Chapter 6 - § 6.3 • FEDERAL GIFT TAX IMPLICATIONS — I.R.C. CHAPTER 14 SPECIAL VALUATION RULES

• Jurisdiction: Colorado

§ 6.3 • FEDERAL GIFT TAX IMPLICATIONS — I.R.C. CHAPTER 14 SPECIAL VALUATION RULES

§ 6.3.1—Overview

Owners of valuable assets such as business interests and real property have traditionally sought to deliver these assets to their descendants, often as inter vivos conveyances, while avoiding or minimizing transfer costs, which primarily are estate, gift, and inheritance taxes. In making such inter vivos conveyances, these owners have very often sought at the same time to retain certain benefits of ownership, such as income and a measure of control over the enterprise or asset.

In an effort to combat perceived valuation abuses in family settings and to subject such inter vivos conveyances to transfer taxes, in 1990 Congress enacted Chapter 14 of the Internal Revenue Code, and its predecessor, I.R.C. § 2036(c) (now repealed). Chapter 14, I.R.C. §§ 2701 to 2704, is entitled "Special Valuation Rules."

Chapter 14 focuses on the gift tax effects of transfers made to avoid or artificially depress transfer taxes, such as "freezes" of estate assets. Despite its sometimes harsh effects, Chapter 14 gives a good deal of certainty to planning for family transfers.

I.R.C. § 2701 of Chapter 14 provides valuation and deemed transfer rules that apply to transfers of "junior" interests in corporations and partnerships where the donor retains a "senior" preferred interest. I.R.C. § 2702 applies special valuation rules to transfers of interests in trusts and for joint purchases of term and remainder interests by family members. I.R.C. § 2703 addresses buy-sell agreements, options, and restrictions on the right to sell or use property at less than fair market value. I.R.C. § 2704 deals with lapsing rights and privileges over certain family partnership and corporate interests by providing that the lapse of voting or liquidation rights will be treated as a taxable gift or testamentary transfer to the other shareholders. Chapter 14 also extends the statute of limitations on payment of gift taxes owing.⁴

Extension of Gift Tax Statute of Limitation

Rather than the usual three years, enactment of Chapter 14 extends the gift tax statute of limitation indefinitely with respect to "any gift of property the value of which (or any increase in taxable gifts required under section 2701(d) which) is required to be shown on a return of tax imposed by chapter 12 [I.R.C. §§ 2501, et seq.] (without regard to section 2503(b)), and is not shown on such return." I.R.C. § 6501(c). Thus, the transferor must file a gift tax return to start the clock running under the statute of limitations. Furthermore, a transfer must be "adequately disclosed" even if the transfer is not a gift or qualifies for the $15,000 annual exclusion under I.R.C. § 2503(b). Treas. Reg. § 301.6501(c)-1(e).

§ 6.3.2—Transfers of Interests in Corporations and Partnerships (I.R.C. § 2701)

Prior to the advent of I.R.C. § 2036(c), estate and tax planning in the family business setting often involved estate "freezes" intended to freeze the value of the senior generation's interest at its current level and pass future appreciation to the junior generation, typically outside the transfer tax system. I.R.C. § 2701 addresses gifts of equity interests to family members in closely held business corporations and partnerships.

Triggering Conditions, Effects, and Exceptions

I.R.C. § 2701 generally applies special valuation rules to transfers of (1) a junior equity interest in a controlled entity, such as common stock of a corporation (2) to a spouse or descendant of the transferor, if the transferor, his spouse or other senior family member (3) retains (4) a preferred interest to distributions or payments, such as preferred stock.

For I.R.C. § 2701 to apply, the transferor must transfer or make a deemed transfer of stock in a corporation or interest in a partnership to or for the benefit of a "member of the transferor's family." I.R.C. § 2701(a)(1); Treas. Reg. § 25.2701-1(a)(1). However, note that I.R.C. § 2701 does not apply to transfers to the transferor's collateral relatives, ancestors, or unrelated persons. I.R.C. § 2701(e)(1); Treas. Reg. § 25.2701-1(d)(1). Normal valuation techniques and rules apply to such excluded transfers. I.R.C. § 2701 applies to determine the existence and amount of a gift, regardless of whether the transfer would otherwise be deemed a taxable gift under general gift tax principles.

I.R.C. § 2701 generally applies to gifts, sales, and exchanges (I.R.C. § 2701(a)(1) and Treas. Reg. § 25.2701-1(a)(1)); to transfers for full value (Treas. Reg. § 25.2701-1(b)(1)); to a change in an entity's capital structure such as a redemption or recapitalization (I.R.C. § 2701(e)(5) and Treas. Reg. § 25.2701-1(b)(2)(i)(B)); and to a contribution to capital or termination of an interest in an entity held indirectly, such as through a trust (Treas. Reg. §§ 25.2701-1(b)(2)(i)(C) and 25.2701-1(b)(2)(ii)).

