ESTATE FREEZES AND CHAPTER 14: CONSTRAINTS ON INTRA-FAMILY TRANSFERS AND ESTATE FREEZE
I. CHAPTER 14 CONSISTS OF FOUR SECTIONS, EACH DESIGNED TO ADDRESS A DIFFERENT TYPE OF
TRANSFER:
A.
Section 2701 applies to transfers of interests in partnerships and corporations and attempts to limit abuses in recapitalizations, which freeze the value of a senior retained interest.B.
Section 2702 applies to transfers in trust where the transferor retains an interest in the trust and gives other interests in the trust to junior generation members. Under Section 2702, the value of a gift in a trust in which the transferor retains an interest will be determined as if the retained interest had a value equal to zero, unless the retained interest is a qualified interest (e.g., an annuity or unitrust interest or an interest in a trust holding a residence). Grantor Retained Annuity Trusts, or GRATs, are an attractive vehicle for gifts of real estate with significant cash flow. See Section VII above.C.
Section 2703 applies to options and buy-sell agreements and addresses the use of such arrangements to limit the value of interests in family corporations and partnerships. Under Section 2703, the value of a decedent’s interest in a corporation or partnership will be determined without regard to any option, agreement, or other right to acquire or use the property at less than its fair market value, or any other restriction on the sale or disposition of such property, unless it is a bona fide business arrangement on arms’ length terms.§25.2703-1(b)(3) provides that a right or restriction is not subject to Section 2703 if more than 50% by value of the property subject to the right or restriction is owned by persons who are not members of the transferor’s family.
D.
Section 2704 applies to certain rights and restrictions on liquidation and control and provides that a lapse of any voting or liquidation right in an entity controlled by the holder’s family constitutes a taxable gift, or an increase in the value of the holder’s gross estate if it occurs at death.II.
SECTION 2701:A.
Section 2701 must be considered in any gift of equity interests in a corporation or partnership.B.
In general, Section 2701 applies when:1.
An interest in a corporation or partnership is transferred2.
To or for the benefit of a member of the transferor’sfamily, and
3.
A junior interest in the corporation or partnership is held4.
By the transferor or an applicable family memberimmediately after the transfer.
C.
An “interest” in a corporation or partnership is limited to an equity interest. §25.2701-1(a)(1).D.
A “member of the transferor’s family” is defined to include the following:1.
The transferor’s spouse;2.
A lineal descendant of the transferor or the transferor’s spouse;3.
The spouse of any such descendant. Section 2701(e)(1).4.
For this purpose, then, a member of the transferor’s family would not include someone in a generation senior to the transferor’s generation.(a)
EXAMPLE: H owns all of the outstanding common and preferred stock of XYZ Corp. H transfers all of his XYZ Corp. stock equally to his child C, his wife W, W’s child S (from a prior marriage), H’s brother B and his father P. For purposes of Section 2701, C, W and S are members of the transferor’s family and B and P are not.E.
Transfers.1.
The term “transfer” includes both direct and indirect transfers, such as transfers in trust and transfers to a corporation or partnership in which a member of the transferor’s family is a shareholder or partner. Capital structure transactions, such as recapitalizations, capital contributions, and redemptions are also “transfers” for purposes of Section 2701. Section 2701(e)(5); §25.2701-1(b)(2)(1)(A). See also Priv. Ltr. Rul. 9808010 (Nov. 13, 1997).2.
Section 2701 is not limited to transfers that are taxable gifts. It applies to any transfer whether or not it is a transfer under Chapter 12 and even if made in exchange for full and adequate consideration. §25.2701-1(b)(1).F.
Since Section 2701 is concerned with shifts of wealth to family members in lower generations, its applicability depends on whether the transferor or an “applicable family member”retained an interest in the entity after the transfer. For this purpose an “applicable family member” includes:
1.
The transferor’s spouse;2.
An ancestor of the transferor or the transferor’s spouse;3.
The spouse of any such ancestor. Section 2701(e)(2).(a)
EXAMPLE: Donor owns all of the common and preferred stock of XYZ Corp. Donor transfers all of the common stock to her husband and children and transfers all of the preferred stock to her parents.Section 2701 applies to the transfer because Donor transferred an equity interest to a member of his family and a senior interest in the entity transferred was held by an applicable family member immediately after the transfer.
G.
Retained Interest1.
The “applicable retained interest” which is retained must be a senior equity interest. §25.2701-2(b)(1).2.
