SERVICE ISSUES FINAL SPECIAL GIFT TAX VALUATION RULES ON TRANSFERS OF INTERESTS IN CORPORATIONS AND PARTNERSHIPS.

The Service has released final regulations (T.D. 8395) under sections 2701 through 2704, providing special valuation rules relating to estate and gift taxation. The Service did not issue final rules on adjustments to mitigate double taxation; proposed rules in that area were issued simultaneously with the final regulations. The final regulations issued are effective January 28, 1992.

Responding to criticisms that the regulations were too vague in defining "transfer," the Service clarifies in the regulations the situations in which a "capital structure transaction" will be treated as a transfer subject to section 2701. In general, the Service said, "if an individual receives an applicable retained interest in connection with a redemption, recapitalization, or other change in the capital structure of an entity, the transaction is subject to section 2701 if other conditions of that section are met." The regulations also describe situations in which the surrender of an equity interest to a corporation or partnership by an individual holding an applicable retained interest may be treated as subject to section 2701.

In addition, the regulations provide that the termination of an interest held indirectly through a trust will be subject to section 2701 if "(1) the indirectly-held property would have been includable in the gross estate of the individual if the individual had died at the time of the termination, or (2) the indirectly-held property is in a trust as to which the individual is considered the owner under the grantor trust rules."

According to the Service, the final regulations modify the proportionate transfer exception to provide that "the exception is available to the extent the transfer results in the required proportionate reduction in the holdings of the transferor and applicable family members." The exception, the Service emphasized, applies only with respect to a transfer by a single individual.

The Service made a handful of modifications with respect to the valuation of applicable retained interests. According to the Service, the final regulations clarify that for section 2701 purposes, "a payment that is contingent as to time or amount is not a guaranteed payment of a fixed amount." On the other hand, the Service said, a right to receive a specific amount payable at death should qualify as a mandatory payment right.

The Service defended itself against complaints regarding the proposed subtraction method of valuation. The Service rejected the suggestion that section 2701 works within the general gift tax valuation framework of section 2512, insisting that section 2701 and chapter 14 stand independently. Nevertheless, the Service modified the three-step valuation method outlined in regulation section 25.2701-3 by simplifying the first step and adding a fourth.

The Service made a number of changes in the section 2702 regulations, governing transfers of interests in trusts. According to the Service, the rules now provide that section 2702 does not apply to the transfer of an interest in trust "if the only interest in the trust, other than the remainder interest or a qualified annuity or unitrust, is an interest qualifying for a charitable deduction under section 2522."

The section 2702 rules also clarify, the Service said, that "a cumulative power of withdrawal does not meet the requirements of a qualified interest." The Service also explained that the final regulations provide a measure of flexibility regarding increases in the annuity and unitrust amounts to be permitted throughout the term.

The Service said it adopted the suggestion of commentators that an individual be permitted to hold term interests in more than two personal residence trusts. It made no change, however, in the definition of "personal residence." Among the other changes made in the qualified personal residence trust rules was a clarification that such a trust must distribute any income to the term holder at least once a year, and a rule providing that on termination of the term interest, any cash in the trust may be used to pay unpaid expenses and termination expenses.

Finally, the Service indicated that it made one substantive change in the section 2704 rules relating to the treatment of lapsing rights and restrictions. A commentator, the Service said, objected to the application of section 2704 to a transfer of a voting interest that results in the termination of a liquidation right with respect to an interest other than the transferred interest. The Service said the final regulations have been modified to apply the rule to situations in which the transferred interest is senior to the interest as to which the liquidation right terminates.

Full Text Citations: AccServ & Microfiche: Doc 92-923 (131 pages); Electronic: 92 TNT 21-24 ; Print: H&D, Jan. 31, 1992, p. 1428