Split Interest Valuation: The Devil is in the Detail

• Author: James M. Delaney
• Position: Centennial Distinguished Professor of Law, University of Wyoming College of Law; University of Florida College of Law, LL.M. (Taxation)
• Pages: 929-964

Page 929

SPLIT INTEREST VALUATION:

THE DEVIL IS IN THE DETAIL

JAMES M. DELANEY* I. BACKGROUND

With respect to valuation, the estate and gift tax provisions of the Internal Revenue Code (I.R.C.) operate under similar principles. In order to determine taxable estate, a taxpayer must first determine gross estate and subtract any authorized exemptions and deductions.¹In determining taxable gifts in a given year, a taxpayer may reduce the total value of the gifts which were made during the year by any authorized exclusions and deductions.²The focus of these materials will be on how certain assets are valued for purposes determining the estate and gift tax liability. Specifically, the discussion will focus on valuation of annuities, life, term and remainder or reversionary interests.

For federal estate tax purposes, valuation principles are generally governed by I.R.C. §§ 2031 through 2044 and the regulations there under.³

While the I.R.C. is silent as to specific valuation methods, the estate tax regulations fill in the detail.⁴The gift tax code and regulations conform to and adopt the approach taken by the estate tax regulations.⁵

_______________________________________________________

* Centennial Distinguished Professor of Law, University of Wyoming College of Law; University of Florida College of Law, LL.M. (Taxation); Gonzaga University School of Law, J.D.; University of Washington, B.A (Economics). This article was written in connection with Capital University Law School’s annual symposium on Small Business Succession Planning. The author would like to thank Capital University for its gracious invitation to participate in the Symposium. I would also like to thank the Centennial Professorship endowment for its continued support. Copyright is retained by author.

¹Treas. Reg. § 20.0-2(b)(2)–(3) (as amended in 1992).

²Treas. Reg. §§ 25.2503-1 to -2 (as amended in 1995).

³Treas. Reg. § 20.0-2(b)(2).

⁴See, e.g., Treas. Reg. §§ 20.2031-1 to -8 (as amended in 2000).

⁵See RICHARD B. STEPHENS ET AL., FEDERAL ESTATE AND GIFT TAXATION ¶ 10.02[2][a] (8th ed. 2002).

Page 930

930 CAPITAL UNIVERSITY LAW REVIEW [37:929

Each item of property included in a decedent’s gross estate is valued at the time of decedent’s death.⁶The fair market value of an item of property included in gross estate is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge of relevant facts.”⁷The regulations under I.R.C. § 2031 contain substantial guidance on application of this standard. For example, specific rules and methods apply to valuation of stocks, notes, bonds, interests in a business, and household personal effects.⁸The same valuation standards apply when assets are gifted during life.⁹

Complications, however, arise when an asset that is transferred is split into more than one interest. For example, if a donor seeks to gift or bequest an annuity for life, income interest for life, or a corresponding remainder interest, the value of each is dependent upon an estimation of the remaining years of life of the life interest holder.¹⁰Valuation of such “partial” or “split” interests in a single asset requires knowledge of the lifespan of the relevant interest holder or the specific term which the interest will be held. The closest that we can come to determining the length of a human lifespan is an actuarial determination or estimation of the lifespan of the relevant individual.¹¹Without assistance from the Internal Revenue Service (IRS) or the U.S. Department of the Treasury (Treasury), taxpayers imposed upon by the I.R.C. to value a partial interest in property for a person’s life must engage a professional actuary to perform a statistical calculation of risk or life expectancy for valuation purposes. However, requiring such a valuation in every instance of a gift would be expensive, inefficient, and time consuming.

Not surprisingly, legal analysis in this area of taxation requires a substantial amount of calculations to compare different scenarios over time. Although the calculations involve actuarial tables and use of interest

_______________________________________________________

⁶Treas. Reg. § 20.2031-1(b). Note, however, that under I.R.C. § 2032, a decedent’s estate may elect to use an alternative valuation date which, if elected, allows assets to be valued six months after decedent’s date of death. I.R.C. § 2032(a) (2006).

⁷Treas. Reg. § 20.2031-1(b).

⁸See, e.g., id. §§ 20.2031-1 to -6.

⁹See Treas. Reg. § 25.2512-1 (as amended in 1992).

¹⁰See Treas. Reg. § 20.2031-7(a) (as amended in 2000).

¹¹See id. § 20.2031-7(d).

