Final Regs on Adjustments Under Special Valuation Rules

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations providing for an adjustment in computing the Federal estate or gift tax imposed on the transfer of interests to which the special valuation rules of section 2701 of the Internal Revenue Code previously applied. This document also contains a technical amendment to the final regulations under section 2702 pertaining to short taxable years of trusts. Changes to the applicable law were made by the Omnibus Budget Reconciliation Act of 1990 (the 1990 Act). The final regulations provide needed guidance for taxpayers to comply with the 1990 Act.

 EFFECTIVE DATE: May 4, 1994.

FOR FURTHER INFORMATION CONTACT: Fred E. Grundeman, (202) 622-3090 (not a toll-free telephone number).

 SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection-of-information requirements contained in the final regulations under sections 2701(e)(6) and 2702 have been reviewed and approved by the Office of Management and Budget in accordance with the requirements of the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1273. The estimated average annual burden per recordkeeper attributable to these final regulations is two minutes. The estimated average annual burden per respondent attributable to these final regulations is ten minutes.

 These estimates approximate the average time expected to be necessary for the collection of information. They are based upon the information available to the IRS and do not include an estimate of annual burden per recordkeeper applicable to Forms 706 and 709. Individual respondents and recordkeepers may require more or less time depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, D.C. 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503.

BACKGROUND

PROPOSED REGULATIONS

 Proposed section 25.2701-5 (relating to adjustments to mitigate double taxation) was published in the Federal Register on February 4, 1992. This document adopts final regulations under section 25.2701-5.

MITIGATION OF EFFECTS OF DOUBLE TAXATION

 Section 2701 of the Internal Revenue Code (Code) provides special valuation rules to determine the amount of the gift when an individual transfers an equity interest in a corporation or partnership to a member of the individual's family. For section 2701 to apply, the transferor or an applicable family member must, immediately after the transfer, hold an equity interest having liquidation rights or distribution rights that are preferential to the rights of the transferred interest (an applicable retained interest).

 If section 2701 applies to a transfer, the amount of the transferor's gift is determined using a subtraction method of valuation. Generally, in determining the value of any applicable retained interest held by the transferor or an applicable family member, liquidation rights and certain distribution rights in a controlled entity are valued at zero.

 Section 2701(e)(6) provides that if there is a subsequent transfer or inclusion in the gross estate of any applicable retained interest that was valued under the rules of section 2701, appropriate adjustments are to be made, pursuant to regulations, to reflect the increase in the amount of any prior taxable gift made by the transferor or decedent by reason of such valuation.

 The proposed regulations mitigate the effect of double taxation through a reduction to a decedent's adjusted taxable gifts. In general, the amount of the reduction is the lesser of: (1) the amount by which the transferor's taxable gifts were increased as a result of the application of section 2701 to the initial transfer, or (2) the amount by which the individual's taxable transfers were increased as a result of not applying the valuation rules of section 2701 upon the subsequent transfer of the applicable retained interest.

 Under certain circumstances, the proposed regulations provide that the transferor's spouse is treated as the transferor for purposes of making the adjustment. However, because a transferor will often acquire (by gift, inheritance, or purchase) an applicable retained interest initially held by an applicable family member and because of the administrative complexity inherent in allowing assignability of the adjustment between the transferor and any other applicable family member, the proposed regulations do not provide for an adjustment by any individual other than the transferor or the transferor's spouse.

POTENTIAL FOR LOSS OF BENEFIT

 One commentator argued that some taxpayers will be deprived of the benefit of the adjustment if it is not: (1) available for lifetime transfers, and (2) freely assignable to all applicable family members. In response to this comment, the final regulations adopt a rule generally allowing the adjustment in the computation of the transferor's gift tax if either the transferor or an applicable family member transfers an applicable retained interest to or for the benefit of an individual other than the transferor or an applicable family member.

 In addition, if the applicable retained interest has not been so transferred prior to the death of the transferor, the executor of the transferor's estate is entitled to make the adjustment in computing the transferor's estate tax provided that the executor can demonstrate the fair market value of the applicable retained interest as of the date of death of the transferor.

