Thaw on estate freezes: the repeal of Section 2036(c). (Internal Revenue Code)by Keiser, Laurence
Here is good news and bad news. Sec. 2036(c) has been repealed, and will be treated as though it never existed. The new rules for estate freezes are somewhat simpler and possibly more logical. But it will still be virtually impossible to effect an estate freeze at low cost. The author leads us through the major intricacies of recent years' tax acts and court rulings on this complex subject, to a result that may be discouraging to all but the most resourceful and innovative.
Sec. 2036(c) has been repealed! It now stands in the halls of Congress's "Tax Bloopers, Blunders and Practical Jokes," taking its place next to such tax legislation as carry-over basis at death, allocable installment indebtedness and the late, great Sec. 89.
Do not despair, practitioners, for Congress has provided a replacement. This article acquaints accountants in general practice with the basics of the new rules.
The purpose of an estate freeze is to cap the value of the interest of an older family member at its present value and pass anticipated future appreciation to younger members.
Before proceeding, let's lay out a typical set of facts:
Father owns 100% of the common stock of X Inc., a C corporation with a net book value of $1 million. Its average after-tax income for the past five years has been $300,000. Companies in its industry customarily sell at six times earnings. Father exchanged his common stock for $1 million of voting preferred stock with a 6% noncumulative dividend. Son, who has been active in the business, was allowed to purchase newly issued common stock for $1.
In this scenario it was argued that the common stock had no value other than the $1 which was paid for it, with the result that no gift tax was due on its transfer. Then, at the father's death, his estate would take the position that the value of the preferred stock must be discounted. After all, who would pay face value for a 6% noncumulative preferred?
If the IRS reached the transactions on audit, it would assert two gifts. First, based on "price times earnings," the IRS would assert a market value of $1.8 million for X Inc., and the exchange of the common for $1 million of preferred would result in an $800,000 gift. This is a valuation issue which transcends legislation. Second, a 6% noncumulative preferred stock would certainly be valued at less than face; the amount of discount would also be a gift to the son. Retention of the right to vote has always been an important factor at the time of an estate tax audit. Should this retention give rise to a premium for control? The IRS would likely assert one on audit of the father's estate. In addition, voting power often has been hidden in a voting trust or irrevocable proxy agreement that terminated at death. The IRS position has been to attribute a value to a voting right which passes at death (PLR 8510002).
Practitioners have extended the freeze transaction to partnerships, providing a senior limited partnership interest with a fixed income distribution and a preference at liquidation. The joint purchase transaction by which an older member purchases the income interest and a younger member purchases the remainder is also a variation of the freeze technique.
PRE 2036(c) ATTEMPTS TO THAW FREEZES
In 1983, the IRS issued two revenue rulings. Rev. Rul. 83-120 specified the primary factors to be taken into account in valuing preferred stock: yield, dividend coverage and protection of liquidation preference. The IRS stated that for the face value to equal fair market value, 1) the dividend rate must be adequate in comparison to high-grade publicly traded preferred stock, 2) the corporation must have sufficient earnings to cover the dividend, and 3) the dividend must be cumulative.
Rev. Rul. 83-119 involved a recapitalization like the one in our example. Applying Rev. Rul. 83-120 factors to value the preferred, the IRS held that the preferred was worth only 60% of face when issued. It further ruled that since the preferred had to be redeemed at death of the holder at a premium over the issue price, the excess would be treated as a distribution under Sec. 305(c), effectively a dividend, constructively paid out over the holder's life expectancy.
Despite the 1983 rulings, the IRS continued to have a difficult time attacking freeze transactions. In most instances, gift tax returns were not filed at the time of the transaction on the theory that no gift was made, and by the time the donor's estate tax return was filed, the transaction was "old and cold." Auditors often did not inquire as to how the decedent came to own the preferred stock. Practitioners also put in features to shore up the value of the preferred to support the theory that no gift had been made. For example, the preferred would be redeemable at face at the option of the holder. Or the preferred would be convertible back into common. Of course, the holder never really intended to redeem or convert. But it could then be argued that because of the conversion right, the preferred was worth its face or an equivalent amount of common shares.
