The progeny of Sec. 2036(c); the valuation of retained interests.Historically, estate planners Estate Planner, a professional that creates an estate plan. This professional works with an estate owner to maximize their goals. This is a legal and tax specialty for an attorney or an accountant. have advised their clients of the tax-saving wisdom of giving property before it appreciated in value. This allowed a leveraged use of the unified credit unified credit A credit used against federal taxes due on estates and large gifts. Under current law, the unified credit is sufficient to offset taxes on values of approximately $1 million in estates and large gifts. and caused greater value than the original gift to be excluded from the estate on the client's death. The corporate recapitalization Recapitalization Restructuring a company's debt and equity mixture often with the aim of making a company's capital structure more stable. Notes: Companies often want to diversify their debt-to-equity ratio to improve liquidity. and the limited partnership freeze were methods used by planners to shift appreciation out of a client's estate with even greater leveraged use of the unified credit. Likewise, the use of installment sales Installment sale The sale of an asset in exchange for a specified series of payments (the installments). installment sale A sale in which the buyer is scheduled to make a series of payments over a period of time. or options could "freeze" the value of property at the date of the transaction and allow the transferee to simply reimburse re·im·burse tr.v. re·im·bursed, re·im·burs·ing, re·im·burs·es 1. To repay (money spent); refund. 2. To pay back or compensate (another party) for money spent or losses incurred. the transferor for the original fair market value (FMV FMV - full-motion video ) with no gift or estate tax consequence. The Omnibus omnibus: see bus. Budget Reconciliation Act of 1987 (OBRA) made a rather overzealous o·ver·zeal·ous adj. Excessively enthusiastic: overzealous movie fans; an overzealous manager. o and clumsy attempt at trapping trapping, most broadly, the use of mechanical or deceptive devices to capture, kill, or injure animals. It may be applied to the practice of using birdlime to capture birds, lobster pots to trap lobsters, and seines to catch fish. this appreciation in the transferor's estate. The broad brush approach used in Sec. 2036(c) made it difficult to adequately counsel a client on the potential application of the statute to any given situation. The complexity, overbreadth and vagueness of Sec. 2036(c) created an uproar in the business and professional communities, encouraging Congress to reevaluate the use of both legitimate and abusive Tending to deceive; practicing abuse; prone to ill-treat by coarse, insulting words or harmful acts. Using ill treatment; injurious, improper, hurtful, offensive, reproachful. estate freezing techniques. The result was the retroactive Having reference to things that happened in the past, prior to the occurrence of the act in question. A retroactive or retrospective law is one that takes away or impairs vested rights acquired under existing laws, creates new obligations, imposes new duties, or attaches a repeal The Annulment or abrogation of a previously existing statute by the enactment of a later law that revokes the former law. The revocation of the law can either be done through an express repeal of Sec. 2036(c) back to its effective date of Dec. 17, 1987,(1) and its replacement with new Secs. 2701, 2702, 2703 and 2704(2) by the Revenue Reconciliation Act of 1990 (RRA RRA Registered Record Administrator. ). Secs. 2701-2704 are generally applicable to transfers and agreements entered into or substantially modified after Oct. 8, 1990.(3) The first of two parts of proposed regulations for Chapter 14 of the Code (i.e., Secs. 2701-2704) was filed Apr. 4, 1991. The second installment was filed on Sept. 10, 1991. New Chapter 14 describes valuation rules used strictly for gift, estate and generation-skipping taxes. It addresses perceived abuses relating to relating to relate prep → concernant relating to relate prep → bezüglich +gen, mit Bezug auf +acc certain buy-sell arrangements, option transfers, transfers in trust, term interests in property and the tax consequences of certain lapsing lapse v. lapsed, laps·ing, laps·es v.intr. 1. a. To fall from a previous level or standard, as of accomplishment, quality, or conduct: rights. The significant shift of emphasis from Sec. 2036(c) is to recognize a higher value on the transferred interest by limiting the value of the retained rights and interests rather than attempting to attribute subsequent appreciation to the transferor, and his estate, many years after the transfer. This allows the planner and the client a much higher degree of certainty. This article will explain the statute; identify issues and provide some insight on their possible resolution; relate the statute and proposed regulations to common situations that may be found in practice; and offer some thoughts on future planning. Transfers of Interests in Corporations and Partnerships * Rules and definitions New Sec. 2701 provides the framework for valuing certain rights (i.e., "applicable retained interest Retained interest (also colloquially known as a payout penalty) is future, currently unpaid, interest that some lenders add to the remaining principal of a loan to determine a payout figure in the event that the loan is terminated before the completion of the original term. ") retained by a transferor (or an "applicable family member") immediately after a transfer of an interest in a corporation or partnership to a "member of the transferor's family."(4) An applicable retained interest is any interest in an entity with respect to which there is a distribution right (provided the transferor and applicable family members control the entity before the transfer) or an extraordinary payment right (defined generally as a liquidation The collection of assets belonging to a debtor to be applied to the discharge of his or her outstanding debts. A type of proceeding pursuant to federal Bankruptcy , put, call or conversion right).(5) An applicable family member is defined as the transferor's spouse, ancestors Ancestors See also father; heredity; mother; origins; parents; race. archaism an inclination toward old-fashioned things, speech, or actions, especially those of one’s ancestors. Also archaicism. — archaist, n. of the transferor or the transferor's spouse, and the spouse of any such ancestor ANCESTOR, descents. One who has preceded another in a direct line of descent; an ascendant. In the common law, the word is understood as well of the immediate parents, as, of these that are higher; as may appear by the statute 25 Ed. III. De natis ultra mare, and so in the statute of 6 R. .