 However, after carefully considering the merits of a freely assignable adjustment, the IRS and the Treasury have determined that in light of the relief otherwise provided, the administrative complexity involved in tracking the adjustment would far outweigh the additional benefit that would be gained therefrom.

"PURGE" METHOD

 One commentator argued that double taxation is avoided only if the adjustment produces no greater tax than would be produced if the initial transfer had not been made (and the value of the entity did not change prior to the transferor's death). In the view of this commentator, section 2701 requires prepayment of transfer tax as the "cost" of a corporate or partnership freeze. Under this view, the section 2701(e)(6) adjustment would be accomplished through a mechanism whereby the transferor's transfer tax base is "purged" of the effect of section 2701.

 The final regulations continue the approach of the proposed regulations in that they provide the same relief as that advocated above except in those cases where the retained interest declines in value between the date of the initial transfer and the date of the subsequent transfer. Because a reduction in the value of the entity may occur as the result of indirect (hard to detect) transfers to younger generations, the IRS and the Treasury believe that adoption of the purge method is inconsistent with the purpose of section 2701 and would perpetuate the abuses Congress sought to eliminate.

SPLIT GIFTS

 The proposed regulations provide that the effects of section 2513 (pertaining to gift splitting between spouses) are to be ignored in making the adjustment under section 2701(e)(6). One commentator argued that part of the adjustment could be lost depending upon which spouse died first. In response to this comment, the final regulations provide adjustments for split gifts that are generally consistent with the principles of section 2001(d) and (e) (pertaining to the treatment of split gifts in the computation of the estate tax).

TRANSFERS TO SPOUSE

 Under the proposed regulations, the transfer of an applicable retained interest to the transferor's spouse results in the automatic assignment of the adjustment to the spouse. One commentator argued that this automatic assignment will result in loss of the adjustment if the spouse has not made sufficient prior gifts. Under the final regulations, the adjustment is not assigned to the spouse but, instead, is generally available to the transferor or the executor of the transferor's estate.

EFFECT ON PRIOR SECTION 2701 TRANSFERS

 The final regulations are effective with respect to section 2701 interests transferred after May 4, 1994. For section 2701 transfers occurring on or before May 4, 1994, taxpayers may rely on the final regulations, the previously proposed regulations or any other reasonable interpretation of the statute.

FINAL REGULATIONS UNDER SECTION 2702

 The final regulations contain a technical amendment to the regulations under section 2702 pertaining to the governing instrument requirements for qualified interests under section 2702. The amendment, pertaining to the treatment of short taxable years, simplifies the valuation of an annuity or unitrust interest by eliminating the need to pro-rate the first year's payment in the case of a short taxable year.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedures Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Fred E. Grundeman, Office of Chief Counsel, IRS. Other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR Part 25

 Gift taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

 Reporting and recordkeeping requirements

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 25 and 602 are amended as follows:

PART 25 -- GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954

Paragraph 1. The authority citation for part 25 is amended by adding an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 25.2701-5 also issued under 26 U.S.C. 2701(e)(6). * * *

Par. 2. In section 25.2701-0, table of contents entries are added under section 25.2701-5 to read as follows:

 SECTION 25.2701-0  TABLE OF CONTENTS.

Par. 3. In section 25.2701-1, paragraph (a)(1) is amended by adding a sentence at the end to read as follows:

SECTION 25.2701-1 SPECIAL VALUATION RULES IN THE CASE OF TRANSFERS OF CERTAIN INTERESTS IN CORPORATIONS AND PARTNERSHIPS.

(a) * * * (1) * * * Section 25.2701-5 provides an adjustment to mitigate the effects of double taxation when an applicable retained interest is subsequently transferred.

* * * * *

Par. 4. Text is added to section 25.2701-5 to read as follows:

SECTION 25.2701-5 ADJUSTMENTS TO MITIGATE DOUBLE TAXATION.

