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©2016, N. Todd Angkatavanich, All Rights Reserved US-4728282/1

Skills Training for Estate Planners

Real Property, Trust and Estate Law

New York Law School

New York, NY

July 22, 2016

1:30 p.m.

Family Business Planning

with Chapter 14 Implications

N. Todd Angkatavanich, Esq.

Withers Bergman, LLP

New York, Greenwich and New Haven, Connecticut

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©2016, N. Todd Angkatavanich, All Rights Reserved

N. Todd Angkatavanich is a partner at Withers Bergman, LLP, in the firm’s Greenwich,

New Haven and New York offices. He serves as Regional Practice Group Co-Leader of

the firm’s US Trust, Estate and Charities Practice Group. Todd is a Fellow of the American

College of Trust and Estate Counsel and is a member of the Society of Trusts & Estates

Practitioners. Todd has published articles in publications such as Trusts & Estates, ACTEC

Law Journal, Estate Planning, BNA Tax Management, Probate & Property and other

publications. He serves as Co-Chair of the Estate Planning & Taxation Committee of the

Editorial Advisory Board of Trusts & Estates magazine, as well as a member of the

Advisory Board for BNA/Tax Management Estates, Gifts and Trusts Journal. Todd is co-

author of the pending BNA/Tax Management Portfolio No. 875, entitled “Wealth Planning

with Hedge Fund and Private Equity Fund Interests.” A frequent speaker, Todd has given

presentations for a number of organizations including the Heckerling Institute on Estate

Planning, the Federal Tax Institute of New England, the Notre Dame Tax and Estate

Planning Institute, the Washington State Bar Association Annual Estate Planning Seminar,

the ABA Real Property, Trusts and Estates Section (Spring Symposia, Fall Joint Meetings

and the joint ABA/New York Law School Skills Training Programs), BNA/Tax

Management, as well as numerous estate planning councils, CPA societies and family

office groups. Todd has been quoted in articles that have appeared in Barron's, Bloomberg

Businessweek, The Boston Globe, The Philadelphia Inquirer, The Chicago Tribune, The

Miami Herald, Forbes, MSN Money and other publications. Todd is Co-Chair of the

ABA/RPTE Business Planning Group – Business Investment Entities, Partnerships, LLC’s

and Corporations Committee and serves as a member of the ABA/RPTE Diversity

Committee. He is a member of the Executive Committee of the Connecticut Bar

Association, Estates and Probate Section, and on behalf of the Section also serves on the

Planning Committee for the Federal Tax Institute of New England. He is the 2012 recipient

of the award for “Private Client Lawyer of the Year” from Family Office Review. Todd

has been included in The Best Lawyers in America® (for New York City, Greenwich and

New Haven, Connecticut) and is also the recipient of the Best Lawyers® 2015 Trusts &

Estates “Lawyer of the Year” award for New Haven, Connecticut. He has been rated AV

Preeminent® by Martindale-Hubbell® Peer Review Ratings™ and has been listed in Who's

Who Legal: Private Client. Todd received his B.A., in Economics, magna cum laude, from

Fairleigh Dickinson University, his J.D., Tax Law Honors, from Rutgers University School

of Law, Camden, his M.B.A. from Rutgers University Graduate School of Management,

and his LL.M, in Taxation, from New York University School of Law.

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TABLE OF CONTENTS

I. INTRODUCTION ...................................................................................................1 II. SECTION 2701—RECAPITALIZATIONS AND OTHER

“TRANSFERS” OF BUSINESS INTERESTS. ......................................................3

A. The Perceived Abuse. ..................................................................................3 1. Discretionary Rights. ...................................................................... 3 2. Example. ......................................................................................... 4

B. Overview of Application..............................................................................5 1. Deemed Gifts. ................................................................................. 5

2. Zero Valuation Rule. ....................................................................... 6 C. General Definitions. .....................................................................................6

1. Transfer. .......................................................................................... 6

2. Applicable Family Member. ........................................................... 6 3. Member of the Family of the Transferor. ....................................... 7 4. Subtraction Method. ........................................................................ 7

D. Applicable Retained Interests. .....................................................................7 1. Extraordinary Payment Rights. ....................................................... 8

2. Distribution Rights. ......................................................................... 8 3. Section 2701 Applied to LLC Recapitalization. ............................. 9

E. Exception To Distribution Right: “Qualified Payment Right”. .................11

1. “Qualified Payment Right” defined, § 2701(c)(3): ....................... 11 2. “Lower Of” Rule - For Valuing a Qualified Payment Right

Held in Conjunction with an Extraordinary Payment Right. ........ 11 F. Minimum Value of Junior Equity Interest. ................................................12 G. Rights that are Not Extraordinary Payment Rights or Distribution

Rights. ........................................................................................................12

1. Mandatory Payment Rights........................................................... 12 2. Liquidation Participation Rights. .................................................. 13 3. Guaranteed Payment Rights. ......................................................... 13

4. Non-Lapsing Conversion Rights................................................... 13 H. § 2701 Subtraction Method. .......................................................................13

1. Step 1: Valuation of family-held interests. .................................. 13 2. Step 2: Subtract value of senior equity interest. .......................... 13

3. Step 3: Allocate. ........................................................................... 14 4. Step 4: Determine the amount of the gift. .................................... 14 5. Adjustment to Step 2. .................................................................... 14 6. “Lower of” Rule Application. ....................................................... 14

I. Circumstances Where § 2701 is Inapplicable. ...........................................15

1. Same Class. ................................................................................... 15 2. Market Quotations. ....................................................................... 16

3. Proportionate Transfers. ................................................................ 16 J. Limited Relief For Distribution Right Only: Election into Qualified

Payment Right Treatment. .........................................................................16 K. Section 2701 Hypothetical. ........................................................................17

III. THE 2701 ATTRIBUTION RULES. ....................................................................19 A. Entity Attribution Rules. ............................................................................19

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B. Corporations and Partnerships. ..................................................................19

C. Trust Attribution Rules. .............................................................................20 1. The “Basic” Trust Rules. .............................................................. 20 2. The Grantor Trust Attribution Rules. ............................................ 21

3. The Multiple Attribution Rules. .................................................... 22 IV. OTHER SECTION 2701 APPLICATIONS ..........................................................24

A. Section 2701 in the Carried Interest Planning Context: The

“Vertical Slice” ..........................................................................................24 1. Deemed Gift Problem. .................................................................. 24

2. The Vertical Slice Approach. ........................................................ 24 3. Problems With The Vertical Slice. ............................................... 26

B. Proactive Planning with § 2701 and Preferred “Freeze”

Partnerships. ...............................................................................................26

1. Structuring the Preferred Interest. ................................................. 27 2. Valuation of the Preferred Coupon. .............................................. 28

C. Section 2701 Applied to Sales to Intentionally Defective Grantor

Trusts (“IDGTs”). ......................................................................................29

V. SECTION 2702: SPECIAL VALUATION RULES FOR TRANSFERS

OF INTERESTS IN TRUST .................................................................................31 A. Section 2702 Overview. .............................................................................31

B. General Definitions. ...................................................................................31 1. Member of the Family. ................................................................. 31

2. Applicable Family Member. ......................................................... 32 3. Qualified Interest. ......................................................................... 32 4. Fixed Amount. .............................................................................. 32

C. Section 2702 Hypothetical. ........................................................................32

D. Grantor Retained Annuity Trusts (“GRATs”). ..........................................33 1. Gift Value...................................................................................... 33 2. Adjustment Feature. ...................................................................... 33

3. Mortality Risk. .............................................................................. 34 4. Rolling GRATs. ............................................................................ 34

5. Greenbook Proposals. ................................................................... 34 E. GRAT GST Issue: Preferred Partnership GRAT. ......................................35

1. The ETIP Issue. ............................................................................. 35 2. Preferred Partnership GRAT to Address ETIP Issue. ................... 36

F. Qualified Personal Residence Trusts (“QPRTs”). .....................................37 1. QPRTs Generally. ......................................................................... 37 2. During the QPRT Term. ............................................................... 37

3. After the QPRT Term. .................................................................. 37 4. Factors Determining the Gift. ....................................................... 38

5. QPRT Example. ............................................................................ 38 6. Disadvantages. .............................................................................. 39

G. Certain Property Interests Treated as Held in Trust, § 2702(c). ................39 1. Term Interests. .............................................................................. 40 2. Joint Purchases. ............................................................................. 40 3. Leases. ........................................................................................... 41

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4. Property Interests Not Treated as Term Interests. ........................ 41

5. Exception to § 2702 for Personal Residence Trusts. .................... 41 H. Sale of Remainder Interest in Personal Residence. ...................................42

1. Generally. ...................................................................................... 42

2. Example: PLR 200728018. .......................................................... 42 I. Section 2702 Applied to Sales to IDGTs. ..................................................46

1. Karmazin v. Commissioner. .......................................................... 46 2. Estate of Woelbing. ....................................................................... 46

VI. SECTION 2703 – CERTAIN RIGHTS AND RESTRICTIONS

DISREGARDED. ..................................................................................................48 A. The Perceived Abuse. ................................................................................48 B. Valuation Provision. ..................................................................................48 C. Example of “Sweetheart Deal” § 2703 Designed to Prevent. ....................48

D. Application of Section 2703 to Post October 8, 1990 Agreements

& “Substantially Modified” Pre-October 8, 1990 Agreements. ................49

1. Bona Fide. ..................................................................................... 49 2. Not a Device. ................................................................................ 50

3. Arms’-Length Comparability........................................................ 50 E. Pre-October 8, 1990 Agreements: Treas. Reg. § 20.2031-2(h)

Rule. ...........................................................................................................50

1. Requirements. ............................................................................... 50 2. Factors. .......................................................................................... 50

3. Relevant Cases. ............................................................................. 51 F. Overlap of Pre-§ 2703 Law with § 2703 Requirements. ...........................52

1. Bona Fide. ..................................................................................... 52

2. No Disguised Gift. ........................................................................ 52

3. Arms’-Length Comparability........................................................ 52 G. Treas. Reg. § 25.2703-1(a) & (b). ..............................................................52

1. Pre-§ 2703 Rule Plus Comparability Prong. ................................. 52

2. Prongs Must Be Independently Satisfied. ..................................... 53 3. Sources of Rights and Restrictions. .............................................. 53

4. Arms’-Length Transaction. ........................................................... 53 5. Consequences for Failure. ............................................................. 53

6. Relevant Cases. ............................................................................. 54 H. Section 2703 Hypothetical. ........................................................................55

1. Facts. ............................................................................................. 55 2. The Issue. ...................................................................................... 55 3. Applicable Standards. ................................................................... 56

4. Circular Problem. .......................................................................... 56 I. “Substantial Modification”. .......................................................................56

1. Discretionary Modification. .......................................................... 56 2. Failure to Update........................................................................... 57 3. Exceptions. .................................................................................... 57

J. Safe Harbor Exception for Property Controlled by Unrelated

Persons. ......................................................................................................57 1. Members of the Transferor’s Family. ........................................... 57

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2. Natural Object of the Transferor’s Bounty. .................................. 58

K. Section 2703(b) Exception. ........................................................................58 1. Bona Fide. ..................................................................................... 58 2. No Disguised Gift. ........................................................................ 58

3. Arms’-Length Comparability........................................................ 58 L. Section 2703(b)(1): Bona Fide Business Arrangement. ...........................58 M. Section 2703(b)(2): Not a Device to Transfer Less than Full and

Adequate Consideration. ............................................................................60 1. Testamentary Purpose Test. .......................................................... 60

2. Adequacy-of-Consideration Test. ................................................. 61 N. Section 2703(b)(3): Comparable Arrangements. ......................................62

1. Smith v. United States. .................................................................. 62 2. Estate of Blount. ............................................................................ 62

3. Estate of Amlie. ............................................................................. 62 4. Holman v. Commissioner. ............................................................. 64

O. Section 2703 Applied to Family Limited Partnerships. .............................64 1. Initial Application of § 2703. ........................................................ 64

2. Church v. United States. ............................................................... 65 3. Estate of Strangi v. Commissioner. ............................................... 67 4. Section 2703 and FLPs Before Holman and Smith. ...................... 70

5. Resurrected and Re-Crafted § 2703 Challenges to FLPs.............. 70 6. Holman v. Commissioner. ............................................................. 72

VII. SECTION 2704: CERTAIN LAPSING RIGHTS & DISSOLUTION

RESTRICTIONS. ..................................................................................................75 A. Section 2704(a): Treatment of Lapsed Voting or Liquidation

Rights. ........................................................................................................75

1. Background. .................................................................................. 75 2. Lapse of Voting or Liquidation Rights. ........................................ 77 3. Exceptions to § 2704(a): The following exceptions exist

with respect to §2704(a)................................................................ 78 4. Section 2704(a) Hypothetical. ...................................................... 79

5. Estate of Smith. ............................................................................. 80 B. Section 2704(b): Certain Liquidation Restrictions Disregarded. ...............80

1. Perceived Abuse............................................................................ 81 2. General Overview. ........................................................................ 81 3. Withdrawal Rights. ....................................................................... 82

C. Section 2704 Applied to FLPs. ..................................................................82 1. Kerr. .............................................................................................. 82

2. Effect of Disregarding an Applicable Restriction. ........................ 83 D. Possible Expansion of § 2704(b). ..............................................................84

1. FLP and LLC Valuation Discounts............................................... 84 2. Proposed Expansion. ..................................................................... 85 3. Disregarded Restrictions. .............................................................. 85 4. Default Assumptions. .................................................................... 85 5. Safe Harbors.................................................................................. 86 6. Other Predictions – Operating Business Exception ...................... 86

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7. Other Predictions – Marital and Charitable Deduction

Mismatch....................................................................................... 86 8. Questions Regarding Validity. ...................................................... 87

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“Chapter 14 Soup to Nuts”:

A Practitioner’s Guide Through The Minefield

N. Todd Angkatavanich, Partner

Withers Bergman LLP

Greenwich and New Haven, Connecticut

I. INTRODUCTION

There are a number of transfer tax issues that may arise under Internal Revenue

Code (the “Code”) Chapter 14 in connection with transfers of business interests or

transfers in trust when family members are involved. Contained within Chapter 14

generally there are numerous gift and estate tax provisions that are designed to

discourage certain types of transactions or arrangements entered into between

members of the same extended family. The violation of one or more of these

provisions can cause an unanticipated deemed gift or increase in the value of one’s

estate, which can potentially result in substantial gift or estate tax. Many of these

sections of the Code are written very broadly and are not intuitive and can

unexpectedly apply even when a transaction has not been structured with the

intention of achieving estate or gift tax savings, or in circumstances where wealth

transfer may not even be the objective.1

Generally, Chapter 14 of the Code, which is divided into §§ 2701 through 2704,

attempts to prevent perceived transfer tax abuses in the context of business or other

interests held within a family. Chapter 14 achieves this by treating certain

transactions as deemed gifts as well as through provisions that ignore certain

agreements or restrictions that would otherwise affect the valuation of transferred

interests. In very broad terms, the assumption underlying Chapter 14 is that a senior

family member will make decisions relating to the ownership and disposition of

family business interests or other interests so as to shift value to younger family

members with reduced or minimal transfer tax consequences. Chapter 14

discourages certain transactions by treating them as deemed gifts, and others by

disregarding certain agreements or restrictions that would otherwise affect value.

The “Deemed Gift Provisions” are found in three sections of the Code: § 2701,

regarding recapitalizations and other types of “transfers” of business interests;

1 For excellent general commentaries and discussions regarding Chapter 14, see generally; Louis A.

Mezzullo, “Transfers of Interests in Family Entities Under Chapter 14: Sections 2701, 2702, 2703 and 2704,”

835-4th Tax Mgmt. (BNA) Estates, Gifts, and Trusts (2011); HOWARD M. ZARITSKY & RONALD D. AUCUTT,

STRUCTURING ESTATE FREEZES: ANALYSIS WITH FORMS (2d ed. 1997); Blattmachr on Anti-Freeze

Provisions of the IRC New Chapter 14 (91-08.18) (Mass. C.L.E. 1991); DOUGLAS K. FREEMAN & STEPHANIE

G. RAPKIN, PLANNING FOR LARGE ESTATES (LexisNexis 2012); CHERYL E. HADER, ESTATE PLANNING &

CHAPTER 14: UNDERSTANDING THE SPECIAL VALUATION RULES (Practising Law Institute, 2d ed. 2011).

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§ 2702, regarding transfers to trusts with retained interests and joint purchases of

property; and § 2704(a), regarding lapses of liquidation or voting rights. Generally,

the deemed gifts determined under these Sections are created by applying a “zero

valuation” concept (except for § 2704(a)), that assigns a value of zero to an interest

in a business or trust that is held or retained by senior family members. This has

potential to result in a deemed gift of some or perhaps even all of the value of the

business or other interests in connection with transfers of certain interests in which

another interest is retained.

For purposes of this outline, the term “Disregard Provisions” refers to the Chapter

14 provisions that have the effect of disregarding, for transfer tax purposes, certain

agreements or restrictions that would otherwise artificially assign a lower value to

a business interest or would artificially reduce its value for estate or gift tax

purposes. These provisions are included in Code §§ 2703 and 2704(b).

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II. SECTION 2701—RECAPITALIZATIONS AND OTHER “TRANSFERS” OF

BUSINESS INTERESTS.

Section 2701 can cause a deemed gift to occur typically in connection with a

“transfer” of subordinate equity interest (i.e., common interests) in a corporation,

partnership or LLC to a junior family member when certain discretionary rights

(typically associated with preferred interests) are retained by a senior family

member. The classic example of a transfer to which § 2701 can potentially apply

is when a parent who initially owns both common and preferred stock in a

corporation (or the preferred interest in a partnership or LLC) transfers the common

stock (or the common interest) to his children while retaining the preferred stock

(or preferred interest).

For gift tax valuation purposes of the transferred common interest, the parent would

want the retained preferred interest to have as high a value as possible so as to take

the position that the value of the transferred common interest had a minimal value

for gift tax purposes; determined under the assumption that the value of the

preferred and common interests together make up 100% of the value of the entity

so that the value of the transferred common is determined by first subtracting the

value of the retained preferred (the “Subtraction Method”).

A. The Perceived Abuse.

Congress enacted the special valuation rules under Chapter 14 of the Code

(§§ 2701 through 2704), effective for transfers after October 8, 1990, in an

attempt to prevent perceived abuses with respect to family transactions that

would transfer wealth between family members (typically from senior to

junior generations) with minimal gift and estate tax consequences through

the perceived manipulation of value.

1. Discretionary Rights.

Prior to the enactment of § 2701, in order to artificially increase the

value of the retained preferred interests, the preferred interests might

have been given certain discretionary rights, such as rights to non-

cumulative dividends and redemption or conversion rights. It was

often expected that these discretionary rights would never actually

be exercised, but, nonetheless, would be able to boost the value of

the parent’s retained preferred interest, thereby reducing the value

of the gift of the common interest under a subtractive method of

valuation. Section 2701 aims to discourage this perceived abuse by

essentially ignoring the existence of such discretionary rights and,

instead assigning a zero value to these retained rights in determining

how much value or “credit” the senior family member should get for

gift tax purposes under the Subtraction Method of valuation. Under

§ 2701, only specific types of non-discretionary rights that fit within

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specific and narrow exceptions to the broader zero-valuation rule

will be given any consideration or “credit” when determining the

value of the senior family member’s retained preferred interest.

2. Example.

The classic transaction that § 2701 was designed to prevent involved

parent forming a preferred partnership, or perhaps recapitalizing an

existing single class partnership into a multi-class preferred

partnership. Prior to § 2701, the new or recapitalized partnership

would have preferred “frozen” interests that provided for a fixed

coupon, as well as common “growth” interests entitled to all the

economic upside beyond the preferred coupon and liquidation

preference. After forming the preferred partnership (or

recapitalizing an existing one into a preferred partnership), parent

would transfer by gift, sale, or perhaps a combination, the common

“growth” interest to the younger generation (or a trust for their

benefit), and would retain the preferred “frozen” interests. The

preferred interest would be structured so as to include various

discretionary rights, such as non-cumulative preferred payment

rights, rights to compel liquidation, puts and calls. When computing

the value of the transferred common interests, these discretionary

“bells and whistles” would artificially increase the value of the

parent’s retained preferred interest, and consequently, artificially

depress the value of the transferred common interest; thus resulting

in a “low ball” gift tax value of the gifted common interest.

However, if the discretionary rights associated with parent’s

retained preferred interest were never actually exercised following

the transfer of the common interest (or if preferred payments were

never actually made), this would result in a shifting of value in the

entity to the common interests then owned by the younger

generation, thus achieving a gift tax-free shift of value.

Jerome Manning colorfully and succinctly described the perceived abuse

associated with this type of arrangement as follows:

In the old days when restructurings were built with

creative maneuvers ... to give the preferred [retained

by the parent] a respectable facade for gift tax

purposes [the preferred stock] was hung like a

Christmas tree with voting rights, conversion rights,

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options to put and call, and liquidation

opportunities.2

Section 2701 was enacted in order to curtail this perceived abuse by

manipulation of entity value by imposing a draconian “zero value” rule,

which essentially ascribes a value of “zero” to certain components (known

as “Distribution Rights” and “Extraordinary Payment Rights”) of the

preferred interest retained by the senior family member. The consequence

is to attribute more or perhaps even all of the entity value to the common

interest when determining the gift tax value of transferred common under a

“subtraction method” of valuation, even though only one class of interest

(the common interest) is actually transferred.

