The progeny of Sec. 2036(c); the valuation of retained interests.

• Author: Freeman, Todd I.

Historically, estate planners 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 and caused greater value than the original gift to be excluded from the estate on the client's death. The corporate recapitalization 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 or options could "freeze" the value of property at the date of the transaction and allow the transferee to simply reimburse the transferor for the original fair market value (FMV) with no gift or estate tax consequence.

The Omnibus Budget Reconciliation Act of 1987 (OBRA) made a rather overzealous and clumsy attempt at trapping 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 estate freezing techniques. The result was the retroactive 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). 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 certain buy-sell arrangements, option transfers, transfers in trust, term interests in property and the tax consequences of certain lapsing 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 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, put, call or conversion right).(5) An applicable family member is defined as the transferor's spouse, ancestors of the transferor or the transferor's spouse, and the spouse of any such ancestor.(6) Members of the transferor's family include the transferor's spouse, lineal descendants 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 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 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 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. 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 of the same value is addressed in the proposed regulations by providing that the estate of the individual who made a transfer under Sec. 2701 is entitled 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 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...