(a) REDUCTION OF TRANSFER TAX BASE -- (1) IN GENERAL. This section provides rules under which an individual (the initial transferor) making a transfer subject to section 2701 (the initial transfer) is entitled to reduce his or her taxable gifts or adjusted taxable gifts (the reduction). The amount of the reduction is determined under paragraph (b) of this section. See paragraph (e) of this section if section 2513 (split gifts) applied to the initial transfer.

(2) FEDERAL GIFT TAX MODIFICATION. If, during the lifetime of the initial transferor, the holder of a section 2701 interest (as defined in paragraph (a)(4) of this section) transfers the interest to or for the benefit of an individual other than the initial transferor or an applicable family member of the initial transferor in a transfer subject to Federal estate or gift tax, the initial transferor may reduce the amount on which the initial transferor's tentative tax is computed under section 2502(a). The reduction is first applied on any gift tax return required to be filed for the calendar year in which the section 2701 interest is transferred; any excess reduction is carried forward and applied in each succeeding calendar year until the reduction is exhausted. The amount of the reduction that is used in a calendar year is the amount of the initial transferor's taxable gifts for that year. Any excess reduction remaining at the death of the initial transferor may be applied by the executor of the initial transferor's estate as provided under paragraph (a)(3) of this section. See paragraph (a)(4) of this section for the definition of a section 2701 interest. See section 25.2701-6 for rules relating to indirect ownership of equity interests transferred to trusts and other entities.

(3) FEDERAL ESTATE TAX MODIFICATION. Except as otherwise provided in this paragraph (a)(3), in determining the Federal estate tax with respect to an initial transferor, the executor of the initial transferor's estate may reduce the amount on which the decedent's tentative tax is computed under section 2001(b) (or section 2101(b)) by the amount of the reduction (including any excess reduction carried forward under paragraph (a)(2) of this section). The amount of the reduction under this paragraph (a)(3) is limited to the amount that results in zero Federal estate tax with respect to the estate of the initial transferor.

(4) SECTION 2701 INTEREST. A section 2701 interest is an applicable retained interest that was valued using the special valuation rules of section 2701 at the time of the initial transfer. However, an interest is a section 2701 interest only to the extent the transfer of that interest effectively reduces the aggregate ownership of such class of interest by the initial transferor and applicable family members of the initial transferor below that held by such persons at the time of the initial transfer (or the remaining portion thereof).

(b) AMOUNT OF REDUCTION. Except as otherwise provided in paragraphs (c)(3)(iv) (pertaining to transfers of partial interests) and (e) (pertaining to initial split gifts) of this section, the amount of the reduction is the lesser of --

(1) The amount by which the initial transferor's taxable gifts were increased as a result of the application of section 2701 to the initial transfer; or

(2) The amount (determined under paragraph (c) of this section) duplicated in the transfer tax base at the time of the transfer of the section 2701 interest (the duplicated amount).

(c) DUPLICATED AMOUNT -- (1) IN GENERAL. The duplicated amount is the amount by which the transfer tax value of the section 2701 interest at the time of the subsequent transfer exceeds the value of that interest determined under section 2701 at the time of the initial transfer. If, at the time of the initial transfer, the amount allocated to the transferred interest under section 25.2701-3(b)(3) (Step 3 of the valuation methodology) is less than the entire amount available for allocation at that time, the duplicated amount is a fraction of the amount described in the preceding sentence. The numerator of the fraction is the amount allocated to the transferred interest at the time of the initial transfer (pursuant to

SECTION 25.2701-3(b)(3)) AND THE DENOMINATOR OF THE FRACTION IS THE AMOUNT AVAILABLE FOR ALLOCATION AT THE TIME OF THE INITIAL TRANSFER (DETERMINED AFTER APPLICATION OF SECTION 25.2701-3(b)(2)).