Certain relatively narrow exceptions were worked into the statute that do

allow value to be ascribed to certain components of the parent’s retained

preferred interest under limited circumstances when the parent’s preferred

interest is structured within certain strict parameters designed to ensure that

the parent has retained rights that are essentially mandatory and quantifiable

in nature. In other words, there is an implicit acknowledgement that if it

can be determined that the parent must receive certain value (as opposed to

discretionary rights) and such can be quantified then it makes sense that the

parent should get proper “credit” for such mandatory and quantifiable rights

(and thus, should not be valued at zero) under the Subtraction Method of

gift tax valuation.

B. Overview of Application.

1. Deemed Gifts.

Broadly, Section 2701 applies and can cause a deemed gift to occur

when a senior generation family member, typically a parent (the

“Transferor”) or other senior family member (an “Applicable

Family Member”) holds an “Applicable Retained Interest” after a

“transfer” to a “Member of the Family” of the Transferor has

occurred. For these purposes, a “transfer” is very broadly defined

to include, not only a traditional gift transfer (e.g., I give my child

ten shares of common stock), but also a contribution to the capital

of a new or existing entity, a redemption, recapitalization, or other

change in the capital structure of an entity.3 Thus, it is quite possible

for a potential § 2701 transfer to occur without intending to make a

gift or even being aware that a potential gift has been triggered, for

2 MANNING ON ESTATE PLANNING, 10-67 (Practising Law Institute, 5th ed. 1995). Unless otherwise

specified, all “Section” or “§” references herein are to the Code, or to the Treasury Regulations (the

“Regulations” or “Treas. Reg.”) promulgated thereunder.

3 Treas. Reg. § 25.2701-1(b)(2)(i).

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instance in the context of a recapitalization or initial capitalization

of an entity. Additionally, there is no intent requirement to the

statute and ignorance of law is not a basis to determine the statute

inapplicable. Thus, it is quite possible for a deemed gift to arise

under the statute in the context of a transaction, such as the initial

capitalization of an entity, when one might otherwise think that no

gift tax component or implication existed at all. Indeed, the

provisions of Chapter 14 in general, and certainly the provisions of

§ 2701 are not intuitive and, consequently, present a number of

thorny traps for the unwary.

2. Zero Valuation Rule.

There are two types of rights, the retention of which by the senior

generation can trigger Applicable Retained Interest status, and thus

the § 2701 zero valuation rule with respect to those retained rights:

“Extraordinary Payment Rights” and “Distribution Rights” (both of

which are discussed further, below).

If § 2701 is applicable and the interest retained by the senior family

member is not a “Qualified Payment Right” or other type of right to

which the statute does not apply, certain rights associated with the

retained interest are valued at zero in applying the Subtraction

Method.4 This essentially results in some or perhaps even all of the

family held interests in the entity being attributed to the transferred

interest (typically a common or subordinate interest), thereby

causing a Deemed Gift of some or potentially all of the interests

retained by the senior family member.

C. General Definitions.

1. Transfer.

The term “transfer” is broadly defined, and includes, in addition to

a traditional transfer, a capital contribution to a new or existing

entity, as well as a redemption, recapitalization or other change in

the capital structure of an entity.5

2. Applicable Family Member.

The term “Applicable Family Member” includes the Transferor’s

spouse, any ancestor of the Transferor or his or her spouse, and the

4 Treas. Reg. § 25.2701-2(a)(1) & (2).

5 Treas. Reg. § 25.2701-1(b)(2)(i).

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spouse of any such ancestor.6 (While this term is somewhat broader

than just “senior family members,” sometimes in this outline that

term will be used as a shorthand for “Applicable Family Member,”

as that is the most typical situation in which the definition would

apply.)

3. Member of the Family of the Transferor.

The term “Member of the Transferor’s Family” includes the

Transferor’s spouse, any lineal descendant of the Transferor or his

or her spouse, and the spouse of such descendant.7 (While this term

is somewhat broader than just “junior family members,” sometimes

in this outline that term will be used as a shorthand for “Member of

the Family of the Transferor,” as that is the most typical situation in

which the definition would apply.)

4. Subtraction Method.

If § 2701 applies to a transfer, the value of an interest transferred to

a junior family member will be determined by subtracting from the

value of the entire family-held interests the value of the interest

retained by the senior family member, a deemed gift will have

occurred from the senior family member to the junior family

member of the value of all family held interests less the value of the

senior interests retained by the senior family member determined

under the Subtraction Method.8

D. Applicable Retained Interests.

Section 2701 applies to a transfer to a Member of the Family of the

Transferor if the Transferor or an Applicable Family Member, holds an

“Applicable Retained Interest” immediately after the transfer. There are

two types of rights the retention of which will cause an Applicable Retained

Interest to exist; the existence of either of which will cause the zero-

valuation rule of § 2701 to apply in valuing those retained rights:

(1) Extraordinary Payment Rights; and (2) Distribution Rights.

6 Code § 2701(e)(2); Treas. Reg. § 25.2701-1(d)(2). For purposes of this discussion, the Transferor and

Applicable Family Members are referred to as the “senior family members,” although this is not technically

always the case.

7 Code § 2701(e)(1); Treas. Reg. § 25.2701-1(d)(1) (persons in any generation higher than the Transferor

are NOT included in this group). For purposes of this discussion, the Transferor and Members of the Family

of the Transferor are referred to as the “junior family members,” although this is not technically always the

case since the “spouse” of the Transferor is also included in this definition.

8 Treas. Reg. § 25.2701-1(a)(2).

8


1. Extraordinary Payment Rights.

Generally, these include liquidation, put, call and conversion rights

the exercise or non-exercise of which would affect the value of the

transferred common interest when the holder of such rights has

discretion as to whether (or when) to exercise them. A call right

includes any warrant, option, or other right to acquire one or more

equity interest(s).9

Because it is assumed that such discretionary Extraordinary

Payment Rights would never be exercised by the senior family

member, so that greater value will pass to the younger generation

family members holding common interests, they are given a value

of zero in determining the worth of the retained preferred interest

for gift tax purposes under the Subtraction Method.

2. Distribution Rights.

The second type of right that will result in an Applicable Retained

Interest is a “Distribution Right,” which is the right to receive

distributions with respect to an equity interest. However, a

Distribution Right does not include: (i) a right to receive

distributions with respect to an interest that is of the “same class” as,

or a class that is “subordinate to,” the transferred interest, (ii) an

Extraordinary Payment Right, or (iii) one of the other rights

discussed below.10

a. Control Requirement.

Unlike Extraordinary Payment Rights, with respect to which

the interest holder individually has the discretion to

participate or not participate in the growth of the entity, any

discretion associated with a Distribution Right is not held by

the interest holder. Rather, such discretion to make or not

make distributions is held by the entity itself. As such, a

Distribution Right will only be considered to exist with

respect to an Applicable Retained Interest if “control” of the

entity exists in the family. Control exists for these purposes

if the Transferor and family members (including both junior

and senior and more remote family members) “control” the

entity immediately before the transfer.

9 Treas. Reg. § 25.2701-2(b)(2).

10 Treas. Reg. § 25.2701-2(b)(3).

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(1) “Control” means:

(a) In the case of any partnership, at least 50% of

the capital or profit interest in a partnership,

or, any equity interest as a general partner of

a limited partnership;11 or

Query: whether an interest in a

general partner constitutes an

interest “as a general partner”?

(b) In the case of a corporation, at least 50% (by

vote or value) of the stock of the

corporation.12

(2) The presumption here appears to be that a family-

controlled entity that holds such discretion would not

make discretionary distributions to senior family

members, so that greater value will remain in the

entity, thereby benefiting the junior family members

holding the common interests. Presumably such

would not be the case with an entity that is not

family-controlled.

3. Section 2701 Applied to LLC Recapitalization.

a. Facts.

In CCA 201442053, the IRS determined that § 2701 was

triggered in connection with the recapitalization of an LLC.

In the CCA, an LLC was initially created by mother as a

single class LLC, followed by gifts of LLC interests to her

two sons and her grandchildren all of whom shared capital,

profits and losses in proportion to their percentages interests.

The LLC was later recapitalized, as a result of which all

future profits or gains would be allocated to the sons only, as

consideration for the sons agreeing to manage the LLC.

Following the recapitalization, the mother’s only interest

was the right to the return of her capital account upon

liquidation based on her membership interest as it existed

immediately prior to the recapitalization.

11 Code § 2701(b)(2)(B).

12 Code § 2701(b)(2)(A).

10


b. Conclusion.

The IRS determined that the recapitalization was a § 2701

“transfer” under Treas. Reg. Sec. 25.2701-1(b)(2)(B)(2). It

reasoned that the mother held an Applicable Retained

Interest (her “Distribution Right”) both before and after the

recapitalization, and that her sons’ right to receive future

profits was a subordinate interest.13

c. Criticism.

In his article, Richard L. Dees argues that the IRS should

withdraw the CCA and criticizes it as containing a rather

muddled analysis in determining that the mother’s retained

interest was an “Applicable Retained Interest” due to the fact

that “[b]oth before and after the recapitalization, Donor held

an Applicable Retained Interest, an equity interest in

Company coupled with a Distribution Right.” Dees argues

that the mother’s right to receive her capital account upon

termination of the LLC was not an “Applicable Retained

Interest;” rather, such would have been either a “Mandatory

Payment Right” or a “Liquidation Participation Right,”

neither of which is subject to valuation under § 2701.

Additionally, he points out that mother did not retain an

“Extraordinary Payment Right” since she did not have the

discretionary right to withdraw her capital interest from the

LLC which was subject to a stated term. (Since the

publication of Dees’ article, it has since been determined that

mother had a large enough percentage interest to unilaterally

liquidate the LLC, which would have constituted an

Extraordinary Payment Right.14) After the recapitalization,

mother retained no rights to receive distributions with

respect to her equity interests, but only the right to a return

of her capital account.15

13 For a comprehensive and critical commentary on this CCA, see Richard L. Dees, Is Chief Counsel

Resurrecting The Chapter 14 “Monster?” TAX NOTES (December 15, 2014).

14 Richard L. Dees, The Preferred Partnership Freeze And The Reverse Freeze (Part II) - IRC Section 2701

And The Regulatory Scheme, Forty-First Notre Dame Tax and Estate Planning Institute, at 6-39 (September

17-18, 2015).

15 For an excellent in-depth discussion of CCA 201442053 and further analysis of Section 2701 generally,

see generally, Richard L. Dees, The Preferred Partnership Freeze And The Reverse Freeze (Part II) - IRC

Section 2701 And The Regulatory Scheme, Forty-First Notre Dame Tax and Estate Planning Institute

(September 17-18, 2015).

11


E. Exception To Distribution Right: “Qualified Payment Right”.

The Code and Regulations contain an exception to the application of the

zero valuation rule to a Distribution Right when the Distribution Right fits

the definition of a “Qualified Payment Right.”

1. “Qualified Payment Right” defined, § 2701(c)(3):

a. Any dividend payable on a periodic basis (at least annually)

under any cumulative preferred stock, to the extent that such

dividend is determined at a fixed rate;

b. Any other cumulative distribution payable on a periodic

basis (at least annually) with respect to an equity interest, to

the extent determined at a fixed rate or as a fixed amount; or

c. Any Distribution Right for which an election has been made

to be treated as a Qualified Payment.16

Because Qualified Payment Rights are mandatory, and no discretion of the

family controlled entity to make or not make distributions exists with

respect to a Qualified Payment Right, the perceived opportunity to

manipulate value that § 2701 was designed to prevent is not present with a

Qualified Payment Right, and, therefore, the zero valuation rule will not

apply.

A “Qualified Payment Right” is NOT an exception to an Extraordinary

Payment Right; it is only an exception to a Distribution Right.

2. “Lower Of” Rule - For Valuing a Qualified Payment Right Held in

Conjunction with an Extraordinary Payment Right.

a. If an Applicable Retained Interest provides the holder with a

Qualified Payment Right and one or more Extraordinary

Payment Rights, the value of all of these rights is determined

by assuming that each Extraordinary Payment Right is

exercised in a manner resulting in the lowest total value

being determined for all the rights.17

b. An example of the “Lower Of” rule is as follows, based upon

Regulation § 25.2701-2(a)(5):

16 Treas. Reg. § 25.2701-2(b)(6)(i).

17 Treas. Reg. § 25.2701-2(a)(3).

12


Example: Dad, the 100% stockholder of a corporation, transfers

common stock to Child and retains preferred stock which provides

(1) a Qualified Payment Right having a value of $1,000,000; and (2)

a right to put all the preferred stock to the corporation at any time

for $900,000 (an Extraordinary Payment Right). At the time of the

transfer, the corporation’s value is $1,500,000. Under the “Lower

Of” rule, the value of Dad’s retained interest is $900,000, even

though he retains a Qualified Payment Right worth $1,000,000.

This is because his retained interests are valued under the

assumption that Dad exercises his Extraordinary Payment Right (the

put right) in a manner resulting in the lowest value being determined

for all of his retained rights (i.e., in a manner that would yield him

$900,000). As a result, Dad has made a gift of $600,000

($1,500,000 - $900,000), rather than $500,000 if the value of his

preferred interest was based upon the $1,000,000 value of the

Qualified Payment Right.

F. Minimum Value of Junior Equity Interest.

If § 2701 applies, in the case of a transfer of a junior equity interest, such

interest shall not be valued at an amount less than 10% of the total value of

all of the equity interests, plus the total indebtedness of the entity to the

Transferor or an Applicable Family Member.18

G. Rights that are Not Extraordinary Payment Rights or Distribution Rights.

Certain rights may be retained in connection with preferred interests that are

neither Extraordinary Payment Rights nor Distribution Rights, and,

therefore, are not “Applicable Retained Interests” that trigger the

application of § 2701. These kinds of rights may take any of the following

forms:

1. Mandatory Payment Rights.

A “Mandatory Payment Right,” which is a right to receive a required

payment of a specified amount payable at a specific time (e.g.,

mandatory redemption required at certain date at certain value);19

18 Code § 2701(a)(4)(A).

19 Treas. Reg. § 25.2701-2(b)(4)(i).

13


2. Liquidation Participation Rights.

A “Liquidation Participation Right,” which is a right to participate

in a liquidating distribution20 (this is in contrast to a right to compel

liquidation);

3. Guaranteed Payment Rights.

A “Guaranteed Payment Right,” which is a right to a guaranteed

payment of a fixed amount without any contingency, under

§ 707(c);21 or

4. Non-Lapsing Conversion Rights.

A “Non-Lapsing Conversion Right,” which is a right to convert an

equity interest into a specific number or percentage of shares (if the

entity is a corporation), or into a specified interest (if the entity is a

partnership or other non-stock entity).22

H. § 2701 Subtraction Method.

The methodology used to determine the amount of a gift resulting

from any transfer to which §2701 applies is as follows:

1. Step 1: Valuation of family-held interests.

Determine fair market value of all family-held equity interests in the

entity immediately after the transfer.

Special rule for contributions to capital apply which direct that the

“fair market value of the contribution” be determined.

2. Step 2: Subtract value of senior equity interest.

The value determined in Step 1 is reduced by:

a. an amount equal to the sum of the fair market value of all

family-held senior equity interests (other than Applicable

Retained Interests held by the Transferor or Applicable

Family Members) and the fair market value of any family-

held equity interests of the same class or a subordinate class

to the transferred interests held by persons other than the

20 Treas. Reg. § 25.2701-2(b)(4)(ii).

21 Treas. Reg. § 25.2701-2(b)(4)(iii).

22 Treas. Reg. § 25.2701-2(b)(4)(iv).

14


Transferor, members of the Transferor’s family, and

Applicable Family Members of the Transferor; and/or

b. the value of all Applicable Retained Interests held by the

Transferor or Applicable Family Members.

Special rules for contributions to capital apply which instruct one to

“subtract the value of any applicable retained interest received in

exchange for the contribution to capital” determined under the zero

valuation rule.

3. Step 3: Allocate.

Allocate the remaining value among the transferred interests and

other family-held subordinate equity interests

4. Step 4: Determine the amount of the gift.

The amount allocated in Step 3 is reduced by any adjustments for:

a. minority discounts;

b. transfers with a retained interest; and/or

c. consideration received by Transferor (in case of contribution

to capital, any consideration received in the form of an

Applicable Retained Interest is zero)

5. Adjustment to Step 2.

If the percentage of any class of Applicable Retained Interest held

by Transferor and Applicable Family Members (i.e., spouse and

ancestors, but not junior family members) exceeds the highest

percentage family held interests in the subordinate interests, the

excess percentage is treated as not held by Transferor or applicable

family members.

6. “Lower of” Rule Application.

Election to treat Distribution Right as a Qualified Payment Right

under Section 2701(c)(3)(C)(ii).

Example:23 Corporation X has outstanding 1,000 shares of $1,000

par value voting preferred stock, each share of which carries a

23 Treas. Reg. §25.2701-3(d), Ex. 1.

15


cumulative annual dividend of 8% and a right to put the stock to X

for its par value at any time. In addition, there are outstanding 1,000

shares of non-voting common stock. A holds 600 shares of the

preferred stock and 750 shares of the common stock. The balance

of the preferred and common stock is held by B, a person unrelated

to A. Because the preferred stock confers both a qualified payment

right and an extraordinary payment right, A’s rights are valued

under the “lower of” rule of § 25.2701-2(a)(3). Assume that A’s

rights in the preferred stock are valued at $800 per share under the

“lower of” rule (taking account of A’s voting rights). A transfers all

of A’s common stock to A’s child. The method of determining the

amount of A’s gift is as follows:

Step 1: Assume the fair market value of all the family-held

interests in X, taking account of A’s control of the

corporation, is determined to be $1,000,000;

Step 2: From the amount determined under Step 1, subtract

$480,000 (600 shares x $800)

Step 3: The result of Step 2 is a balance of $520,000. This

amount is fully allocated to the 750 shares of family-held

common stock.

Step 4: Because no consideration was furnished for the

transfer, the adjustment under Step 4 is limited to the amount

of any appropriate minority or similar discount. Before the

application of Step 4, the amount of A’s gift is $520,000.

I. Circumstances Where § 2701 is Inapplicable.

Section 2701 does not apply in the following circumstances:

1. Same Class.

Where the retained interest and the transferred interest are of the

“same class,” meaning the rights associated with the retained

interests are identical (or proportional) to the rights associated with

the transferred interests, except for non-lapsing differences in voting

rights (or, for a partnership, non-lapsing differences with respect to

management and limitations on liability). For purposes of this

section, non-lapsing provisions necessary to comply with

partnership allocation requirements of the Internal Revenue Code

16


(e.g., § 704(b)) are non-lapsing differences with respect to

limitations on liability.24

2. Market Quotations.

If there are readily available market quotations on an established

securities market for either the transferred interest or the retained

interest;25 and

3. Proportionate Transfers.

Also known as the “Vertical Slice” approach, this occurs where the

transfer results in a proportionate reduction of each class of equity

interest held by the senior and junior family members26 (e.g., dad

transfers 5% of both of his common and preferred stock to child, so

that dad’s interest in both his ownership of common and preferred

is reduced by 5% for each class).

J. Limited Relief For Distribution Right Only: Election into Qualified

Payment Right Treatment.

In the case of a Distribution Right, relief from the application of the zero

valuation rule may be obtained by making an irrevocable election to treat

such right as if it were a Qualified Payment Right.27 No such relief is

provided for Extraordinary Payment Rights.

a. If an election is made, then under the Subtraction Method,

the Distribution Right would not be valued at zero. Rather,

the fair market value of such interests will be determined

based upon traditional valuation principals, based upon facts

assumed and agreed to in the election filed with the

Transferor’s gift tax return.

b. An election is made by attaching a statement to the

Transferor’s timely filed Gift Tax Return on which the

transfer is reported. Detailed information must be included

in the statement describing the transaction and providing

24 Code § 2701(a)(2)(B); Treas. Reg. § 25.2701-1(c)(3).

25 § 2701(a)(2)(A); Treas. Reg. § 25.2701-1(c)(1) & (2).

26 § 2701(a)(2)(C); Treas. Reg. § 25.2701-1(c)(4).

27 Treas. Reg. § 25.2701-2(c)(2).

17


additional information as set forth in the Treasury

Regulations.28

c. An election assumes for § 2701 purposes that a fixed annual

payment will be made to the holder of the interest regardless

of whether the entity has adequate cash-flow. In the case of

such an election, the Distribution Right will be treated as a

Qualified Payment Right and, as such, some flexibility is

therefore provided to extend the period for actually making

these payments:

(1) a four-year grace period to actually make a payment

is permitted;29

(2) deferral is permitted by satisfying payment of a

Qualified Payment with a debt obligation bearing

compound interest from the due date at an

appropriate discount rate, provided that the term of

the debt obligation does not exceed four years; and30

(3) if a Qualified Payment is not made within the four-

year grace period, certain increases are made under

the “compounding rule” upon the subsequent

transfer of the interest by gift or death to account for

such arrearages.31

K. Section 2701 Hypothetical.

Mom and child form a partnership into which Mom contributes $8,000,000

and child contributes $2,000,000 in exchange for their respective

partnership interests. Child receives common interests and Mom receives

preferred interests. The preferred interests provide Mom with the ability to

require the partnership at any time to redeem her interest and return her

contribution, as well as a non-cumulative priority preferred return equal to

5% annually provided that the partnership has adequate cash flow to satisfy

the preferred return.

