Federal Estate

March 13, 2024

937 / How are corporate and partnership transactions, such as recapitalizations, transfers and other changes in capital structure impacted by the Chapter 14 special valuation rules?

<div class="Section1"> Effect on Corporate and Partnership Transactions Recapitalizations and Transfers of Stock If a parent recapitalizes a corporation into common and preferred stock and gives the common stock to his children, the value of the common stock is determined by subtracting from the value of the entire corporation the value of the preferred stock as determined under IRC Section 2701. If the parent treats the preferred stock’s right to dividends as qualified payments, the right to such payments is assigned a present value. However, the value assigned to the common stock must be at least equal to the value determined under the junior equity rule (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="935">935</a>). If the parent does not receive the preferred dividends within four years of their due dates, the parent may be treated as making additional transfers of the accumulated, but undistributed dividends, at the time of a subsequent transfer of the preferred stock. On the other hand, if the parent does not treat the right to dividends as qualified payments; such a right is assigned a value of zero. Similarly, if a parent owns 80 percent of a corporation and a child owns 20 percent of the same corporation and the parent’s common stock is exchanged for preferred stock, the value of what the parent has transferred and what the parent has retained are determined under IRC Section 2701. Even if the child pays consideration for the common stock, whether the parent has made a transfer (and the value of such transfer) is determined under IRC Section 2701. If a parent and a child each contribute to the startup of a new business and the parent receives preferred stock while the child receives common stock, the parent is treated as if he received common stock and preferred stock and then exchanged the common stock for the balance of the preferred stock. The value of what the parent has transferred and what the parent has retained are determined under IRC Section 2701. However, a gift or a sale of stock to a child is not subject to IRC Section 2701 if the stock is of the same class as that retained by the parent. Also, a gift or a sale of stock to a child is not subject to IRC Section 2701 if the stock is proportionately the same as that retained by the parent (e.g., retained stock is entitled to $2 of dividends for every $1 of dividends paid to transferred stock), without regard to nonlapsing voting rights (i.e., parent can retain control with nonlapsing voting right). If applicable family members receive or retain applicable retained interests at the time of a gift or a sale of stock to a child, the transaction may be subject to IRC Section 2701 even though the parent is willing to terminate his equity relationship with the corporation.<a href="#_ftn1" name="_ftnref1">1</a> IRC Section 2701 could be avoided by selling the common stock to a nonfamily member, such as a valuable employee. Proceeds of the sale could then be distributed to the children. Of course, IRC Section 2701 does not apply if either the transferred interest (common stock) or retained interest (preferred stock) is publicly traded. Also, with regard to retained distribution rights, IRC Section 2701 does not apply if the transferor and applicable family members do not control the corporation immediately before the transfer. However, with regard to liquidation, put, call, or conversion rights (other than those treated as distribution rights, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="935">935</a>), IRC Section 2701 can apply even if the transferor and applicable family members do not control the corporation. If the typical recapitalization is reversed (i.e., the parent retains the common stock and transfers the preferred stock), IRC Section 2701 should not apply (assuming no retention of applicable retained interests by parent or applicable family members). Partnership Freezes The traditional partnership freeze worked similarly to the traditional estate freeze recapitalization. It too is caught by the IRC Section 2701 special valuation rules. Most of the techniques employed to reduce the effect of, or to avoid, the valuation rules with respect to a recapitalization will also work with a partnership. Examination of the partnership agreement will be required to determine which partners hold which rights. Note that in the case of a limited partnership, “control” includes the holding of any interest as a general partner. Also, any right to receive a guaranteed payment of a fixed amount from a partnership under IRC Section 707(c) is not treated as a distribution right. Other Changes in Capital Structure Other changes in capital structure may also be caught by the IRC Section 2701 special valuation rules. Except as provided in regulations, a contribution to capital, a redemption, a recapitalization, or other change in capital structure of a corporation or partnership is treated as a transfer if the taxpayer or an applicable family member receives an applicable retained interest in the transaction, or as provided under regulations, holds such an interest immediately after the transfer. Nonequity Interests The IRC Section 2701 special valuation rules apply only to equity interests. Thus, none of the following should be treated as a retained interest for purposes of IRC Section 2701: an installment sale of an interest in a corporation or partnership, an exchange of an interest in a corporation or partnership for a private annuity, an employment contract or deferred compensation, or debt owed by a corporation or partnership to a transferor or applicable family member.<a href="#_ftn2" name="_ftnref2">2</a> However, the total amount of debt owed the transferor or an applicable family member by the entity is a factor in the junior equity rule (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="935">935</a>). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.    See, for example, IRS CCA 201442053. <a href="#_ftnref2" name="_ftn2">2</a>.    See TAM 9436006. </div></div>

March 13, 2024

939 / What special valuation rules apply to the transfer of qualified tangible property under Chapter 14?

<div class="Section1">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).<a href="#_ftn1" name="_ftnref1">1</a> Qualified tangible property is tangible property (1) for which a depreciation or depletion allowance would not be allowable if the property were used in a trade or business or held for the production of income, and (2) as to which the nonexercise of any rights under the term interest would not affect the value of the property passing to the remainderperson. A de minimis exception is provided at the time of the transfer to trust for improvements to the property which would be depreciable provided such improvements do not exceed 5 percent of the fair market value of the entire property.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> Term interests in qualified tangible property are valued using actual sales or rentals that are comparable both as to the nature and character of the property and the duration of the term interest. Little weight is given appraisals in the absence of comparables. Tables used in valuing annuity, unitrust, estate, and remainder interests under IRC Section 7520 are not evidence of what a willing buyer would pay a willing seller for an interest in qualified tangible property.<a href="#_ftn3" name="_ftnref3">3</a> If the taxpayer cannot establish the value of the term interest, the interest is valued at zero.<a href="#_ftn4" name="_ftnref4">4</a> If, during the term, the term interest is converted into property other than qualified tangible property, the conversion is treated as a transfer of the unexpired portion of the term interest (valued as of the time of the original transfer) unless the trust is converted to a qualified annuity interest (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="938">938</a>).<a href="#_ftn5" name="_ftnref5">5</a> If an addition or improvement is made to qualified tangible property such that the property would no longer be treated as qualified tangible property, the property is subject to the conversion rule above. If the addition or improvement would not change the nature of the qualified tangible property, the addition or improvement is treated as an additional transfer subject to IRC Section 2702.<a href="#_ftn6" name="_ftnref6">6</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.    IRC § 2702(c)(4). <a href="#_ftnref2" name="_ftn2">2</a>.    Treas. Reg. § 25.2702-2(c)(2). <a href="#_ftnref3" name="_ftn3">3</a>.    Treas. Reg. § 25.2702-2(c)(3). <a href="#_ftnref4" name="_ftn4">4</a>.    Treas. Reg. § 25.2702-2(c)(1). <a href="#_ftnref5" name="_ftn5">5</a>.    Treas. Reg. § 25.2702-2(c)(4). <a href="#_ftnref6" name="_ftn6">6</a>.    Treas. Reg. § 25.2702-2(c)(5). </div></div>

March 13, 2024

941 / Are there any exceptions to the general rule that a qualified personal residence trust must only hold the taxpayer's principal residence?