(2) TRANSFER TAX VALUE -- IN GENERAL. Except as provided in paragraph (c)(3) of this section, for purposes of paragraph (c)(1) of this section the transfer tax value of a section 2701 interest is the value of that interest as finally determined for Federal transfer tax purposes under chapter 11 or chapter 12, as the case may be (including the right to receive any distributions thereon (other than qualified payments)), reduced by the amount of any deduction allowed with respect to the section 2701 interest to the extent that the deduction would not have been allowed if the section 2701 interest were not included in the transferor's total amount of gifts for the calendar year or the transferor's gross estate, as the case may be. Rules similar to the rules of section 691(c)(2)(C) are applicable to determine the extent that a deduction would not be allowed if the section 2701 interest were not so included.

(3) SPECIAL TRANSFER TAX VALUE RULES -- (i) TRANSFERS FOR CONSIDERATION. Except as provided in paragraph (c)(3)(iii) of this section, if, during the life of the initial transferor, a section 2701 interest is transferred to or for the benefit of an individual other than the initial transferor or an applicable family member of the initial transferor for consideration in money or money's worth, or in a transfer that is treated as a transfer for consideration in money or money's worth, the transfer of the section 2701 interest is deemed to occur at the death of the initial transferor. In this case, the estate of the initial transferor is entitled to a reduction in the same manner as if the initial transferor's gross estate included a section 2701 interest having a chapter 11 value equal to the amount of consideration in money or money's worth received in the exchange (determined as of the time of the exchange).

(ii) INTERESTS HELD BY APPLICABLE FAMILY MEMBERS AT DATE OF INITIAL TRANSFEROR'S DEATH. If a section 2701 interest in existence on the date of the initial transferor's death is held by an applicable family member and, therefore, is not included in the gross estate of the initial transferor, the section 2701 interest is deemed to be transferred at the death of the initial transferor to or for the benefit of an individual other than the initial transferor or an applicable family member of the initial transferor. In this case, the transfer tax value of that interest is the value that the executor of the initial transferor's estate can demonstrate would be determined under chapter 12 if the interest were transferred immediately prior to the death of the initial transferor.

(iii) NONRECOGNITION TRANSACTIONS. If an individual exchanges a section 2701 interest in a nonrecognition transaction (within the meaning of section 7701(a)(45)), the exchange is not treated as a transfer of a section 2701 interest and the transfer tax value of that interest is determined as if the interest received in exchange is the section 2701 interest.

(iv) TRANSFER OF LESS THAN THE ENTIRE SECTION 2701 INTEREST. If a transfer is a transfer of less than the entire section 2701 interest, the amount of the reduction under paragraph (a)(2) or (a)(3) of this section is reduced proportionately.

(v) MULTIPLE CLASSES OF SECTION 2701 INTEREST. For purposes of paragraph (b) of this section, if more than one class of section 2701 interest exists, the amount of the reduction is determined separately with respect to each such class.

(vi) MULTIPLE INITIAL TRANSFERS. If an initial transferor has made more than one initial transfer, the amount of the reduction with respect to any section 2701 interest is the sum of the reductions computed under paragraph (b) of this section with respect to each such initial transfer.

(d) EXAMPLES. The following examples illustrate the provisions of paragraphs (a) through (c) of this section.

FACTS. (1) IN GENERAL. (i) P, an individual, holds 1,500 shares of $1,000 par value preferred stock of X corporation (bearing an annual noncumulative dividend of $100 per share that may be put to X at any time for par value) and 1,000 shares of voting common stock of X. There is no other outstanding common stock of X.

(ii) On January 15, 1991, when the aggregate fair market value of the preferred stock is $1,500,000 and the aggregate fair market value of the common stock is $500,000, P transfers common stock to P's child. The fair market value of P's interest in X (common and preferred) immediately prior to the transfer is $2,000,000, and the section 2701 value of the preferred stock (the section 2701 interest) is zero. Neither P nor P's spouse, S, made gifts prior to 1991.