In Dickman v. Commissioner, 465 U.S. 330 (1984), the U.S. Supreme Court held that a parent who made an interest-free loan to a child had made a gift to the child of the value of the use of the money. The Dickman result was later codified in the 1984 Tax Act as Sec. 7872. The IRS has also attempted to apply the Dickman rationale to contend with estate freezes, but this approach has not been successful in the courts. The IRS began issuing private letter rulings extending Dickman beyond interest-free loans (PLRs 8723007, 8726005). Its attempt to extend it to equity was beaten back in Snyder v. Commissioner, 93 T.C. No. 43 (1989).
In Snyder, the taxpayer owned stock in a public corporation. A personal holding company was created, with taxpayer exchanging the public stock for non-cumulative, 7% preferred stock with a liquidation preference equal to the public stock's fairmarket value. The common was gifted to trustees for the benefit of other family members. The non- cumulative preferred was convertible into cumulative, 7% preferred. The cumulative preferred was convertible into common.
In PLRs 843010 and 873077, the IRS had ruled that failure to enforce rights to a preferred stock dividend was the equivalent of a gift to the common shareholders. The Tax Court in Snyder agreed with the IRS ruling position. It sustained a gift based on the taxpayer's failure to convert the non-cumulative preferred to cumulative preferred. However, the taxpayer was not bound to convert the preferred shares to common shares. The Tax Court held that there is a real economic significance in the difference between preferred stock and common stock. There is also no right to be paid for the use of the capital contributed in exchange for an equity interest, in contrast to the rules dealing with loans.
The Tax Court pointed out that, while at the decedent's death the value of the corporation's public shares had increased, at some prior point the value of these shares had decreased, wiping out, in essence, the value of the common. This finding illustrated the importance of the liquidation preference. Thus, the Tax Court held that Snyder successfully froze the value of the estate.
ENACTMENT OF IRC SEC. 2036(C)
To stem the tide of estate freezes, Congress enacted Sec. 2036(c) in the RA 87. The purpose of this section was to cause inclusion of the appreciation of the entire corporation or partnership in the taxable estate of the donor where there was an inappropriate retention of an interest. The rule applied when a person holding a substantial interest in an enterprise made a transfer of property having a disproportionate share of the potential appreciation in the interest, while retaining an interest in the income of, or rights in, the enterprise.
The statute was broadly drafted and TAMRA 88, rather than clarifying, broadened it even further. The rules were so broad that they essentially put a freeze on estate planning.
The statute was also amended in 1988 to deal with Grantor Retained Income Trusts (GRITs). GRITs proliferated because they allowed donors to pass property to donees (after the income retention period) at the value of the property reduced by the present value of the income interest (presuming, of course, that the donor survived the income retention period). The 1988 amendment to Sec. 2036(c) sanctioned the GRIT device, but provided that the GRIT would escape Sec. 2036(c) rules only if the retention period did not extend beyond 10 years, the income beneficiary was the grantor, and the grantor was not a trustee of the trust.
Businesspeople and tax practitioners strenuously opposed applications of the section. All recognized that total repeal was unlikely because of the revenue at stake, but it was generally believed that any alternative had to be better.
Ways and Means Committee Chairman Rostenkowski took the first step in April 1990, issuing a discussion draft that essentially targeted valuation abuses at the time of transfer, making it costlier to make gifts. After hearings, a provision repealing Sec. 2036(c) was included in RRA 90. Instead, "special valuation rules" in Secs. 2701 to 2704 were added. The repeal of the old rules was retroactive to their date of enactment, December 17, 1987. The new rules apply to transfers after October 8, 1990.
The New Law
Under the new sections the value of the gift subject to gift tax is the value of the entire property transferred, reduced by any rights directly or indirectly retained. The new law focuses on the rights retained, disregarding those which may, in reality, not exist. Rights are valued under Sec. 2701 if there is a transfer of an interest in a corporation or partnership to or for the benefit of a member of the transferor's family and the transferor or an applicable family member retains any "applicable retained interest."
An applicable retained interest is either 1) a distribution right in an entity that before the transfer is controlled by the transferor and his family, or 2) a liquidation, put, call or conversion right.
Let's pause for two comments and a brief definition break.
First, note that we focus on a partnership and a corporation. The problematical "enterprise" concept used in Sec. 2036(c) is eliminated. Second, the rules do not apply to a retained interest that is marketable or a similar interest that differs from a marketable interest only with respect to voting rights for stock and management rights and liability limits for partnerships.