There are two types of retained interests: (A) Extraordinary payment rights and (B) Distribution rights.(a)
Extraordinary payment rights(i)
“Extraordinary payment rights” include a liquidation, put, call or conversion right.Section 2701(b)(1)(B). Because such rights grant the holder the ability to participate in the future growth of the corporation or partnership, they enhance the value of the retained interest and decrease the value of the transferred interest.
For this reason, the Code classifies any right, which is similar to a liquidation, put, call or conversion right as a retained interest. Section 2701(c)(2)(A).
(A) EXAMPLE: Donor owns all of the common and preferred stock of XYZ Corp.
Donor transfers all of the common stock to her children and retains the preferred stock. The preferred stock is senior to the common stock because the Donor has the right to put the preferred shares to the
Company whenever she desires.
However, because the put is a discretionary right, it is valued at zero for purposes of Section 2701.
(ii)
There are two exceptions for extraordinary payment rights.(A) The first is a liquidation, put, call or conversion right which must be exercised at a specific time and for a specific amount. Section 2701(c)(2)(B)(i).
(1)
EXAMPLE: Same facts as previous example except that Donor must put the preferred stock to the Company by December 31, 2004 for the price of $1,000 a share.Because the redemption has a fixed date and a fixed price, the put will be valued at its fair market value for purposes of Section 2701.
(B) The second exception for extraordinary payment rights is a conversion right permitting the holder to convert the senior retained interest into the common interest, which was transferred. Such right must not lapse and must be subject to adjustment for splits, combinations or similar changes in capital and must provide for the payment of accumulated but unpaid distributions. Section 2701(c)(2)(C). The rationale is that value of the senior interest retained would increase in value as the junior interest increases in value.
(1)
EXAMPLE: Same facts as previous example except instead of a put, Donor has the right to converther preferred stock into shares of stock equal to 250 shares (representing twenty-five (25%) percent of the outstanding common stock) of XYZ Corp. In addition, Donor’s conversion right will be increased or decreased for splits on common shares so as not to dilute the conversion right. The conversion right will be valued at its fair market value for purposes of Section 2701.
3.
Distribution rights.(a)
The second type of retained interest is a “distribution right”. This is the right to receive distributions from a corporation or partnership with respect to the holder’s equity interest in such entity – such as corporate dividends and partnership distributions. Unlike extraordinary payment rights, a distribution right is not discretionary with the holder. Therefore, such a right is not considered an applicable retained interest unless the transferor, an applicable family member, or a lineal descendant of the parents of the transferor or the transferor’s spouse “controls” the entity immediately before the transfer. §25.2701-2(a)(2);§25.2701-2(b)(5).
(b)
In the case of a corporation, control means holding 50% of the total voting power or fair market value of the equity interests §25.2701-2(b)(5)(ii)(A). In the case of a partnership, control means holding at least 50% of the capital or profits interest. In the case of a limited partnership, any general partner interest, however small, is deemed to control the partnership.§25.2701-2(b)(5)(iii).
(c)
Distribution rights do not include guaranteed payments, fixed cumulative dividends or any other fixed cumulative distributions. §25.2701-2(6)(i).(d)
EXAMPLE: Donor owns 20% of the common and all of the preferred stock of XYZ Corp. The preferred stock has no vote and is worth 10% of the value of XYZ Corp. Donor’s parents own 20% of the common stock of XYZ Corp. The preferred stock is entitled to an annual 12% cumulative dividend. Donor transfers the common stock to his children and retains the preferred stock. Donor’s transfer is not subject to Section 2701 despite his retention of a distribution right because he and his parents do not control XYZ Corp. immediately before the transfer.(e)
EXAMPLE: Assume same facts as the previous example except Donor owns 40% of XYZ Corp.common stock before the transfer. Section 2701 applies to the transfer because Donor controls XYZ Corp. when his interest is aggregated with his parents’ interests. However, the distribution right (i.e., the cumulative dividend) is valued at fair market value because it is a “qualified payment right.”
H.
Section 2701 contains a number of exceptions, either based on the type of transfer or based on the type of interests being transferred. Very roughly speaking, transfers that do not offer the potential for shifting untaxed value between the transferor and transferee will be excepted from the special valuation rules of Section 2701. Examples of excepted transactions are:1.
Transfers in which the transferor retains interests of the same class as those transferred to a junior generation member, Section 2701(a)(2)(B);2.
Transfers in which the senior generation family members hold a “vertical slice” of all classes of equity interests after the transfer (e.g., the senior generation owns 25% of the preferred and 25% of the common, §25.2701-1(c)(4);3.