(2) ADDITIONAL FACTS APPLICABLE TO EXAMPLES 1 THROUGH 3. P's transfer consists of all 1,000 shares of P's common stock. With respect to the initial transfer, the amount remaining after Step 2 of the subtraction method of section 25.2701-3 is $2,000,000 ($2,000,000 minus zero), all of which is allocated to the transferred stock. P's aggregate taxable gifts for 1991 (including the section 2701 transfer) equal $2,500,000.

(3) ADDITIONAL FACTS APPLICABLE TO EXAMPLES 4 AND 5. P's initial transfer consists of one-half of P's common stock. With respect to the initial transfer in this case, only $1,000,000 (one-half of the amount remaining after Step 2 of the subtraction method of section 25.2701-3) is allocated to the transferred stock. P's aggregate taxable gifts for 1991 (the section 2701 transfer and P's other transfers) equal $2,500,000.

EXAMPLE 1. INTER VIVOS TRANSFER OF ENTIRE SECTION 2701 INTEREST. (i) On October 1, 1994, at a time when the value of P's preferred stock is $1,400,000, P transfers all of the preferred stock to P's child. In computing P's 1994 gift tax, P, as the initial transferor, is entitled to reduce the amount on which P's tentative tax is computed under section 2502(a) by $1,400,000.

(ii) The amount of the reduction computed under paragraph (b) of this section is the lesser of $1,500,000 (the amount by which the initial transferor's taxable gifts were increased as a result of the application of section 2701 to the initial transfer) or $1,400,000 (the duplicated amount). The duplicated amount is 100 percent (the portion of the section 2701 interest subsequently transferred) times $1,400,000 (the amount by which the gift tax value of the preferred stock ($1,400,000 at the time of the subsequent transfer) exceeds zero (the section 2701 value of the preferred stock at the time of the initial transfer)).

(iii) The result would be the same if the preferred stock had been held by P's parent, GM, and GM had, on October 1, 1994, transferred the preferred stock to or for the benefit of an individual other than P or an applicable family member of P. In that case, in computing the tax on P's 1994 and subsequent transfers, P would be entitled to reduce the amount on which P's tentative tax is computed under section 2502(a) by $1,400,000. If the value of P's 1994 gifts is less than $1,400,000, P is entitled to claim the excess adjustment in computing the tax with respect to P's subsequent transfers.

EXAMPLE 2. TRANSFER OF SECTION 2701 INTEREST AT DEATH OF INITIAL TRANSFEROR. (i) P continues to hold the preferred stock until P's death. The chapter 11 value of the preferred stock at the date of P's death is the same as the fair market value of the preferred stock at the time of the initial transfer. In computing the Federal estate tax with respect to P's estate, P's executor is entitled to a reduction of $1,500,000 under paragraph (a)(3) of this section.

(ii) The result would be the same if P had sold the preferred stock to any individual other than an applicable family member at a time when the value of the preferred stock was $1,500,000. In that case, the amount of the reduction is computed as if the preferred stock were included in P's gross estate at a fair market value equal to the sales price. If the value of P's taxable estate is less than $1,500,000, the amount of the adjustment available to P's executor is limited to the actual value of P's taxable estate.

(iii) The result would also be the same if the preferred stock had been held by P's parent, GM, and at the time of P's death, GM had not transferred the preferred stock.

EXAMPLE 3. TRANSFER OF AFTER-ACQUIRED PREFERRED STOCK. On September 1, 1992, P purchases 100 shares of X preferred stock from an unrelated party. On October 1, 1994, P transfers 100 shares of X preferred stock to P's child. In computing P's 1994 gift tax, P is not entitled to reduce the amount on which P's tentative tax is computed under section 2502(a) because the 1994 transfer does not reduce P's preferred stock holding below that held at the time of the initial transfer. See paragraph (a)(4) of this section.

EXAMPLE 4. INTER VIVOS TRANSFER OF ENTIRE SECTION 2701 INTEREST. (i) On October 1, 1994, at a time when the value of P's preferred stock is $1,400,000, P transfers all of the preferred stock to P's child. In computing P's 1994 gift tax, P, as the initial transferor, is entitled to reduce the amount on which P's tentative tax is computed under section 2502(a) by $700,000.