(6) Members of the transferor's family include the transferor's spouse, lineal descendants lineal descendant n. a person who is in direct line to an ancestor, such as child, grandchild, great-grandchild and on forever. A lineal descendant is distinguished from a "collateral" descendant which would be from the line of a brother, sister, aunt or uncle. of the transferor or the transferor's spouse, and the spouse of any such descendant.(7) It is apparent from these definitions that Sec. 2701 is oriented o·ri·ent n. 1. Orient The countries of Asia, especially of eastern Asia. 2. a. The luster characteristic of a pearl of high quality. b. A pearl having exceptional luster. 3. to transfers to the lower generations in a family. Therefore, a transfer from a child to a parent would not be governed under these rules. After determining the value of the rights retained by the transferor, the value of the rights transferred is established by subtracting the retained interest's value from the value of the transferor's entire entity ownership before the transfer.(8) While this valuation method is not new, Sec. 2701 will cause certain retained rights to be deemed to have no value or a value much lower than under prior law, thus increasing the value of the gift or creating a gift even if full and adequate consideration is given.(9) Under the new valuation principles, any liquidation, put, call or conversion right will have no value unless the right must be exercised at a specific time and at a specific amount.(10) Any distribution right retained will also be deemed to have no value if the transferor (or an "applicable family member") is in "control" of the entity immediately before the transfer and the distribution right is not a "qualified payment."(11) A distribution right is a right to distributions from a corporation with respect to its stock or a right to distributions from a partnership with respect to the partners' interest in the partnership; it does not include, however, any right to receive distributions with respect to an interest that is of the same class as or a class that is subordinate to the transferred interest; extraordinary payment rights; any right of a partner to receive guaranteed payments of a fixed amount; mandatory payment rights; liquidation participation rights; and non-lapsing conversion rights.(12) All extraordinary payment rights are valued at zero.(13) Payments on debt, lease payments or payments as compensation are not considered distribution rights because they are not "with respect to an equity interest." For purposes of determining the existence of a distribution right, control is the direct or indirect holding of at least 50% of a corporation's stock or 50% of a partnership's capital or profits interest.(14) The holding of a general partnership interest in a limited partnership is also deemed control.(15) A qualified payment is any dividend payable on a periodic basis on any cumulative preferred stock Cumulative preferred stock Preferred stock whose dividends accrue, should the issuer not make timely dividend payments. Related: Non-cumulative preferred stock. to the extent that the dividend is determined at a fixed rate (or a comparable partnership payment).(16) * Cumulative vs. noncumulative dividends A noncumulative preferred stock Noncumulative preferred stock Preferred stock whose holders must forgo dividend payments when the company misses a dividend payment. Related: Cumulative preferred stock. interest that is retained by a transferor will be deemed to have no value, while an interest in a cumulative preferred stock that pays a dividend at a fixed rate will be deemed to have a value equal to the present value of the dividend stream. Example 1: Parent P owns all of the stock of a corporation with one class of stock worth $2,000,000. P exchanges his stock for 1,000 shares of voting preferred stock Stock shares that have preferential rights to dividends or to amounts distributable on liquidation, or to both, ahead of common shareholders. Preferred stock is given preference over common stock. Holders of preferred stock receive dividends at a fixed annual rate. . Each share of voting preferred has a par value and a liquidation preference of $1,000, a put back to the corporation at the liquidation preference and a 14% noncumulative dividend. P also receives 1,000 shares of nonvoting common stock, which he gives to child C. P does not elect to treat his distribution right as a qualified payment. The gift to C is valued for gift tax purposes by subtracting the value of the retained interest determined under Sec. 2701 from the total value of $2,000,000. Because the dividend is noncumulative, it does not constitute a qualified payment and the preferred stock retained by P is valued at zero. Therefore, the value of the gift to C is $2,000,000. Total value of corporation $2,000,000 Less Sec. 2701 value of P's stock ($1,000,000 liquidation preference, 14% noncumulative dividend) 0 Value of gift to C $2,000,000 P must recognize a gift of 100% of the corporation's value. On P's death, P's ownership (which is substantial) will be valued and included in P's gross estate along with the prior taxable gift of $2,000,000 to C. Note: This double counting Double counting may refer to:
tr.v. en·ti·tled, en·ti·tling, en·ti·tles 1. To give a name or title to. 2. To furnish with a right or claim to something: to a credit against the estate tax equal to the increase in the gift tax resulting from the application of Sec. 2701 to the initial transfer.(17) Three-step valuation of gifts: The proposed regulations outline a three-step approach to valuing gifts under Sec. 2701. 1. Value the entity. 2. Subtract A relational DBMS operation that generates a third file from all the records in one file that are not in a second file. the value of senior equity interests. 3. Allocate remaining value among the transferred interests and other interests of the same and subordinate classes.(18) Example 2, above, illustrates this three-step calculation. Example 2: Determining the Value of a Transferred Interest P owns all of the stock of a corporation with one class of stock worth $2,000,000. P exchanges his stock for 1,000 shares of voting preferred stock. Each share of voting preferred has a par value of $1,000 and a 12% cumulative dividend. P also receives 1,000 shares of nonvoting common stock with a par value of $1,000 per share, which he gives to C, his child. Because the preferred stock has a cumulative dividend, the dividend payments are treated as qualified payments under Sec. 2701 and the preferred stock is valued at the present value of the qualified payments. Therefore, assuming that the 12% dividend rate is a proper return and a 15% control premium is reasonable, P's gift to C is valued as follows. Step 1: Total value of corporation $2,000,000 Step 2: Less the value of P's stock:
Present value of qualified payments $1,000,000
Control premium 150,000
1,150,000
Step 3: Value of gift to C $850,000
