Impact of Sec. 704(e)(2) on family partnership freezes.

Earlier this year, the IRS published proposed regulations to implement the new Chapter 14 rules for the valuation of gifts to family members made in connection with "estate freezes" of corporations and partnerships. In general, if a donor retains a preferred senior interest in a corporation or partnership, the value of any transferred junior interest must be determined by subtracting the value of the retained interest from the total value of the donor's interest before the transfer. Income distribution rights retained by the donor are valued at zero, however, unless they are "qualified payment rights" that provide for cumulative distributions payable at least annually at a fixed rate.

The gift valuation rules contained in Sec. 2701 and the proposed regulations do not address the possible impact of Sec. 704(e)(2) on the transfer of a junior equity interest in an "estate freeze" partnership. When a partnership interest is transferred or created by gift, Sec. 704(e)(2) provides that the distributive share of partnership income attributable to the donee's capital may not be proportionately greater than the distributive share attributable to the donor's retained capital interest. Consequently, if the partnership freeze is successful, the retention of a fixed and limited income right designed to satisfy the qualified payment rules of Sec. 2701 is likely to result in an allocation of taxable income to the donee partner (who acquires the "common" equity ownership) that is excessive when measured by Sec. 704(e)(2).

The reallocation of taxable income to the donor required by Sec. 704(e)(2) does not prevent the partnership from actually distributing income to the donee partner in accordance with the provisions of the partnership agreement. Prior to the enactment of Sec. 2701, it was suggested that distributions made to a donee partner that exceeded the allocation permitted by Sec. 704(e)(2) create an implicit or imputed gift to the donee partner. Under this view, a typical partnership estate freeze will result in annual additional taxable gifts when actual distributions or income allocations that exceed the permissible Sec. 704(e)(2) allocation are made to the donee partner. Such a result appears to be directly contrary to the intent of Sec. 2701, however, which attempts to value the entire transferred interest in a business initially at the time of transfer.

It has also been suggested that Sec. 704(e)(2) is effective for income tax purposes only, and does not create any taxable transfer for gift tax purposes. Under this view, no direct conflict exists between Secs. 704(e)(2) and 2701. The disparity between the income and gift tax treatment resulting under this approach will generally be beneficial from an estate planning standpoint, since it enables the donor to further reduce his future taxable estate by charging him with the tax burden for partnership income attributable to the gifted interest.

The uncertain gift tax implications of Sec. 704(e)(2) are avoided entirely, if the proportionality requirement of Sec. 704(e)(2) can be viewed as satisfied by taking into account the different classes or types of capital interests of the donor and donee that exist in a typical estate freeze partnership. However, there is no direct support for such a result in the regulations or reported case law dealing with Sec. 704(e)(2).

IRS representatives have indicated in informal discussions that the interaction of Secs. 704(e)(2) and 2701 was not specifically considered when the proposed Sec. 2701 regulations were drafted. Until additional guidance becomes available, planners should proceed with caution when implementing family partnership freezes.