(ii) The amount of the reduction computed under paragraph (b) of this section is the lesser of $750,000 (($1,500,000 X .5 ($1,000,000 over $2,000,000)) the amount by which the initial transferor's taxable gifts were increased as a result of the application of section 2701 to the initial transfer) or $700,000 (($1,400,000 X .5) the duplicated amount). The duplicated amount is 100 percent (the portion of the section 2701 interest subsequently transferred) times $700,000; e.g., one-half (the fraction representing the portion of the common stock transferred in the initial transfer ($1,000,000/$2,000,000)) of the amount by which the gift tax value of the preferred stock at the time of the subsequent transfer ($1,400,000) exceeds zero (the section 2701 value of the preferred stock at the time of the initial transfer).

EXAMPLE 5. SUBSEQUENT TRANSFER OF LESS THAN THE ENTIRE SECTION 2701 INTEREST. On October 1, 1994, at a time when the value of P's preferred stock is $1,400,000, P transfers only 250 of P's 1,000 shares of preferred stock to P's child. In this case, the amount of the reduction computed under paragraph (b) is $175,000 (one-fourth (250/1,000) of the amount of the reduction available if P had transferred all 1,000 shares of preferred stock.

(e) COMPUTATION OF REDUCTION IF INITIAL TRANSFER IS SPLIT UNDER SECTION 2513 -- (1) IN GENERAL. If section 2513 applies to the initial transfer (a split initial transfer), the special rules of this paragraph (e) apply.

(2) TRANSFERS DURING JOINT LIVES. If there is a split initial transfer and the corresponding section 2701 interest is transferred during the joint lives of the donor and the consenting spouse, for purposes of determining the reduction under paragraph (a)(2) of this section each spouse is treated as if the spouse was the initial transferor of one-half of the split initial transfer.

(3) TRANSFERS AT OR AFTER DEATH OF EITHER SPOUSE -- (i) IN GENERAL. If there is a split initial transfer and the corresponding section 2701 interest is transferred at or after the death of the first spouse to die, the reduction under paragraph (a)(2) or (a)(3) of this section is determined as if the donor spouse was the initial transferor of the entire initial transfer.

(ii) DEATH OF DONOR SPOUSE. Except as provided in paragraph (e)(3)(iv) of this section, the executor of the estate of the donor spouse in a split initial transfer is entitled to compute the reduction as if the donor spouse was the initial transferor of the section 2701 interest otherwise attributable to the consenting spouse. In this case, if the consenting spouse survives the donor spouse --

(A) The consenting spouse's aggregate sum of taxable gifts used in computing each tentative tax under section 2502(a) (and, therefore, adjusted taxable gifts under section 2001(b)(1)(B) (or section 2101(b)(1)(B)) and the tax payable on the consenting spouse's prior taxable gifts under section 2001(b)(2) (or section 2101(b)(2))) is reduced to eliminate the remaining effect of the section 2701 interest; and

(B) Except with respect to any excess reduction carried forward under paragraph (a)(2) of this section, the consenting spouse ceases to be treated as the initial transferor of the section 2701 interest.

(iii) DEATH OF CONSENTING SPOUSE. If the consenting spouse predeceases the donor spouse, except for any excess reduction carried forward under paragraph (a)(2) of this section, the reduction with respect to any section 2701 interest in the split initial transfer is not available to the estate of the consenting spouse (regardless of whether the interest is included in the consenting spouse's gross estate). Similarly, if the consenting spouse predeceases the donor spouse, no reduction is available to the consenting spouse's adjusted taxable gifts under section 2001(b)(1)(B) (or section 2101(b)(1)(B)) or to the consenting spouse's gift tax payable under section 2001(b)(2) (or section 2101(b)(2)). See paragraph (a)(2) of this section for rules involving transfers by an applicable family member during the life of the initial transferor.