* Elective rights Two central issues for democracies are the right to candidate, and suffrage or the franchise—that is, the decision as to who is entitled to vote. For example, Athenian democracy limited the vote to male citizens, while slaves, foreigners, and women of any status were excluded. If a retained interest consists of the right to a qualified payment and there are also extraordinary payment rights, the value of all such rights will be determined as if each extraordinary payment right were exercised in a manner resulting in the lowest possible value for purposes of valuing the interests retained by the transferor.(19) Example 3: P retains cumulative preferred stock in a transaction to which Sec. 2701 applies. The cumulative dividend is $100 per year and the stock may be redeemed re·deem tr.v. re·deemed, re·deem·ing, re·deems 1. To recover ownership of by paying a specified sum. 2. To pay off (a promissory note, for example). 3. at any time after two years for $1,000. The value of the cumulative preferred stock is the lesser of (1) the present value of receiving $100 dividends for two years plus the present value of the redemption of $1,000 in year 2, or (2) the present value of $100 paid every year in perpetuity Of endless duration; not subject to termination. The phrase in perpetuity is often used in the grant of an Easement to a utility company. in perpetuity adj. forever, as in one's right to keep the profits from the land in perpetuity. . * Exemptions Certain retained interests are exempt from valuation under Sec. 2701. The retention of stock that is quoted on an established securities market or a retained interest in stock that is of the same class or is proportionally pro·por·tion·al adj. 1. Forming a relationship with other parts or quantities; being in proportion. 2. Properly related in size, degree, or other measurable characteristics; corresponding: the same (without regard to nonlapsing differences in voting power) as the transferred stock is exempt from the new valuation rules.(20) Example 4: P owns 100% of a corporation's stock consisting of 100 shares of voting common stock and 1,000 shares of nonvoting common stock. P gives the 1,000 shares of nonvoting stock Nonvoting stock A security that does not entitle the holder to vote on the corporation's resolutions or elections. nonvoting stock to C. Because the only distinction between the classes of stock is voting rights Voting rights The right to vote on matters that are put to a vote of security holders. For example the right to vote for directors. voting rights The type of voting and the amount of control held by the owners of a class of stock. and such distinction does not lapse (language) LAPSE - A single assignment language for the Manchester dataflow machine. ["A Single Assignment Language for Data Flow Computing", J.R.W. Glauert, M.Sc Diss, Victoria U Manchester, 1978]. , Sec. 2701 would not apply to the gift. * Qualified payment elections The transferor may irrevocably ir·rev·o·ca·ble adj. Impossible to retract or revoke: an irrevocable decision. ir·rev elect to treat any distribution right held by the transferor in a controlled entity as a qualified payment to be paid in the amounts and at such times as specified in the election.(21) The amounts and times so specified in the election cannot be inconsistent with the underlying legal agreement governing the right. By making the election, the transferor increases the value attributed to the retained interest and decreases the value of the current transfer, but not in excess of the FMV of such interest. However, by electing into qualified payment treatment, the payments become subject to certain rules that create subsequent gifts when payments are not made in accordance Accordance is Bible Study Software for Macintosh developed by OakTree Software, Inc.[] As well as a standalone program, it is the base software packaged by Zondervan in their Bible Study suites for Macintosh. with the election (within a four-year grace period).(22) Example 5: P and C are partners in a partnership to which P contributes an existing business. P is entitled to 80% of the partnership's net cash receipts until he receives $1,000,000, after which time P and C receive 50% each of the partnership's cash flow. P's liquidation preference equals $1,000,000. The retained right to $1,000,000 is valued at zero, unless P elects to treat it as a right to receive qualified payments in the amounts, and at the times, specified in the election. If P elects such treatment, amounts not paid at the time specified in the election become subject to the interest compounding rules. Conversely con·verse 1 intr.v. con·versed, con·vers·ing, con·vers·es 1. To engage in a spoken exchange of thoughts, ideas, or feelings; talk. See Synonyms at speak. 2. , a transferor who retains an interest may irrevocably elect to have distribution rights, which would otherwise qualify, not be treated as qualified payments.(23) By electing to waive To intentionally or voluntarily relinquish a known right or engage in conduct warranting an inference that a right has been surrendered. For example, an individual is said to waive the right to bring a tort action when he or she renounces the remedy provided by law for such qualified payment treatment, the value of the transferor's retained interest will be decreased, thereby increasing the value of the interest transferred. This waiver The voluntary surrender of a known right; conduct supporting an inference that a particular right has been relinquished. The term waiver is used in many legal contexts. will prevent any late payments on cumulative preferred Noun 1. cumulative preferred - preferred stock whose dividends if omitted accumulate until paid out cumulative preferred stock preference shares, preferred shares, preferred stock - stock whose holders are guaranteed priority in the payment of dividends but dividends from being subject to the rules applicable to nontimely qualified payments. * Taxable events Taxable event An event or transaction that has a tax consequence, such as the sale of stock holding that is subject to capital gains taxes. If a qualified payment is not made on its scheduled due date, then, on the occurrence of a "taxable event," the taxable gift or taxable estate Taxable Estate The total value of a deceased person's assets that are subject to taxation - minus liabilities and minus the prescribed tax-deductible portion of assets left behind by the deceased. of a transferor will be increased by a certain compounded value.(24) The amount of the increase is the excess of the value of the qualified payments payable during the period beginning on the date of the original transfer and ending on the date of the "taxable event," determined as if all payments were made according to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. schedule, followed by the reinvestment Reinvestment Using dividends, interest and capital gains earned in an investment or mutual fund to purchase additional shares or units, rather than receiving the distributions in cash. 1. In terms of stocks, it is the reinvestment of dividends to purchase additional shares. of the payment at an adequate rate, over the value of the payments made during the same period on the basis of the time when the payments were actually paid.