<div class="Section1">A qualified personal residence trust is generally prohibited for the entire term of the trust from holding any property other than one residence to be used as the personal residence of the term holder(s), but certain exceptions are available. Thus, a qualified personal residence trust is permitted to hold cash in a separate account, but not in excess of the amount needed (1) for payment of trust expenses (including mortgage payments) currently due or expected within the next six months, (2) for improvements to the residence to be paid within the next six months, and (3) for purchase of a personal residence either (a) within three months of the creation of the trust, or (b) within the next three months pursuant to a previously entered into contract to purchase. Improvements to the personal residence which meet the personal residence requirements are permitted.<a href="#_ftn1" name="_ftnref1">1</a></div> <div class="Section1"> Generally, sales proceeds (including income thereon) may be held in a qualified personal residence trust in a separate account until the earlier of (1) two years from the date of sale, (2) termination of the term holder's interest, or (3) purchase of a new residence. Insurance proceeds (including, for this purpose, certain amounts received upon an involuntary conversion) paid to a qualified personal residence trust for damage or destruction to the personal residence may also be held in the trust in a separate account for a similar period of time.<a href="#_ftn2" name="_ftnref2">2</a> However, with respect to trusts created after May 16, 1996, a qualified personal residence trust must be prohibited from selling or transferring, directly or indirectly, the residence to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse, during the original trust term and at any time after the original term interest during which the trust is a grantor trust. A distribution upon or after the expiration of the original duration of the trust term to another grantor trust of the grantor or the grantor's spouse pursuant to the trust terms will not be treated as a sale or transfer to the grantor or grantor's spouse if the second trust prohibits sale or transfer of the property to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse. This prohibition against a transfer to the grantor or the grantor's spouse does not apply to a transfer pursuant to the trust document or a power retained by the grantor in the event the grantor dies prior to the expiration of the original duration of the trust term. Nor does this prohibition apply to a distribution (for no consideration) of the residence to the grantor's spouse pursuant to the trust document at the expiration of the original duration of the trust term.<a href="#_ftn3" name="_ftnref3">3</a> Cash held by a qualified personal residence trust in excess of the amounts permitted above must be distributed to the term holder at least quarterly. Furthermore, upon termination of the term holder's interest, any cash held by a qualified personal residence trust for payment of trust expenses must be distributed to the term holder within 30 days.<a href="#_ftn4" name="_ftnref4">4</a> The qualified personal residence trust must provide that any trust income be distributed at least annually to the term holder.<a href="#_ftn5" name="_ftnref5">5</a> Distributions from a qualified personal residence trust cannot be made to anyone other than the term holder during any term interest.<a href="#_ftn6" name="_ftnref6">6</a> Commutation (generally, an actuarially based acceleration or substitution of benefits) of a qualified personal residence trust is not permitted.<a href="#_ftn7" name="_ftnref7">7</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 25.2702-5(c)(5). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. §§ 25.2702-5(c)(5)(ii), 25.2702-5(c)(7). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. §§ 25.2702-5(c)(9), 25.2702-7. <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 25.2702-5(c)(5)(ii)(A)(2). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 25.2702-5(c)(3). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 25.2702-5(c)(4). <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. § 25.2702-5(c)(6). </div>

March 13, 2024

943 / What special valuation rules apply to certain agreements, options, rights, or restrictions exercisable at less than fair market value under Chapter 14?

<div class="Section1">For estate, gift, and generation-skipping transfer tax purposes, the value of any property is to be determined without regard to any restriction on the right to sell or use such property, or any option, agreement, or other right to acquire or use the property at less than fair market value (determined without regard to such an option, agreement, or right). However, the previous sentence is not applicable if the option, agreement, right, or restriction: (1) is a bona fide business arrangement, (2) is not a device to transfer the property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth, and (3) has terms comparable to those entered into by persons in an arm’s length transaction.<a href="#_ftn1" name="_ftnref1">1</a> The three prongs of the test must be independently satisfied.<a href="#_ftn2" name="_ftnref2">2</a> All three prongs of the test are considered met if more than 50 percent of the value of the property subject to the right or restriction is owned by persons who are not members of the transferor’s family or natural objects of the transferor’s bounty. The property owned by such other persons must be subject to the right or restriction to the same extent as the property owned by the transferor.<a href="#_ftn3" name="_ftnref3">3</a><div class="Section1"> To determine whether a buy-sell agreement or other restrictive agreement has terms comparable to those entered into by persons in an arm’s length transaction, the following factors are to be considered: (1) “the expected term of the agreement, (2) the current fair market value of the property, anticipated changes in value during the term of the agreement, and (3) the adequacy of any consideration given in exchange for the rights granted.”<a href="#_ftn4" name="_ftnref4">4</a> The terms of a buy-sell agreement or other restrictive agreement must be comparable to those used as a general practice by unrelated persons under negotiated agreements in the same business. Isolated comparables do not meet this requirement. More than one recognized method may be acceptable. Where comparables are difficult to find because the business is unique, comparables from similar businesses may be used.<a href="#_ftn5" name="_ftnref5">5</a> In the case of a partnership (or LLC) created on a decedent’s deathbed, the IRS has stated that the partnership was the agreement for purposes of IRC Section 2703, and the partnership should be ignored because the partnership was not a valid business arrangement and the partnership was a device to transfer the underlying property to the family members for less than adequate consideration. Even if the partnership was not ignored, the Service stated that it would ignore the restrictions on use of the property contained in the partnership’s agreement; such restrictions also would fail IRC Section 2703.<a href="#_ftn6" name="_ftnref6">6</a> Courts have also rejected the idea that the partnership can be ignored for purposes of IRC Section 2703.<a href="#_ftn7" name="_ftnref7">7</a> The Tax Court has applied IRC Section 2703 to certain gifts of family limited partnership interests.<a href="#_ftn8" name="_ftnref8">8</a> Certain restrictions on the sale or use of property in a restricted management account are disregarded for transfer tax purposes under IRC Section 2703.<a href="#_ftn9" name="_ftnref9">9</a> For more information on valuing a closely held business interest, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="927">927</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="929">929</a>. Effective Date and Transition Rules This provision applies to agreements, options, rights, or restrictions entered into or granted after October 8, 1990, and agreements, options, rights, or restrictions substantially modified after October 8, 1990.<a href="#_ftn10" name="_ftnref10">10</a> Any discretionary modification of an agreement that results in other than a de minimis change in the quality, value, or timing of the agreement is a substantial modification. Generally, a modification required by the agreement is not considered a substantial modification. However, if the agreement requires periodic modification, the failure to update the agreement is treated as a substantial modification unless the updating would not have resulted in a substantial modification. The addition of a family member as a party to a right or restriction is treated as a substantial modification unless (1) the addition is mandatory under the terms of the right or restriction, or (2) the added family member is in a generation (using the generation-skipping transfer tax definitions of generations) no lower than the lowest generation of any individuals already party to the right or restriction. The modification of a capitalization rate in a manner that bears a fixed relationship to a specified market rate is not treated as a substantial modification. Furthermore, a modification that results in an option price that more closely approximates fair market value is not treated as a substantial modification.<a href="#_ftn11" name="_ftnref11">11</a> Effect on Options and Buy-sell Agreements In order to help fix values for estate, gift, and generation-skipping transfer tax purposes, newly executed or substantially modified options and buy-sell agreements exercisable at less than fair market value between persons who are the natural objects of each other’s bounty will generally have to meet all three of IRC Section 2703’s requirements. Otherwise, such agreement will be disregarded in valuing the property. Old options and buy-sell agreements which are not substantially modified after October 8, 1990 are not affected by IRC Section 2703. IRC Section 2703’s provisions apply to agreements involving either business or nonbusiness property. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.      IRC § 2703. <a href="#_ftnref2" name="_ftn2">2</a>.      Treas. Reg. § 25.2703-1(b)(2). <a href="#_ftnref3" name="_ftn3">3</a>.      Treas. Reg. § 25.2703-1(b)(3). <a href="#_ftnref4" name="_ftn4">4</a>.      Treas. Reg. § 25.2703-1(b)(4)(i). <a href="#_ftnref5" name="_ftn5">5</a>.      Treas. Reg. § 25.2703-1(b)(4)(ii). <a href="#_ftnref6" name="_ftn6">6</a>.      TAMs 9723009, 9725002, 9730004, 9735003, 9736004, 9842003. <a href="#_ftnref7" name="_ftn7">7</a>.      Est. of Strangi v. Comm., 2002-2 USTC ¶ 60,441 (5th Cir. 2002), aff’g 115 TC 478 (2000); Church v. U.S., 2000-1 USTC ¶ 60,369 (W.D. Tex. 2000). <a href="#_ftnref8" name="_ftn8">8</a>.      Holman v. Comm., 130 TC 170 (2008). <a href="#_ftnref9" name="_ftn9">9</a>.      Rev. Rul. 2008-35, 2008-29 IRB 116. <a href="#_ftnref10" name="_ftn10">10</a>.    OBRA ’90, § 11602(e)(1)((A)(ii). <a href="#_ftnref11" name="_ftn11">11</a>.  Treas. Reg. § 25.2703-1(c). </div></div>

