942 / What special valuation rules apply to remainder interests and joint purchase transactions under Chapter 14?

Attribution

A “member of the family” with respect to an individual includes such individual’s spouse, any ancestor or lineal descendant of such individual or such individual’s spouse, any brother or sister of the individual, and any spouse of the above.⁵ An “applicable family member” with respect to a transferor includes the transferor’s spouse, an ancestor of the transferor or transferor’s spouse, and the spouse of any such ancestor.⁶

Adjustment to Mitigate Double Taxation

A gift tax and estate tax adjustment is provided to mitigate the double taxation of retained interests previously valued under IRC Section 2702. In the case of a transfer by gift of a retained interest previously valued under IRC Section 2702 using the zero valuation rule or the qualified tangible property rule, a reduction in aggregate taxable gifts is available in calculating gift tax. If a retained interest previously valued under IRC Section 2702 using the zero valuation rule or using the qualified tangible property rule is later included in the gross estate, a reduction in adjusted taxable gifts is available in calculating estate tax. The amount of the reduction in aggregate taxable gifts or adjusted taxable gifts is equal to the lesser of (1) the increase in the taxable gifts resulting from the retained interest being initially valued under the zero valuation rule or the qualified tangible property rule, or (2) the increase in taxable gifts or gross estate resulting from the subsequent transfer of the interest. For purposes of (2), the annual exclusion is applied first to transfers other than the transfer valued under the zero valuation rule or the qualified tangible property rule. One-half of the amount of reduction may be assigned to a consenting spouse if gifts are split under IRC Section 2513.⁷

Miscellaneous

These provisions apply to transfers after October 8, 1990. However, with respect to property transferred before October 9, 1990, any failure to exercise a right of conversion, to pay dividends, or to exercise other rights to be specified in regulations, is not to be treated as a subsequent transfer.⁸

With respect to gifts made after October 8, 1990, the gift tax statute of limitations on a transfer subject to these provisions does not run unless the transaction is disclosed on a gift tax return in a manner adequate to apprise the IRS of the nature of the retained and transferred interests.⁹

Effect on Trust, Remainder Interest, and Joint Purchase Transactions

GRITs, GRATs, and GRUTs

Generally, a grantor retained income trust (GRIT) should no longer be used unless the only property to be held by the trust is a residence to be used as a personal residence by persons holding term interests in the trust. Under IRC Section 2702, the grantor is treated as though he transferred the entire property to the remainderperson at the time of the creation of the GRIT since his retained income interest is valued at zero (except with respect to the personal residence exception or unless the remainderperson is not a member of the transferor’s family).¹⁰

Instead, grantor retained annuity trusts (GRATs) and grantor retained unitrusts (GRUTs) can be used to leverage gifts. The retained annuity or unitrust interest is valued using the government valuation tables provided under IRC Section 7520. Notes, other debt instruments, options or similar financial arrangements cannot be used in satisfaction of the annuity or unitrust requirements. The value of the transferred remainder interest is equal to the value of the entire property reduced by the value of the retained interest. A reversion or general power of appointment retained by the grantor which is contingent upon the grantor dying during the trust term will no longer reduce the value of the transferred property. However, the value of the retained interest is reduced by such a contingency.

Charitable Trusts

Transfers to charitable remainder annuity trusts (CRATs), certain charitable remainder unitrusts (CRUTs), and pooled income funds are not subject to IRC Section 2702. Also, IRC Section 2702 does not apply to a charitable lead trust in which the only interest in the trust other than the remainder interest or a qualified annuity or unitrust interest is the charitable lead interest. For transfers to a trust made after May 17, 1997, regulations exempt CRUTs from IRC Section 2702 only if the trust provides for simple unitrust payments, or in the case of a CRUT with a lesser of trust income or the unitrust amount provision, the grantor and/or the grantor’s spouse (who is a citizen of the U.S.) are the only noncharitable beneficiaries.¹¹

Irrevocable Life Insurance Trusts

Irrevocable life insurance trusts should not be affected by IRC Section 2702. Generally, the full value of transfers to an irrevocable life insurance trust are already treated as gifts (except to the extent that annual exclusions are available).

Other Trusts

If a term interest (whether for life or term of years) is given to the transferor’s spouse, an ancestor of the transferor or transferor’s spouse, or the spouse of any such ancestor, and a remainder interest is given to any member of the transferor’s family, IRC Section 2702 should not apply because the grantor has not retained a term interest.

Remainder Interest Transaction (RIT)

In general, if a person retains a term interest (whether for life or term of years) in property and sells or gives a remainder interest in the property to another family member, the value of the transferred property will be equal to the full value of the property unless the transferor retained an annuity or unitrust interest in the property (i.e., the value of a retained income interest is valued at zero).

However, if the nonexercise of rights under a term interest in tangible property would not have a substantial effect on the valuation of the remainder interest, the interest is valued at the amount for which it could be sold to an unrelated third person (i.e., market value is used instead of the valuation tables or zero valuation). The Senate Committee Report to OBRA ’90 gives a painting, or undeveloped real estate, as examples of such tangible property. Depletable property is given as an example of property which would not qualify for this special rule. See “Qualified Tangible Property,” Q 939.

Split Purchases (Splits)

If a person acquires a term interest in property in a joint purchase (or series of related transactions) with members of his family, then such person is treated as though he acquired the entire property and then transferred the interests acquired by the other persons in the transaction to such persons in return for consideration furnished by such persons. Thus, if a father and son purchase rental property and the father receives an interest for life and the son receives a remainder interest; the father is treated as though he sold the remainder interest to his son for the consideration furnished by the son. The transaction is then essentially treated as a sale of a remainder interest (see above).