(25) Any distribution made before the end of a four-year period beginning on its due date is treated as having been made on its due date.(26) A taxable event includes (1) the transferor's death if the retained interest is includible in the transferor's estate, (2) the lifetime transfer of the retained interest and (3) at the election of the taxpayer, the payment of a qualified payment after the close of the four-year grace period.(27) Example 6: P retains 12% cumulative preferred stock with a face value of $1,000,000 in a transaction to which Sec. 2701 applies. Five years after the transfer, P dies. No dividends were ever paid on the preferred stock. P's taxable estate will be increased by an amount determined as follows. Value of "missed" payments of $120,000 per year reinvested at an adequate rate of return (assume 10%) at the end of five years $732,612 Less the value of actual payments received reinvested at 10% at the end of five years 0 Increase in P's taxable estate $732,612 * Minimum valuation of junior equity A junior equity interest, such as common stock or any partnership interest in which rights to income and capital are junior to the rights of other partnership interests, that is transferred under Sec. 2701 is subject to a minimum valuation rule. The minimum value of all junior equity interests in a corporation or partnership must equal at least 10% of the sum of the total value of all equity interests in the entity plus the total debt the entity owes to the transferor or to an applicable family member.(28) Debt generally does not include current payables for services or pursuant to a lease.(29) * Attribution at·tri·bu·tion n. 1. The act of attributing, especially the act of establishing a particular person as the creator of a work of art. 2. Transfers to persons whose ownership is attributed to the transferor are not treated as transfers.(30) The attribution extends to indirect ownership through corporations, partnerships, trusts or other entities.(31) Attribution relating to the "control" issue would include lineal descendants of the transferor's parents or the transferor's spouse's parents.(32) Trusts and Term Interests * Rules and definitions Sec. 2702 provides new rules for determining whether a transfer of an interest in trust to a member of the transferor's family is a gift and the value of any such gift. Generally, the value of a transferred interest is determined by subtracting the value of the retained interest from the value of the entire property interest.(33) Under Sec. 2702, any retained interest that is not a "qualified interest" will have no value.(34) A qualified interest includes (1) the right to receive fixed amounts payable at least annually, (2) the right to receive a fixed percentage of the FMV of the property in trust at least annually and (3) any noncontingent remainder interest, if all other interests in the trust consist of interests described in (1) or (2).(35) The regulations define a qualified interest as a qualified annuity annuity: see insurance. annuity Payment made at a fixed interval. A common example is the payment received by retirees from their pension plan. There are two main classes of annuities: annuities certain and contingent annuities. interest, a qualified unitrust interest or a qualified remainder interest.(36) The values of qualified annuity interests and qualified remainder interests are determined under the Sec. 7520 valuation tables.(37) The values of qualified unitrust interests are determined as if they were unitrust interests described in Sec. 664. Example 7: P transfers $1,000,000 to a grantor retained income trust Grantor Retained Income Trust (GRIT) A tax-saving trust in which a grantor transfers property to a beneficiary, but receives income until termination, at which time the beneficiary begins receiving the income. (GRIT). It provides that P receives all trust income for 10 years. At the end of the 10-year term, if P is still alive, the trust principal is to be distributed to C. If P dies during the term, the trust principal is to be distributed to P's estate. Under Sec. 2702, P's gift to C will be valued at the entire $1,000,000 because none of P's interest in the trust is "qualified." Example 8: P transfers $1,000,000 to a trust, retaining a right to receive $100,000 per year for 10 years. At the end of the term, the trust corpus is to be paid to C. P has retained a qualified annuity interest. The value of P's gift to C, assuming a prescribed pre·scribe v. pre·scribed, pre·scrib·ing, pre·scribes v.tr. 1. To set down as a rule or guide; enjoin. See Synonyms at dictate. 2. To order the use of (a medicine or other treatment). rate of 10% under Sec. 7520, is determined using IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. Publication 1457 (Aug. 1989), Table B.
Total value of the trust assets $1,000,000
Value of P's retained interest 614,457
Value of gift to C $ 385,543
Like Sec. 2701, Sec. 2702 presents the possibility of double taxation. Such a situation would occur when an individual, who has previously made a transfer of property to a trust and retained an interest valued under Sec. 2702, transfers the retained interest by gift. Under the proposed regulations, the individual is allowed to decrease the amount of the taxable gift on the transfer of the retained interest to avoid any double taxation.(38) * Exceptions Sec. 2702 does not apply to the transfer in trust of an interest in the transferor's personal residence as the sole asset of the trust or to transfers that would not be treated as completed gifts under the applicable gift tax rules.(39) Example 9: P transfers his personal residence worth $1,000,000 to a GRIT. It provides that P will receive all trust income for 10 years. At the end of the 10-year term, if P is still alive, the trust principal is to be distributed to C. If P dies during the term, the trust principal is to be distributed to P's estate. Due to the exception in Sec. 2702 for personal residences, P's gift to C is valued under traditional valuation methods. Assuming a prescribed rate of 10% under Sec. 7520, the gift value is determined using IRS Publication 1457, Table B. Total value of trust assets $1,000,000 Value of P's retained interest 614,457 Value of gift to C $ 385,543 The proposed regulations deal extensively with personal residence trusts. A personal residence trust is a trust the governing instrument of which prohibits the trust from holding, for the entire term of the trust, any asset other than one residence to be used as a personal residence by the term holders.(40) An individual may not be the holder of a term interest in more than two personal residence trusts at any one time.