Section 2701 will apply to the hypothetical transaction outlined above for

the following reasons:

28 Treas. Reg. § 25.2701-2(c)(5).

29 Treas. Reg. § 25.2701-4(c)(5).

30 Treas. Reg. § 25.2701-4(c)(5).

31 See Treas. Reg. § 25-2701-4(c).

18


a. The transaction would constitute a “transfer” within the

meaning of the regulations which specifically includes “a

capital contribution to a new or existing entity;”

b. Mom has retained the following two types of “Applicable

Retained Interests”:

(1) Extraordinary Payment Right. The preferred interest

retained by Mom gives her the ability to require the

partnership to redeem her interest at any time, and

return her investment contribution, which is

considered an Extraordinary Payment Right.

(2) Distribution Right. In this case, Mom and Child are

the only partners in the partnership and, therefore,

they have the requisite “control” of the entity. In

addition, Mom’s preferred interest includes a

Distribution Right which does not satisfy the

definition of a Qualified Payment Right. A Qualified

Payment Right requires, by its terms, cumulative,

mandatory fixed rate payments on a periodic basis

payable at least annually. In this case, the preferred

return to mom is non-cumulative and is a fixed rate

payment, but it is not required to be distributed at

least annually.

(3) Application. Consequently, in determining the value

of Mom’s retained interest under the Subtraction

Method, the Extraordinary Payment Right and the

Distribution Right will each be valued at zero.

However, Mom may elect to treat the Distribution

Right as if it is a Qualified Payment Right via a

timely-filed gift tax return. In such case, any gift

would be determined by application of the “lower of”

rule because mom would then have both a Qualified

Payment Right and an Extraordinary Payment Right.

The gift will be determined based upon the lower

value of the Qualified Payment Right and the

Extraordinary Payment Right being ascribed to

mom’s preferred interest in applying the Subtraction

Method of valuation.

19


III. THE 2701 ATTRIBUTION RULES.

Various attribution rules apply under § 2701 with respect to equity interests

indirectly owned by way of entities such as partnerships, corporations and LLCs,

as well as through trusts.32 In addition, these rules are further complicated by the

fact that it is possible to have “multiple attribution” in which the rules determine an

equity interest to be owned by different people for purposes of § 2701. In such

case, certain “tie-breaker” rules apply, which set forth ordering rules as to whom

will be attributed ownership of a particular interest depending upon the particular

generational assignment of certain individuals as well as whether the equity interest

in question is a senior interest or a subordinate interest. Given the complexity of

these rules and how seemingly insignificant variations in the facts can lead to

different conclusions, it is critical that a § 2701 analysis include proper

consideration of these rules.

A. Entity Attribution Rules.

The attribution rules under § 2701 applicable to entities such as

corporations, partnerships and LLCs are relatively straightforward. The

rules apply a proportionate ownership in the entity type of approach, which

generally attributes ownership of an equity interest owned by an entity as

owned by the owner of the entity to the extent of his or her percentage

ownership in the entity.33 In the case of entities that hold interests in other

entities, the attribution rules have provisions to apply a “tiered” attribution

approach.34 An example is provided in the Treasury Regulations as follows:

A, an individual, holds 25% by value of each class of stock of Y

Corporation. Persons unrelated to A hold the remaining stock. Y

holds 50% of the stock of Corporation X …. Y’s interests in X are

attributable proportionately to the shareholders of Y. Accordingly,

A is considered to hold a 12.5% (25% x 50%) interest in X.35

B. Corporations and Partnerships.

In the case of interests in corporations, the attribution rules refer to the fair

market value of the stock as a percentage of the total fair market value of

all stock in the corporation.36 In the case of partnerships and other entities

32 Treas. Reg. § 25.2701-6.

33 Treas. Reg. § 25.2701-6(a)(1). If the individual holds directly and indirectly in multiple capacities, the

rules are applied in a manner that results in the individual being treated as having the largest possible total

ownership. Id.

34 Id.

35 Treas. Reg. § 25.2701-6(b), Ex. 1.

36 Treas. Reg. § 25.2701(a)(2).

20


treated as partnerships for federal tax purposes, the rules attribute to a

partner interests based upon the greater of a partner’s profit percentage or

capital percentage.37 For example, if a partner X makes a capital

contribution of 10% of the partnership’s assets and receives a 25% profits

interest, and partner Y contributes 90% of the capital and receives a 75%

profits interest, the attribution rules will treat X as having a 25% interest B

as having a 90% interest in the Partnership; in each case the greater of the

profit or capital percentage for each partner.

C. Trust Attribution Rules.

The attribution rules under § 2701 with respect to trusts are not as

straightforward as the entity attributions rules. This is because there are

different sets of attribution rules that can apply and can result in multiple

attribution, as well as a set of “tie-breaker” rules that can also apply.

A proper analysis of the trust attribution rules often involves a multi-step

process. First, one must proceed through the so-called “basic” trust

attribution rules. Then, if the trust at issue is recognized as a grantor trust

under Code § 671 et seq., one must also consider the “grantor trust”

attribution rules, followed by further analysis under the “tie-breaker” or

“multiple attribution” ordering rules, which calls for an examination of both

the grantor’s and the beneficiaries’ generational assignments and a

determination regarding whether the trust’s equity interest is subordinate or

senior. When parsing through these rules it becomes apparent that

seemingly negligible changes in any of the foregoing factors can produce

quite different results under the trust attribution rules and, in turn, the § 2701

analysis.

1. The “Basic” Trust Rules.

It is often difficult to express a trust beneficiary’s interest in a trust

with any degree certainty; especially if there are multiple

beneficiaries or if its trustees have been given substantial discretion

with respect to distributions or other decisions affecting the

beneficiaries’ interests in the trust. In this sense (and many others),

trusts are unlike entities where ownership percentages are more

often readily determinable. This distinction is one of the underlying

policy rationales for the above-referenced “basic” trust attribution

rules, which generally provide that a person has a beneficial interest

in a trust whenever they may receive distributions from the trust in

exchange for less than full and adequate consideration.38 The basic

37 Treas. Reg. § 25.2701-6(a)(3).

38 Treas. Reg. § 25.2701-6(a)(4)(ii)(B).

21


rules also attribute the trusts equity interests among its beneficial

owners to the extent that they may each receive distributions from

the trust, and based on a presumption that trustee discretion will be

exercised in their favor to the maximum extent permitted.39

a. There is one exception to this rule: the equity interest held

by the trust will not be attributed to a beneficiary who cannot

receive distributions with respect to such equity interest,

including income therefrom or the proceeds from the

disposition thereof, as would be the case, for example, if

equity interests in the entity are earmarked for one or more

beneficiaries to the exclusion of the other beneficiaries.40

b. Ownership of the interest may be attributed to a beneficiary,

even where the trust instrument states that he or she cannot

own it or receive dividends or other current distributions

from it, if he or she may receive a share of the proceeds

received from its future disposition. Indeed, the Treasury

Regulations provide that a trust’s equity interest may be

fully-attributed to its remainder beneficiaries.41 A single

equity interest owned by a discretionary trust could,

therefore, be 100% attributable to each of its beneficiaries if

only the “basic” trust attribution rule was considered.

However, the above-mentioned grantor trust attribution and

multiple-attribution ordering rules may very well modify

this result in some cases, as is further discussed below.

2. The Grantor Trust Attribution Rules.

The grantor trust attribution rules attribute the ownership of an

equity interest held by or for a “grantor trust” (i.e., a trust described

under subpart E, part 1, subchapter J of the Code, regarding grantors

and others treated as substantial owners of a trust) to the substantial

owner(s) (or “grantor(s)”) of such grantor trust.42 Thus, a grantor of

a grantor trust will also be considered the owner of any equity

interest held by such trust for purposes of the § 2701 analysis.

However, if a transfer occurs which results in such transferred

interest no longer being treated as held by the grantor for purposes

39 Treas. Reg. § 25.2701-6(a)(4)(i). These rules generally apply to estates as well, but for ease of discussion,

the analysis herein will refer only to trusts.

40 Id.

41 Id.

42 Treas. Reg. § 25.2701-6(a)(4)(ii)(C).

22


of the grantor trust rules, then such shall be considered a transfer of

such interest for purposes of Section 2701.43

3. The Multiple Attribution Rules.

If the “basic” and “grantor trust” attribution rules are both applied,

ownership of an equity interest in an entity owned by a trust may

often be attributable to the grantor and one or more beneficiaries of

the same trust. To resolve such situations, one must look to the “tie-

breaker” or “multiple attribution” rules. These rules resolve such

situations by application of a rule that orders the interests held and

thereby determines how ownership should be attributed between the

grantor, other persons and/or different beneficiaries. However, the

way in which this ordering rule is applied will vary depending on:

(1) whether the equity interest at issue is senior or subordinate; and

(2) the status of particular persons in relation to the Transferor.

a. More specifically, if the above rules would otherwise

attribute an “Applicable Retained Interest”44 to more than

one person in the group consisting of the Transferor and all

“Applicable Family Members,”45 the multiple-attribution

ordering rules re-attribute such Applicable Retained Interest

in the following order:

(1) to the person whom the grantor trust attribution rules

treat as the holder of the Applicable Retained Interest

(if the trust is a grantor trust);

(2) to the Transferor of the Applicable Retained Interest;

(3) to the spouse of the Transferor of the Applicable

Retained Interest; or

(4) pro rata among the Applicable Family Members.

b. By contrast, if the above rules would otherwise attribute a

“subordinate equity interest” to more than one person in the

group consisting of the Transferor, all Applicable Family

Members and “members of the Transferor’s family,”46 the

43 Treas. Reg. 25.2701-1(b)(2)(C)(1).

44 See discussion in Part II, Section D, above.

45 See discussion in Part II, Section C, above.

46 See discussion in Part II, Section C, above (and note that “Applicable Family Member” and “member of

the Transferor's family” have different meanings).

23


multiple-attribution ordering rules attribute such subordinate

equity interest in the following order:

(1) to the transferee of the subordinate equity interest;

(2) pro rata among members of the Transferor’s family;

(3) to the person whom the grantor trust attribution rules

treat as the holder of the subordinate equity interest

(if the trust is a grantor trust);

(4) to the Transferor of the subordinate equity interest;

(5) to the spouse of the Transferor of the subordinate

equity interest; or

(6) pro rata among the “Applicable Family Members” of

the Transferor of the subordinate equity interest.

c. The distinction between the two sets of ordering rules

appears to be motivated by two goals: (1) maximizing the

chance that ownership of an Applicable Retained Interest

will be attributed to a Transferor (or related parties grouped

with the Transferor for § 2701 purposes); and (2)

maximizing the chance that ownership of a subordinate

equity interest will be attributed to a transferee (or younger

generations of the Transferor’s family). The net result in

both cases is an increase in the likely applicability of § 2701.

24


IV. OTHER SECTION 2701 APPLICATIONS

A. Section 2701 in the Carried Interest Planning Context: The “Vertical

Slice”47

Based on the legislative history surrounding § 2701, it is clear that Congress

did not intend for transfers of carried interests in funds to be targeted by the

statute. Instead the aim was to prevent certain types of preferred partnership

transactions that ended in overly generous wealth transfers without the

attendant gift tax liability through the manipulation of rights within a family

held entity.

The problem for estate planners, however, is that the language of the statute

is overly broad. Coupled with the draconian consequences in the event of

its possible application, § 2701 has thus become a major concern for estate

planners representing hedge and private equity Fund Principals in

connection with the transfer of carried interests.

1. Deemed Gift Problem.

If § 2701 were to apply to the transfer of a general partner interest

in the fund (that hold the carried interest), the Transferor may be

deemed to have made a gift for gift tax purposes of not just the

carried interest actually transferred, but, perhaps more, perhaps

significantly more, of his interests in the fund (e.g., general partner

interest and limited partner interest). Because a fund principal often

invests a sizeable amount of capital into a fund as a limited partner

(either directly or perhaps via his or her interest in the general

partner of the fund), such a deemed gift could be problematic from

a gift tax perspective – if the amount of the principal’s investment

as a limited partner in the fund is large enough, the amount of the

deemed gift could be dramatic and could cause a significant deemed

gift tax liability; despite the fact that the principal had not actually

transferred his limited partner interest nor intended to do so.

2. The Vertical Slice Approach.

To date, the most elegant and straightforward solution adopted by

the estate planning community in this area is to structure the transfer

of the carried interest within the proportionality exception to the

statute (or making a so-called “Vertical Slice” transfer of all of the

47 For a more detailed discussion of the possible application of § 2701 in the context of estate planning with

carried interests, see generally N. Todd Angkatavanich & David A. Stein, Going Non-Vertical With Fund

Interests - Creative Carried Interest Transfer Planning: When The “Vertical Slice” Won’t Cut It, TR. & EST.

(Nov. 2010) [hereinafter “Angkatavanich & Stein, Going Non-Vertical”].

25


Transferor’s interests in the fund). Indeed, in the wealth transfer

planning context, the term “carried interest” is rarely uttered without

being followed by the words “Vertical Slice.”

Simply put, making a Vertical Slice transfer requires the Fund

Principal who wishes to transfer a portion of his carried interest to

his family members to proportionately transfer all of his or her other

equity interests in the fund in order to avoid triggering a deemed

gift.

a. The Vertical Slice exception to § 2701 is provided for in

Regulation § 25.2701-1(c)(4), which provides that “§ 2701

does not apply to a transfer by an individual to a member of

the individual’s family of equity interests to the extent the

transfer by that individual results in a proportionate

reduction of each class of equity interest held by the

individual and all Applicable Family Members in the

aggregate immediately before the transfer.”

b. For purposes of the Vertical Slice exception, it is interesting

to note that the interests transferred by the Transferor are

aggregated with any interests transferred simultaneously by

the Transferor’s spouse, any ancestors of the Transferor and

the Transferor’s spouse, and the spouses of any such

ancestors. Thus, if a Transferor owned 100% of the common

interests in an entity and only 25% of the preferred interests,

with the other 75% of the preferred interests being owned by

the Transferor’s parent, a transfer to a junior family member

by the Transferor of 50% of the common interests and 25%

of the preferred interests could be aggregated with an

additional transfer of 25% of the preferred interests by the

Transferor’s parent to satisfy the Vertical Slice exception.

The logic behind this exception, presumably, is that because by

making a Vertical Slice transfer parent has reduced every interest in

the entity on a pro-rata basis, and consequently, the opportunity to

disproportionately shift wealth to the next generation, through the

retention of some artificially inflated equity interests and the transfer

of an artificially depressed different interest, does not exist. Instead,

the Vertical Slice ensures that the younger generation and parent

would share proportionally in the future growth, or decrease in

value, of the entity and thus not allow for a shift in value away from

the parent to the younger generation by way of the non-exercise of

discretionary rights.

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3. Problems With The Vertical Slice.

While this “safe harbor” approach has the advantage of being

relatively low-risk and straightforward to implement, it often

prevents the client from fully achieving his wealth transfer

objectives. The problem is that very often the principal wants to

transfer all or most of his carried interest but only some or none of

his limited partner interest, for both economic reasons (Transferor

wants to retain some portion of his capital investment in the fund)

and gift tax reasons (Transferor does not want to make a taxable

transfer of high-value assets). Because a disproportionate transfer

cannot fit within the Vertical Slice exception, fund principals are

frequently advised to transfer a smaller percentage of the carried

interest so that a proportional limited partner interest can be

transferred in compliance with the “rule” without triggering a

deemed gift.48

B. Proactive Planning with § 2701 and Preferred “Freeze” Partnerships.49

Preferred Partnerships are often referred to as “Freeze Partnerships”

because such partnerships effectively “freeze” the return of one class of

partnership interests at a fixed rate. Such interests are preferred vis-à-vis

the common interests in that they have priority over the common interests

with respect to the payment of a fixed coupon on the holder’s investment

and up liquidation of the entity. They do not, however, participate in the

upside growth of the partnership as all the future appreciation in excess of

the preferred coupon and liquidation preference inures to the benefit of the

other common “growth” class of partnership interests, typically held by the

younger generation or trusts for their benefit. The preferred interests are

usually held by a senior generation family member.

48 While beyond the scope of this outline, it is important to note that some uncertainty exists as to whether

the parents’ interest in the fund management company should also be included when making a transfer of a

Vertical Slice of all of the equity interests. The analysis of whether an interest in the management company

should be included in the Vertical Slice revolves around whether an interest in the management company

would be considered to be an “equity interest” in the fund within the meaning of the Code. Arguably, an

interest in the management company is not considered to be an “equity interest” in the fund.

While also beyond the scope of this outline, it should be noted nonetheless that the utilization of the Vertical

Slice exception is not the only way to avoid the application of § 2701 in the context of carried interest

planning and that there are available other exceptions as set forth in the statute and techniques that have been

developed to capitalize on them. See generally, Angkatavanich & Stein, Going Non-Vertical, supra note 47.

49 For excellent comprehensive discussions of preferred partnership planning, see generally Milford B.

Hatcher, Jr., Preferred Partnerships: The Neglected Freeze Vehicle, 35-3 Univ. of Miami Law Center on Est.

Planning (Jan. 2001). See also Paul S. Lee & John W. Porter, Family Investment Partnerships: Beyond the

Valuation Discount (Sept. 2009), available at http://apps.americanbar.org/rppt/meetings_cle/joint/2009/

Materials/Stand_Alone_Programs/LeeFamilyInvestmentPartnershipsOutlineSeptember2009.pdf

27


1. Structuring the Preferred Interest.50

A parent’s preferred partnership interest is typically structured as a

“qualified payment right” under § 2701 to ensure that the parent’s

contribution of assets to the Preferred Partnership is not a deemed

gift under the § 2701 “zero valuation” rule. To be a qualified

payment right, the parent generally must receive a fixed percentage

payment on his or her capital contribution, payable at least annually

and on a cumulative basis. The use of this “qualified payment right”

structure will result in the parent’s preferred interest being valued

under traditional valuation principles for gift tax purposes, and not

the unfavorable “zero valuation rules” of § 2701.

a. Typically, the preferred interest would also provide Parent

with a priority liquidation right in addition to the preferred

coupon; meaning that upon liquidation, parent will receive a

return of his or her capital before the common interest

holders receive their capital. Parent, however, will not

receive any of the potential upside growth in the Preferred

Partnership based on his or her preferred interest.51

Anything in excess of the amount needed to pay the

preferred coupon will accrue to the benefit of the common

interest holders (i.e., child, or trust for the child’s benefit).

b. For purposes of avoiding the “lower of” rule of § 2701, even

if the preferred interest is structured as a qualified payment

right, it is critical that no “extraordinary payment rights” be

retained by the Parent, including discretionary rights, such

as puts, calls, conversion rights and rights to compel

liquidation, the exercise or non-exercise of which affects the

value of the transferred interest.52 The restriction on

extraordinary payment rights is intended to make sure that

the preferred interest holder does not retain any discretionary

rights that could otherwise ascribe additional value to the

parent’s retained preferred interest, but if not exercised

would shift value to the common interests as a result of such

inaction. Inadvertently retaining an extraordinary payment

50 For a more detailed discussion of planning with preferred partnerships, see generally N. Todd

Angkatavanich & Edward A. Vergara, Preferred Partnership Freezes: They Come in Different “Flavors”

and Provide a Menu of Creative Planning Solutions, TR. & EST. (May 2011).

51 Typically, the parent will also receive a 1% common interest to ensure that his or her preferred interest is

not re-characterized as debt. Such common interest would participate by its terms in any upside experienced

by the Preferred Partnership.

52 Treas. Reg. § 25.2701-1(a)(2)((i).

28


right along with a qualified payment right could still result

in a deemed gift upon the parent’s capital contribution under

the so-called “lower of” rule.53

2. Valuation of the Preferred Coupon.

Even if the parent’s preferred interest is properly structured to avoid

the draconian aspects of § 2701, there are still deemed gift issues to

consider as the foregoing structuring merely ensures that the

parent’s distribution right component of the preferred interest is not

valued at “zero” for purposes of determining parent’s gift to younger

generation family members. There may still be a partial gift under

traditional valuation principals if the parent’s retained preferred

coupon is less than what it would have been in an arms’-length

situation. For example, if the Parent’s retained coupon under the

partnership agreement is a 5% coupon but a 7% return would be

required in an arms’-length transaction then a deemed gift has still

been made by the parent to the extent of the shortfall; albeit not as

dramatic a gift as would occur by violating § 2701.

a. Vital to arriving at the proper coupon rate is the retention of

a qualified appraiser to prepare a valuation appraisal to

determine the preferred coupon required for the parent to

receive value equal to par value for his or her capital

contribution. In preparation of the appraisal the appraiser

will need to take into account the factors set forth by the IRS

in Revenue Ruling 83-120.54 The starting point under this

guidance is to analyze comparable preferred interest returns

on high quality publicly-traded securities. Additional

factors for consideration include the security of the preferred

coupon and liquidation preference, the size and stability of

the partnership’s earnings, asset coverage, management

expertise, business and regulatory environment and any

other relevant facts or features of the Preferred Partnership.

b. The partnership’s “coverage” of the preferred coupon, which

is the ability to pay the required coupon when due, and its

coverage of the liquidation preference, which is its ability to

pay the liquidation preference upon liquidation of the

partnership, will impact the required coupon. A higher

percentage of the partnership interests being preferred

interests, and correspondingly less common interests, puts

53 Treas. Reg. § 25.2701-2(a)(3).

54 Rev. Rul. 83-120, 1983-2 C.B. 170.

29


greater financial pressure on the partnership’s ability to pay

the coupon on time; this translates to weaker coverage of the

coupon, and thus greater risk, and ultimately a higher

required coupon to account for this greater risk. Conversely,

a partnership that has a higher percentage of common

interests relative to preferred would provide stronger

coverage which would result in lower risk and consequently

a lower required coupon. A lower coupon may be more

desirable from a wealth transfer standpoint as growth above

the lower coupon will shift to the younger generation owning

the common interests.