March 13, 2024

938 / What special valuation rules apply to the transfer of an interest in trust under the Chapter 14 special valuation rules?

<div class="Section1">As a general rule, the value of a transferred remainder interest is equal to the value of the transferor’s entire interest prior to the transfer reduced by the value of the interest retained by the transferor. For purposes of determining whether a transfer of an interest in a trust to (or for the benefit of) a member of the transferor’s family is a gift (and the value of the transfer), the value of any interest retained by the transferor or an applicable family member ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="935">935</a>) is treated as being zero unless the retained interest is a qualified interest. This rule does not apply to an incomplete gift (a transfer that would not be treated as a gift whether or not consideration was received), to a transfer to a trust if 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, or to the extent that the Regulations provide that a transfer is not inconsistent with IRC Section 2702.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> Also, IRC Section 2702 does not apply to the following: (1)     certain charitable remainder trusts; (2)     pooled income funds; (3)     charitable lead trusts 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; (4)     the assignment of a remainder interest if the only interest retained by the transferor or an applicable family member is as a permissible recipient of income in the sole discretion of an independent trustee; and (5)     a transfer in trust to a spouse for full and adequate consideration in connection with a divorce if any remaining interests in the trust are retained by the other spouse.<a href="#_ftn2" name="_ftnref2">2</a> For transfers to a trust made after May 17, 1997, regulations exempt charitable remainder unitrusts (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 U.S. citizen) are the only noncharitable beneficiaries.<a href="#_ftn3" name="_ftnref3">3</a> Modified rules apply to certain qualified tangible property. For these purposes, a transfer in trust does not include (1) the exercise, release, or lapse of a power of appointment over trust property that would not be a transfer for gift tax purposes, or (2) the exercise of a qualified disclaimer. An interest in trust includes a power with respect to a trust which would cause any portion of the transfer to be incomplete for gift tax purposes.<a href="#_ftn4" name="_ftnref4">4</a> Retained Interests “Retained” is defined as the same person holding an interest both before and after the transfer in trust. Thus, a transfer of an income interest for life in trust to an applicable family member in conjunction with the transfer of a remainder interest in trust to a member of the transferor’s family is not subject to IRC Section 2702. However, with respect to the creation of a term interest (e.g., a joint purchase creating a term and remainder interest), any interest held by the transferor immediately after the transfer is treated as held both before and after the transfer.<a href="#_ftn5" name="_ftnref5">5</a> A negotiable note received in exchange for publicly traded stock sold to a trust was not treated as a retained interest in a trust.<a href="#_ftn6" name="_ftnref6">6</a> Qualified Interests A “qualified interest” is an annuity or unitrust interest, or, if all other interests in the trust are annuity or unitrust interests, a noncontingent remainder interest. A qualified annuity interest means a right to receive fixed amounts (or a fixed fraction or percentage of the property transferred to the trust) not less frequently than annually. A qualified unitrust interest means a right to receive amounts which are payable not less frequently than annually and are a fixed percentage of the fair market value of the property in the trust (determined annually).<a href="#_ftn7" name="_ftnref7">7</a> A qualified annuity interest can provide for an annuity amount (or fixed fraction or percentage) which increases by not more than 120 percent of the stated dollar amount (or fixed fraction or percentage) payable in the preceding year.<a href="#_ftn8" name="_ftnref8">8</a> A qualified unitrust interest can provide for a unitrust percentage which increases by not more than 120 percent of the fixed percentage payable in the preceding year.<a href="#_ftn9" name="_ftnref9">9</a> The retention of a power to revoke a qualified annuity or unitrust interest of the transferor’s spouse is treated as retention of the qualified annuity or unitrust interest.<a href="#_ftn10" name="_ftnref10">10</a> Contingent annuity interests retained by the grantor or given to the grantor’s spouse were not qualified interests.<a href="#_ftn11" name="_ftnref11">11</a> Regulations treat an interest with the following characteristics as a qualified interest retained by the grantor: an annuity or unitrust interest that is (1) given to the spouse of the grantor; and (2) contingent only on (a) the spouse surviving, or (b) that the grantor does not revoke the spouse’s interest.<a href="#_ftn12" name="_ftnref12">12</a> The grantor makes an additional gift to the remainder person when the spouse’s interest is revoked or the grantor survives the trust term without having revoked the interest. A right to receive each year the lesser of an annuity interest or a unitrust interest is not treated as a qualified interest. The right to receive each year the greater of an annuity interest or a unitrust interest is treated as a qualified interest. However, the qualified interest is valued at the greater of the two interests.<a href="#_ftn13" name="_ftnref13">13</a> A right of withdrawal, whether or not cumulative, is not a qualified annuity or unitrust interest.<a href="#_ftn14" name="_ftnref14">14</a> A qualified annuity or unitrust interest may permit the payment of income in excess of the annuity or unitrust amount to the transferor or applicable family member with the retained annuity or unitrust interest. However, the annuity or unitrust interest is valued without regard to the right to excess income (which is not a qualified annuity or unitrust interest).<a href="#_ftn15" name="_ftnref15">15</a> Also, a qualified annuity interest may permit the payment of an amount sufficient to reimburse the grantor for any income tax due on income in excess of the annuity amount; the annuity interest is valued without regard to such reimbursement right.<a href="#_ftn16" name="_ftnref16">16</a> Distributions from the trust cannot be made to anyone other than the transferor or applicable family member who holds the qualified annuity or unitrust interest.<a href="#_ftn17" name="_ftnref17">17</a> The term of the annuity or unitrust interest must be for the life of the transferor or applicable family member, for a specified term of years, or for the shorter of the two periods.