(41) A term holder's personal residence is defined as either his principal residence or one other residence, as defined in Sec. 280A(d)(1) (relating to vacation homes Vacation Home A home separate from an individual's primary residence that is used for recreational purposes and may also be rented out at unused times. Notes: For tax purposes, those who rent their vacation homes may result in a lower amount of allowable expense ).(42) The proposed regulations present significant planning opportunities using personal residence trusts. If the qualifications of the proposed regulations are met, a significant amount of wealth in the form of personal residences may be passed to another generation at a substantial discount. * Certain property treated as held in trust Sec. 2702 treats the retention of a term interest in property as if it were a retention of an interest in trust.(43) A term interest includes a life interest in the property as well as an interest in the property for a term of years.(44) * Joint purchases Joint purchases of property creating a term interest among family members will be treated as if the person acquiring the term interest had acquired the entire property and then transferred the remainder interest to the other purchaser.(45) The transfer is treated as being made for the consideration provided by the remainder purchaser on the acquisition of the property. Example 10: P and C jointly purchase a $1,000,000, 20-year bond with a 10% yield. P purchases a 20-year term interest (i.e., the income interest) in the bond for $796,330 and C purchases the remainder interest for $203,670. Under Sec. 2702, P is treated as acquiring the entire $1,000,000 bond and transferring a remainder interest to C for $203,670. On the date of the purchase, the prescribed rate under Sec. 7520 is 11%. Using Table B of IRS Publication 1457, the value of P's term interest is $796,330. Because P's interest is a qualified interest (i.e., provides for fixed payments), P has therefore made no gift to C. By equating e·quate v. e·quat·ed, e·quat·ing, e·quates v.tr. 1. To make equal or equivalent. 2. To reduce to a standard or an average; equalize. 3. a joint purchase with the purchase of the entire property by the term interest holder followed by a transfer of the remainder interest, a Sec. 2702 concern over the effect of the Gradow(46) case may arise. In Gradow, a spouse transferred an interest in certain community property to a trust already containing her deceased deceased 1) adj. dead. 2) n. the person who has died, as used in the handling of his/her estate, probate of will and other proceedings after death, or in reference to the victim of a homicide (as: "The deceased had been shot three times. husband's share of such property. She was an income beneficiary Income beneficiary One who receives income from a trust. of the trust for her life. The court held that what she actually transferred was her entire interest in the property and did not adopt the taxpayer's position that she transferred only a remainder interest. The case implies that a transfer of a remainder interest will be equivalent to the transfer of the entire value of the property. Sec. 2702 treats the holder of the retained interest as transferring the remainder interest in exchange for the consideration provided by the remainderman in the joint purchase. In Example 10, if the Gradow theory applied, P would have transferred a remainder interest (deemed to be the entire interest) valued at $1 million to C in exchange for $203,670, resulting in a $796,330 gift. This appears to be a result contrary to the concept and pattern of Chapter 14 and a strained interpretation of Gradow (given that Gradow dealt with community property, Sec. 2036(a), a transferor who was a beneficiary beneficiary Person or entity (e.g., a charity or estate) that receives a benefit from something (e.g., a trust, life-insurance policy, or contract). A primary beneficiary receives proceeds from a trust or insurance policy before any other. of the transferee trust and the fact that the case is still subject to appeal). * Limited applicability It is important to note that Sec. 2702 applies solely for purposes of determining the existence and valuation of gifts.(47) Therefore, while Sec. 2702 treats joint purchases creating a life estate and a remainder interest as the purchase by the life tenant of the property followed by a transfer of a remainder interest, this treatment does not result in a "transfer" under Sec. 2036(a) (potentially resulting in the entire value of the property being included in the life tenant's estate). This should be contrasted with the actual purchase of an entire interest by the life tenant, followed by a gift or sale of a remainder interest. In such a case, Sec. 2036(a) may apply and the considerations under Gradow would be relevant as to "full and adequate consideration." Therefore, a joint purchase continues to be a more desirable alternative than an acquisition followed by the transfer of remainder interest. * Valuation rule for certain term interests A special rule provides that if the nonexercise of rights under a term interest in tangible property tangible property n. physical articles (things) as distinguished from "incorporeal" assets such as rights, patents, copyrights, and franchises. Commonly tangible property is called "personalty. would not have a substantial effect on the valuation of the remainder interest in such property, the value of the term interest is the amount for which it could be sold to an unrelated third party.(48) The proposed regulations indicate this rule would not generally apply to depreciable depreciable Of, relating to, or being a long-term tangible asset that is subject to depreciation. or depletable de·plete tr.v. de·plet·ed, de·plet·ing, de·pletes To decrease the fullness of; use up or empty out. [Latin d property, but does allow for a de minimis An abbreviated form of the Latin Maxim de minimis non curat lex, "the law cares not for small things." A legal doctrine by which a court refuses to consider trifling matters. exception.(49) The proposed regulations provide the following examples. Example 11: P purchases a 10-year income interest in a painting. The painting does not possess an ascertainable as·cer·tain tr.v. as·cer·tained, as·cer·tain·ing, as·cer·tains 1. To discover with certainty, as through examination or experimentation. See Synonyms at discover. 2. useful life. C purchases the remainder interest in the painting. Each pays a portion of the total purchase price ($2,000,000), determined by valuing their respective interests under Sec. 7520. As holder of the term interest, P is treated as acquiring the painting and transferring the remainder interest to C. P's income interest is not a qualified interest under Regs. Sec. 25.2702-3. However, because of the nature of the property, P's failure to exercise P's rights with regard to the painting would not be expected to cause the value of the painting to be higher than it would otherwise be at the time it passes to C. For example, if P placed the painting in storage, forgoing for·go also fore·go tr.v. for·went , for·gone , for·go·ing, for·goes To abstain from; relinquish: unwilling to forgo dessert. P's right to realize the rental value rental value n. the amount which would be paid for rental of similar property in the same condition in the same area. Evidence of rental value becomes important in lawsuits in which loss of use of real property or equipment is an issue, and the rental value is the or otherwise to enjoy P's rights in the painting, the value of the painting would not be increased at the time it passed to C. In addition, the painting would not be depreciable if it were used in a trade or business or held for the production of income. Accordingly, P's interest is valued under Prop. Regs. Sec. 25.2702-2(c)(1). P furnishes $750,000 of the purchase price and establishes that a willing buyer of P's interest would pay $100,000 for the interest.(50)