C. Section 2701 Applied to Sales to Intentionally Defective Grantor Trusts

(“IDGTs”).

In Karmazin55, the IRS argued that § 2701 applied to a sale of FLP interests

to an intentionally defective grantor trust (“IDGT”). In the transaction, the

taxpayer created an FLP and sold LP interests to an IDGT in exchange for

a promissory note. The IDGT financed the entire purchase price with the

promissory note.

a. The IRS argued that the promissory note was not debt, but

rather disguised equity and recited the following factors in

support of its position:

(1) the trust’s debt-to-equity ratio was too high;

(2) there was insufficient security for the note to be

considered debt;

(3) it was unlikely that the LP interests would generate

sufficient income to make the note payments; and

(4) no commercial lender would make a loan under such

conditions.

b. By treating the promissory note as equity and not debt, the

IRS sought to apply the provisions of § 2701 which would

result in the amount of the taxable gift being the value

transferred minus the value of any “qualified payment

rights” under the subtraction method. Their argument was

that the taxpayer made a transfer of subordinate interests (the

LP interests) to the IDGT and retained a senior interest (the

promissory note). Since the retained interest includes a

55 Karmazin v. Comm’r, T.C. Docket No. 2127-03 (2003).

30


“Distribution Right” for § 2701 purposes and because the

note payments would not be considered a “qualified payment

right,” the taxpayer would be treated as having made a gift

of the LP units while retaining an interest in the FLP (the

disguised equity, in the form of the promissory note) worth

zero. Thus, a gift of the entire FLP interest would result with

no offset for the promissory note. If the note is not a

“qualified payment right,” then the sale would result in a

deemed gift. In this matter, the note payments were

apparently not “fixed” and did not make payments at least

annually, and thus, were not “qualified payment rights.”

c. Note, that had the promissory note been structured with

fixed, cumulative, annual payments, such that it was a

“qualified payment right,” this would not have completely

saved the transaction. The required return for a preferred

equity interest would be higher than the AFR provided under

the promissory note, so the value of the taxable gift would

be less than the full value, but still more than zero – thus, a

partial gift.

d. Ultimately, the matter was settled. However, the § 2701

argument remains a threat that needs to be considered when

structuring gift/sale transactions to grantor trusts. If the IRS

is able to successfully argue that a promissory note received

in connection with such a transaction is, in fact, disguised

equity, and if LP interests transferred to younger

generational family members (or trusts for their benefit) are

considered as subordinate to the retained promissory note

recharacterized as equity, then potentially Section 2701

could result in a deemed gift. In such case, however,

arguably the recharacterized promissory note may

nonetheless constitute either a mandatory payment right or

liquidation participation right that should be ascribed some

value under the subtraction method.

31


V. SECTION 2702: SPECIAL VALUATION RULES FOR TRANSFERS OF

INTERESTS IN TRUST

Section 2702 is a deemed gift provision that generally provides that when an

individual makes a transfer of an interest in trust to a family member in which such

individual (or certain other senior family members) retains an interest in the trust,

in determining the amount of any resulting gift the value of the retained interest is

zero, unless the retained interest satisfies the definition of a “Qualified Interest.” In

the event that the retained interest is a “Qualified Interest” its value shall be

determined actuarially under § 7520 of the Code.

Section 2702 and its definition of a “Qualified Interest” provides the statutory basis

for many estate planning vehicles involving transfers to trusts, such as Grantor

Retained Annuity Trusts (“GRATs”) and Qualified Personal Residence Trusts

(“QPRTs”). Additionally, § 2702(c) contains provisions with respect to certain

joint purchases of property and other property interests being treated as transfers

held in trust, which are likewise subject to the zero valuation rule. This Section

may have important implications in the case of joint purchases between family

members, when term interests are acquired, and should be considered whenever

contemplating such a transaction.

A. Section 2702 Overview.

Section 2702 applies the “zero valuation” rule to determine the amount of a

gift when an individual makes a transfer in trust to or for the benefit of a

“Member of the Family” and such individual or an “Applicable Family

Member” retains an interest in the trust.

If § 2702 applies to a transfer and the retained interest is not a “Qualified

Interest,” or some other exception does not apply, the retained interest is

valued at zero and the amount of the gift is equal to the entire value of the

transferred property. If the retained interest is a “Qualified Interest,” its

value is determined actuarially and subtracted from the value of the

transferred interest to determine the amount of the taxable gift.

B. General Definitions.

1. Member of the Family.

The term “Member of the Family” means with respect to an

individual Transferor, such Transferor’s spouse, any ancestor or

lineal descendant of the Transferor or the Transferor’s spouse, any

brother or sister of the Transferor, and any spouse of the foregoing.56

56 § 2704 (c)(2); Treas. Reg. § 25.2702-2(a)(1).

32


2. Applicable Family Member.

The term “Applicable Family Member” means with respect to the

individual Transferor, the Transferor’s spouse, and any ancestor of

the Transferor or the Transferor’s spouse, and the spouse of any such

ancestor.57

3. Qualified Interest.

Typically, a “Qualified Interest” is structured as a “Qualified

Annuity Interest,” which is an irrevocable right to receive a fixed

amount, payable at least annually.58

4. Fixed Amount.

A “Fixed Amount” means either:

a. A stated dollar amount, payable periodically (at least

annually), but only to the extent the dollar amount does not

exceed 120% of the stated dollar amount payable in the

preceding year;59 or

b. A fixed fraction or percentage of the initial fair market value

of the property transferred to the trust, payable periodically

(at least annually), but only to the extent the fractional

percentage does not exceed 120% of the fixed fractional

percentage payable in the preceding year.60

C. Section 2702 Hypothetical.

Mom transfers a commercial building into an irrevocable trust in which she

retains the right to receive all of the income (whatever income that may be)

for 20 years with the remainder of the trust to pass to child at the end of the

20-year term. The building has a fair market value of $20 million (assume

no debt) and produces rental income of $1 million per year. Because mom’s

retained income interest is not a “Qualified Interest,” in determining the

value of the gift, her interest is valued at zero. Thus, mom has made a gift

of $20 million to the trust.

57 Treas. Reg. § 25.2701-1(d)(2)

58 Treas. Reg. § 25.2702-3(a).

59 Treas. Reg. § 25.2702-3(b)(1)(ii)(A).

60 Treas. Reg. § 25.2702-3(b)(1)(ii)(B).

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If instead, mom had retained a right to receive a fixed annual annuity of $1

million for twenty years with the remainder to child, her retained interest

would have been a “Qualified Interest.” Thus, based upon a § 7520 rate of

5%, the value of her retained Qualified Interest would be $12,462,200 and

the amount of the gift would be $7,537,800, although the economics of the

deal would be quite similar (this type of trust is a GRAT).

D. Grantor Retained Annuity Trusts (“GRATs”).

A GRAT is a statutorily blessed vehicle under § 2702, whereby assets are

transferred into an irrevocable trust that provides a stream of annuity

payments, typically to the grantor, for a selected term of years. If the grantor

survives the selected term of years, upon the termination of the annuity

stream, the remaining assets pass to the remainder beneficiaries, either

outright or perhaps in further trust, without the imposition of additional gift

tax.

1. Gift Value.

The value the gift is determined upon the GRAT’s creation by

calculating the present value of the remainder interest: the present

value of the annuity stream payable to the grantor using the § 7520

rate applicable for the month of the GRAT funding.61 If the GRAT

is “zeroed-out” (a “Zeroed-Out GRAT”), which is typical, the

present value of the annuity stream is structured to roughly equal the

value of the assets transferred into the GRAT. This results in a gift

of “zero” for gift tax purposes. However, if the assets in the GRAT

are invested to grow in excess of the annuity stream required to be

paid to the grantor/annuitant, and if the grantor outlives the selected

trust term, the excess assets pass to the remainder beneficiaries free

of gift taxes; essentially providing for a gift-tax-free transfer of the

future appreciation (if any) in the assets.62

2. Adjustment Feature.

Some practitioners consider GRATs to be relatively conservative

planning vehicles, (e.g., as compared to a sale to an IDGT, etc.)

because this technique is specifically authorized under Code § 2702.

Additionally, the Regulations specifically provide for a valuation

adjustment feature to ensure that no unanticipated additional gift

61 The Section 7520 Rate is equal to 120% of the AFR. Accordingly, there is potential that the GRAT will

underperform the Gift/Sale Transaction.

62 Walton v. Comm’r, 115 T.C. 589 (T.C. 2000), acq. in result, I.R.S. Notice 2003-72, 2003-2 C.B. 964.

34


will occur from the creation of a GRAT.63 Thus, if the value of the

asset contributed into a GRAT is increased on a gift tax audit, the

amount of the annuity payment due will be automatically

recalculated accordingly so as to result in a larger annuity payment

due, but will still result in the same amount of gift (or, in the case of

a Zeroed-Out GRAT, will still result in a gift of roughly zero).64

3. Mortality Risk.

While GRATs may in one sense be considered to be “more

conservative,” there are relative pros and cons that should be

considered. Mortality risk is the most significant downside to the

GRAT: the grantor must outlive the trust term to remove the gifted

assets from his estate under § 2036(a)(1). If the grantor dies during

the trust term, then a portion of the assets necessary to produce the

remaining annuity payments will be included in the grantor’s gross

estate.65

4. Rolling GRATs.

Many GRATs are structured as short-term (e.g., two or three year)

GRATs, or as a series of “rolling” short-term GRATs in which

annuity payments from existing GRATs are used to fund additional

short-term GRATs. This results in a reduction of the potential

mortality risk by increasing the chance that the grantor will survive

the term of each GRAT. In addition, the short-term nature of each

of the GRATs allows for an opportunity to “lock-in” the upside of

the volatile market, while reducing the potential negative effects of

a volatile market’s downside.

5. Greenbook Proposals.

Proposals to place some limitations on the use of GRATs have

surfaced in recent years, reflecting the Treasury Department and

Obama Administration’s shared sentiment that the use of short-term

GRATs to achieve a gift-tax-free shift of future appreciation

provides too much of an opportunity for taxpayers to shift wealth

free of gift tax.66 The President’s Greenbook proposal would require

63 Treas. Reg. § 25.2702-3(b)(2).

64 In contrast, a sale to an IDGT generally cannot have such an adjustment feature without risk of the IRS

challenging the validity of such a feature as being contrary to public policy.

65 Treas. Reg. § 20.2036-1(b)(1)(ii).

66 See GENERAL EXPLANATIONS OF THE ADMINISTRATION’S FISCAL YEAR 2016 REVENUE PROPOSALS, DEPT.

OF THE TREASURY (Feb. 2015) (referred to as the “Greenbook”).

35


GRATs to have a minimum annuity term of ten years, a maximum

annuity term of the annuitant’s life plus ten years, and it would also

require any GRAT’s remainder interest to have a minimum value of

the greater of 25% of the value of the contributed assets or $500,000

(but not more than the value of the assets contributed), thus

eliminating the Zeroed-Out GRAT technique, and by extension, the

utility of the Rolling GRAT technique.67

If these changes were to become law, the concomitant increase in

the mortality risk normally associated with GRATs would

effectively eliminate the use of the Rolling GRAT technique, and it

would impose a significant limitation on the use of Zeroed-Out

GRATs.

E. GRAT GST Issue: Preferred Partnership GRAT.68

1. The ETIP Issue.

The general inability to allocate generation skipping transfer

(“GST”) tax exemption to a GRAT is another negative planning

aspect, as it effectively prevents practitioners from structuring

GRATs as multi-generational, GST-exempt trusts, in a tax-efficient

manner. This is because of the “estate tax inclusion period” rule (the

“ETIP Rule”), which basically provides that GST exemption cannot

be allocated to a trust during its trust term if the assets would

otherwise be included in the grantor’s estate if he or she died during

that term.69 If the grantor were to die during the annuity term, a

portion of the GRAT assets would be included in his or her estate.

As a result, the ETIP Rule would preclude the grantor from

allocating GST exemption to a GRAT until the end of the ETIP (i.e.,

the end of the annuity term). Because of this limitation, there would

be little if any ability to leverage the grantor’s GST exemption with

a GRAT. Allocation of the grantor’s GST exemption to the trust at

the end of the ETIP would have to be made based upon the then

values of the trust’s assets, and therefore would be an inefficient use

of GST exemption. As a result, GST exemption is very often not

allocated to a trust remaining at the expiration of a GRAT annuity

term; as a consequence, such assets will typically be subject to estate

tax at the death of the second generation beneficiaries or will be

67 Id. at 128.

68N. Todd Angkatavanich & Karen E. Yates, The Preferred Partnership GRAT: A Way Around the ETIP

Issue?, 35 ACTEC J. 290 (2009).

69 Code § 2632(c)(4).

36


subject to a GST tax upon a GST event at the second generation’s

death.

2. Preferred Partnership GRAT to Address ETIP Issue.

The creation of a “Preferred Partnership GRAT,” which involves the

combination of a statutory GRAT with a statutory preferred

partnership, may provide a way to obtain the statutory certainty of a

GRAT while at the same time shifting appreciation into a GST-

exempt trust and, perhaps even containing the amount of potential

estate tax inclusion if the grantor dies during the GRAT term. This

technique dovetails the planning advantages of the preferred

partnership with those of a GRAT by combining these two

statutorily mandated techniques.

a. With this technique, parent could create a preferred

partnership, initially owning both common “growth” and

preferred “frozen” interests. Thereafter, the parent would

make gift transfers of preferred interest to a long-term

Zeroed-Out GRAT, which would not trigger any gift taxes.

Parent would also create a GST-exempt trust into which

parent would make taxable gifts of common interests, and

would allocate GST exemption. The GRAT would be

structured so that the preferred payments made annually to

the GRAT would be sufficient to satisfy its annuity

payments to the grantor. The GST-exempt trust owning the

common interests would receive all growth above the

preferred coupon payable to the GRAT. At the end of the

GRAT term, if the parent is living, the GRAT remainder

would be distributed to the remainder beneficiaries, however

these assets would have been “frozen” to the amount of the

liquidation preference and the coupon (as this would be

payable in non GST-exempt manner). Any appreciation

above the coupon will exist in the common interests held by

the GST-exempt trust.

b. Perhaps even more significant is the limit on the mortality

risk, particularly if the Greenbook Proposal becomes law. If

the grantor dies during the GRAT’s annuity term, the estate

tax inclusion would be limited to the frozen preferred

interest gifted into the GRAT. However, because the

common “growth” interest would never have been held in

the GRAT, but, rather, it was obtained by the GST-exempt

trust via initial capital contribution, the grantor’s death

during the annuity term would become irrelevant with

respect to the appreciated common interests.

37


F. Qualified Personal Residence Trusts (“QPRTs”).

A QPRT is an estate planning vehicle which is authorized under § 2702. A

QPRT allows an individual to transfer the future ownership in a personal

residence typically to the next generation at a significantly reduced gift tax

cost, while continuing to enjoy the use of the property for a set period of

years.

1. QPRTs Generally.

With a QPRT, the grantor transfers his personal residence to an

irrevocable trust that satisfies the requirements of a QPRT. Under

the provisions of the trust, the Grantor retains the right to live in the

house for a specified period of years rent free. If the grantor outlives

the stated trust term, the residence is removed from the grantor’s

estate; if the grantor dies during the trust term, the residence is fully

included in the grantor’s estate at the date of death value. At the end

of the QPRT term, ownership of the home passes automatically to

the remainder beneficiaries of the QPRT, typically to the children of

the Grantor or a continuing trust for their benefit. If the Grantor dies

during the trust term, then the house is subject to estate tax inclusion

under § 2036(a)(1).

2. During the QPRT Term.

During the QPRT term, the trust is disregarded for income tax

purposes, allowing the Grantor to take full advantage of all

deductions (such as real estate taxes) associated with the home and

any capital gains exclusions available for the sale of a primary

residence.

During the trust term, the Grantor, as Trustee, may have control over

the home and can even sell it, though the proceeds of the sale would

remain in trust and generally would need to be used to purchase a

replacement home. If some or all of the proceeds from the sale of

the house are not used to purchase a new residence, then the

proceeds are paid out to the Grantor as an annuity over the remainder

of the QPRT term.

3. After the QPRT Term.

At the end of the QPRT term, the remainder beneficiaries and the

grantor may (or may not) agree to rent the property from the new

owners at fair market value and to continue to live in the home. The

rental payments allow the Grantor to pass additional wealth to his or

her children in a gift tax-free manner. If the residence continues in

38


a trust for the Grantor’s children, and the continuation trust is a

“grantor trust” as to the Grantor, the rental payments will be both

income tax and gift tax free.

4. Factors Determining the Gift.

When the QPRT is funded with the residence, the Grantor’s children

or their trusts, as the remainder beneficiaries of the QPRT, are

treated as receiving a gift of a future interest in the residence. In

calculating the taxable gift, the IRS permits a reduction to account

for the Grantor’s use of the residence during the QPRT term. The

value of the gift of the future interest in the residence is influenced

by three factors:

a. First, the gift is impacted by the § 7520 Rate. The higher the

interest rate, the greater the value of the Grantor’s retained

term interest and therefore the smaller the gift. Thus, QPRTs

are more effective vehicles in high interest rate

environments;

b. Second, the gift value is impacted by the length of the QPRT

term. The longer the QPRT term, the greater the value of the

Grantor’s term interest and, thus, the smaller the value of the

gift. However, a longer term has greater estate tax risk since

the Grantor must survive the trust term to remove the

residence from the gross estate; and

c. Third, the gift is impacted by the Grantor’s life expectancy.

The older the Grantor, the greater the actuarial possibility

that he or she may die before the QPRT term is completed,

causing a “reversion” or taxable inclusion in the Grantor’s

estate.

Thus, assuming the Grantor outlives the trust term, a QPRT will

afford the greatest transfer tax savings when the QPRT term is long,

when interest rates are high and when the Grantor is older.

5. QPRT Example.

In May of 2012, Jane is a 55-year-old, single parent whose net worth

well exceeds her then $5.12 million estate tax exemption.70 She has

three adult children and has made no taxable gifts. At a time when

the § 7520 rate is 1.6%,71 she transfers her vacation home, valued at

70 Rev. Proc. 2011-52, 2011-45 I.R.B.

71 The Section 7520 Rate was 1.6% in May of 2012. Rev. Rul. 2012-13, 2012-19 I.R.B. 878.

39


$5 million to a QPRT (assume no mortgage). The trust terms

provide Jane with the right to live in the residence rent-free for a 15-

year term, with the property passing to her children thereafter.

Again assuming a § 7520 rate of 1.6%, Jane will exhaust

approximately $3,231,350 of her $5.12 million lifetime gift tax

exemption to make the gift to the QPRT. If Jane outlives the QPRT

term and the property appreciates at 4% annually, the vacation home

will be worth approximately $9,004,178 in year 15. If Jane dies

after the QPRT term ends in year 15, the planning will save over

approximately $2,886,684 of estate taxes for Jane’s children. If Jane

lives to age 85, property worth approximately $16,216,988 will pass

to the family tax free.

6. Disadvantages.

There are some potential negative aspects of utilizing a QPRT. It is

not advisable to use a QPRT on a mortgaged home, as each

mortgage payment will be treated as an additional gift to the trust

which would have to be reported and would be rather cumbersome.

Hence, it is advisable for any mortgage on the residence to be paid

in full before gifting it to a QPRT. Also, the trust must prohibit the

sale of the residence to the grantor, grantor’s spouse or a controlled

entity either during or after the QPRT term. Additionally, a

residence contributed to a QPRT does not enjoy a “step-up” in basis

to its fair market value for income tax purposes upon the owner’s

death, as it would if the Grantor retained the home instead.

Accordingly, the children, as remainder beneficiaries of the QPRT,

would be liable for capital gains tax on any appreciation in the value

of the residence contributed to the QPRT on its subsequent sale.

Further, a QPRT is inefficient for GST tax planning purposes due to

the ETIP Rule, discussed above. Finally, some people are

uncomfortable with the prospect of giving up the future control over

their residence and the idea of having to pay rent to their children to

live in their own home. Since a QPRT is an irrevocable trust, it is a

permanent estate planning technique.