<a href="#_ftn18" name="_ftnref18">18</a> There is a split of authority as to whether valuation may be based on two lives, or just one life.<a href="#_ftn19" name="_ftnref19">19</a> Regulations permit certain revocable spousal interests (see above), but value the retained grantor and spouse’s interests separately as for a single life.<a href="#_ftn20" name="_ftnref20">20</a> An example in the regulations had provided that where a grantor retained the right to annuity payments for 10 years and the payments continued to his estate if he died during the 10-year term, the annuity was valued as for 10 years or until the grantor’s prior death (i.e., as a temporary annuity).<a href="#_ftn21" name="_ftnref21">21</a> The Tax Court ruled that the example was invalid, that the annuity should be valued as for 10 years (i.e., as a term annuity).<a href="#_ftn22" name="_ftnref22">22</a> The IRS has changed the regulations so as to follow Walton.<a href="#_ftn23" name="_ftnref23">23</a> Note that if the trust property reverted to the grantor’s estate if the grantor died during the 10-year term, the annuity is valued as for 10 years or until the grantor’s prior death.<a href="#_ftn24" name="_ftnref24">24</a> These results should apply likewise to unitrust payments. <hr> Planning Point: A grantor retained annuity trust (GRAT) can be zeroed out (i.e., the value of the gift of the remainder reduced to zero) using an annuity payable to the grantor for a term of years with payments continuing to the grantor’s estate for the balance of the term of years if the grantor dies during the term. In general, the GRAT is zeroed out if the annuity payment is made to equal the value of the property transferred to the trust divided by the appropriate annuity factor (including adjustments for frequency of payment). <hr> The IRS will not issue rulings or determination letters on whether annuity interests are qualified interests under IRC Section 2702 where (1) the amount of the annuity payable annually is more than 50 percent of the initial fair market value of the property transferred to trust, or (2) the value of the remainder interest is less than 10 percent of the initial fair market value of the property transferred to trust. For purposes of the 10 percent test, the value of the remainder interest is determined under IRC Section 7520 without regard to the possibility that the grantor might die during the trust term, or that the trust property might revert to the grantor or the grantor’s estate.<a href="#_ftn25" name="_ftnref25">25</a> Commutation (generally, an actuarially based acceleration or substitution of benefits) of a qualified annuity or unitrust interest is not permitted.<a href="#_ftn26" name="_ftnref26">26</a> Additional contributions are not permitted with qualified annuity interests.<a href="#_ftn27" name="_ftnref27">27</a> The use of notes, other debt instruments, options or similar financial arrangements in satisfaction of the annuity or unitrust requirements under IRC Section 2702 is prohibited.<a href="#_ftn28" name="_ftnref28">28</a> A remainder (or reversion) interest is treated as a qualified remainder interest if: (1) all interests in the trust (other than non-contingent remainder interests) are either qualified annuity interests or qualified unitrust interests (thus, an excess income provision is not permitted for this purpose); (2) each remainder interest is entitled to all or a fractional share of the trust property when all or a fractional share of the trust terminates (a transferor’s right to receive the original value of the trust property, or a fractional share, would not qualify); and (3) the remainder is payable to the beneficiary or the beneficiary’s estate in all events (i.e., it is non-contingent).<a href="#_ftn29" name="_ftnref29">29</a> A qualified interest is to be valued using the valuation tables prescribed by IRC Section 7520.<a href="#_ftn30" name="_ftnref30">30</a> For valuation rules for certain qualified tangible property, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="939">939</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.      IRC § 2702(a). <a href="#_ftnref2" name="_ftn2">2</a>.      Treas. Reg. § 25.2702-1(c). <a href="#_ftnref3" name="_ftn3">3</a>.      Treas. Reg. § 25.2702-1(c)(3). <a href="#_ftnref4" name="_ftn4">4</a>.      Treas. Reg. § 25.2702-2(a). <a href="#_ftnref5" name="_ftn5">5</a>.      Treas. Reg. § 25.2702-2(a)(3). <a href="#_ftnref6" name="_ftn6">6</a>.      TAM 9436006. <a href="#_ftnref7" name="_ftn7">7</a>.      IRC § 2702(b). <a href="#_ftnref8" name="_ftn8">8</a>.      Treas. Reg. § 25.2702-3(b)(1)(ii). <a href="#_ftnref9" name="_ftn9">9</a>.      Treas. Reg. § 25.2702-3(c)(1)(ii). <a href="#_ftnref10" name="_ftn10">10</a>.    Treas. Reg. § 25.2702-2(a)(5). <a href="#_ftnref11" name="_ftn11">11</a>.    TAMs 9707001, 9717008, 9741001; Cook v. Comm., 269 F.3d 854 (7th Cir. 2001), aff’g 115 TC 15 (2000). <a href="#_ftnref12" name="_ftn12">12</a>.    Treas. Reg. § 25.2702-3(d)(2). <a href="#_ftnref13" name="_ftn13">13</a>.    Treas. Reg. § 25.2702-3(d)(1). <a href="#_ftnref14" name="_ftn14">14</a>.    Treas. Reg. §§ 25.2702-3(b)(1)(i), 25.2702-3(c)(1)(i). <a href="#_ftnref15" name="_ftn15">15</a>.    Treas. Reg. §§ 25.2702-3(b)(1)(iii), 25.2702-3(c)(1)(iii). <a href="#_ftnref16" name="_ftn16">16</a>.    Let. Ruls. 9441031, 9345035. <a href="#_ftnref17" name="_ftn17">17</a>.    Treas. Reg. § 25.2702-3(d)(2). <a href="#_ftnref18" name="_ftn18">18</a>.    Treas. Reg. § 25.2702-3(d)(3). <a href="#_ftnref19" name="_ftn19">19</a>.    Schott v. Comm., 2003-1 USTC 60,457 (9th Cir. 2003), rev’g TC Memo 2001-110; Cook v. Comm., 269 F.3d 854 (7th Cir. 2001), aff’g 115 TC 15 (2000). <a href="#_ftnref20" name="_ftn20">20</a>.    Treas. Reg. § 25.2702-3(e)(Ex. 8). <a href="#_ftnref21" name="_ftn21">21</a>.    Treas. Reg. § 25.2702-3(e)(Ex. 5). <a href="#_ftnref22" name="_ftn22">22</a>.    Walton v. Comm., 115 TC 589 (2000). <a href="#_ftnref23" name="_ftn23">23</a>.    Treas. Reg. § 25.2702-3(e)(Ex. 5). <a href="#_ftnref24" name="_ftn24">24</a>.    Treas. Reg. § 25.2702-3(e)(Ex. 1). <a href="#_ftnref25" name="_ftn25">25</a>.    Rev. Proc. 2009-3, § 4.51, 2009-1 IRB 107 and Rev. Proc. 2010-3, 2010-1 IRB 110, superseded by Rev. Proc. 2019-3. <a href="#_ftnref26" name="_ftn26">26</a>.    Treas. Reg. § 25.2702-3(d)(4). <a href="#_ftnref27" name="_ftn27">27</a>.    Treas. Reg. § 25.2702-3(b)(4). <a href="#_ftnref28" name="_ftn28">28</a>.    Treas. Reg. § 25.2702-3. <a href="#_ftnref29" name="_ftn29">29</a>.    Treas. Reg. § 25.2702-3(f). <a href="#_ftnref30" name="_ftn30">30</a>.  IRC § 2702(a)(2)(B). </div></div>

March 13, 2024

940 / What special valuation rules apply to the transfer of an interest in a personal residence trust or qualified personal residence trust under Chapter 14?