The value of such transfer is deemed equal to the value of the transferor's entire interest minus the value of the interests the transferor retained. Subject to certain exceptions, retained rights are assigned zero value, meaning that the value of the conveyance will be the pre-transfer value of the transferor's entire interest. In other words, if I.R.C. § 2701 applies to the transfer of common stock and retention of preferred stock, under this "Zero Value Rule" the entire value of the family-held entity will be attributed to the common stock transferred, and any value supposedly attributed to the preferred stock will be ignored. See I.R.C. §§ 2701(a)(3)(B) and (c)(2)(B); Treas. Reg. § 25.2701-2(a)(3); PLR 9417024.

I.R.C. § 2701 requires that the transferor retain a fixed rate cumulative preferred stock interest or its equivalent, if the retained interest is to be given any value when valuing the interest transferred. Under this exception to I.R.C. § 2701, if the transferor does not retain this right to a "qualified payment," the zero value rule applies and the transfer is valued for gift tax purposes as if the transferor had conveyed his or her entire interest.

However, even if a transferor generally complies with I.R.C. § 2701, I.R.C. § 2701(a)(4) nevertheless imposes a minimum valuation rule. All "junior equity interests" must be valued at an amount equal to at least 10 percent of the sum of all equity interests in the entity, plus the total amount of indebtedness owed by the entity to the transferor and family members.

For example, assume Parent owns a 60 percent profits and capital interest in a family partnership. Parent conveys the capital interest to Child and retains the profits interest. Since Parent did not retain the equivalent of a fixed cumulative preferred stock interest, the zero value rule of I.R.C. § 2701 applies and the transfer is valued for gift tax purposes as if Parent conveyed both the capital and profits interests to Child. However, if Parent had structured the transaction to receive a fixed guaranteed payment with respect to his or her retained interest, the fair market value of Parent's retained interest would be subtracted from the value of the entire 60 percent capital and profits interest to determine the gift tax value of the transfer to Child.

Note that I.R.C. § 2701 applies only to determine if a gift has been made and the amount of the gift. It does not change the value of the transferred property for other tax purposes, such as determining basis under I.R.C. § 1015 or the generation-skipping transfer tax. Treas. Reg. § 25.2701-1(a)(1).

A relatively routine recapitalization using preferred stock can trigger the zero value rule unless careful work is done in advance and a special election is made on a timely filed Form 709 gift tax return. PLR 200839029.

Definitions

Almost every concept and term used in I.R.C. § 2701 is specially defined for purposes of the statute. As with all of Chapter 14, careful study of the definitions in the statute and regulations is needed to understand the comprehensive scope and effect of the statute. The material in this section is merely an overview.

Among the key definitions for I.R.C. § 2701, a "member of the transferor's family" includes the transferor's spouse, descendants, and spouses of the descendants (I.R.C. § 2701(e)(1); Treas. Reg. § 25.2701-1(d)(1)), including persons related through adoption (I.R.C. § 2701(e)(4); Treas. Reg. § 25.2701-1(d)(3)).

The definition of "applicable family member" is important to the retention requirement and includes the transferor's spouse, ancestors of the transferor and spouse, and spouses of those ancestors. I.R.C. § 2701(e)(2); Treas. Reg. § 25.2701-1(d)(2). Note that for purposes of determining whether a corporation or partnership is "controlled" for purposes of I.R.C. §§ 2701 and 2704, "'applicable family member' includes any lineal descendant of any parent of the transferor or the transferor's spouse" (I.R.C. § 2701(b)(2)(C)), and thus includes the transferor's children, brothers and sisters, and nieces and nephews.

A "transfer" is a direct transfer to or for the benefit of a member of the transferor's family of an interest in a corporation or partnership after which the transferee holds an applicable retained interest. Treas. Reg. § 25.2701-1(b)(2)(i)(B)(1). The term includes transfers from a grantor trust and those following a redemption, recapitalization, or other change in the capital structure of the entity. Treas. Reg. § 25.2701-1(b)(2)(i)(B). However, note that the exercise of a qualified disclaimer under I.R.C. § 2518 or the exercise, release, or lapse of a true non-general power of appointment will not constitute a transfer under I.R.C. § 2701. Treas. Reg. § 25.2701-1(b)(3).

An "applicable retained interest" can be either a distribution right if the transferor and applicable family members control the entity (I.R.C. § 2701(b)(1)), or a liquidation, put, call, or conversion right, further defined as "extraordinary payment rights" (id.; Treas. Reg. §§ 25.2701-2(b)(1) and...