Consideration furnished by P $750,000
Willing buyer purchase price 100,000
Value of gift to C $650,000
Example 12: Assume the same facts as in Example 11, except that the only evidence produced by P to establish the value of P's 10-year term interest is the amount paid by a museum for the right to use a comparable painting for one year. P asserts that the value of the 10-year term is 10 times the value of the one-year term. P has not established the value of the 10-year term interest; a series of short-term rentals, the aggregate duration of which equals the duration of the actual term interest, does not establish what a willing buyer would pay a willing seller for the 10-year term interest. However, the value of the 10-year interest is not less than the value of the one-year term because it can be assumed that a willing buyer would pay no less for a 10-year term interest than a one-year term interest.(51) Although some of the examples in the proposed regulations confusingly con·fuse v. con·fused, con·fus·ing, con·fus·es v.tr. 1. a. To cause to be unable to think with clarity or act with intelligence or understanding; throw off. b. describe a joint purchase situation, the implication of the proposed regulations seems to be that a transferor of a painting may retain the right to hang the painting over a period of years and subtract the FMV of the right to hang the painting for those years from the total value of the painting in arriving at the gift amount of the remainder interest. Evidently, the "no substantial effect on value" determination is to be made on the date the term interest expires rather than the initial transfer date. Buy-Sell Agreements buy-sell agreement n. a contract among the owners of a business which provides terms for their purchase of a withdrawing partner's or stockholder's interest in the enterprise. * General rule New Sec. 2703 was enacted to curb perceived abuses in the discounting of value based on restrictions and provisions in buy-sell and option agreements. Congress believed that while buy-sell agreements and options serve many valid business purposes, they also cause abusive distortions of gift and estate tax valuations. Therefore, the new rules ignore certain rights contained in buy-sell agreements when valuing retained and transferred interests in corporations and partnerships. * Exception Sec. 2703 does not apply to any option or agreement that (1) is a bona fide [Latin, In good faith.] Honest; genuine; actual; authentic; acting without the intention of defrauding. A bona fide purchaser is one who purchases property for a valuable consideration that is inducement for entering into a contract and without suspicion of being business arrangement, (2) is not a device to transfer property to members of the decedent's family for less than full and adequate consideration and (3) has terms comparable to similar arrangements entered into by persons in an arm's-length transaction.(52) In determining whether a transaction is an arm's length arm's length adj. the description of an agreement made by two parties freely and independently of each other, and without some special relationship, such as being a relative, having another deal on the side or one party having complete control of the other. agreement, relevant considerations include the current value of the property, its expected future value, the expected duration of the agreement, and the amount of any consideration paid for the option.(53) A right or restriction is considered to meet each of these three requirements if it is "a binding agreement exclusively among persons who are not the natural objects of each other's bounty bounty, payment made by a government bounty, amount paid by a government for the achievement of certain economic or other goals. It often takes the form of a premium paid for the increased production or export of certain goods. ."(54) Example 13: P and C own 50% each of the stock of a corporation that has one class of stock. After Oct. 8, 1990, P and C enter into a buy-sell agreement. The terms of the buy-sell agreement require the executor executor n. the person appointed to administer the estate of a person who has died leaving a will which nominates that person. Unless there is a valid objection, the judge will appoint the person named in the will to be executor. of the estate of the first to die to sell the decedent's stock to the survivor at a price determined under a formula. The formula sets the purchase price at the average of the last three years earnings times a multiple of two. The agreement also states that any stock transferred during the life of P and C must first be offered to the other at the formula price. If it cannot be established that this formula would have been used by persons in an arm's-length transaction, on P's death the value of his stock in the corporation will be determined for estate tax purposes without regard to the buy-sell agreement. Example 14: P owns a building and leases it to C after Oct. 8, 1990 for use in C's business. The term of the lease is 30 years. The rental payments are fixed for the entire term at an amount that represented fair rental value at the time it was entered into. On P's death, 10 years after the lease was entered into, the rent is well below a fair market rate. If the taxpayer cannot prove that the lease was a bona fide business arrangement, was not a device to transfer property to a family member at a bargain price, and has terms comparable to similar arm's-length transactions, the real estate will be includible in P's estate at its then FMV without regard to the terms of the lease to which it remains subject. * Effective date Sec. 2703 is effective for arrangements entered into or substantially modified after Oct. 8, 1990.(55) A right or restriction that is substantially modified is treated as created on the modification date. Any discretionary modification, whether or not authorized au·thor·ize tr.v. au·thor·ized, au·thor·iz·ing, au·thor·iz·es 1. To grant authority or power to. 2. To give permission for; sanction: by the terms of the agreement, that results in other than a de minimis change to the quality, value or timing of the right or restriction is a substantial modification. If the terms of the right or restriction require periodic updating, the failure to update is presumed to substantially modify the right or restriction unless it can be shown that updating would not have resulted in a substantial modification. The addition of any family member as a party to a right or restriction is considered a substantial modification (unless the addition is mandatory under the terms of the right or restriction).