<div class="Section1">IRC Section 2702 does not apply to the transfer of an interest in a personal residence trust or a qualified personal residence trust.<a href="#_ftn1" name="_ftnref1">1</a> However, a person is limited to holding a term interest in only two such trusts.<a href="#_ftn2" name="_ftnref2">2</a> A personal residence trust or a qualified personal residence trust which does not meet the requirements in the regulations may be modified (by judicial modification or otherwise, so long as the modification is effective under state law), if the reformation commences within 90 days of the due date (including extensions) for filing the gift tax return and is completed within a reasonable time after commencement. In the case of a trust created before 1997, the reformation had to commence within 90 days after December 23, 1997, and be completed within a reasonable time after commencement.<a href="#_ftn3" name="_ftnref3">3</a></div> <div class="Section1"> A personal residence is defined as either (1) the principal residence of the term holder, (2) a residence of the term holder which the term holder uses for personal use during the year for a number of days which exceeds the greater of 14 days or 10 percent of the days during the year that the residence is rented at fair market value, or (3) an undivided fractional interest in either (1) or (2). A personal residence includes appurtenant residential structures and a reasonable amount of land (taking into account the residence's size and location). Personal property, such as household furnishings, is not included in a personal residence. A personal residence is treated as such as long as it is not occupied by any other person (other than the spouse or a dependent) and is available at all times for use by the term holder as a personal residence. A personal residence can be rented out if the rental use is secondary to the primary use as a personal residence (but see above). Use of the residence as transient lodging is not permitted if substantial services are provided (e.g., a hotel or a bed and breakfast). Spouses may hold interests in the same personal residence or qualified personal residence trust.<a href="#_ftn4" name="_ftnref4">4</a> A personal residence trust is a trust which is prohibited for the entire term of the trust from holding any property other than one residence to be used as the personal residence of the term holder(s). A personal residence trust cannot permit the personal residence to be sold, transferred, or put to any other use. Expenses of the trust can be paid by the term holder. A personal residence trust can hold proceeds payable as a result of damage to, or destruction or involuntary conversion of, the personal residence for reinvestment in a personal residence within two years of receipt of such proceeds.<a href="#_ftn5" name="_ftnref5">5</a> Also, with respect to trusts created after May 16, 1996, a personal residence trust must be prohibited from selling or transferring, directly or indirectly, the residence to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse, at any time after the original term interest during which the trust is a grantor trust. A distribution upon or after the expiration of the original duration of the trust term to another grantor trust of the grantor or the grantor's spouse pursuant to the trust terms will not be treated as a sale or transfer to the grantor or grantor's spouse if the second trust prohibits sale or transfer of the property to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse. This prohibition against a transfer to the grantor or the grantor's spouse does not apply to a transfer pursuant to the trust document or a power retained by the grantor in the event the grantor dies prior to the expiration of the original duration of the trust term. Nor does this prohibition apply to a distribution (for no consideration) of the residence to the grantor's spouse pursuant to the trust document at the expiration of the original duration of the trust term.<a href="#_ftn6" name="_ftnref6">6</a> A qualified personal residence trust ceases to be a qualified personal residence trust if the residence ceases to be used or held for use as the personal residence of the term holder. A residence is held by the trust for use as the personal residence of the term holder so long as the residence is not occupied by any other person (other than the spouse or a dependent of the term holder) and is available at all times for use by the term holder. A sale of a personal residence is not treated as a cessation of use as a personal residence if the personal residence is replaced by another within two years of the sale. The trust must provide that if damage to or destruction of the residence renders it unusable as a residence, the trust ceases to be a qualified personal residence trust unless the residence is repaired or replaced within two years.<a href="#_ftn7" name="_ftnref7">7</a> A qualified personal residence trust must provide that within 30 days of ceasing to be a qualified personal residence trust with respect to any assets, either (1) the assets must be distributed to the term holder; (2) the assets must be put into a separate share of the trust for the balance of the term holder's interest as a qualified annuity interest; or (3) the trustee may elect either (1) or (2). The amount of such an annuity must be no less than the amount determined by dividing the lesser of the original value of all interests retained by the term holder or the value of all the trust assets by an annuity valuation factor reflecting the valuation table rate on the date of the original transfer and the original term of the term holder's interest. If only a portion of the trust continues as a qualified personal residence trust, then the annuity determined in the preceding sentence is reduced in proportion to the ratio that assets which still qualify as a personal residence trust bear to total trust assets.<a href="#_ftn8" name="_ftnref8">8</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 2702(a)(3)(A)(ii); Treas. Reg. § 25.2702-5(a). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 25.2702-5(a). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 25.2702-5(a)(2). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. §§ 25.2702-5(b), 25.2702-5(c)(2). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 25.2702-5(b). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. §§ 25.2702-5(b)(1), 25.2702-7. <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. § 25.2702-5(c)(7). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 25.2702-5(c)(8). </div>

March 13, 2024

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

<div class="Section1">The transfer of an interest in property with respect to which there are one or more term interests (e.g., transfer of a remainder interest) is to be treated as a transfer of an interest in trust.<a href="#_ftn1" name="_ftnref1">1</a> A leasehold interest in property is not treated as a term interest provided a good faith effort is made to set the lease at a fair rental value.<a href="#_ftn2" name="_ftnref2">2</a> 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.<a href="#_ftn3" name="_ftnref3">3</a> For this purpose, the amount considered transferred by such individual is not to exceed the amount which such individual furnished for such property.<a href="#_ftn4" name="_ftnref4">4</a> Special rules apply to “qualified tangible property” (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="939">939</a>).<div class="Section1"> 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.<a href="#_ftn5" name="_ftnref5">5</a> 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.<a href="#_ftn6" name="_ftnref6">6</a> 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.<a href="#_ftn7" name="_ftnref7">7</a> 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.<a href="#_ftn8" name="_ftnref8">8</a> 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.<a href="#_ftn9" name="_ftnref9">9</a> 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).<a href="#_ftn10" name="_ftnref10">10</a> 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.<a href="#_ftn11" name="_ftnref11">11</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="939">939</a>. 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). </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.      IRC § 2702(c)(1). <a href="#_ftnref2" name="_ftn2">2</a>.      Treas. Reg. § 25.2702-4(b). <a href="#_ftnref3" name="_ftn3">3</a>.      IRC § 2702(c)(2). <a href="#_ftnref4" name="_ftn4">4</a>.      Treas. Reg. § 25.2702-4(c). <a href="#_ftnref5" name="_ftn5">5</a>.      IRC § 2702(e). <a href="#_ftnref6" name="_ftn6">6</a>.      IRC §§ 2702(a)(1), 2701(e)(2). <a href="#_ftnref7" name="_ftn7">7</a>.      Treas. Reg. § 25.2702-6. <a href="#_ftnref8" name="_ftn8">8</a>.      OBRA ’90, § 11602(e)(1). <a href="#_ftnref9" name="_ftn9">9</a>.      IRC § 6501(c)(9); OBRA ’90, § 11602(e)(2). <a href="#_ftnref10" name="_ftn10">10</a>.    Let. Rul. 9109033. <a href="#_ftnref11" name="_ftn11">11</a>.  Treas. Reg. § 25.2702-1(c)(3). </div></div>

March 13, 2024

944 / What special valuation rules apply to certain lapsing rights and restrictions under Chapter 14?