G. Certain Property Interests Treated as Held in Trust, § 2702(c).

Section 2702(c) treats certain property interests as being held in trust, which

will be subject to the zero valuation rule unless such property interests

qualify as “Qualified Interests.” Specifically, § 2702(c) can apply to joint

purchases in which a family member retains a term interest, or potentially

with respect to leasehold interests, both of which, although not actually

transfers into trust, may be treated as transfers into trust for purposes of

§ 2702(c).

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1. Term Interests.

A transfer of an interest in property with respect to which there are

one or more term interests is treated as a transfer in trust. For these

purposes, a term interest is one of a series of successive (as

contrasted with concurrent) interests.72

2. Joint Purchases.

Solely for purposes of § 2702, if an individual acquires a term

interest in property and, in the same transaction or series of

transactions, one or more members of the individual’s family

acquire an interest in the same property, the individual acquiring the

term interest is treated as acquiring the entire property so acquired,

and transferring to each of those family members the interests

acquired by that family member in exchange for any consideration

paid by that family member. The amount of the individual’s gift will

not exceed the amount of consideration furnished by that individual

for all interests in the property.73

a. Example. A purchases a 20-year interest in an apartment

building and A’s child purchases the remainder interest in

the property. A and A’s child each provide the portion of the

purchase price equal to the value of their respective interests

in the property determined [actuarially] under § 7520.

Solely for purposes of § 2702, A is treated as buying the

entire property and transferring the remainder interest to his

child in exchange for the portion of the purchase price

provided by A’s child. To determine the amount of A’s gift,

A’s retained interest is valued at zero because it is not a

qualified interest.74 In this example, if the entire value of the

property is $10 million, and A’s child paid consideration of

$3 million, because A’s retained interest is valued at zero, A

would be deemed to have made a gift of $7 million to her

child ($10 million - $3 million).

b. Example. K holds rental real estate valued at $100,000. K

sells a remainder interest in the property to K’s child,

retaining the right to receive the income from the property

for 20 years. Assume the purchase price paid by K’s child

for the remainder interest is equal to the value of the interest

72 Treas. Reg. § 25.2702-4(a).

73 Treas. Reg. § 25.2702-4(c).

74 Treas. Reg. § 25.2702-4(d), Example 1.

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determined under § 7520. K’s retained interest is not a

qualified interest and is therefore valued at zero. K has made

a gift in the amount of $100,000 less the consideration

received from K’s child.

3. Leases.

A leasehold interest in property is not a term interest to the extent

the lease is for full and adequate consideration. The lease will be

considered for full and adequate consideration if, under all the facts

and circumstances as of the time the lease is entered into or

extended, a good faith effort is made to determine the fair rental

value of the property and the terms of the lease conform to the values

determined.75

4. Property Interests Not Treated as Term Interests.

The following are not treated as term interests:

a. A fee interest in property is not treated as a term interest

merely because it is held as a tenants-in-common;

b. Tenants by the entireties; and

c. Tenants with rights of survivorship.76

(1) Example. G and G’s child each acquire a 50%

undivided interest as tenants-in-common in an office

building. The interests of G and G’s child are not

term interests to which § 2702 would apply, but

rather are concurrent interests.

5. Exception to § 2702 for Personal Residence Trusts.

Section 2702 does not apply to a transfer in trust that meets the

requirements of being a “Personal Residence Trust.”77 Thus, § 2702

permits transfers of an individual’s residence into a personal

residence trust, which meets the specific requirements of this

Section. In such case, the zero valuation rule will not apply to the

transfer, and the Transferor will be able to value his or her retained

interest in the property actuarially under § 7520. In other words, in

determining the value of the gift, the Transferor will be able to

75 Treas. Reg. § 25.2702-4(b).

76 Treas. Reg. § 25.2702-4(a).

77 § 2702(a)(3)(A)(ii).

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subtract the actuarial value of his or her retained interest in the

transferred property to the trust, in determining the gift of the

remainder interest to the younger generation family members.78

H. Sale of Remainder Interest in Personal Residence.

A sale of a remainder interest in a personal residence provides the

possibility for a parent to have the use of a personal residence for the

balance of his or her life, with the remaining passing to or for the benefit of

the younger generation at a perhaps significantly discounted gift tax value,

while also possibly avoiding estate tax inclusion of the asset. There are gift

tax issues under § 2702 and estate tax issues under § 2036 that must be

carefully considered, however, before deciding to implement this technique.

1. Generally.

This technique involves the parent, who is the current owner of a

personal residence, selling a remainder interest in the residence to

or for the benefit of the next generation, typically, in a trust for the

benefit of the younger generation. The parent would retain the right

to occupy the residence for the balance his or her lifetime on terms

equivalent to those present in a QPRT. If the transaction is property

structured, the sale of the remainder interest should not result in any

deemed gift under the zero valuation rules of § 2702(c);

additionally, the retained use of the residence by the parent should

not result in estate taxation under § 2036, as long as the sale satisfies

the bona fide sale for adequate and full consideration exception to

§ 2036.

2. Example: PLR 200728018.

a. Facts.

In PLR 200728018,79 the taxpayers were two parents that

were the beneficial owners of real property that was included

in a nominee trust. The parents had full rights to withdraw

the real property from the trust. The taxpayers proposed that

they would withdraw the property from the nominee trust

and would sub-divide it. They would then enter into a

transaction whereby they would execute a new trust that

qualifies as a QPRT. Such trust would provide the taxpayers

with a joint life estate with the remainder ultimately passing

78 See Treas. Reg. § 25.2702-5.

79 See also, I.R.S. Priv. Ltr. Rul. 200840038 (Oct. 3, 2008); I.R.S. Priv. Ltr. Rul. 200919002 (May 8, 2009).

43


to a trust that the father had previously settled for the benefit

of his children. In return for the taxpayers transferring the

residence to the new QPRT, the established children’s trust

agreed to transfer cash and marketable securities to the

taxpayers. Upon the death of the survivor of the parents, the

balance of the property would pass to the children’s trust for

the benefit of the kids that purchased the remainder interest.

The value of the cash and securities was based upon the

actuarial value calculated under § 7520 for the remainder

interest in the real property, with the parents retaining a joint

life estate, the value of which was likewise calculated under

§ 7520.

b. Ruling.

The IRS concluded that the zero valuation rule under

§ 2702(c) would not be triggered, and therefore no deemed

gift would occur as a result of the transaction. Section

2702(c) generally provides a prohibition against split

purchase transactions between junior and senior family

members. Under the general rule of § 2702(c), if different

term interests in real property are purchased by senior and

junior family members, the senior member is deemed to have

made a gift of the entire interest in the property to the junior

family member; however, in determining the value of the

gift, the senior family member would get “credit” for any

consideration that he or she received from the junior family

member. However, under § 2702(c), in the case of a term

interest in real property, the senior family member’s

contribution would be considered to be valued at “zero,” thus

resulting in a deemed gift of the entire value of the property,

less any consideration received, unless an exception applies.

An exception is carved out of the statute, however, with

respect to personal residence trusts and qualified personal

residence trusts, which is the exception upon which the Sale

of Remainder Interest technique is based. If the retained

interest satisfies the requirement of a qualified personal

residence trust, then the zero valuation rule will not apply,

and the parent will be given full value for the retained

interest in the residence for purposes of determining the

value of the gift.

In the Private Letter Ruling, the transaction was structured

so that the parents’ joint retained interest in the residence

was held in a trust that satisfied the requirements of a

44


personal qualified residence trust under § 2702(c);

accordingly, in determining the value of any gift, the parents

were deemed to have made a transfer of the remainder

interest in the property, reduced by the consideration

furnished by the children’s trust, and also received full

“credit” for the value of their retained life interest. This

resulted in a gift of zero for gift tax purposes.

c. Limitations.

With respect to § 2036, the IRS specifically indicated that it

was providing no opinion with respect to gross estate

inclusion under. At first blush, it could be argued that § 2036

may apply to cause inclusion in the gross estate in that the

parents presumably made a “transfer” and retained the life

use of the residence. However, a carve-out exists under

§ 2036 for transfers for “adequate and full consideration.”

Thus, to the extent that the parents retained a lifetime interest

in the transferred residence but received adequate and full

consideration in exchange for that transfer (in this case,

payment by the children’s trust of its actuarial value of the

remainder interest), arguably, such should not result in estate

tax inclusion under § 2036(a).

The determination as to whether the parents’ receipt of the

actuarial value of the remainder interest by the children’s

trust, however, is not entirely clear, and the estate tax

consequences will revolve around whether the older

Gradow80 line of cases, or the more modern Wheeler,81

80 Gradow v. United States, 11 Cl. Ct. 808 (1987); aff’d, 897 F.2d 516 (Fed. Cir. 1990). Gradow held that in

order to constitute adequate and full consideration for the sale of a remainder interest, the donor must receive

the full value of property transferred rather than the actuarial value of the remainder interest.

81 Wheeler v. United States, 1996 U.S. Dist. LEXIS 20531 (W.D. Tex. 1996), rev’d, 116 F.3rd 749 (5th Cir.

1997). The Wheeler case involved the sale by the taxpayer of the remainder interest in a ranch to his sons in

exchange for the actuarial value of the remainder interest. The District Court for the Western District of

Texas followed the holding of the United States Claims Court in Gradow and determined that, for purposes

of Section 2036(a), in order to constitute adequate and full consideration, the decedent was required to have

received the entire value of the underlying property that he had transferred rather than the actuarial value of

the remainder interest. The United States Court of Appeals for the Fifth Circuit reversed the decision of the

District Court, holding that the actuarial value of the remainder interest paid to the taxpayer satisfied the

adequate and full consideration exception.

45


Magnin82 and D’Ambrosio83 line of cases will apply.

Gradow, which was decided by the Federal Circuit in 1990,

requires that in order to constitute adequate and full

consideration for purposes of § 2036 exception, the full

value of the asset would have to be paid to the parent. In

contrast, the more recent line of cases in Wheeler, Magnin

and D’Ambrosio, which were decided by the Fifth, Seventh

and Ninth Circuits, indicate that adequate and full

consideration can be satisfied based upon the actuarial

values of property.

The effectiveness of this technique will depend upon the

more recent line of cases under Wheeler applying. In other

words, under the Wheeler line of cases, if a parent is paid the

actuarial value for the remainder interest by the children’s

trust, that should be sufficient to constitute adequate and full

consideration and, therefore, avoid inclusion in the parents’

gross estate as a result of their retained interest in the

property. If the Gradow line of cases is determined to apply,

then the transaction will not work and the asset will be fully

included in the parent’s estate at his or her death. It does

appear that the more modern line of cases does support this

technique for purposes of avoiding § 2036 inclusion with a

properly structured transaction.

Assuming that the § 2702 and § 2036 issues are properly addressed, the sale

of the remainder interest in a residence can produce estate and gift tax

82 Magnin v. Comm’r, T.C. Memo 1996-25 (1996), rev’d, 184 F.3rd 1074 (9th Cir. 1999), on remand, T.C.

Memo 2001-31 (T.C. 2001). In Magnin, the decedent entered into an agreement with his father whereby his

father promised to bequeath to him his stock in the family corporations in exchange for the decedent’s

promise to bequeath his remainder interest in the family corporations to his children. The Tax Court

determined that the adequacy of the consideration for the transfer should be based upon the entire value of

the stock at the time of the transfer, rather than the actuarial value of the remainder interest that the children

would receive. The United States Court of Appeals for the Ninth Circuit reversed the holding of the Tax

Court. The Court indicated, based upon its reading of the language of Section 2036(a) as well as the principal

that “time appreciates value,” that the phrase “adequate and full consideration” is measured by the actuarial

value of remainder interests rather than the fee simple value of the property transferred to a trust. Id. at 1080.

83 D’Ambrosio v. Comm’r, 105 T.C. 252 (1995), rev’d, 101 F.3rd 309 (3rd Cir. 1996), cert. denied, 520 U.S.

1230 (1997). In D’Ambrosio, the decedent had transferred a remainder interest in preferred stock back to the

issuing corporation in exchange for a private annuity which had an actuarial value equal to the remainder

interest. The decedent died a few years later having received significantly less than the fair market value of

the annuity interest at the time of the transfer. The Tax Court followed the holding of Gradow and determined

that the decedent had not received adequate and full consideration under the exception to Section 2036(a).

The United States Court of Appeals for the Third Circuit reversed the holding of the Tax Court, rejecting the

Gradow case’s construction of the exception under Section 2036(a). It indicated that, considering time value

of money principals, the actuarial value of the remainder interest on the date of the sale would equal the value

of the underlying property on the date of the seller’s death.

46


savings. Of course, before embarking upon or before implementing this

kind of transaction, it is critical that the gift and estate tax issues under

§ 2036 and § 2702 be thoroughly analyzed and the practitioner and the

client must be mindful of the fact that some gray area does exist with respect

to the § 2036 issue. Nevertheless, this is a valuable potential technique that

can be used to significantly reduce the estate tax bite in the estate of wealthy

individuals where a traditional term of years QPRT may not be suitable.

I. Section 2702 Applied to Sales to IDGTs.

1. Karmazin v. Commissioner.

In Karmazin, in addition to § 2701, the IRS also raised the argument

that § 2702 applied to the sale transaction. The IRS essentially

argued that the sale of the LP interest by the taxpayer in exchange

for a promissory note constituted a “transfer in trust” within the

meaning of § 2702. Under § 2702, the value of a retained interest is

zero unless it is a “qualified interest”. Accordingly, the IRS argued

that the interest retained by the taxpayer, in the form of the

promissory note, was actually a transfer in trust with a retained

income interest that did not qualify as a “qualified interest” under

§ 2702 and, therefore, the value of the parents’ retained interest was

zero under the subtraction method. Thus, the IRS took the position

that the value of the sold LP interests should be recharacterized as a

gift to the IDGT, in exchange for an interest that was valued at zero;

thus resulting in a taxable gift of all the LP interests sold (with no

reduction for the promissory note received back).

2. Estate of Woelbing.

More recently, the IRS attacked a sale transaction in Estate of

Woelbing84, a pending Tax Court case, as subject to zero valuation

under Section 2702 reminiscent of Karmazin. In Woelbing, the

Transferor sold an interest if the family business (Carmex lip balm

company) to a grantor trust in exchange for a promissory note with

a face value of approximately $60 million with the applicable

federal interest rate. The trust had assets of over $12 million before

the transfer, some of which were available to service the note in

addition to the company shares, and two trust beneficiaries had

signed personal guarantees for 10% of the purchase price. In

addition to the Section 2702 argument, the IRS also challenged the

valuation of the interest.

84 Estate of Woelbing v. Comm’r, T.C. Docket No. 30260-13 (2013).

47


It seems that the pivotal issue is whether or not the sale of the LP interest to

the trust could be considered a “transfer in trust” within the meaning of

§ 2702. Prior to Karmazin, it was assumed that a “transfer” did not include

a sale. If the IRS is successful in arguing that such a transaction does

constitute a “transfer in trust”, then the Section 2702 potential risk becomes

more pronounced.

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VI. SECTION 2703 – CERTAIN RIGHTS AND RESTRICTIONS DISREGARDED.

Section 2703 and its predecessor, § 2031, can have the effect of disregarding for

transfer purposes the value set in a buy-sell or similar agreement or restrictions on

the right to sell or use property. If applicable, § 2703 will cause rights, restrictions

or other provisions included in an agreement (typically, but not always, a buy-sell

agreement) to be ignored for purposes of determining value for transfer tax

purposes. Although § 2703 was primarily intended to address perceived abuses in

connection with buy-sell agreements, it is widely applicable to other types of

agreements such as partnership agreements, options, bylaws and articles of

incorporation as well as restrictions contained within agreements that may

otherwise impact valuation.

A. The Perceived Abuse.

The abuse that § 2703 attempts to prevent historically arose in the context

of buy-sell agreements in which an artificially low buy-out price was set to

be effective at the death of a parent-stockholder, which resulted in the child-

stockholder purchasing the deceased parent’s interest for less than what the

IRS considered to be fair market value. In the absence of § 2703 (or § 2031)

the below market price that the child paid the deceased parent’s estate for

the stock would set the value of the parent’s stock for federal estate tax

purposes (even though the stock may have actually been worth significantly

more).

B. Valuation Provision.

Section 2703 attempts to curtail this perceived abuse by ignoring the value

established in the buy-sell agreement for purposes of determining the

federal gift or estate tax value. It is important to note, however, that § 2703

does not affect the contractual obligation of the parent’s estate to sell the

stock at the agreed upon price; it only affects the transfer tax value. Thus,

the parent’s estate could be contractually obligated to sell the parent’s stock

for a lower price, but may be required to pay estate tax based upon a much

higher estate tax value of the stock – if the discrepancy is large enough, it

is possible that the price the estate receives for the sale of the stock to the

surviving stockholder may not even be enough to pay the estate tax liability

attributable to such stock.

C. Example of “Sweetheart Deal” § 2703 Designed to Prevent.

Dad and child each own 50% common interests in a corporation that holds

a piece of real estate. The fair market value of the real estate is $10 million.

Dad and child enter into a cross-purchase buy-sell agreement that provides

that at the death of either stockholder, the survivor will be required to

purchase the deceased stockholder’s shares. Dad and child set a buy-out

49


price of $2 million for each stockholder’s 50% interest, and each acquires a

$2 million life insurance policy on the other’s life to fund the purchase at

death.

Dad dies and his estate takes the position for estate tax purposes that the

value of his 50% interest is $2 million (rather than $5 million) due to the

legal obligation of dad’s estate under the buy-sell agreement to sell the

interest to child for $2 million. Dad’s estate pays estate tax on $2 million

of value while child receives dad’s 50% interest, which has a pro-rata value

of $5 million (leaving aside valuation discounts for purposes of this

example).

D. Application of Section 2703 to Post October 8, 1990 Agreements &

“Substantially Modified” Pre-October 8, 1990 Agreements.

Section 2703, generally provides that, for transfer tax purposes, the value of

any property is determined without regard to (1) any option, agreement or

other right to acquire or use the property at a price less than fair market

value, or (2) any right or restriction relating to the property,85 unless all of

the following are satisfied:

1. Bona Fide.

It is a bona fide business arrangement;

85 Code § 2703(a). The complete text of § 2703 is as follows:

(a) GENERAL RULE.- For purposes of this subtitle, the value of any property

shall be determined without regard to-

(1) any option, agreement, or other right to acquire or use the property at

a price less than the fair market value of the property (without regard to such

option, agreement, or right), or

(2) any restriction on the right to sell or use such property.

(2) EXCEPTIONS.- Subsection (a) shall not apply to any option, agreement, right,

or restriction which meets each of the following requirements:

(1) It is a bona fide business arrangement.

(2) It is not a device to transfer such property to members of the

decedent’s family for less than full and adequate consideration in money or

money’s worth.

(3) Its terms are comparable to similar arrangements entered into by

persons in an arms’ length transaction.

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2. Not a Device.

It is not a device to transfer such property to a member of the

decedent’s family for less than full and adequate consideration in

money or money’s worth; and

3. Arms’-Length Comparability.

Its terms are comparable to similar arrangements entered into by

persons in an arms’-length transaction.86

E. Pre-October 8, 1990 Agreements: Treas. Reg. § 20.2031-2(h) Rule.

There is a common misconception that a pre-§ 2703 agreement is “safe” and

that a buy-out price established in such an agreement will be accepted for

estate tax purposes. Pre-§ 2703 agreements, while subject to a lesser

standard, are still subject to scrutiny under the standard of Treas. Reg.

§ 20.2031-2(h), which itself is a difficult standard.

1. Requirements.

To be enforceable for transfer tax purposes a pre-§ 2703 agreement

must satisfy the following:

a. Price must be fixed and determinable under the agreement;

b. Agreement must be binding upon a decedent during his or

her lifetime (i.e., while alive, he cannot be able to dispose of

the interest at any price he decides);

c. Must represent a “bona fide business arrangement”; and

d. Must not be a device to pass the interest to the natural object

of the taxpayer’s bounty for less than adequate and full

pecuniary consideration.

2. Factors.

Many of the cases considering these agreements focus on the third

and fourth prongs of this test. Factors considered generally include:

a. The parties’ health and ages when agreement executed;

86 Code § 2703(b).

51


b. Relationship between the parties and whether testamentary

intentions existed;

c. Whether any negotiations were conducted to determine the

value set in the agreement, and how price was determined

(i.e., were appraisals obtained and were the parties

represented by separate counsel?), and if the buy-out price

was reflective of fair market value at that time;

d. Whether the parties periodically reviewed the buy-out price;

e. Any unusual events (e.g., significant change in business

subsequent to agreement affecting valuation); and

f. Whether other provisions of the agreement have been

respected.