(56) * Book value There are undoubtedly many buy-sell agreements between both related and unrelated parties that use book value as the purchase price for stock. Therefore, it might be argued that such an agreement between related parties falls within the exceptions to Sec. 2703, since its terms are comparable to similar arrangements entered into by persons in arm's-length transactions and may well be a bona fide business arrangement. This is true even though, in many cases, book value may be considerably less than FMV and less than the price at which a party to the agreement would sell to an outsider Outsider often refers to one identified as on the periphery of social norms, one living or working apart from mainstream society, or one observing a group from the outside, as used in:
tr.v. an·a·lyzed, an·a·lyz·ing, an·a·lyz·es 1. To examine methodically by separating into parts and studying their interrelations. 2. Chemistry To make a chemical analysis of. 3. as to the bona fide requirement. * Conservation easements EASEMENTS, estates. An easement is defined to be a liberty privilege or advantage, which one man may have in the lands of another, without profit; it may arise by deed or prescription. Vide 1 Serg. & Rawle 298; 5 Barn. & Cr. 221; 3 Barn. & Cr. 339; 3 Bing. R. 118; 3 McCord, R. When clients have very valuable residential properties in their families and wish to be bound by restrictions against commercial or industrial use, conservation easements granted to qualifying entities under Sec. 170(h) act to dramatically reduce the value of the property in the estate. The proposed regulations specifically provide that such easements are not treated as a "right or restriction," thus rendering Sec. 2703 inapplicable in·ap·pli·ca·ble adj. Not applicable: rules inapplicable to day students. in·ap ,(57) even if the easement easement, in law, the right to use the land of another for a specified purpose, as distinguished from the right to possess that land. If the easement benefits the holder personally and is not associated with any land he owns, it is an easement in gross (e.g. is conveyed after Oct. 8, 1990. Example 16: A owns 100 acres on the ocean with a home that has been in the family for generations. The property is worth $10,000,000. On Oct. 10, 1990, A grants conservation organization XYZ XYZ interj. Informal Used to indicate to someone that the zipper of his or her pants is open. [ex(amine) y(our) z(ipper).] a conservation easement qualifying under Sec. 170(h), which permanently prohibits any commercial development, etc. The value of the property has now dropped to $2,000,000. Sec. 2703 would not apply, thus allowing the restriction to reduce the property's estate value to $2,000,000. Treatment of Certain Lapsing Rights and Restrictions * Lapsed LEGACY, LAPSED. A legacy is said to be lapsed or extinguished, when the legatee dies before the testator, or before the condition upon which the legacy is given has been performed, or before the time at which it is directed to vest in interest has arrived. Bac. Ab. Legacy, E; Com. Dig. rights Under new Sec. 2704, the lapse of a voting right Voting Right The right of a stockholder to vote on matters of corporate policy as well as on who is to compose the board of directors. Notes: Most voting involves decisions on issuing securities, initiating stock splits, and making substantial changes in the corporation's or a liquidation right in a corporation or partnership results in either a transfer of value by gift or inclusion in the gross estate.(58) For Sec. 2704 to apply, the voting or liquidation rights Liquidation rights The rights of a firm's securityholders in the event the firm liquidates. must be held by an individual (or a member of the individual's family) who is in "control" (determined under the Sec. 2701 definition) of the entity both before and after the lapse.(59) For purposes of this section, "family" includes the transferor's spouse, ancestors, and lineal descendants of the transferor or the transferor's spouse, siblings siblings npl (formal) → frères et sœurs mpl (de mêmes parents) and spouses of such individuals.(60) The amount of the gift is the value of the individual's interest in the entity before the lapse of the right less the value of the individual's interest in the entity after the lapse.(61) Example 17: P and C own a corporation. P's stock has a voting right that lapses on P's death. Under Sec. 2704, P's stock is valued for estate tax purposes as if the voting right of P's stock were nonlapsing. Example 18: P and C own all the stock in a corporation. P's stock carries a right that lapses after 10 years to liquidate To pay and settle the amount of a debt; to convert assets to cash; to aggregate the assets of an insolvent enterprise and calculate its liabilities in order to settle with the debtors and the creditors and apportion the remaining assets, if any, among the stockholders or owners of the the corporation. C's stock has no such right. Under Sec. 2704, there is a gift at the time the liquidation right lapses equal to the excess of the value of P's stock determined as if P held the right to liquidate over the value of P's stock determined as if he did not hold the liquidation right. Sec. 2704(a) is not applicable to the lapse of liquidation rights to the extent the holder and members of the holder's family cannot exercise such liquidation rights following the lapse.(62) Also, Sec. 2704(a) does not apply to the lapse of a voting or liquidation right that was previously valued under Sec. 2701(a).(63) * Disregard of restrictions On the transfer of an interest in a corporation or partnership to a member of the transferor's family when the transferor (or a member of the transferor's family) controls the entity, any restriction on the ability of the corporation or partnership to liquidate will be disregarded dis·re·gard tr.v. dis·re·gard·ed, dis·re·gard·ing, dis·re·gards 1. To pay no attention or heed to; ignore. 2. To treat without proper respect or attentiveness. n. in determining the value of the transferred interest if the restriction by its terms lapses on or after the transfer or if the transferor (or a member of the transferor's family) has the right after such transfer to remove the restriction.