<div class="Section1"> In general, IRC Section 2704(a) provides that the lapse of certain voting or liquidation rights in a family owned business results in a taxable transfer by the holder of the lapsing right. IRC Section 2704(b) provides generally that certain restrictions on liquidating a family owned business are ignored in valuing a transferred interest. These provisions apply to restrictions or rights (or limitations on rights) created after October 8, 1990.<a href="#_ftn1" name="_ftnref1">1</a> Regulations proposed in 2016 would have modified certain aspects of these special valuation rules, including the definition of applicable restriction discussed below. However, these regulations were withdrawn in 2017. For more information on valuing a closely held business interest, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="927">927</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="929">929</a>. Lapse of Certain Rights For estate, gift, and generation-skipping transfer tax purposes, if there is a lapse of a voting or liquidation right in a corporation or partnership and the individual holding such right (the “holder”) immediately before the lapse and members of the holder’s family control the entity (both before and after the lapse), then the holder is treated as if making a transfer. The value of the transfer is equal to the amount (if any) by which the value of all interests in the entity held by the holder immediately prior to the lapse (determined as if all voting and liquidation rights were nonlapsing) exceeds the sum of (1) the value of such interests immediately after the lapse (determined as if held by one individual), and (2) in the case of a lapse during the holder’s life, any consideration in money or money’s worth received by the holder with respect to such lapse.<a href="#_ftn2" name="_ftnref2">2</a> A voting right is defined as a right to vote with respect to any matter of the entity. Also, with respect to a partnership, the right of a general partner to participate in partnership management is treated as a voting right. A liquidation right is the right to compel (including by aggregate voting power) the entity to acquire all or a portion of the holder’s equity interest in the entity.<a href="#_ftn3" name="_ftnref3">3</a> A lapse of a voting or liquidation right occurs when a presently exercisable right is restricted or eliminated.<a href="#_ftn4" name="_ftnref4">4</a> The transfer of an interest which results in the lapse of a liquidation right is not subject to IRC Section 2704(a) if the rights with respect to the transferred interest are not restricted or eliminated.<a href="#_ftn5" name="_ftnref5">5</a> However, a transfer that results in the elimination of the transferor’s right to compel the entity to acquire an interest of the transferor which is subordinate to the transferred interest is treated as a lapse of a liquidation right with respect to the subordinate interest. The lapse rule does not apply to the lapse of a liquidation right with respect to (1) a transfer that was previously valued in the hands of the holder as a transfer of an interest in a corporation or partnership under IRC Section 2701 (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="935">935</a>), or (2) the lapse of a liquidation right to the extent that immediately after the lapse the holder (or the holder’s estate) and members of the holder’s family cannot liquidate an interest that the holder could have liquidated prior to the lapse. Whether an interest can be liquidated immediately after the lapse is determined under state law or, if the governing instruments are less restrictive than the state law which would apply in the absence of such instruments, the governing instruments. For this purpose, any applicable restriction under IRC Section 2704(b) (see below) is disregarded.<a href="#_ftn6" name="_ftnref6">6</a> If a lapsed right may be restored only upon the occurrence of a future event not within the control of the holder or the holder’s family, the lapse is deemed to occur at the time the lapse becomes permanent with respect to the holder (e.g., upon the transfer of the interest).<a href="#_ftn7" name="_ftnref7">7</a> For attribution rules, see below. Transfers Subject to Applicable Restrictions If there is a transfer of an interest in a corporation or partnership to (or for the benefit of) a member of the transferor’s family and the transferor and members of transferor’s family control the entity (immediately before the transfer), any applicable restriction is to be disregarded in valuing the transferred interest for estate, gift, or generation-skipping transfer tax purposes.<a href="#_ftn8" name="_ftnref8">8</a> If an applicable restriction is disregarded under this rule, the rights of the transferor are valued under the state law that would apply but for the limitation (meaning that the interest is valued as though the restriction does not exist).<a href="#_ftn9" name="_ftnref9">9</a> “Applicable restriction” means any restriction which effectively limits the ability of the corporation or partnership to liquidate if either (1) the restriction lapses (in whole or in part) after the transfer, or (2) the transferor or any member of the transferor’s family, acting alone or collectively, can remove the restriction (in whole or in part) after the transfer.<a href="#_ftn10" name="_ftnref10">10</a> Applicable restriction treatment was avoided where the consent of all parties was required and a charity (a nonfamily member) had become a partner.<a href="#_ftn11" name="_ftnref11">11</a> However, any restriction imposed or required by any federal or state law was not previously treated as an applicable restriction.<a href="#_ftn12" name="_ftnref12">12</a> Thus, the definition of an applicable restriction was limited to a restriction that was more restrictive than the limitations which would apply under state law if there were no restriction. Also, whether there is the ability to remove a restriction is determined under the state law that would apply in the absence of the restrictive provision in the governing instruments.<a href="#_ftn13" name="_ftnref13">13</a> An applicable restriction does not include any commercially reasonable restriction which arises as part of any financing by the corporation or partnership with a person who is not related to the transferor or transferee, or a member of the family of either.<a href="#_ftn14" name="_ftnref14">14</a> Regulations provide that an applicable restriction does not include any commercially reasonable restriction which arises as a result of any unrelated person providing capital in the form of debt or equity to the corporation or partnership for the entity’s trade or business operations. For this purpose, the regulations apply the relationship rules of IRC Section 267(b), except that the term “fiduciary of a trust” under the relationship rules is modified to generally exclude banks, trust companies, and building and loan associations.<a href="#_ftn15" name="_ftnref15">15</a> Furthermore, an applicable restriction does not include an option, right to use property, or other agreement subject to IRC Section 2703 (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="943">943</a>).<a href="#_ftn16" name="_ftnref16">16</a> With respect to a partnership (or LLC) created on a decedent’s deathbed, the IRS has disregarded restrictions where the partnership provided that a partner could not liquidate his interest, while state law provided a less restrictive provision.<a href="#_ftn17" name="_ftnref17">17</a> A few cases have held that partnership liquidation provisions were no more restrictive than state law and should not be ignored under IRC Section 2704(b).<a href="#_ftn18" name="_ftnref18">18</a> Attribution The following attribution rules or definitions generally apply for purposes of the rules which apply to certain lapsing rights and applicable restrictions under IRC Section 2704: In the case of a corporation, “control” means 50 percent ownership (by vote or value) of the stock. In the case of a partnership, “control” means 50 percent ownership of the capital or profits interests, or in the case of a limited partnership, the ownership of any interest as a general partner.<a href="#_ftn19" name="_ftnref19">19</a> 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.<a href="#_ftn20" name="_ftnref20">20</a> An individual is treated as holding interests held indirectly through a corporation, partnership, trust, or other entity.<a href="#_ftn21" name="_ftnref21">21</a> Thus, transfers may be either direct or indirect. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.      OBRA ’90, § 11602(e)(1)(A)(iii). <a href="#_ftnref2" name="_ftn2">2</a>.      IRC § 2704(a); Treas. Reg. §§ 25.2704-1(a), 25.2704-1(d). <a href="#_ftnref3" name="_ftn3">3</a>.      Treas. Reg. § 25.2704-1(a)(2). <a href="#_ftnref4" name="_ftn4">4</a>.      Treas. Reg. §§ 25.2704-1(b), 25.2704-1(c)(1). <a href="#_ftnref5" name="_ftn5">5</a>.      Prop. Treas. Reg. § 25.2704-1(c)(1). The proposed regulations released in 2016 (and withdrawn in 2017) provided that this exception should not apply when the transfer occurs on a decedent’s deathbed, so that the exception would apply only to transfers occurring more than three years prior to death (transfers occurring within three years of death would have been treated as a transfer occurring at death). <a href="#_ftnref6" name="_ftn6">6</a>.      Treas. Reg. § 25.2704-1(c). <a href="#_ftnref7" name="_ftn7">7</a>.      Treas. Reg. § 25.2704-1(a)(3). <a href="#_ftnref8" name="_ftn8">8</a>.      IRC § 2704(b)(1). <a href="#_ftnref9" name="_ftn9">9</a>.      Treas. Reg. § 25.2704-2(c). <a href="#_ftnref10" name="_ftn10">10</a>.    IRC § 2704(b)(2). <a href="#_ftnref11" name="_ftn11">11</a>.    Kerr v. Comm., 292 F.3d 490, 2002-1 USTC ¶ 60,440 (5th Cir. 2002). <a href="#_ftnref12" name="_ftn12">12</a>.    IRC § 2704(b)(3)(B). <a href="#_ftnref13" name="_ftn13">13</a>.    Treas. Reg. § 25.2704-2(b). Proposed regulations released in 2016 (and withdrawn in 2017) would have modified the definition of “applicable restriction.” These modifications were partially motivated by the fact that courts previously interpreted the definition as applying only to restrictions on liquidations of an entire entity, rather than on restrictions on liquidating a transferred interest in the entity. The proposed regulations would have also eliminated the reference to state law, and disregarded the following types of restrictions: (1) restrictions on the ability to liquidate the transferred interest and (2) restrictions attendant upon the nature or extent of the property to be received in the exchange for the liquidated interest, or the timing of the payment of that property. <a href="#_ftnref14" name="_ftn14">14</a>.    IRC § 2704(b)(3)(A). <a href="#_ftnref15" name="_ftn15">15</a>.    Treas. Reg. § 25.2704-2(b). <a href="#_ftnref16" name="_ftn16">16</a>.    Treas. Reg. § 25.2704-2(b). <a href="#_ftnref17" name="_ftn17">17</a>.    TAMs 9723009, 9725002, 9730004, 9735003, 9736004, 9842003. <a href="#_ftnref18" name="_ftn18">18</a>.    Kerr v. Comm., 113 TC 449 (1999); Knight v. Comm., 115 TC 506 (2000). <a href="#_ftnref19" name="_ftn19">19</a>.    IRC §§ 2704(c)(1), 2701(b)(2). <a href="#_ftnref20" name="_ftn20">20</a>.    IRC § 2704(c)(2). <a href="#_ftnref21" name="_ftn21">21</a>.  IRC §§ 2704(c)(3), 2701(e)(3). </div></div>