Transfers of interests that are publicly traded and for which market quotations are available, Section 2701(a)(2)(A); and4.
Recapitalizations in which the percentage interests of the family members are the same before and after the transaction, Section 2701(a)(2)(C).1. The primary sources for this outline are Lesk & Elliott, Estate Planning with Real Estate Assets, Ninth Annual Real Estate Tax Forum, February 2007, and Mancini
& Tucker, Estate Planning for Real Estate (ABA Section of Taxation May 2006 meeting).
2. The “trifecta bill” that was introduced in July 2006 would have unified the estate and gift tax applicable exclusion amounts.
3. All references to the Code refer to the Internal Revenue Code of 1986, as amended. All references to “Section” or “Chapter” refer to the corresponding provisions of the Code. All references to “Reg.” or “§” refer to the corresponding provisions of Treasury Regulations.
4. The Service had some success in arguing that taxpayers had made gifts to family members on the formation of an FLP where the value of the capital account credited to the taxpayer was less than the value of the underlying assets contributed to the FLP by the taxpayer. The lost value must be credited to the other contributing partners who are receiving more than their contribution to the partnership. In pro rata partnerships where each partner’s capital account is credited with the value of the partner’s contribution to the partnership, the taxpayers were generally successful. Stone v. Comm’r, T.C. Memo 2003-309, Estate of Jones v. Comm’r, 116 T.C. 121 (2001), Church v. United States, 85 AFTR 2d 2000-804 (W.D. Tex. 2000), aff’d, 2268 F.3d 1063 (5th Cir. 2001).
Under Section 2703(a)(2), the estate and gift tax value of property is determined without regard to any restriction on the right to sell or use the property that is not a bona fide arms’ length business arrangement. The Service has argued unsuccessfully that the underlying FLP assets are the “property” to which Section 2703 applies.
The Service has also argued, with mixed success, for the inclusion of FLP assets in a taxpayer’s estate where the FLP lacked a business purpose. See Tech. Adv.
Mems. 9719006 (May 9, 1997), 9723004 (Jun. 6, 1997), 9723009 (Jun. 6, 1997), 9725002 (Jun. 20, 1997), 9725003 (Aug. 29, 1997), 9736004 (Sept. 5, 1997); but see Estate of Harrison, T.C. Memo 1987-8, and more recently, Stone v. Comm’r, T.C. Memo 2003-309. These cases now appear to be a dead-end branch on the evolutionary tree leading to Bongard.
5. When the partnership formalities have been followed and the taxpayer had sufficient assets outside the partnership to support her lifestyle, taxpayers were successful in rebuffing government claims asserting the economic benefit argument. See Stone v. Comm’r, TC Memo 2003-309; Church v. United States, 268 F.3d 1063 (5th Cir. 2001); Shepard v. Comm’r, 283 F.3d 1258 (11th Cir.
2002).
6. In United States v. Byrum, 408 U.S. 125 (1972), the Supreme Court articulated the key concept that allowed a transferor to make a completed gift of an interest in an FLP and still retain control over the FLP. In Byrum, the taxpayer transferred shares of stock of three unlisted corporations to a trust for the benefit of his
descendants. Taxpayer retained the right to vote the stock. The Court held that taxpayer did not retain control within the meaning of Section 2036 because he had a fiduciary duty as majority stockholder. The Court held that although decedent had the power to elect the board of directors of the corporations, he could not legally compel the board to declare dividends and thereby control the flow of income to the trust. Moreover, the board has a fiduciary duty to the shareholders of the corporations and such duty is legally enforceable.
Although Congress overturned the specific result in Byrum – by enacting Section 2036(b), which provides that the retention of voting rights in a controlled corporation is considered a retention of enjoyment of transferred property – the rationale used by the Supreme Court in Byrum still appeared to be valid. The Service ruled privately that a transferor may retain control over a limited partnership by retaining a general partnership interest without triggering estate tax inclusion under Sections 2036 and 2038. Priv. Ltr. Ruls. 9710021 (Dec. 6, 1996), 9546006 (Aug. 14, 1995), 9415007 (Jan. 12, 1994); Tech. Adv. Mem. 9131006 (Apr. 30, 1991). In the context of corporations, the value of nonvoting shares of stock gifted by donor during life will not be includible in the gross estate of the donor who retained shares of voting stock in the same entity. Rev. Rul. 81-15, 1981 CB 457.