(64) Example 19: P and C are the sole partners in a partnership. The partnership agreement provides that the partnership cannot be terminated. P dies leaving his interest to C. C, as the sole partner, can now remove the restriction on partnership termination. Under Sec. 2704, the value of P's partnership interest in his estate is determined without regard to the liquidation restriction. Commercially reasonable restrictions imposed by unrelated persons providing financing to the entity for trade or business operations Business operations are those activities involved in the running of a business for the purpose of producing value for the stakeholders. Compare business processes. The outcome of business operations is the harvesting of value from assets are disregarded for purposes of Sec. 2704(b).(65) * Gift tax consequences? Sec. 2704 merely treats lapses as transfers without identifying to whom the transfer is made. This rule applies only when the family controls the entity before and after the lapse. Therefore, unrelated parties could own anything less than 50%. The identity of the transferee and the allocation of the value of the transfer are important for purposes of the gift tax exclusion, generation-skipping tax exemption tax exemption, immunity from the requirement of paying taxes. Federal, state, and usually local law provide exemption from taxation for a wide variety of organizations, usually not-for-profit, such as churches, colleges, universities, health care providers, various and the basis allocated to transferees. Example 20: Assume the same facts as in Example 17, except that P owns 20% and C owns 41%. Twenty unrelated persons own the other 39%, acquired in an employee stock purchase program. The lapse of the right gives rise to a $210,000 transfer. Is this a gift to the other 21 shareholders allocated per capita [Latin, By the heads or polls.] A term used in the Descent and Distribution of the estate of one who dies without a will. It means to share and share alike according to the number of individuals. so that each receives a present interest of $10,000 or is it allocated pro rata [Latin, Proportionately.] A phrase that describes a division made according to a certain rate, percentage, or share. In a Bankruptcy case, when the debtor is insolvent, creditors generally agree to accept a pro rata share of what is owed to them. based on percent ownership or is all $210,000 allocated to C? If P's stock had a basis of $1,000,000 and current value of $2,100,000, does $100,000 (10% of $1,000,000 [$210,000 in proportion to $2,100,000 total value]) of basis transfer with the gift? Conclusion While there are still a substantial number of issues to be resolved under the new legislation, the potential traps for the unwary have been dramatically reduced compared to the general and subjective language of repealed Sec. 2036(c). This represents a much more pinpointed attempt at curbing perceived abuses. It also allows a determination of the treatment at the time of transfer in most cases, rather than waiting until the transferor's death. Congress' warming to the idea of freezing estates to allow the succession of family businesses and attracting children into the business may result in further legislation that will make the new rules more workable. For example, the double taxation of dividends can be a serious hindrance hin·drance n. 1. a. The act of hindering. b. The condition of being hindered. 2. One that hinders; an impediment. See Synonyms at obstacle. to a recapitalization using qualified payments. Allowing preferred stock in an S corporation could greatly enhance the desirability of a recapitalization by avoiding taxes at the corporate level. (1)RRA Section 11601(a). (2)RRA Section 11602(a). (3)RRA Section 11602(e). (4)Sec. 2701(a)(1); Prop. Regs. Sec. 25.2701-1(a)(1). (5)Sec. 2701(b)(1); Prop. Regs. Sec. 25.2701-2(b). (6)Sec. 2701(e)(2); Prop. Regs. Sec. 25.2701-1(d)(2). (7)Sec. 2701(e)(1); Prop. Regs. Sec. 25.2701-1(d)(1). (8)Prop. Regs. Sec. 25.2701-1(a)(2). (9)Prop. Regs. Sec. 25.2701-1(b)(1). (10)Sec. 2701(a)(3)(A). (11)Sec. 2701(a)(3)(A) and (b)(1)(A). (12)Sec. 2701(c)(1)(A); Prop. Regs. Sec. 25.2701-2(b)(3) and (4). (13)Prop. Regs. Sec. 25.2701-2(a)(1). (14)Sec. 2701(b)(2); Prop. Regs. Sec. 25.2701-2(b)(5). (15)Sec. 2701(b)(2)(B)(ii); Prop. Regs. Sec. 25.2701-2(b)(5)(iii). (16)Sec. 2701(c)(3)(A); Prop. Regs. Sec. 25.2701-2(b)(6). (17)Prop. Regs. Sec. 25.2701-5. (18)Prop. Regs. Sec. 25.2701-3(b). (19)Sec. 2701(a)(3)(B); Prop. Regs. Sec. 25.2701-2(a)(3). (20)Sec. 2701(a)(2); Prop. Regs. Sec. 25.2701-1(c). (21)Sec. 2701(c)(3)(C)(ii); Prop. Regs. Sec. 25.2701-2(c)(2). (22)Sec. 2701(d)(2)(C). (23)Sec. 2701(c)(3)(C)(i); Prop. Regs. Sec. 25.2701-2(c)(1). (24)Sec. 2701(d); Prop. Regs. Sec. 25.2701-4(a). (25)Sec. 2701(d)(2)(A); Prop. Regs. Sec. 25.2701-4(c)(1). (26)Sec. 2701(d)(2)(C); Prop. Regs. Sec. 25.2701-4(c)(3). (27)Sec. 2701(d)(3)(A). (28)Sec. 2701(a)(4)(A); Prop. Regs. Sec. 25.2701-3(c)(1). (29)Prop. Regs. Sec. 25.2701-3(c)(2). (30)Sec. 2701(e)(3)(A); Prop. Regs. Sec. 25.2701-4(b)(1). (31)Sec. 2701(e)(3)(A); Prop. Regs. Sec. 25.2701-6(a). (32)Prop. Regs. Sec. 25.2701-2(b)(5)(i). (33)Prop. Regs. Sec. 25.2702-1(b). (34)Sec. 2702(a)(2)(A); Prop. Regs. Sec. 25.2702-1(b). (35)Sec. 2702(b). (36)Prop. Regs. Sec. 25.2702-2(a)(4). (37)Prop. Regs. SEc. 25.2702-2(b)(2). (38)Prop. Regs. Sec. 25.2702-6. (39)Sec. 2702(a)(3)(A); Prop. Regs. Sec. 25.2702-1(c)(1) and (2). (40)Prop. Regs. Sec. 25.2702-5(d). (41)Prop. Regs. Sec. 25.2702-5(b). (42)Prop. Regs. Sec. 25.2702-5(c)(1)(i) and (ii). (43)Sec. 2702(c)(1); Prop. Regs. Sec. 25.2702-4(a). (44)Sec. 2702(c)(3); Prop. Regs. Sec. 25.2702-4(a). (45)Sec. 2702(c)(2); Prop. Regs. Sec. 25.2702-4(c). (46)George S George, river, c.345 mi (560 km) long, rising in a lake on the Quebec-Labrador boundary, E Canada. It flows N through Indian Lake (125 sq mi/324 sq km) to Ungava Bay (an arm of Hudson Strait). . Gradow, 897 F2d 516 (Fed. Cir. 1990) (65 AFTR AFTR American Federal Tax Reports (Prentice-Hall) AFTR Americans For Tax Reform AFTR Air Force Training Ribbon AFTR Air Force Training Record AFTR atrophy, fasciculation, tremor, rigidity AFTR Atomic Frequency Time Reference 2d 90-1229, 90-1 USTC USTC University of Science and Technology of China USTC United States Tax Cases (Commerce Clearing House) USTC United States Transportation Command (see USTRANSCOM) [P] 60,010). (47)Sec. 2702(a)(1); Prop. Regs. Sec. 25.2702-1(a). (48)Sec. 2702(c)(4); Prop. Regs. Sec. 25.2702-2(c)(1). (49)Prop. Regs. Sec. 25.2702-2(c)(2)(i)(A) and (ii). (50)Prop. Regs. Sec. 25.2702-2(d), Example 7. (51)Prop. Regs. Sec. 25.2702-2(d), Example 8. (52)Sec. 2703(b); Prop. Regs. Sec. 25.2703-1(b). (53)Prop. Regs. Sec. 25.2703-1(b)(4). (54)Prop. Regs. Sec. 25.2703-1(b)(3). (55)RRA Section 11602(e)(1)(A)(ii). (56)Prop. Regs. Sec. 25.2703-1(c)(1). (57)Prop. Regs. Sec. 25.2703-1(a)(4). (58)Sec. 2704(a)(1); Prop. Regs. Sec. 25.2704-1(a). (59)Sec. 2704(a)(1)(B) and (c)(1); Prop. Regs. Sec. 25.2704-1(a). (60)Sec. 2704(c)(2); Prop. Regs. Secs. 25.2704-2(a) and 25.2702-2(a)(1). (61)Sec. 2704(a)(2); Prop. Regs. Sec. 25.2704-1(f). (62)Prop. Regs. Sec. 25.2704-1(e)(1)(i). (63)Prop. Regs. Sec. 25.2704-1(e)(2). (64)Sec. 2704(b). (65)Sec. 2704(b)(3)(A); Prop. Regs. Sec. 25.2704-2(b). |
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