3. Relevant Cases.

a. Estate of Lauder v. Commissioner. In this case, the Tax

Court disregarded a contractually established buy-out price

in focusing on whether the agreement was entered into for

bona fide business reasons and whether the agreement was a

substitute for a testamentary disposition.87 The Tax Court

rejected the buy-out price while noting the following factors:

(1) the decedent’s son accepted the price without

negotiating; (2) no consideration was given to comparable

companies; (3) the adopted valuation method excluded the

goodwill value of the “Estee Lauder” name; and (4) the

estate’s own valuation expert refused to apply a book value

valuation methodology as it would not be applied by “real

world” investors.

b. Bommer Revocable Trust v. Commissioner. In this case, the

Tax Court rejected a restrictive valuation agreement of stock

held in the decedent’s revocable trust at death, which held

86% of the outstanding stock at the time of the decedent’s

death.88 The stockholder’s agreement set an option to

purchase in favor of the other stockholder’s (son and 3

grandchildren) at a purchase price of $11,333 per share and

the stockholder’s agreement could be amended or altered by

a vote of at least 75% of the stockholders. Prior to decedent’s

87 Estate of Lauder v. Comm’r, T.C. Memo 1992-736 (1992),

88 Bommer Revocable Trust v. Comm’r, T.C. Memo 1997-380 (1997).

52


death the stockholders agreement was amended to raise this

threshold to 87.5%, thereby removing decedent’s right to

amend unilaterally. The Tax Court disregarded the buy-out

price in the agreement. It noted the following: (1) the

agreement contained no provision for periodic revaluation of

the stock; (2) the stock valuation in the agreement was

calculated in one day by the family/corporation’s attorney

who was also its tax advisor; (3) the family attorney

represented all parties to the agreement; (4) no professional

valuation appraisals were obtained by any parties before

accepting the price set in the agreement; and (5) no

negotiation of the price was conducted.

F. Overlap of Pre-§ 2703 Law with § 2703 Requirements.

For post October 8, 1990 agreements, § 2703(a) codifies the case law

authority that existed under pre-§ 2703 law, adds a “Comparability

Requirement”, and provides that, for transfer tax purposes, the value of any

property is determined without regard to (1) any option, agreement or other

right to acquire or use the property at a price less than fair market value, or

(2) any right or restriction relating to the property, unless all of the following

are satisfied:

1. Bona Fide.

It is a bona fide business arrangement (included in pre-§ 2703

rule);

2. No Disguised Gift.

It is not a device to transfer such property to a member of the


money or money’s worth (included in pre-§ 2703 rule); and



persons in an arms’-length transaction (NOT included in pre-

§ 2703 rule).

G. Treas. Reg. § 25.2703-1(a) & (b).

1. Pre-§ 2703 Rule Plus Comparability Prong.

Agreements subject to § 2703 have to satisfy all of the requirements

discussed under the old rule, discussed above; however, such an

53


agreement must also satisfy the additional third prong, that its terms

are comparable to a similar arms’-length transaction.

2. Prongs Must Be Independently Satisfied.

Each of the three requirements to the § 2703 exception must be

independently satisfied. For example, a showing that a right or

restriction is a bona fide business arrangement is not sufficient to

establish that it is not a device to transfer property for less than full

and adequate compensation.89

3. Sources of Rights and Restrictions.

The rights and restrictions referred to in § 2703 may be imposed by

a partnership agreement, articles of incorporation or bylaws of a

corporation or more commonly by a stockholder’s buy-sell

agreement or any other or arrangement.90

4. Arms’-Length Transaction.

A right or restriction is treated as comparable to similar

arrangements entered into by persons in an arms’-length transaction

if the right or restriction is one that could have been obtained in a

fair bargain among unrelated parties in the same business dealing at

arms’-length.91 Factors to be considered generally include:

a. Expected term of the agreement;

b. Current fair market value of the property;

c. Anticipated changes in value during the term of the

agreement; and

d. Adequacy of any consideration given in exchange for rights

granted.

5. Consequences for Failure.

If the § 2703 requirements are not satisfied, then the value of the

property is determined without regard to the rights or restrictions

included in the agreement.

89 Treas. Reg. § 25.2703-1(b)(2).

90 Treas. Reg. § 25.2703-1(a)(3).

91 Treas. Reg. § 25.2703-1(b)(4).

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6. Relevant Cases.

a. Estate of True v. Commissioner. This case involved gifts by

members of the True family, and transfers from the estate of

Dave True.92 One of the issues decided by the Tax Court was

whether the book value price as specified in the buy-sell

agreements controlled the estate and gift tax values of the

interests in the True family companies. The Tax Court found

facts indicating that the buy-sell agreements at issue: (1)

were not the result of arms’-length dealings and served

taxpayer’s testamentary purposes; and (2) included a tax

book value price that was not comparable to a price that

would be negotiated by adverse parties dealing at arms’-

length. True demonstrates that the enactment of § 2703 did

not significantly change the rules for determining whether a

buy-sell agreement among related parties would establish

the value of an interest in a business entity for transfer tax

purposes. In True, the Tax Court relied heavily upon the

standards discussed in Lauder II, a case determined under

the old § 2031 standard. While the § 2031 standard did not

specifically include the “comparable to similar arms’-length

arrangement” requirement, nonetheless the Tax Court

considered this as a factor.

b. Estate of Blount v. Commissioner. In this case, the taxpayer

entered into a buy-sell agreement in 1981 that was

substantially modified by a 1996 agreement.93 The Tax

Court determined that the buy-sell agreement satisfied

neither pre-1990 law nor § 2703. The Tax Court disregarded

the 1996 agreement because it did not find it comparable to

similar arrangements entered into by persons at arms’-

length. The Tax Court did not agree with the taxpayer’s

method for valuing shares because: (1) the valuation price

ignored the receipt of the life insurance proceeds; and (2) it

reduced the value of company assets by the company’s

obligation to purchase the decedent’s shares. The Tax Court

indicated that a willing, third-party buyer would account for

both the liability arising from the company’s redemption

obligation and the shift in the remaining shareholder’s

92 Estate of True v. Comm’r, T.C. Memo 2001-167 (2001), aff’d by, 390 F.3d 1210 (10th Cir. 2004).

93 Estate of Blount v. Comm’r, T.C. Memo 2004-116 (2004), aff’d by, 428 F.3d 1338, 1339-1340 (11th Cir.

2005).

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proportionate ownership interest resulting from the

redemption.94

H. Section 2703 Hypothetical.

1. Facts.

Dad and child each own 50% of the common stock of a corporation

that holds one piece of real estate. In addition to dad’s 50% interest,

his estate also includes cash of $5 million. The fair market value of

the real estate is $10 million. Dad and child enter into a cross-

purchase buy-sell agreement in 1995, which provides that at the

death of either stockholder, the survivor will be required to purchase

the deceased stockholder’s shares. Dad and child set a buy-out price

of $2 million for each stockholder’s 50% interest, and each acquires

a $2 million life insurance policy on the other’s life to fund the buy-

out. Dad’s personal attorney who also serves as counsel to the

corporation drafts the buy-sell agreement including the $2 million

buy-out price based upon dad’s instructions. Child, who is not

represented by counsel, executes the agreement at dad’s request.

Assume that it is typical in this industry that a buy-out between

unrelated parties would be based upon the fair market value of the

corporation’s assets valued at death. Assume further that dad also

has interests in other real estate corporations with unrelated third

parties, and that the buy-sell agreements relating to those

corporations set the buy-out price based upon the fair market value

of the corporation’s assets at death (assume no discounts are applied

for lack of marketability).

2. The Issue.

Dad’s estate may have a very difficult time satisfying the third prong

of the test: namely, that the buy-sell agreement’s buy-out terms were

comparable to similar arrangements entered into at arms’-length,

because the industry standard for a buy-out is the fair market value

of the assets, and dad’s other arrangements provide for a different

valuation methodology.

94 The Tax Court applied a similar analysis in a recent case, disregarding a restriction on the right to partition

under § 2703(a)(2) and determining an appropriate valuation discount for a fractional interest in artwork by

reference to a hypothetical willing, third-party buyer. Estate of Elkins v. Comm’r, 140 T.C. 86 (2013), aff’d

in part, rev’d in part, 767 F.3d 443 (5th Cir. 2014). For further analysis and commentary regarding Elkins,

see Diana Wierbicki, Appeals Court Grants Substantial Discount for Art Interests, TRUSTS & ESTATES (Sept.

2014).

56


3. Applicable Standards.

Since the agreement was executed after October 8, 1990, § 2703

would be the applicable standard. If § 2703 is not satisfied, at dad’s

death, the $2 million buy-out price set in the buy-sell agreement

would be disregarded when valuing dad’s stock for estate tax

purposes. Assuming the IRS establishes the at-death fair market

value of dad’s stock to be $5 million, based upon the fair market

value of the corporation’s assets, his stock would be subject to

federal estate tax based upon the $5 million value (assuming, for

these purposes, that no valuation discount applies). However, dad’s

estate would still be contractually obligated to sell his stock to child

for $2 million, because § 2703 only affects the valuation for estate

or gift tax purposes (and not for contract, property, or other legal

purposes). Thus, dad’s estate would be valued at $10 million for

estate tax purposes ($5 million stock value + $5 million cash), but it

would only have assets of $7 million ($2 million buy-out proceeds

+ $5 million cash).

4. Circular Problem.

Even if 100% of the remaining assets ($7 million) pass to dad’s

spouse, a $3 million taxable estate results, because you cannot get a

marital deduction for property that does not pass to the spouse.

Then, in order to pay the estate tax attributable to the $3 million

taxable estate (assuming dad’s gift tax exemption was exhausted

during his lifetime), the estate would have to take more money out

of the marital share, further reducing the marital deduction and

increasing the estate tax. The calculation becomes “circular”

because each dollar of estate paid out of the estate to the IRS will

not qualify for the marital deduction and will, therefore, trigger “tax

on tax.”

I. “Substantial Modification”.

Section 2703 applies to buy-sell agreements entered into on and after

October 8, 1990,95 and to pre-October 8, 1990 agreements that have been

“substantially modified.”

1. Discretionary Modification.

A “substantial modification” is any discretionary modification of a

right or restriction, whether or not authorized by the terms of the

95 Pre October 8, 1990 agreements remain subject to Treas. Reg. § 20.2031-2(h).

57


agreement, that results in a more than de minimis change to the

quality, value, or timing of the rights of any party with respect to

property that is subject to the right or restriction.96

2. Failure to Update.

Additionally, failure to update a right or restriction that requires

periodic updating may constitute a “substantial modification,”

unless the taxpayer can prove otherwise.

3. Exceptions.

Treas. Reg. § 25.2703-1(c)(2) provides that the following are not

considered substantial modifications:

a. A modification required by the terms of the agreement;

b. A discretionary modification of an agreement conferring a

right or restriction if the modification does not change the

right or restriction;

c. A modification of a capitalization rate used with respect to a

right or restriction if the rate is modified in a manner that

bears a fixed relationship to a specified market interest rate;

and

d. A modification that results in an option price that more

closely approximates fair market value.

J. Safe Harbor Exception for Property Controlled by Unrelated Persons.

A right or restriction is considered to meet each of the three requirements

of the exception to § 2703 “if more than 50% by value of the property

subject to the right or restriction is owned directly or indirectly by

individuals who are not members of the Transferor’s family.”97

1. Members of the Transferor’s Family.

For these purposes, “members of the Transferor’s family” include

both junior and senior family members (as described in § 2701

96 Treas. Reg. § 25.2703-1(c)(1).

97 Treas. Reg. § 25.2703-1(b)(3).

58


above) and any other individual who is a “natural object of the

Transferor’s bounty.”98

2. Natural Object of the Transferor’s Bounty.

Under this safe-harbor test, it is possible that an unrelated

stockholder of a corporation may be considered to be a “natural

object of the Transferor’s bounty” and, therefore, a “member of the

Transferor’s family” although unrelated to the Transferor.

K. Section 2703(b) Exception.

As mentioned above, § 2703(b) provides an exception to the application of

§ 2703(a), by imposing any obligation upon the taxpayer or his estate to

disprove the assumption made against the validity of the arrangement for

transfer tax purposes. Thus, for the agreement or restriction to be respected

for estate or gift tax purposes, the following three-prong test described in

§ 2703(b) must be met by the taxpayer or the taxpayer’s estate (in addition

to the pre-2703 requirements):

1. Bona Fide.

It is a bona fide business arrangement;

2. No Disguised Gift.

It is not a device to transfer such property to members of the


money or money’s worth; and



persons in an arms’-length transaction.

L. Section 2703(b)(1): Bona Fide Business Arrangement.

The first requirement of § 2703(b) is that the buy-sell agreement must be a

“bona fide business arrangement.” While not defined in the Code, case law

indicates that the following reasons for entering into a buy-sell agreement

have constituted a bona fide business arrangement:

98 Treas. Reg. § 25.2703-1(b)(3).

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a. The maintenance of family ownership and control of the

business;99

b. The retention of a family member as a key employee of a

company where the family members were hostile to each

other and the resulting buy-sell agreement was an arms’-

length transaction;100

c. To create an incentive for effective management where an

owner wished to withdraw from management of a

business;101

d. To ensure the continued employment of the stockholders

who were valued employees and to facilitate a transition of

the ownership of the company between the shareholders,

thereby ensuring the permanency of the company;102

e. To avoid expensive appraisals in determining the purchase

price;103

f. To prevent the transfer to an unrelated party;104

g. To provide a market for the equity interest;105 and

h. To allow owners to plan for future liquidity needs in

advance.106

99 St. Louis County Bank v. United States, 674 F.2d 1207, 1210 (8th Cir. 1982).

100 Bensel v. Comm’r, 100 F.2d 639 (3rd Cir. 1938).

101 Cobb v. Comm’r, T.C. Memo 1985-208 (1985).

102 I.R.S. Priv. Ltr. Rul. 8541005 (June 21, 1985). Note that some of the stockholders were not family

members.

103 136 Cong. Rec. S15681 (Oct. 18, 1990). In explaining § 2703, the Committee on Finance stated its

understanding of the section in the Congressional Record as follows:

the committee believes that buy-sell agreements . . . are generally entered

into for legitimate business reasons . . . buy-sell agreements are

commonly used to control the transfer of ownership in a closely held

business, to avoid expensive appraisals in determining purchase price, to

prevent the transfer to an unrelated party, to provide a market for the

equity interest, and to allow owners to plan for future liquidity needs in

advance. 104 Id.

105 Id.

106 Id.

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M. Section 2703(b)(2): Not a Device to Transfer Less than Full and Adequate

Consideration.

Courts have bifurcated the § 2703(b)(2) requirement into a two-part test: (1)

the “testamentary purpose test”, and (2) the “adequacy-of-consideration

test.”

1. Testamentary Purpose Test.

A buy-sell agreement cannot have a testamentary purpose. In Estate

of True,107 the Tax Court listed eight factors that would tend to

indicate that a buy-sell agreement will fail the testamentary purpose

test:

a. The decedent’s poor health when he entered into the

agreement;108

b. No negotiation of buy-sell agreement terms;109

c. Inconsistent enforcement of buy-sell agreement

provisions;110

d. Failure to seek significant professional advice in selecting a

formula price;111

e. Failure to obtain or rely on appraisals in selecting a formula

price;112

f. Exclusion of significant assets from the formula price;113

g. No periodic review of the formula price;114 and

h. The decedent’s business arrangements fulfilled his

testamentary intent (e.g., that the children received equal

percentage interests in the business despite their different

107 Estate of True v. Comm’r, T.C. Memo. 2001-167 (2001), 2001 Tax Ct. Memo LEXIS 199. Please note

that subsequent citations refer to Lexis pagination.

108 Id. at 122.

109 Id. at 123.

110 Id. at 130.

111 Id. at 132.

112 Id. at 135.

113 Id. at 139.

114 Id. at 140.

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management responsibilities, indicated that the transfers

were based on family relationships, not business

relationships).115

2. Adequacy-of-Consideration Test.

Courts appear to apply two different standards in determining the

adequacy of consideration under a buy-sell agreement: one where

the buy-sell agreement is between unrelated parties and another

when it is between related parties.

a. Unrelated Parties. Where the parties to the agreement are

unrelated and there is no apparent intent for the agreement

to serve as a testamentary device, courts have stated that “the

mutual promises of the parties to a restrictive shareholders

agreement generally provide full and adequate consideration

for the agreement where the parties deal at arm’s length.”116

b. Related Parties. However, where the parties to the

agreement are family members, “it cannot be said that the

mere mutuality of covenants and promises is sufficient to

satisfy the taxpayer’s burden of establishing that the

agreement is not a testamentary device. Rather, it is

incumbent on the estate to demonstrate that the agreement

establishes a fair price for the subject stock.”117

c. In Estate of Lauder, the court stated “the phrase is best

interpreted as requiring a price that is not lower than that

which would be agreed upon by persons with adverse

interests dealing at arm’s length.”118 That being said,

commentators have concluded that, “the determination of

full and adequate consideration will often be solved only

through a battle between the taxpayer and the IRS’s expert

witnesses.”119

115 Id. at 143-45.

116 Estate of Lauder v. Comm’r, T.C. Memo 1992-736 (1992), 1992 Tax Ct. Memo LEXIS 784 at 67. Please

note that subsequent citations refer to Lexis pagination.

117 Id. at 68-69.

118 Id. at 71.

119 RICHARD B. STEPHENS, ET AL., FEDERAL ESTATE & GIFT TAXATION, ¶19.04(3)(b)(ii) (9th ed.).

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N. Section 2703(b)(3): Comparable Arrangements.

Section 2703(b)(3) provides that the terms of a buy-sell agreement “must

be comparable to similar arrangements entered into by persons in an arms’

length transaction.”

1. Smith v. United States.

This requirement was addressed in Smith120 involving a valuation

provision in a family-limited partnership. The court remanded the

case, which was a decision on the IRS’s motion for summary

judgment, for further fact-finding. However, in its discussion of the

comparable arrangements test, the court appears to have set out a

very difficult evidentiary standard for a taxpayer to meet in order to

satisfy this third-prong of § 2703(b). Both the IRS and the taxpayer

agreed that “it would be inherently difficult to find an agreement

between unrelated parties dealing at arms’[-]length that would be

comparable to a family limited partnership, which, by its terms, is

restricted to related parties.”121 Yet, in rejecting as conclusory the

affidavits of two attorneys attesting to the comparability of the

arrangement, the judge appears to have set out just such a

requirement.

2. Estate of Blount.

In Blount,122 the Tax Court also found that the taxpayer failed

§ 2703(b)(3) by failing to show a comparable agreement. Blount

involved a 1981 agreement that was substantially modified in 1996,

thus triggering § 2703. The Tax Court stated that “the regulations

under § 2703 . . . contemplate the introduction of evidence of actual

comparable transactions.”123 As with Smith, the Blount decision sets

a very high evidentiary standard for a taxpayer to pass the

comparable arrangements test.

3. Estate of Amlie.

The Tax Court’s ruling in Estate of Amlie124 is also relevant, as it

provided further guidance on the interpretation of § 2703(b)’s three

120 Smith v. United States, 2004 U.S. Dist. LEXIS 14839 (W.D. Pa. 2004). Please note that subsequent

citations refer to Lexis pagination.

121 Id. at 22.

122 Estate of Blount v. Comm’r, T.C. Memo 2004-116 (2004), aff’d by, 428 F.3d 1338 (11th Cir. 2005).

123 Id. at 747.

124 Estate of Amlie v. Comm’r, T.C. Memo 2006-76 (2006).

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safe harbor requirements. Amlie involved a conservator who

secured a fixed-price buyer for his decedent-ward’s minority interest

in a closely held bank. As the buyer was also a prospective heir, the

IRS attempted to disregard the fixed-value agreement in valuing the

decedent-ward’s estate by applying § 2703 principles. The ultimate

issue in the case was not whether § 2703(a) covered such an

agreement, but whether the safe harbor requirements of § 2703(b)

were satisfied.

a. The IRS argued that the agreement did not satisfy the “bona

fide business arrangement requirement” because the subject

of the agreement was not an actively managed business but

a mere investment asset, but the argument gained little

traction. The Tax Court ruled that the conservator’s reasons

for entering the agreement, hedging the risk involved in

holding a minority interest in a closely held business and

planning for future liquidity needs of the decedent’s estate,

constituted a bona fide business purpose under § 2703(b)(1).

b. With respect to the second requirement of § 2703(b), the IRS

argued that the fixed-value agreement was a “testamentary

device” because the decedent-ward received nothing in

return for entering into it. The Tax Court disagreed again,

and ruled that the agreement was not a § 2703(b)(2)

“testamentary device” because the fixed-price agreement

provided the decedent-ward with security against any

downside risk.

c. With respect to the third and final § 2703(b) requirement, the

estate submitted an expert legal opinion that the restrictive

agreement’s terms were identical to those found in an earlier

agreement reached between the conservator and the closely-

held bank in a similar arms’-length transaction, in

satisfaction of the requirement under § 2703(b)(3). The IRS

countered, arguing that the example was simply an “isolated

comparable,” insufficient for § 2703(b)(3) purposes. Again,

the Tax Court agreed with the estate, noting that the price

settled upon in the agreement was based on a survey of

comparable prices and that the agreement, despite being

between family members, was an arms’-length transaction

because each side had adverse interests. As all three

requirements of § 2703(b) were satisfied, the court ruled that

§ 2703(a) did not apply and the IRS could not, therefore,

disregard the restrictive agreement for valuation purposes.

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4. Holman v. Commissioner.

