Important gift tax return requirements under secs. 2701 and 2702.

With the enactment of Secs. 2701 and 2702 by the Revenue Reconciliation Act of 1990, many transactions involving family-held corporate or partnership equity interests and certain trust transactions must now be fully disclosed on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. This reporting requirement may apply even though the transaction was implemented solely for business reasons or did not result in a taxable gift. The Sec. 2701 reporting requirements may be invoked for corporate or partnership equity transactions (e.g., capital contributions, redemptions, recapitalizations, gifts and sales) if (1) more than one family member owns an equity interest and (2) there is more than one class of equity interest (other than interests that differ solely due to voting rights or legal liability limitations). Special reporting requirements also apply to grantor retained annuity trusts and unitrusts (GRATs and GRUTs). When Sec. 2701 or 2702 applies, special disclosures are necessary to begin the running of the gift tax statute of limitations (SOL). Certain Sec. 2701 elections necessary to avoid unexpected gift tax can be made only on timely filed (with extensions) gift tax returns.

General scope of Sec. 2701

Sec. 2701 provides special rules for determining the value of an interest in a corporation or partnership for gift tax purposes. The primary impact of Sec. 2701 is to increase the gift tax value of a junior equity interest directly or indirectly transferred to a family member, by arbitrarily valuing at zero certain senior equity interests and discretionary distribution rights held by the transferor or applicable family members.

The zero valuation rule generally applies if (1) a junior (e.g., common stock) equity interest in a corporation or partnership is directly or indirectly transferred to a family member and (2) the transferor or an applicable family member retains a more senior equity interest (e.g., preferred stock or preferential partnership interest). Nonqualified senior equity interests (e.g., noncumulative preferred stock, most preferential partnership income and capital rights, and discretionary rights, such as a liquidation, put, call or conversion right) are generally valued at zero in determining the gift tax value of a transferred junior equity interest.

Common examples of Sec. 2701 transactions include:

* A gift or sale of a common equity interest to a family member when the transferor or applicable family member holds a more senior equity interest. Sec. 2701 may apply even though the more senior interest was created before its Oct. 9, 1990 effective date.

* A recapitalization of a family member's junior equity interest into a senior equity interest.

* A capital contribution to a partnership in exchange for a partnership interest that is senior to the interests held by other family members.

* A capital contribution of cash or property to a corporation in exchange for preferred stock.

* A redemption of a common equity interest in a corporation or partnership if a family member holds a senior interest in the entity.

Required disclosures and elections

If a transaction is subject to the Sec. 2701 or 2702 special valuation rules, proper reporting is required to start the running of the gift tax SOL, even though no senior interests are valued at zero. Even if no gift was intended, it is generally advisable to file a return. For example, assume an individual exchanged common stock of a family-owned business for cumulative preferred stock but made no gifts of common to other family members. Assuming the preferred and common interests are properly valued under Sec. 2701, no gift has occurred. However, the SOL does not begin running until the transaction is disclosed on a properly filed gift tax return.

The disclosures required by Regs. Sec. 301.6501(c)-1(e) include a description of the transaction; the relationship between the transferor and any potential transferees; a detailed description of the method used to determine the gift amount (including the computation of any gift using the subtraction method in Regs. Sec. 25.2701-3(b)); actuarial factors and discount rates; and, if Sec. 2701 applies, detailed historical financial information.

Under Sec. 2701, a preferred interest is considered to have value only to the extent it has the right to receive qualified payments (as defined in Regs. Sec. 25.2701-2(b)(6)). Qualified payment rights generally are dividends or distributions that are cumulative and payable periodically at a fixed rate. In the event a preferred interest does not meet this definition, an election generally can be made under Regs. Sec. 25.2701-2(c)(2) to treat a distribution right as a qualified payment right' However, making this election subjects the owner to the imputed, gift provisions of Sec. 2701(d) if payments are not timely made. This election is irrevocable and must be made on a timely filed Federal gift tax return.

If there is any doubt as to whether a distribution right is a qualified payment, it may be advisable to make a "protective" election to treat it as a qualified payment right.

In some situations, a qualified payment election may be required for in individual not directly involved in the actual transfer. If a preferred interest is held by an applicable family member of the transferor (defined as the transferor's spouse, any ancestor of the transferor or the transferor's spouse, or the spouse of an ancestor), a qualified payment election must be made by the applicable family member and attached to the transferor's gift tax return.

Example: Parent P owns preferred stock and child C gives common stock to grandchild G. Unless P makes a qualified payment election, C must value P's stock at zero to determine the common stock gift value. This election is necessary even if P's preferred stock otherwise meets the definition of qualified payment rights. P's election is made on C's timely filed gift tax return (Regs. Sec. 25.2701-2(c)(5)). If P makes the election, he becomes subject to the Sec. 2701(d) imputed gift rules if the qualified payments are not timely received.