(iv) ADDITIONAL LIMITATION ON REDUCTION. If the donor spouse (or the estate of the donor spouse) is treated under this paragraph (e) as the initial transferor of the section 2701 interest otherwise attributable to the consenting spouse, the amount of additional reduction determined under paragraph (b) of this section is the amount determined under that paragraph with respect to the consenting spouse. If a reduction was previously available to the consenting spouse under this paragraph (e), the amount determined under this paragraph (e)(3)(iv) with respect to the consenting spouse is determined as if the consenting spouse's taxable gifts in the split initial transfer had been increased only by that portion of the increase that corresponds to the remaining portion of the section 2701 interest. The amount of the additional reduction (i.e., the amount determined with respect to the consenting spouse) is limited to the amount that results in a reduction in the donor spouse's Federal transfer tax no greater than the amount of the increase in the consenting spouse's gift tax incurred by reason of the section 2701 interest (or the remaining portion thereof).

(f) EXAMPLES. The following examples illustrate the provisions of paragraph (e) of this section. The examples assume the facts set out in this paragraph (f).

FACTS. (1) In each example assume that P, an individual, holds 1,500 shares of $1,000 par value preferred stock of X corporation (bearing an annual noncumulative dividend of $100 per share that may be put to X at any time for par value) and 1,000 shares of voting common stock of X. There is no other outstanding stock of X. The annual exclusion under section 2503 is not allowable with respect to any gift.

(2) On January 15, 1991, when the aggregate fair market value of the preferred stock is $1,500,000 and the aggregate fair market value of the common stock is $500,000, P transfers all 1,000 shares of the common stock to P's child. Section 2701 applies to the initial transfer because P transferred an equity interest (the common stock) to a member of P's family and immediately thereafter held an applicable retained interest (the preferred stock). The fair market value of P's interest in X immediately prior to the transfer is $2,000,000 and the section 2701 value of the preferred stock (the section 2701 interest) is zero. With respect to the initial transfer, the amount remaining after Step 2 of the subtraction method of section 25.2701-3 was $2,000,000 ($2,000,000 minus zero), all of which is allocated to the transferred stock. P had made no gifts prior to 1991. The sum of P's aggregate taxable gifts for the calendar year 1991 (including the section 2701 transfer) is $2,500,000. P's spouse, S, made no gifts prior to 1991.

(3) P and S elected pursuant to section 2513 to treat one- half of their 1991 gifts as having been made by each spouse. Without the application of section 2701, P and S's aggregate gifts would have been $500,000 and each spouse would have paid no gift tax because of the application of the unified credit under section 2505. However, because of the application of section 2701, both P and S are each treated as the initial transferor of aggregate taxable gifts in the amount of $1,250,000 and, after the application of the unified credit under section 2505, each paid $255,500 in gift tax with respect to their 1991 transfers. On October 1, 1994, at a time when the value of the preferred stock is the same as at the time of the initial transfer, P transfers the preferred stock (the section 2701 interest) to P's child.

EXAMPLE 1. INTER VIVOS TRANSFER OF ENTIRE SECTION 2701 INTEREST. P transfers all of the preferred stock to P's child. P and S are each entitled to a reduction of $750,000 in computing their 1994 gift tax. P is entitled to the reduction because P subsequently transferred the one-half share of the section 2701 interest as to which P was the initial transferor to an individual who was not an applicable family member of P. S is entitled to the reduction because P, an applicable family member with respect to S, transferred the one-half share of the section 2701 interest as to which S was the initial transferor to an individual other than S or an applicable family member of S. S may claim the reduction against S's 1994 gifts. If S's 1994 taxable gifts are less than $750,000, S may claim the remaining amount of the reduction against S's next succeeding lifetime transfers.

EXAMPLE 2. INTER VIVOS TRANSFER OF PORTION OF SECTION 2701 INTEREST. P transfers one-fourth of the preferred stock to P's child. In this case, P and S are each entitled to a reduction of $187,500, the corresponding portion of the reduction otherwise available to each spouse (one-fourth of $750,000).