The Amlie decision provided significant guidance to the Tax Court

in interpreting the requirements of § 2703(b) in Holman.125 In

Holman, which involved an FLP, the Tax Court did not rule on the

third prong of the exception under § 2703(b)(3), regarding whether

the provision was “comparable to similar arrangements entered into

by [other] persons in an arms’ length [sic] transaction”, because the

Tax Court had already determined that the other two requirements

of § 2703(b) were not met and, therefore, § 2703(a) was applicable.

However, the Tax Court did hint that it believed that the taxpayer

had shown all that was needed to satisfy § 2703(b)(3), which may

have been indicative of a relaxation of Smith’s rigid evidentiary

standard regarding § 2703(b)(3).

The taxpayers appealed the Tax Court’s decision to the Eighth

Circuit Court of Appeals,126 but the Eighth Circuit supported the Tax

Court’s view on § 2703 based on the lack of a bona fide business

arrangement and did not, therefore, address the arrangement’s

comparability to similar arms’-length transactions.

O. Section 2703 Applied to Family Limited Partnerships.

Chapter 14 may apply in the FLP planning context due in large part to its

broad underlying assumption that, whenever they engage in a transaction

together, senior and junior family members are working in concert to

transfer value to the younger generation for less than full consideration.

Although the various sections under Chapter 14 were not necessarily

designed for the specific purpose of attacking FLPs, the IRS has,

nonetheless, relied upon Chapter 14 to attack such entities. The broadly

phrased language of many Chapter 14 provisions has allowed the IRS to be

creative in challenging FLP transactions and, indeed, it has had some

success on this front (particularly under § 2703). Some of the IRS’s success

on this front has been due to its ability to refine its argument under § 2703

in challenging FLPs.

1. Initial Application of § 2703.

The IRS has previously used, and continues to utilize, §§ 2036,

2701, 2702, 2703, and 2704 in its attacks against FLPs and related

125 Holman v. Comm’r, 130 T.C. 170 (2008), aff’d by, 601 F.3d 763 (8th Cir. 2010).

126 Holman v. Comm’r, 601 F.3d 763 (8th Cir. 2010).

65


transfer transactions.127 In particular, the IRS deployed § 2703

against FLPs in cases litigated in the late 1990s, but those arguments

proved largely unsuccessful and resulted in taxpayer victories.128

However, in the 2008 Holman case, the IRS prevailed in a § 2703-

based attack on an FLP.129 In that case, the IRS resurrected

previously unsuccessful arguments, which had not been asserted for

several years.130 Therefore, any analysis of § 2703 in the FLP

context requires a look at the IRS’s earlier, unsuccessful challenges.

2. Church v. United States.

a. Facts.

Decided in January 2000, Church involved Elsie Church

(“Elsie”), who created an FLP with two express purposes:131

first, the partners intended to consolidate undivided interests

in a family ranch so as to centralize management and

preserve the ranch as an on-going business; and second, the

decedent, Elsie, sought to protect her assets from creditors,

as she harbored concerns about a significant tort claim

against her. Elsie and her two daughters each contributed

their undivided interests in the family ranch to the

partnership in exchange for limited partner ownership

interests. Elsie also contributed approximately $1 million in

securities to the partnership. Under the proposed entity

structure, each daughter expected to own 50% of a

corporation, which was to serve as the partnership’s general

partner. Only two days after the series of organizing

transactions, Elsie died unexpectedly. Although the

partnership was formed on October 22, 1993, certain aspects

of organization remained incomplete at Elsie’s death (e.g.,

the Certificate of Limited Partnership was not filed with the

Texas Secretary of State until October 26, 1993; the

127 Edward A. Renn & N. Todd Angkatavanich, The Resurrection: How Holman Revived Section 2703

Arguments—Long Thought Dead and Buried—To Defeat a Family Limited Partnership, TR. & EST. (Oct.

2008) [hereinafter “Renn & Angkatavanich, The Resurrection”].

128 Id.


130 See Renn & Angkatavanich, The Resurrection, supra note 127.

131 Church v. United States, 85 A.F.T.R.2d 804, 805 (W.D. Tex. 2000).

66


corporate general partner remained unorganized until

March, 1994, etc.).132

b. IRS Position.

The IRS served a Notice of Deficiency upon Elsie’s estate

nearly two years after the estate tax return was timely filed.

The government assessed a deficiency of $212,503, plus

interest, against Elsie’s estate, which it paid and thereafter

claimed a refund for.133 The IRS argued that the

partnership’s formation lacked substance and served no

other purpose than to decrease the tax liability of Elsie’s

estate. Specifically, the IRS asserted two arguments under

Code § 2703: first, that the term “property” contained in

§ 2703(a) referred to the underlying assets of the partnership

rather than the decedent’s partnership interest; and second,

that § 2703(a) applied to disregard the entire partnership

agreement for purposes of valuing the partnership interests

held by the estate. In other words, the IRS adopted the

position that the partnership agreement in its entirety

operated as a restriction on the sale of the partnership

interest.134 The estate countered by arguing that the

partnership was a bona fide business arrangement, was not a

device to transfer assets for less than full and adequate

consideration, and by offering expert testimony suggesting

the arrangement was similar to comparable, arms’-length

transactions.135

c. Ruling.

The court agreed with the estate’s position and recognized

the partnership as a valid entity. The court concluded that

the limited partnership was a bona fide business arrangement

and was not a vehicle used to transfer property to Elsie’s

family members for less than full and adequate

consideration. The court also accepted the expert testimony

in support of the partnership as being comparable to arms’-

length transactions. According to the court, even without

completing all of the procedural requirements for

132 Id. at 805–07.

133 Id. at 809. The IRS initially denied the claim but later refunded nearly $15,000 on account of deductible

attorney’s fees and appraisal fees incurred during administration of Church’s estate. Id.

134 Id. at 810–11; see also Renn & Angkatavanich, The Resurrection, supra note 127.

135 Church, 85 A.F.T.R. 2d at 808.

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partnership formation, the limited partnership substantially

complied with Texas law, and, therefore, was valid at the

time of Elsie’s death. As such, the decedent’s partnership

interests, rather than the underlying partnership assets, were

subject to estate tax.136

The court also addressed, and squarely rebuffed, the IRS’s

two § 2703 arguments. With regard to the suggestion that

the term “property” under § 2703 referred to the

partnership’s underlying assets contributed by the decedent,

the court observed, “[t]here is no statutory basis for this

contention.”137 Citing the Code and prior cases, the court

noted that Elsie owned a partnership interest at death and the

estate tax applies to those assets “which a decedent transfers

at death without regard to the nature of the property interest

before or after death.”138 The IRS position, therefore, was

not rooted in any statutory or regulatory authority that would

permit taxation of the underlying property transferred by

Elsie to the partnership (rather than her partnership interest).

The court also concluded that § 2703 did not authorize

disregarding the partnership agreement in its entirety for

valuation purposes. After reviewing the legislative history

of § 2703 and related provisions, the court determined that

§ 2703 was intended to deal with buy-sell agreements and

options that artificially deflate the fair market value of

taxable property.139 The court differentiated such buy-sell

agreements and options from partnership agreements, which

“are ‘part and parcel’ of the property interest,” and,

therefore, not covered by § 2703.140

3. Estate of Strangi v. Commissioner.

The IRS offered similar § 2703 arguments in Strangi, which the Tax

Court decided in November of 2000.141

a. Facts.

136 Id. at 808–10.

137 Id. at 810.

138 Id.

139 Id. at 811.

140 Renn & Angkatavanich, The Resurrection, supra note 127.

141 Estate of Strangi v. Comm’r, 115 T.C. 478 (2000), aff’d in part, rev’d in part, 293 F.3d 279 (5th Cir. 2002).

68


Albert Strangi had suffered from a series of medical

conditions, including surgery to remove a cancerous mass, a

diagnosis of supra-nuclear palsy, and prostate surgery,

which together caused Michael Gulig, Strangi’s attorney-in-

fact (“Gulig”), to assume control of Strangi’s affairs

pursuant to a previously executed power of attorney. After

attending a seminar regarding family limited partnership

structures, Gulig formed a Texas limited partnership and a

Texas corporation to serve as the former’s general partner.

Under the partnership agreement, the general partner held

sole authority to conduct the partnership’s business affairs

and the limited partners could not act without its consent. In

August 1994, Gulig transferred Strangi’s assets valued at

nearly $10 million to the partnership in exchange for a 99%

limited partnership interest.142 Under Gulig’s structure, the

decedent and his children owned the partnership’s corporate

general partner and also served on its board of directors.

However, within a few months of the partnership’s creation,

Strangi passed away.143

b. IRS Position.

During Strangi’s life, and for a period of time after his death,

the partnership made various distributions for the benefit of

the decedent’s wife, estate and children. For example, when

Strangi’s wife injured her back and required surgery, the

partnership paid for the procedure. In July 1995, the

partnership distributed more than $3 million to Strangi’s

estate for the state and federal estate and inheritance taxes.

Further, as of December 31, 1998, the decedent’s children

had received $2,662,000 in distributions from the

partnership.144

The decedent’s estate tax return claimed a gross estate of

$6,823,582 and attributed $6,560,730 to the partnership’s

fair market value. For purposes of computing the value of

the partnership, the appraiser applied minority discounts of

142 Contributed assets included interests in real estate, securities, interest and dividends, insurance policies,

annuities, receivables, and partnership interests. Id. at 481.

143 Id. at 480–82.

144 Id. at 482–83. The partnership also distributed $563,000 to each of Strangi’s children in 1995 and 1996.

Additional distributions followed, and the partnership extended lines of credit to Strangi’s children and

Gulig’s wife for hundreds of thousands of dollars. Id.

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33% based on lack of control and marketability. Further, the

return reported a transfer tax due of $2,522,088.145

c. Ruling: Partnership Recognition.

As in Church, the IRS raised multiple § 2703 challenges and

claimed that its provisions should apply to disregard the

partnership for transfer tax purposes. More specifically, the

government argued the Strangi arrangement was precisely

the type of intra-family transaction Congress sought to

combat when it enacted § 2703(a). The estate contended that

the partnership had both economic substance and a business

purpose and further that the business purpose and economic

substance doctrines were inapplicable in the transfer tax

context. The business purposes of the partnership included:

(i) a means to reduce executor and attorneys’ fees payable

upon death; (ii) insulation from tort liability and probate

challenges; and (iii) to create a joint investment vehicle. The

court doubted the stated reasons were the actual motivations

for formation of the partnership but nevertheless

acknowledged it had been validly formed under state law

and determined that the partnership was to be recognized for

tax purposes. The court also rejected the IRS’s § 2703(a)

argument that the term “property” applied to the

partnership’s underlying assets rather than Strangi’s

partnership interest. According to the court, Congress did

not intend to treat partnership assets owned by a partnership

as individually owned by such partner at death.

Further, the court found no statutory or regulatory language

to support disregarding the partnership itself. Thus, the IRS

§ 2703(a) argument failed for a second time in the same year.

Additionally, the IRS raised a § 2703(b) issue and claimed

that the partnership agreement failed to satisfy the safe

harbor provisions. The court declined to address the

§ 2703(b) issue of whether the partnership agreement

satisfied the safe harbor provisions, citing the fact that the

IRS § 2703(a) arguments were invalid.146

145 Id. at 483.

146 Id. at 484–88.

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4. Section 2703 and FLPs Before Holman and Smith.

Church and Strangi left the IRS sufficiently defeated with regard to

its § 2703 arguments aimed at disregarding partnerships entirely.

The courts simply refused to accept the government’s interpretation

that § 2703(a) applied to underlying property held by the partnership

rather than the partner’s interest in the entity. Not only did the courts

reject the IRS’s definition of “property” under § 2703(a), they also

found no statutory or regulatory bases to support such a position.

Decided in 2000, these cases appeared for a while to take § 2703 off

the table in the FLP context. The courts also appeared to defer to

the validity of partnerships created under state law. For example, in

Strangi, the partnership paid for personal medical procedures, yet

the court still declined to disregard the entity. The courts narrowly

construed § 2703 to apply only to specific provisions contained

within partnership agreements (rather than to the agreement as a

whole). It appeared that the IRS largely abandoned use of § 2703

arguments, until 2004, when it litigated and achieved limited

success in Smith.147

5. Resurrected and Re-Crafted § 2703 Challenges to FLPs.

In Smith,148 which was decided in 2004, the IRS successfully

resurrected its FLP challenges based on § 2703. Deviating from its

original argument in Strangi and Knight, the IRS resurrected the

§ 2703 argument, and obtained summary judgment by taking the

position in Smith that the restrictive provisions in the FLP agreement

affecting value should be disregarded, rather than the partnership

itself.

a. Facts.

In Smith, the taxpayer gifted limited partnership interests to

his children. The partnership agreement included a

provision giving the partnership a right of first refusal to the

sale of an interest and allowing the partnership to pay for a

withdrawing partner’s interest in installments over 15 years.

The taxpayer applied a marketability discount.

b. IRS Position.

147 See, Renn & Angkatavanich, The Resurrection, supra note 127, at 20–21.

148 Smith v. United States, 2004 U.S. Dist. LEXIS 14839 (W.D. Pa. 2004).

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The IRS argued that § 2703 should be applied so as to

disregard a restrictive provision in the partnership agreement

when determining the fair market value of the partnership

interests. Thus, the IRS essentially re-crafted the § 2703

argument that it had made, unsuccessfully, in prior cases like

Strangi and Church. This time, the IRS argued that § 2703

applied to disregard certain restrictive provisions contained

within the partnership agreement (rather than applying to

disregard the partnership structure as a whole). The court

determined that § 2703 applied to the restrictive provisions

contained in the partnership agreement and granted

summary judgment to the IRS on the issue of the

applicability of § 2703 to such restrictive provisions.

c. Ruling.

In looking at the three requirements of the safe harbor

exception, the court first found that the restriction at issue

was a “bona fide business arrangement” because it was

designed to maintain family ownership and control of the

FLP. However, on the issues of whether the restriction was

a “testamentary device” and whether it was “comparable to

similar arrangements” the court did not rule because it did

not have sufficient facts to make the determination.

The court did, however, set a very high bar in terms of the

proof that would be needed to satisfy the § 2703(b)(3)

exception. Smith suggests that for a restrictive provision to

meet the “similar arrangements” required of § 2703(b), a

taxpayer must show actual comparable transactions between

unrelated parties that are similar to the restriction for which

a taxpayer wishes to apply a marketability discount. If this

is, in fact, the necessary standard, the burden would be

difficult to meet in the FLP context because partnership

agreements are generally not publicly available, which

makes it unclear how a taxpayer would be able to show an

actual comparable transaction.

In addition, the court determined that the limited partnership

agreement failed pre-§ 2703 law, since, following the gifts,

the taxpayer continued to own enough partnership interests

to cause the partnership to unilaterally amend the agreement,

so that it would not be considered “binding.”

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6. Holman v. Commissioner.

On the heels of the Smith decision, the IRS was next able to fully

resurrect its § 2703 argument in Holman.149 In Holman, the Tax

Court determined that the taxpayer’s gifts of LP interests in an FLP

funded with shares of stock of Dell Computers were subject to

§ 2703 for gift tax purposes. The Tax Court determined that certain

restrictive provisions in the FLP agreement should be ignored for

gift tax purposes under § 2703. The court determined that the

taxpayer failed to satisfy the first two of the three requirements

necessary satisfy the exception to § 2703. The court determined that

the restrictions in the FLP did not reflect a bona fide business

arrangement because the stated purposes of the FLP (to manage and

prevent the dissipation of family assets) were the taxpayer’s

personal goals. It also determined that the FLP agreement’s

restrictive provisions were a device to transfer wealth for less than

full consideration, since they could cause the FLP to acquire a

partner’s interests for less than full consideration. Lastly, although

the court did not need to rule on this issue, it did hint that it thought

that the taxpayer might have satisfied the “comparability” test.

a. Facts.

In Holman, which was a gift tax case, the taxpayer created

an FLP and funded it solely with shares of Dell stock. Over

the next three years, the taxpayer made significant gifts of

limited partnership to a custodian for one of his daughters

and a trust for the benefit of all his daughters. For gift tax

reporting purposes, the taxpayer applied discounts for lack

of marketability. The claimed discount was based primarily

upon restrictions in the partnership agreement providing the

partnership with a right to purchase partnership interests for

fixed terms if the interest was assigned outside the family.

b. IRS Position.

The IRS argued that the restrictions contained in the

partnership agreement should be disregarded for valuation

purposes pursuant to § 2703(a)(2). The taxpayer argued that

the § 2703(b) safe harbor exception requirements were

satisfied, and therefore § 2703(a) did not apply.

c. Ruling: Bona Fide Business.


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In considering the § 2703(b) exception, the court first looked

to whether the restrictions in the partnership agreement were

a “bona fide business arrangement”. The IRS argued that the

restrictions were not part of a “bona fide business

arrangement” because all the FLP was doing was holding

securities, and because the taxpayer’s primary purposes in

forming the FLP, to preserve wealth and educate the

taxpayer’s children about wealth preservation, were solely

personal goals. The court found that the principal purpose

of the restrictive provisions was to discourage the taxpayer’s

children from dissipating the family wealth, which the court

did not believe were goals consistent with a “bona fide

business arrangement”. Therefore, the court found that the

restrictions in the FLP did not satisfy the requirements of

§ 2703(b)(1) that they be a “bona fide business

arrangement”.

d. Ruling: Device.

The court also found that the restrictions were a “device” to

transfer property to members of the decedent’s family for

less than full and adequate consideration” due to the fact that

the partnership agreement gave the general partners an

option to buy back limited partnership interests for less than

the interests’ proportionate share of the net asset value in the

partnership if any of the taxpayer’s children tried to transfer

their interests to a person outside the family. The court noted

that if an impermissible transfer did occur and the general

partners then redeemed the transferred interests, the

remaining limited partners, the taxpayer’s other children,

would see their interests increase in value.

e. No Ruling: Comparable Arrangements.

The court did not rule on the third prong of the exception

under § 2703(b)(3) regarding whether the provision was

“comparable to similar arrangements entered into by persons

in an arms’-length transaction” because the court had already

determined that the other two requirements of § 2703(b)

were not met and, therefore, § 2703 was applicable.

However, as mentioned previously, the court did hint that it

believed that the taxpayer had shown all that was needed to

satisfy § 2703(b)(3), which might indicate a potential

relaxation of the rigid evidentiary standard set out in Smith

in regards to § 2703(b)(3).

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f. Subsequent History.

The taxpayers appealed the Tax Court decision to the Eighth

Circuit Court of Appeals.150 The Eighth Circuit supported

the Tax Court’s view on § 2703 based on the lack of a bona

fide business arrangement and, consequently, did not need to

address the question of whether the arrangement was

comparable to similar, arms’-length arrangements.

The Holman decisions were victories for the IRS and they’re also

demonstrative of the Tax Court’s (and Eighth Circuit’s) more recent

willingness to accept § 2703 arguments in the FLP context. As a

result, taxpayers with an FLP, or considering the use of an FLP for

estate planning purposes, must be aware that the IRS may use a

§ 2703 argument to attack the validity of certain provisions within

the partnership agreement that might otherwise impact value.

150 Holman, 130 T.C. 170 (2008), aff’d by, 601 F.3d 763 (8th Cir. 2010).

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VII. SECTION 2704: CERTAIN LAPSING RIGHTS & DISSOLUTION

RESTRICTIONS.

Section 2704 is divided into two subsections: (1) § 2704(a), a “deemed gift

provision”, which generally treats disappearing voting or liquidation rights as

taxable gifts for gift tax purposes, or as a transfer includible in a decedent’s estate

for estate tax purposes; and (2) § 2704(b), a “disregarding provision”, which

generally ignores certain restrictions against liquidation in a stockholder’s

agreement or partnership agreement if such restrictions are more restrictive than

would otherwise be provided under applicable state law.