Page 931

2009] SPLIT INTEREST VALUATION 931

rates, the mathematics are not complex. The reader is encouraged to take it at his or her own speed. While the calculations are not taxing, the outcomes of certain structures or scenarios can be.

II. ACTUARIAL VALUATION

For estate and gift tax purposes, the fair market value of various types of partial or split interests in annuities, life estates, terms of years, remainders and reversionary interests is the present value of such interests as of the date of transfer.¹²The Treasury has published actuarial tables that may be used by taxpayers to determine the value of partial interests in property.¹³Without the published tables, taxpayers would have to engage a valuation professional in every instance in which a split interest gift required valuation. While the IRS actuarial publications contain hundreds of pages of tables, the regulations under I.R.C. § 2031 contain several of the more commonly used tables.¹⁴

An example helps to explain the application of the IRS tables in valuing a simple partial interest in a gift tax setting. Assume that Brother transfers $1,000,000 to his Sister and her Son in trust. The trust terms provide that Sister, or her estate, will receive all income produced by the trust property for a period of five years. Upon expiration of the five-year term, the trustee of the trust is required to distribute the corpus of the trust to Sister’s Son. At all times the corpus is worth $1,000,000 and the I.R.C. § 7520 interest rate is eight percent (the Applicable Federal Rate or AFR).¹⁵For gift tax purposes, the questions are what value is assigned to the term interest given to Sister and what is the value of the remainder interest given to Sister’s Son?

The elements necessary for the calculation are:

_______________________________________________________

¹²See id. § 20.2031-7(a).

¹³See id. § 20.2031-7(d)(6).

¹⁴See id. § 20.2031-7(d); see also INTERNAL REVENUE SERV., DEP’T OF THE TREASURY, ACTUARIAL VALUATIONS (2009), available at http://www.irs.gov/pub/irs-pdf/p1457.pdf;

Internal Revenue Serv., Dep’t of the Treasury, Section 7520 Actuarial Tables, http://www.irs.gov/retirement/article/0,,id=206601,00.html (last visited Aug. 11, 2009).

¹⁵In general, the value of any annuity, life interest, term of years, or remainder must be valued under the tables provided by the Secretary of the IRS and by using the interest rate equal to 120 percent of the Federal midterm rate in effect under I.R.C. § 1274(d) for the month in which the valuation date falls. I.R.C. § 7520(a) (2006).

Page 932

932 CAPITAL UNIVERSITY LAW REVIEW [37:929

• Term of the income interest: five years
• The Table B,¹⁶five-year term certain remainder factor at eight percent rate = .680583¹⁷

• Five-year term factor = 1 – .680583¹⁸=

0.319417¹⁹

Applying the factors we determine the value of the five-year term income interest to be $319,417 (0.319417 x $1,000,000). Thus, $319,417 is the present value of Sister’s five-year term interest. Correspondingly, $680,583 ($1,000,000 x .680583) is the present value of Sister’s Son’s interest in the remainder after five years. The two amounts must be reported as taxable gifts by Brother. From this it can be seen that Brother has “split” his ownership of the $1,000,000 contributed to the trust into two separate interests, Sister’s present interest in the income stream from the trust and Sister’s Son’s future interest in the assets at the end of the five-year term.

Following with a similar but different example, assume the same facts as above except that the trust instrument provides that Sister is to annually receive only the first $40,000 income each year. If the AFR is eight percent, additional income will accrue to the trust each year in excess of the trust’s obligation to distribute only $40,000 per year. The additional income must be added to the corpus and Sister’s interest is more in the nature of an annuity (as opposed to an income interest as discussed above). In order to determine the value of Sister’s five-year annuity interest, a calculation is necessary, which includes the following elements:

• Term of the annuity: five years
• Table B eight percent annuity factor: 3.9927²⁰

_______________________________________________________

¹⁶Table B contains the actuarial factors for valuing the remainder interest in property after a term certain interest has expired. Treas. Reg. § 20.2031-7(d)(6).

¹⁷Reference must be made to Table B to cross reference the five-year term with the 8% interest rate to obtain this factor. Id.

¹⁸Note that this is the remainder factor and that the term factor plus the remainder factor added together equal “1” or the “whole.”

¹⁹Note here that the full value of the undivided asset is $1,000,000. The value of the term interest plus the remaining interest added together must equal the whole or $1,000,000. Thus, the term factor is arrived at by subtracting the remainder factor from one.

²⁰The annuity factor can be arrived at via the following formula: 1/i[1–1/(1+i)[_2]]. See, e.g., NetMBA, Annuities, http://www.netmba.com/finance/time-value/annuity (last...