can deny the availability of the actuarial tables in valuing the retained annuity, or maintain that a much higher premium should have been paid for the self-canceling feature in the SCIN. (See IRS Letter Ruling (TAM) 9133001.)

Finally, the tax adviser will recall that Notice 89-89 did not prevent an estate freeze "by will." Thus, one could recommend recapitalization of the corporation into preferred and common stocks before the parent's death. The parent's will would bequeath the preferred stock to a marital trust for the surviving spouse (typically structured as a qualified terminable interest property (QTIP) trust in order to maintain control of the ultimate disposition of stock in the stockholder parent's will). The recapitalization would shift most of the value of the stock to the preferred stock, leaving a $600,000 value for the common stock, which would then be bequeathed to a family or credit shelter trust. Any future increase in the value of the enterprise would accrue to the credit shelter trust, rather than the QTIP or other marital trust where such value would be exposed to estate taxation on the surviving spouse's death.