A. Section 2704(a): Treatment of Lapsed Voting or Liquidation Rights.

Generally, § 2704(a) provides that if there is a lapse of any voting or

liquidation right in a corporation or partnership that is family-controlled

immediately before and after the lapse, then the lapse of such right shall be

treated as a gift, in the event of a lifetime transfer, or as a transfer includible

in a decedent’s gross estate, in the event that the lapse occurs at death.151

1. Background.

a. The Anti-Harrison Rule. Section 2704 is sometimes

referred to as the “Anti-Harrison” Rule.152 The perceived

abuse that Congress was attempting to prevent is illustrated

as follows:

Example. Dad owns the general partnership interest, as well

as some limited partnership interests, in a limited

partnership. The general partnership interest gives dad the

right to withdraw from the partnership and receive back his

entire investment at any time during his life. Under the

partnership agreement, immediately before dad’s death, his

withdrawal right expires. Dad dies, and his estate takes the

position that, for federal estate tax purposes, dad’s interest

should be valued as if the withdrawal right did not exist at

his death (because it lapsed immediately before death) and,

therefore, the partnership interest received by his estate

should be entitled to a valuation discount for estate tax

purposes.

b. Lapse of Liquidation or Voting Right. Section 2704(a)

attempts to prevent this type of arrangement by providing

151 Treas. Reg. § 25.2704-1(a)(1).

152 Harrison v. Comm’r, 52 T.C.M. 1306 (1987).

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that any lapse of a liquidation right or voting right during life

or at death will be subject to gift or estate tax. In the case of

the lapse of such a right during the interest holder’s lifetime,

the lapse will result in a deemed transfer by gift. In the event

of a lapse of such a right at death, the lapse will cause the

value of the deemed transfer to be included in the interest

holder’s estate. Generally, the amount of the deemed gift

transfer or the amount of the deemed transfer included in the

estate will equal the difference between the value of the

interest coupled with the liquidation or voting right and the

value of the interest without such right.

c. Amount of Transfer. The amount of the deemed transfer is

the difference between the value of the interests held in the

entity before the lapse (determined as if such rights were

non-lapsing) and the value of such interests immediately

after the lapse.153

d. Control. Section 2704(a) only applies if the interest holder

and the members of his family control the entity immediately

before and after the lapse. For these purposes “control” has

the same meaning as determined under § 2701, discussed

above.

e. Voting Right. A “Voting Right” is a right to vote with

respect to any matter of the entity. In the case of a

partnership, the right of a general partner to participate in

partnership management is a voting right.154Liquidation

Right. A “Liquidation Right” is a right or ability to compel

the entity to acquire all or a portion of the interest holder’s

equity interest in the entity, including by reason of aggregate

voting power, whether or not its exercise would result in the

complete liquidation of the entity.155

Note. Voting and Liquidation Rights may be conferred by,

and may lapse by reason of, state law, corporate charter,

bylaws, an agreement, or by other means.156

153 Treas. Reg. § 25.2704-1(d).

154 Treas. Reg. § 25.2704-1(a)(2)(iv).

155 Treas. Reg. § 25.2704-1(a)(2)(v).

156 Treas. Reg. § 25.2704-1(a)(4).

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2. Lapse of Voting or Liquidation Rights.

a. Lapse of Voting Right. A lapse of a Voting Right occurs at

the time a presently exercisable Voting Right is restricted or

eliminated.157 Lapse of Liquidation Right. A lapse of a

Liquidation Right occurs at the time a presently exercisable

Liquidation Right is restricted or eliminated.158

Note. A transfer of an interest that results in the lapse of a

Liquidation Right is not subject to § 2704(a) if the rights

with respect to the transferred interest are not restricted or

eliminated.

(1) Example. D owns 84% of the single outstanding

class of stock of corporation Y. The bylaws require

at least 70% of the vote to liquidate Y. D gives one-

half of D’s stock in equal shares to D’s three children

(14% to each). Section 2704(a) does not apply to the

loss of D’s ability to liquidate Y, because the voting

rights with respect to the corporation are not

restricted or eliminated by reason of the transfer.159

(a) The example above illustrates that, although

D no longer has the right to liquidate his

interest in the corporation as a result of the

transfer because he no longer owns the

requisite 70% necessary to liquidate, the

transfer is not a lapse under § 2704(a)

because the voting rights associated with the

stock were not eliminated or restricted, but,

rather, were “transferred” to D’s children.

The shares transferred would have a lower

value than they had in D’s hands, since each

gift consisted of a block of stock (14%) that

could not by itself force a liquidation.

(2) Example. D and D’s two children, A and B, are

partners in Partnership X. Each has a 3.33% general

partnership interest and a 30% limited partnership

interest. Under state law, a general partner has the

right to participate in partnership management. The

157 Treas. Reg. § 25.2704-1(b).

158 Treas. Reg. § 25.2704-1(c).

159 Treas. Reg. § 25.2704-1(f), Ex. 4.

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partnership agreement provides that when a general

partner withdraws or dies, X must redeem the general

partnership interest for its liquidation value. Also,

under the agreement any general partner can

liquidate the partnership. A limited partner cannot

liquidate the partnership and a limited partner’s

capital interest will be returned only when the

partnership is liquidated. A deceased limited

partner’s interest continues as a limited partnership

interest. D dies, leaving his limited partnership

interest to D’s spouse. Because of the general

partner’s right to dissolve the partnership, the limited

partnership interest has a greater fair market value

when held in conjunction with a general partnership

interest than one held alone. Section 2704(a) applies

to the lapse of D’s liquidation right because after the

lapse, members of D’s family could liquidate D’s

limited partnership interest. D’s gross estate

includes an amount equal to the excess of the value

of all D’s interests in X immediately before D’s death

(determined immediately after D’s death but as

though the liquidation right had not lapsed and would

not lapse) over the fair market value of all D’s

interests in X immediately after D’s death.160

b. However, a transfer that results in the elimination of the

Transferor’s right or ability to compel the entity to acquire

an interest retained by the Transferor that is subordinate to

the transferred interest is a lapse of a Liquidation Right with

respect to the retained subordinate interest.161

3. Exceptions to § 2704(a): The following exceptions exist with

respect to §2704(a).

a. Family Cannot Obtain Liquidation Value. Section 2704(a)

does not apply to the lapse of a Liquidation Right if the

members of the interest holder’s family cannot immediately

after the lapse liquidate an interest that the interest holder

held directly or indirectly and could have liquidated prior to

the lapse.162

160 Treas. Reg. § 25.2704-1(f), Ex. 5.

161 Treas. Reg. § 25.2704-1(c)(1).

162 Treas. Reg. § 25.2704-1(c)(2)(i)(A).

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(1) Ability to Liquidate. Whether an interest can be

liquidated after the lapse is determined under state

law generally applicable to the entity, as modified by

the governing instruments of the entity, but without

regard to any restriction described in § 2704(b)

(which relates to restrictions on liquidation being

disregarded).163

b. Section 2701 Rights. Rights valued under § 2701 are not

subject to § 2704(a) to the extent necessary to prevent double

taxation.164

Example. D owns all of the single class of stock of

Corporation Y. D recapitalizes Y, exchanging D’s common

stock for voting common stock and non-voting, non-

cumulative preferred stock. The preferred stock carries a

right to put the stock for its par value at any time during the

next 10 years. D transfers the common stock to D’s

grandchild in a transfer subject to § 2701. In determining

the amount of D’s gift under § 2701, D’s retained put right

is valued at zero. D’s child, C, owns the preferred stock

when the put right lapses. Section 2704(a) applies to the

lapse, without regard to the application of § 2701, because

the put right was not valued under § 2701 in C’s hands.165

c. Certain Changes in State Law. Section 2704(a) does not

apply to the lapse of a Liquidation Right that occurs solely

by reason of a change in state law. However, a change in the

governing instrument of an entity is not a change in state

law.166

4. Section 2704(a) Hypothetical.

Mom owns 60% of the common stock of a corporation, with her two

children owning 20% of the common stock each. All of the shares

are voting and, as such, mom has voting control of the corporation.

The value of the corporation is $10 million. The corporation

restructures so that mom’s 60% voting stock is converted into non-

voting stock and the two children retain all of the voting stock.

Under § 2704(a), mom’s voting right has lapsed because it has been

163 Treas. Reg. § 25.2704-1(c)(2)(i)(B).

164 Treas. Reg. § 25.2704-1(c)(2)(ii).

165 Treas. Reg. § 25.2704-1(f), Ex. 8.

166 Treas. Reg. § 25.2704-1(c)(2)(iii).

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restricted or eliminated and, as such, mom is deemed to have made

a gift. The amount of the gift is the difference between the value of

mom’s stock with voting rights and the value of mom’s stock

without voting rights. Assuming that a valuation discount of 35%

is applied in determining the value of the non-voting stock compared

to voting stock, the deemed gift resulting from the lapse of mom’s

voting right would be $2.1 million, determined as follows:

Value of 60% Voting Stock:

($10 million x 60%) $6.0 million

Value of 60% Non-Voting Stock:

($6 million x [1 - 0.35]) ($3.9 million)

Amount of Gift: $2.1 million

Conversely, if mom were to transfer 20% of her voting stock to her

two children so that she only has 40% voting stock remaining, the

transfer would not constitute a “lapse” of her voting right because

the voting right was merely transferred to her children, rather than

being restricted or eliminated. In such an event, no deemed gift

would have been made under § 2704(a).

5. Estate of Smith.

In Smith, the decedent owned class A shares of a company formed

to operate an NFL team.167 The issue was whether § 2704(a) applied

in valuing the decedent’s shares, which converted to class B shares

with greatly reduced voting rights at the decedent’s death. The court

granted summary judgment in favor of the IRS, which caused the

shares to be valued (by stipulated agreement of the parties) under

§ 2704(a) with their preferential voting rights at $30 million rather

than $22.5 million.

B. Section 2704(b): Certain Liquidation Restrictions Disregarded.

Generally, § 2704(b) causes certain restrictions on dissolution (known as

“Applicable Restrictions”) to be ignored for transfer tax purposes with

respect to family controlled entities. In the absence of this section, such

restrictions would otherwise have the effect of reducing the value of an

167 Estate of Smith v. United States, 103 Fed. Cl. 533 (2012).

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interest in an entity for estate or gift tax purposes by making it less

attractive.

1. Perceived Abuse.

For instance, a typical provision that § 2704(b) would apply to is a

restriction in a partnership agreement, which restricts a partner from

dissolving the partnership, when such a dissolution right is

otherwise given to a partner under state law. Such a provision might

be desirable from a transfer tax standpoint in order to lower the value

of the partnership interest that is sold or gifted to the younger

generation. In such case, however, § 2704(b) would ignore such

restrictions for valuation purposes and treat the partnership interest

as containing the dissolution right otherwise provided under state

law when determining the value of this interest for estate or gift tax

purposes; thereby making the partnership interest worth more than

it would be if the restriction against dissolution is taken into

consideration.

2. General Overview.

Section 2704(b) generally provides that, if there is a transfer of an

interest in a corporation or partnership to a family member and

immediately before the transfer the family holds control of the

entity, then any “Applicable Restriction” shall be disregarded in

determining the value of the transferred interest.

a. Applicable Restriction. For the purpose of § 2704(b), the

term “Applicable Restriction” means any restriction which

effectively limits the ability of a corporation or partnership

to liquidate, and with respect to which 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,

alone or collectively, has the right after the transfer to

remove in whole or in part the restriction.168

What this provision is saying is that, if A transfers to her children

limited partnership interests which under the partnership agreement

are subject to restrictions to liquidate the partnership, and if those

restrictions will lapse at some point after the transfer, or if the family

members could simply remove those restrictions after the transfer,

§ 2704(b) will ignore the restrictions for the purpose of determining

the value of the transferred interest. The rationale for this provision

168 Treas. Reg. § 25.2704-2(b).

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is that such restrictions are essentially illusory because they will

either disappear eventually or they can simply be removed by family

members immediately after the transfer. Thus, for transfer tax

valuation purposes, the restrictions should be ignored and no

valuation discount should be permitted as a result of such

restrictions.

3. Withdrawal Rights.

There has been some debate as to whether a restriction against a

withdrawal right should be subject to § 2704(b) (in contrast to an

actual right to dissolve an entity). The Tax Court has determined that

a withdrawal right is not subject to § 2704(b) since, by its terms,

§ 2704(b) pertains to restrictions against dissolution, which are

distinguishable from a restriction against withdrawal.169

C. Section 2704 Applied to FLPs.

1. Kerr.

In Kerr,170 the taxpayer formed a Texas limited partnership. The

partnership agreement contained a restriction preventing limited

partners from withdrawing from the partnership. Texas law,

however, granted a limited partner the right to withdraw from the

partnership at any time, upon giving six months’ notice to the

partnership. The Tax Court analyzed whether the restriction on the

right of withdrawal was an “applicable restriction” that would be

disregarded under § 2704(b) as a restriction that was more restrictive

than the default provisions of state law. The Tax Court concluded

that such a restriction was not an applicable restriction and thus

would not be disregarded under § 2704(b). The Tax Court held that

the provision was a “withdrawal right,” which merely provided the

partner the right to withdraw from the partnership, in contrast to a

“dissolution right,” which is the ability to dissolve the company in

its entirety, and to which § 2704(b) is intended to apply.

On appeal, the Fifth Circuit did not reach the issue of whether the

Tax Court was correct in its conclusion that a restriction on a

partnership withdrawal does not constitute a “restriction on

liquidation” under § 2704(b). Rather, the Fifth Circuit upheld the

decision for the taxpayer because a non-family member held a

169 Kerr v. Comm’r, 113 T.C. 449 (1999), aff’d by, 292 F.3d 490, 491 (5th Cir. 2002); Estate of Harper v.

Commissioner, T.C. Memo 2000-202 (2000).

170 Kerr v. Comm’r, 113 T.C. 449 (1999), aff’d by, 292 F.3d 490, 491 (5th Cir. 2002).

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partnership interest and, therefore, the restriction on withdrawal

could not be an “applicable restriction” under § 2704(b)(2)(ii)

because the family did not alone have the ability to remove the

restriction.

a. Observation. Broadly speaking, §§ 2704(b) and 2701 attack

different sides of a transaction. Section 2704(b) attempts to

prevent the value of transferred interests from being

artificially reduced, so as to have a lower taxable gift.

Section 2701 attempts to prevent the value of retained senior

interests from being artificially increased, so as to result in a

lower taxable gift of the transferred junior interests.

2. Effect of Disregarding an Applicable Restriction.

If an Applicable Restriction is disregarded under § 2704(b), the

transferred interest is valued as if the restriction does not exist and

as if the rights of the Transferor are determined under the state law

that would apply but for the restriction. Thus, if a restriction on

liquidation in a partnership agreement is disregarded under

§ 2704(b) and state law provides that a partner may liquidate at any

time, the transferred partnership interest will be valued based upon

the existence of a liquidation right under state law.171

a. Example. D owns a 76% interest and each of D’s children,

A and B, each own a 12% interest in general partnership X.

The partnership agreement requires the consent of all the

partners to liquidate the partnership. Under the state law that

would apply in the absence of the restriction in the

partnership agreement, the consent of partners owning 70%

of the total partnership interest would be required to

liquidate X. On D’s death, D’s partnership interest passes to

D’s child, C. The requirement that all the partners consent

to liquidation is an applicable restriction. Because A, B and

C (all members of D’s family), acting together after the

transfer, can remove the restriction on liquidation, D’s

interest is valued without regard to the restriction (i.e., as

though D’s interest is sufficient to liquidate the partnership),

which would likely eliminate or substantially reduce any

estate tax valuation discounts in D’s estate for his

partnership interest.

171 Treas. Reg. § 25.2704-2(c).

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b. Example. D owns all of the preferred stock of Corporation

X. The preferred stock carries a right to liquidate X that

cannot be exercised until 1999. D’s children, A and B, own

all of the common stock of X. The common stock is the only

voting stock. In 1994, D transfers the preferred stock to A.

The restriction on D’s right to liquidate is an applicable

restriction and is disregarded. Therefore, the preferred stock

is valued as though the right to liquidate were presently

exercisable.172

c. Example. D owns 60% of the stock of Corporation X. The

corporate bylaws provide that X cannot be liquidated for 10

years, after which time a liquidation requires the approval of

60% of the voting interests. In the absence of the provision

in the bylaws, State law would require approval by 80% of

the voting interests to liquidate X. D transfers the stock to a

trust for the benefit of D’s child, A, during the 10-year

period. The 10-year restriction is an applicable restriction

and is disregarded. Therefore, the value of the stock is

determined as if the transferred block could currently

liquidate X. 173

D. Possible Expansion of § 2704(b).

The Obama Administration has targeted valuation discounts by proposing

to: (1) eliminate discounts for valuation of entities other than those

conducting active trades or businesses; or (2) eliminate discounts through

the implementation of aggregation rules.

1. FLP and LLC Valuation Discounts.

Section 2704(b) and its accompanying Regulations may impact

valuation discounts for FLPs and LLCs as well. § 2704(b) provides

that certain restrictions on liquidation are to be ignored when 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 the Transferor’s family control the entity

immediately before the transfer. Under § 2704(b)(4):

The Secretary may by the regulations provide that other

restrictions shall be disregarded in determining the value of

the transfer of any interest in a corporation or partnership to

172 Treas. Reg. § 25.2704-2(d), Ex. 2.

173 Treas. Reg. § 25.2704-2(d), Ex. 3.

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a member of the Transferor’s family if such restriction has

the effect of reducing the value of the transferred interest for

purposes of this subtitle but does not ultimately reduce the

value of such interest to the transferee.

Thus, § 2704(b)(4) appears to give the IRS broad authority to issue

new regulations that list additional restrictions that should be

ignored when determining the value of an interest in a closely-held

business.

2. Proposed Expansion.

Proposals for the expansion of § 2704(b) appeared in the Obama

Administration’s Greenbook for each of fiscal years 2010-2013.

While Congress has not adopted the statutory expansion of

§ 2704(b) contained in the Greenbook proposals, the IRS has

indicated informally that it intends to issue proposed regulations

under § 2704(b)(4) that are similar to those in the President’s

Greenbooks.

The Greenbook proposals expand the current scope of § 2704(b) by:

(i) creating an additional category of restrictions (known as

“Disregarded Restrictions”) that would be ignored in valuing

interests in a transferred entity; and (ii) replacing the provisions of

state law with enumerated default assumptions that would be used

in valuing such interests.

3. Disregarded Restrictions.

The Greenbook proposals would create an additional category of

Disregarded Restrictions that would be ignored in valuing

transferred interests in family-controlled entities if, after the

transfer, the restrictions would lapse or could be removed by the

Transferor or members of the Transferor’s family. The new

category of Disregarded Restrictions would include (i) limitations

on a holder’s right to liquidate that holder’s interest that are more

restrictive than those standards identified in the regulations, and (ii)

limitations on a transferee’s ability to be admitted as a full partner

(in the case of a partnership) or to hold an equity interest in the

entity.

4. Default Assumptions.

In valuing a transferred interest in a family-controlled entity, the

Greenbook proposals would ignore Disregarded Restrictions and,

instead, value the interest as though the partnership agreement or

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other governing documents of the entity contained certain default

provisions found in regulations. This approach stands in stark

contrast to the existing rules under § 2704(b), which replace

Applicable Restrictions with the provisions of state law that would

govern the entity in the absence of such restrictions. For purposes

of determining whether a Disregarded Restriction may be removed

by a member of the Transferor’s family after the transfer, the

Greenbook proposals would also treat interests held by charities and

others who are not family members of the Transferor as held by the

Transferor’s family.

5. Safe Harbors.

Lastly, the Greenbook proposals envision regulatory safe harbors

which will provide concrete standards for allowable restrictions,

thereby permitting taxpayers to draft the governing documents of a

family-controlled entity so as to avoid the application of § 2704(b).

6. Other Predictions – Operating Business Exception

Some commentators have suggested that the proposed regulations

may include a carve-out for active or “genuine” family-owned

businesses.174 Citing the particular difficulties attendant to valuing

active businesses and the relative policy preference favoring family-

owned operating businesses, these commentators believe the

proposed regulations will exempt such businesses from the

sometimes mechanical application of § 2704(b).

7. Other Predictions – Marital and Charitable Deduction Mismatch

The Greenbook proposals promise, without offing additional detail,

to make “conforming clarifications” with regard to the interaction

of § 2704(b) with the transfer tax marital and charitable deductions.

In his ACTEC Capital Letter, Ronald Aucutt suggests that these

clarifications may mitigate the harsh results seen in IRS Technical

Advice Memoranda 9050004 and 9403005 and ensure, for example,

that a large estate consisting of an interest in a family-controlled

entity left in equal shares to three charities would be entitled to a

charitable deduction equal to the entire gross estate.175

174 Ronald D. Aucutt, ACTEC Capital Letter No. 38: Anticipated Valuation Discount Regulations (Jul. 20,

2015).

175 Id.

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8. Questions Regarding Validity.

In a thoughtful and thorough analysis of the Greenbook proposals,

Richard Dees argues that, absent Congressional action, regulations

based on the Greenbook proposal would be invalid.176 In support of

this conclusion, Dees argues that: (i) the legislative history and

existing case law under Chapter 14, generally, and § 2704(b),

specifically, are intended to protect traditional valuation discounts

and to prohibit family attribution in valuing business interests; and

(ii) Treasury’s authority under § 2704(b)(4) does not extend to the

creation of new categories of disregarded restrictions, the imposition

of regulatory defaults, or the inclusion of charities and other

organizations as members of a family for purposes of § 2704(b).

Apparently in response to these criticisms and concerns expressed by other

commentators, and as of the time of the writing of this Outline, the IRS has delayed

the issuance of proposed regulations. IRS personnel have recently backed away

from earlier comments regarding the content of the proposed regulations, indicating

that the proposed regulations, which the Service now hopes to issue by the end of

2015, might not reflect the contents of the Greenbook proposals and, instead, may

conform more closely to the existing statute.177

176 See Richard L. Dees, Possible New Regulations under Internal Revenue Code Section 2704(b), TAX

NOTES (August 31, 2015).

177 The author would like to thank Eric Fischer, an Associate at Withers Bergman, LLP, Peter Slater, Esq.,

Senior Vice President and Associate Fiduciary Counsel at Bessemer Trust Company N.A., Stephen Putnoki-

Higgins, Esq., an Associate at Shutts & Bowen LLP, and Scott A. Bowman, Esq., a Partner at Proskauer

Rose, LLP, for their thoughtful review of and comments to this outline. The author would also like to thank

Robin Cassidy, Lisa Gardner and Michele Dewar of Withers Bergman LLP for their hard work and patience

revising many versions of this outline.

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