EXAMPLE 3. TRANSFER AT DEATH OF DONOR SPOUSE. P, the donor spouse in the section 2513 election, dies on October 1, 1994, while holding all of the preferred stock. The executor of P's estate is entitled to a reduction in the computation of the tentative tax under section 2001(b). Since no reduction had been previously available with respect to the section 2701 interest, P's estate is entitled to a full reduction of $750,000 with respect to the one-half share of the preferred stock as to which P was the initial transferor. In addition, P's estate is entitled to an additional reduction of up to $750,000 for the remaining section 2701 interest as to which S was the initial transferor. The reduction for the consenting spouse's remaining section 2701 interest is limited to that amount that will produce a tax saving in P's Federal estate tax of $255,500, the amount of gift tax incurred by S by reason of the application of section 2701 to the split initial transfer.

EXAMPLE 4. TRANSFER AFTER DEATH OF DONOR SPOUSE. The facts are the same as in Example 3, except that S acquires the preferred stock from P's estate and subsequently transfers the preferred stock to S's child. S is not entitled to a reduction because S ceased to be an initial transferor upon P's death (and S's prior taxable gifts were automatically adjusted at that time to the level that would have existed had the split initial transfer not been subject to section 2701).

EXAMPLE 5. DEATH OF DONOR SPOUSE AFTER INTER VIVOS TRANSFER. (i) P transfers one-fourth of the preferred stock to P's child. In this case, P and S are each entitled to a reduction of $187,500, the corresponding portion of the reduction otherwise available to each spouse (one-fourth of $750,000). S may claim the reduction against S's 1994 or subsequent transfers. P dies on November 1, 1994.

(ii) P's executor is entitled to include, in computing the reduction available to P's estate, the remaining reduction to which P is entitled and an additional amount of up to $562,500 ($750,000 minus $187,500, the amount of the remaining reduction attributable to the consenting spouse determined immediately prior to P's death). The amount of additional reduction available to P's estate cannot exceed the amount that will reduce P's estate tax by $178,625, the amount that S's 1991 gift tax would have been increased if the application of section 2701 had increased S's taxable gifts by only $562,500 ($750,000 - $187,500).

(g) DOUBLE TAXATION OTHERWISE AVOIDED. No reduction is available under this section if --

(1) Double taxation is otherwise avoided in the computation of the estate tax under section 2001 (or section 2101); or

(2) A reduction was previously taken under the provisions of section 2701(e)(6) with respect to the same section 2701 interest and the same initial transfer.

(h) EFFECTIVE DATE. This section is effective for transfers of section 2701 interests after May 4, 1994. If the transfer of a section 2701 interest occurred on or before May 4, 1994, the initial transferor may rely on either this section, project PS-30-91 (1991-2 C.B. 1118, and 1992-1 C.B. 1239 (see section 601.601(d)(2)(ii)(b) of this chapter)) or any other reasonable interpretation of the statute.

Par. 5. Section 25.2702-3 is amended as follows:

1. A sentence is added to the end of paragraph (b)(3).

2. A sentence is added to the end of paragraph (c)(3).

3. The additions read as follows:

SECTION 25.2702-3 QUALIFIED INTERESTS.

* * * * *

(b) * * *

(3) * * * Solely for purposes of this paragraph (b), the governing instrument meets the requirements of this section with respect to short taxable years, if any, and the last taxable year of the term if the governing instrument provides that the fixed amount or a pro-rata portion thereof must be payable for the final short period of the annuity interest.

* * * * *

(c) * * *

(3) * * * Solely for purposes of this paragraph (c), the governing instrument meets the requirements of this section with respect to short taxable years, if any, and the last taxable year of the term if the governing instrument provides that the fixed amount or a pro-rata portion thereof must be payable for the final short period of the unitrust interest.

* * * * *

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 6. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805

Par. 7. The table in section 602.101(c) is amended by adding the following citation in numerical order to read as follows:

 25.2701-5 .................................. 1545-1273