March 13, 2024

929 / How are shares of stock in closely held corporations valued for federal transfer tax purposes?

<div class="Section1">IRC Section 2031(b) deals with the valuation, for estate tax purposes, of unlisted stocks and securities. It says: “In the case of stock and securities of a corporation the value of which, by reason of their not being listed on an exchange and by reason of the absence of sales thereof, cannot be determined with reference to bid and asked prices or with reference to sales prices, the value thereof shall be determined by taking into consideration, in addition to all other factors, the value of stock or securities of corporations engaged in the same or a similar line of business which are listed on an exchange.”<div class="Section1"> Revenue Ruling 59-60<a href="#_ftn1" name="_ftnref1">1</a> contains a broad discussion of factors that the IRS believes should be considered in valuing shares of stock in closely held corporations or in corporations where market quotations are either lacking or too scarce to be recognized. The Service says that in these cases, “all available financial data, as well as all relevant factors affecting the fair market value, should be considered. The following factors, although not all-inclusive, are fundamental and require careful analysis in each case: (a)     The nature of the business and the history of the enterprise from its inception; (b)     The economic outlook in general and the condition and outlook of the specific industry in particular; (c)     The book value of the stock and the financial condition of the business; (d)     The earning capacity of the company; (e)     The dividend-paying capacity; (f)     Whether or not the enterprise has goodwill or other intangible value; (g)     Sales of the stock and the size of the block of stock to be valued; and (h)     The market price of stock of corporations engaged in the same or a similar line of business having their stock actively traded in a free and open market, either on an exchange or over-the-counter.”<a href="#_ftn2" name="_ftnref2">2</a> <hr> Planning Point: Taxpayers should go over in detail all the facts with the business appraiser relating to the business that would impact the appraiser’s analysis of the facts laid out in Revenue Ruling 59-60. <hr> If a block of stock represents a controlling interest in a corporation, a “control premium” generally adds to the value of the stock. If, however, the shares constitute a minority ownership interest, a “minority discount” is often applied to the value. See, e.g., Martin v. Commissioner,<a href="#_ftn3" name="_ftnref3">3</a> which deals with discounts applied to shares of stock representing a minority interest in a holding company that, in turn, held minority interests in seven operating companies. A premium may also attach for swing vote attributes where one block of stock may exercise control by joining with another block of stock.<a href="#_ftn4" name="_ftnref4">4</a> One memorandum valued stock included in the gross estate at a premium as a controlling interest, while applying a minority discount to the marital deduction (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="847">847</a>) portion which passed to the surviving spouse.<a href="#_ftn5" name="_ftnref5">5</a> Just because an interest being valued is a minority interest does not mean that a minority discount is available.<a href="#_ftn6" name="_ftnref6">6</a> However, one case valued stock with voting rights at no more than stock without voting rights.<a href="#_ftn7" name="_ftnref7">7</a> If a donor transfers shares in a corporation to each of the donor’s children, the Service will no longer consider family control when valuing the gift under IRC Section 2512. Thus, a minority discount will not be disallowed solely because a transferred interest would be part of a controlling interest if such interest were aggregated with interests held by family members.<a href="#_ftn8" name="_ftnref8">8</a> Indeed, a minority discount was allowed even when the person to whom the interest was transferred was already a controlling shareholder.<a href="#_ftn9" name="_ftnref9">9</a> The Tax Court has determined that an estate would not be allowed a minority discount where the decedent transferred a small amount of stock immediately prior to death for the sole purpose of reducing her interest from a controlling interest to a minority interest for valuation purposes.<a href="#_ftn10" name="_ftnref10">10</a> Also, a partnership or LLC may be included in the gross estate under IRC Section 2036 without the benefit of discounts if a decedent puts everything he owns into the partnership or LLC and retains complete control over the income of the partnership or LLC.<a href="#_ftn11" name="_ftnref11">11</a> For a case discussing the valuation of voting trust certificates representing the decedent’s beneficial interest in stock of a closely held corporation, see Estate of McGill v. Commissioner.<a href="#_ftn12" name="_ftnref12">[12]</a> In general, when valuing an operating company that sells goods and services, primary consideration is given to earnings, and when valuing a company that merely holds investments, primary consideration is given to asset values. However, if a company is not easily characterized as one or the other, appropriate weight should be given to both earnings and assets.<a href="#_ftn13" name="_ftnref13">13</a> For the effect of a buy-sell agreement on the valuation of closely held stock, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="928">928</a>. For additional special valuation rules contained in IRC Chapter 14, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="934">934</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="944">944</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.      1959-1 CB 237. <a href="#_ftnref2" name="_ftn2">2</a>.      Rev. Rul. 59-60, § 4.01. <a href="#_ftnref3" name="_ftn3">3</a>.      TC Memo 1985-424. <a href="#_ftnref4" name="_ftn4">4</a>.      TAM 9436005. <a href="#_ftnref5" name="_ftn5">5</a>.      TAM 9403005. <a href="#_ftnref6" name="_ftn6">6</a>.      Godley v. Comm., 286 F.3d 210, 2002-1 USTC ¶ 60,436 (4th Cir. 2002) (partnerships held housing projects subject to long-term government contracts). <a href="#_ftnref7" name="_ftn7">7</a>.      Est. of Simplot v. Comm., 249 F.3d 1191, 2001-1 USTC ¶ 60,405 (9th Cir. 2001). <a href="#_ftnref8" name="_ftn8">8</a>.      Rev. Rul. 93-12, 1993-1 CB 202, revoking Rev. Rul. 81-253, 1981-2 CB 187. <a href="#_ftnref9" name="_ftn9">9</a>.      TAM 9432001. <a href="#_ftnref10" name="_ftn10">10</a>.    Est. of Murphy v. Comm., TC Memo 1990-472. <a href="#_ftnref11" name="_ftn11">11</a>.    Est. of Strangi v. Comm., TC Memo 2003-145; Kimbell v. U.S., 2003-1 USTC ¶ 60,455 (N.D. Tex. 2003). <a href="#_ftnref12" name="_ftn12">12</a>.    Estate of McGill v. Comm., TC Memo 1984-292. <a href="#_ftnref13" name="_ftn13">13</a>.  Martin v. Comm., TC Memo 1985-424. </div></div>

