Demystifying the qualified payment right: structuring and administering a s. 2701-compliant entity.

• Author: Brown, Nathan R.

Estate planning practitioners commonly utilize business entities, such as partnerships and limited liability companies (investment entities), to maximize the transfer tax efficiency of their clients' estate plans. Often, these investment entities are structured with two classes of equity interests: preferred interests and common interests. The preferred interests generally entitle the holder to a preferred return on the holder's investment and the common interests generally entitle the holder to all future growth in excess of the preferred return. Generally, a senior-generation family member holding both preferred interests and common interests will sell or gift his or her common interests to one or more trusts for the benefit of younger-generation family members and retain the preferred interests. This allows the senior-generation family member to transfer all future appreciation in excess of the preferred return to younger-generation family members without the imposition of transfer tax.

Planning with multi-class investment entities is complicated by the application of I.R.C. [section]2701. (1) I.R.C. [section] 2701 is a special valuation rule that applies to determine the gift-tax value of a transferred equity interest in a privately held investment entity if the transferor or a senior family member holds certain equity interests in the investment entity immediately after the transfer. If the retained equity interests are not properly structured, I.R.C. [section] 2701 may treat the transferor as having made a deemed gift of the retained equity interests.

Fortunately, the draconian consequences of I.R.C. [section]2701 may be avoided by structuring the preferred return as a qualified payment right (QPR). (2) If the preferred return is structured as a QPR, there should be no deemed gift under I.R.C. [section] 2701 upon the initial gift or sale of the common interests by a senior-generation family member to, or in trust for the benefit of, younger generation family members. For purposes of this article, a multi-class investment entity having a preferred return that is structured as a QPR is referred to as a "[section]2701-compliant entity."

When using a [section]2701-compliant entity to avoid the application of I.R.C. [section]2701, it is imperative that the QPR is properly structured, valued, and administered. The remainder of this article provides a brief overview of I.R.C. [section]2701 (3) and discusses the proper structure, valuation, and tax implications of administrating a [section]2701-compliant entity.

Overview of I.R.C. [section]2701

Generally, I.R.C. [section]2701 applies when an individual (the transferor) transfers an equity interest in a privately held entity to, or in trust for the benefit of, a younger-generation member of the transferor's family (referred to in the statute as a member of the family) (4) if, immediately after the transfer, the transferor or an older-generation member of the transferor's family (referred to in the statute as an applicable family member) (5) holds an equity interest in the entity that is classified as an "applicable retained interest." (6)

* Applicable Retained Interests --Two types of applicable retained interests exist: extraordinary payment rights and distribution rights in family-controlled entities. (7) An extraordinary payment right is any put, call, conversion right, or right to compel liquidation of the entity, the exercise or nonexercise of which could affect the value of the transferred interest. (8) A distribution right generally includes any right to receive distributions with respect to a retained equity interest that is senior to the right to receive distributions with respect to the transferred equity interest. (9) In the multi-class investment entity context, the preferred return would be classified as a distribution right under I.R.C. [section]2701 if the transferor, either alone or together with applicable family members and any lineal descendants of the transferor's parents or the transferor's spouse's parents, controls the investment entity. (10)

* The Zero-Value Rule--If I.R.C. [section]2701 applies, the gift-tax value of the transferred equity interest is determined under the subtraction method. (11) The subtraction method determines the gift-tax value of the transferred equity interest by subtracting the aggregate value of all equity interests in the entity held by the transferor immediately after the transfer from the aggregate value of all equity interests in the entity held by the transferor immediately before the transfer. If the retained equity interest is classified as an applicable retained interest, its value for purposes of applying the subtraction method is determined by assigning a zero value to any extraordinary payment right and any distribution right (the zero-value rule). I.R.C. [section]2701 is designed to prevent value being assigned to retained rights that are discretionary in nature. I.R.C. [section]2701 assigns a zero value to distribution rights because there is an implicit assumption that no discretionary distributions from a family-controlled investment entity will be made to senior-generation family members in order to preserve value for younger-generation family members.

The result of the zero-value rule is that, for gift tax purposes, the transferor is deemed to have made a gift of his or her retained preferred interest in addition to the common interests that are actually transferred.

If the distribution right is structured as a QPR, however, the zero-value rule does not apply. Instead, the fair market value of the QPR is used to determine the gift-tax value of the transferred interest.

The Qualified Payment...