March 13, 2024

931 / How are mineral properties valued for federal transfer tax purposes?

<div class="Section1">Treasury Regulation Section 1.611-2(d) provides, for income tax purposes, the following:<div class="Section1"> (d) Determination of fair market value of mineral properties, and improvements, if any. – (1)     If the fair market value of the mineral property and improvements at a specified date is to be determined for the purpose of ascertaining the basis (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="692">692</a>), such value must be determined, subject to approval or revision by the district director, by the owner of such property and improvements in the light of the conditions and circumstances known at that date, regardless of later discoveries or developments or subsequent improvements in methods of extraction and treatment of the mineral product. The district director will give due weight and consideration to any and all factors and evidence having a bearing on the market value, such as cost, actual sales and transfers of similar properties and improvements, bona fide offers, market value of stocks or shares, royalties and rentals, valuation for local or State taxation, partnership accountings, records of litigation in which the value of the property and improvements was in question, the amount at which the property and improvements may have been inventoried or appraised in probate or similar proceedings, and disinterested appraisals by approved methods. (2)     If the fair market value must be ascertained as of a certain date, analytical appraisal methods of valuation, such as the present value method will not be used: (i)   If the value of a mineral property and improvements, if any, can be determined upon the basis of cost or comparative values and replacement value of equipment, or (ii)  If the fair market value can reasonably be determined by any other method.” Lambert v. U.S.,<a href="#_ftn1" name="_ftnref1">1</a> concerned the federal estate tax valuation of an estate’s one-half interest in a coal mining business operated as a partnership. The parties agreed that the Treasury Regulations on cost depletion provided guidance as to the valuation of coal properties. Citing Treas. Reg. § 1.611-2(d)(2), above, the court found that the estate’s witness had properly determined the value of the intangible assets, including the coal reserves and good will, upon the basis of comparative values, and that for that reason, the analytical methods applied by the government and its witness were not appropriate. Accordingly, the court found that the estate had met its burden of showing that the government’s valuation of $3,772,326 for the coal company was excessive and that the fair market value, as determined by the estate, was $2,126,000. Treasury Regulation Section 1.611-2(e) provides, for income tax purposes, the following: (e)  Determination of the fair market value of mineral property by the present value method. – (1)     To determine the fair market value of a mineral property and improvements by the present value method, the essential factors must be determined for each mineral deposit. The essential factors in determining the fair market value of mineral deposits are: (i)   The total quantity of mineral in terms of the principal or customary unit (or units) paid for in the product marketed, (ii)  The quantity of mineral expected to be recovered during each operating period, (iii) The average quality or grade of the mineral reserves, (iv)  The allocation of the total expected profit to the several processes or operations necessary for the preparation of the mineral for market, (v)   The probable operating life of the deposit in years, (vi)  The development cost, (vii) The operating cost, (viii) The total expected profit, (ix)  The rate at which this profit will be obtained, and (x)   The rate of interest commensurate with the risk for the particular deposit. (2)     If the mineral deposit has been sufficiently developed, the valuation factors specified in subparagraph (1) of this paragraph may be determined from past operating experience. In the application of factors derived from past experience, full allowance should be made for probable future variations in the rate of exhaustion, quality or grade of the mineral, percentage of recovery, cost of development, production, interest rate, and selling price of the product marketed during the expected operating life of the mineral deposit. Mineral deposits for which these factors cannot be determined with reasonable accuracy from past operating experience may also be valued by the present value method; but the factors must be deduced from concurrent evidence, such as the general type of the deposit, the characteristics of the district in which it occurs, the habit of the mineral deposits, the intensity of mineralization, the oil-gas ratio, the rate at which additional mineral has been disclosed by exploitation, the stage of the operating life of the deposit, and any other evidence tending to establish a reasonable estimate of the required factors. (3)     Mineral deposits of different grades, locations, and probable dates of extraction should be valued separately. The mineral content of a deposit shall be determined in accordance with paragraph (c) of this section. In estimating the average grade of the developed and prospective mineral, account should be taken of probable increases or decreases as indicated by the operating history. The rate of exhaustion of a mineral deposit should be determined with due regard to the limitations imposed by plant capacity, by the character of the deposit, by the ability to market the mineral product, by labor conditions, and by the operating program in force or reasonably to be expected for future operations. The operating life of a mineral deposit is that number of years necessary for the exhaustion of both the developed and prospective mineral content at the rate determined as above. The operating life of oil and gas wells is also influenced by the natural decline in pressure and flow, and by voluntary or enforced curtailment of production. The operating cost includes all current expense of producing, preparing, and marketing the mineral product sold (due consideration being given to taxes) exclusive of allowable capital additions, as described in §§ 1.612-2 and 1.612-4 (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7865">7865</a> through Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7868">7868</a>), and deductions for depreciation and depletion (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7869">7869</a> through Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7883">7883</a>), but including cost of repairs. This cost of repairs is not to be confused with the depreciation deduction by which the cost of improvements is returned to the taxpayer free from tax. In general, no estimates of these factors will be approved by the district director that are not supported by the operating experience of the property or which are derived from different and arbitrarily selected periods. (4)     The value of each mineral deposit is measured by the expected gross income (the number of units of mineral recoverable in marketable form multiplied by the estimated market price per unit) less the estimated operating cost, reduced to a present value as of the date for which the valuation is made at the rate of interest commensurate with the risk for the operating life, and further reduced by the value at that date of the improvements and of the capital additions, if any, necessary to realize the profits. The degree of risk is generally lowest in cases where the factors of valuation are fully supported by the operating record of the mineral enterprise before the date for which the valuation is made. On the other hand, higher risks ordinarily attach to appraisals on any other basis.” </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.    85-2 USTC ¶ 13,637 (W.D. Va. 1985). </div></div>