"Control" means 50% (by vote or by value) of the stock of a corporation or 50% of the capital or profits interest in a partnership. In a limited partnership, all general partners, regardless of interest, are deemed to have control. "Family" includes spouses, ancestors and lineal descendants as well as spouses of ancestors and lineal descendants; attribution rules also apply.
Any retained right which is not a right to receive a "qualified payment" is valued at zero, and thus the value of a transferred interest is the value of the entire property. A qualified payment is a dividend payable on a periodic basis and at a fixed rate, including one bearing a fixed relationship to a specified market rate, under cumulative preferred stock or a comparable payment under a partnership agreement.
Going back to our example, the X Inc. recapitalization would cause Father to be treated as having made a gift to Son of the entire value of the corporation. Retention of non-cumulative preferred is valued at zero under the new statute.
A transferor or applicable family member may irrevocably elect to treat any distribution right as a qualified payment. Amounts not paid at the specified times are treated as transfers subject to compounding rules. The statute also gives transferors or applicable family members the right to irrevocably elect out of the qualified payment rules. Neither the statute nor the Committee Report is clear on just how this election works and what its effects are.
If a retained interest consists of a right to receive a qualified payment and also one or more liquidation rights (including a put, call, liquidation, conversion or similar right), the value of all such rights must be determined as if each liquidation right were exercised in the manner resulting in the lowest value for both the right to receive the qualified payment and the liquidation right.
Focusing again on our example, assume that the 6% dividend on the $1 million preferred was cumulative and that, in addition, the preferred could be redeemed at any time after two years for $1 million. The value of the preferred would be the lesser of 1) the present value of two years of $60,000 dividend payments plus the present value of $1 million in two years, or 2) the present value of $60,000 per year in perpetuity.
The right is not taken into account if it must be exercised at a specific time and for a specific amount or if it can be converted only to a fixed number or percentage of the same class of stock as was transferred and it is non-lapsing, adjusted proportionately for splits, reclassification, combinations and similar changes in common stock and is adjusted for accumulated but unpaid distributions.
If there are unpaid distributions, these amounts (for example, dividends in arrears), adjusted by an interest element, increase the taxable estate at death or adjusted taxable gifts if the retained property is transferred. There is an exception for transfers to a spouse during life or at death. Thus there is an ability to catch up on unpaid distributions after the first spouse's death. A grace period is allowed under the statute so that a distribution made within four years of its due date is treated as if made on the due date.
The value of a transfer of a "junior equity interest" in a corporation or partnership cannot be less than the value determined by assigning to all of the junior equity interests a value equal to 10% of the total of all equity interests plus the total amount of indebtedness to the transferor or an applicable family member. Junior equity interests are common stock in a corporation or any interest in a partnership in which rights to income and capital are junior to other classes.
Back again to the example--if the corporation was indeed worth $1 million and Father retained $1 million of preferred and gave away the common, the common would be worth $100,000 for gift tax purposes. The junior equity would be assigned a value of 10% of $1 million. If the books also reflected a $1 million corporate liability to Father for advances previously made, the value of the gift would be $200,000. Thus it will be impossible for such a transfer not to have some (albeit minor) gift tax effect.
The statute applies to actual transfers as well as to redemptions, contributions to capital, recapitalizations, or other changes in capital structure if the taxpayer or an applicable family member receives an applicable retained interest in the entity or holds such an interest immediately after the transfer.
In the example, if Father and Son had been 50/50 owners of the common stock of the corporation and Father then exchanged his common for new preferred, an applicable retained interest, the section would apply.
The IRS may issue regulations to treat a retained interest as two or more separate interests. For example, a participating feature of a preferred stock would be valued as if it were a separate interest valued as the same class as other stock with the same participation.
Often, the parent who converts to the income interest would like to retain control over the entity, or the right to liquidate the entity. Such a case was the Estate of Harrison Jr. v. Commissioner, T.C. Memo 1987-8.
In that case, Father effectively transferred $59 million of property to a partnership for a 78% limited partnership interest and a 1% general partnership interest. Each of his sons contributed about $8 million of property receiving general partnership interests of about 10.5% each. The agreement gave a general partner the right to liquidate the partnership during life. Father died less than six months later. The estate and the IRS stipulated that the fair market value of Father's interest just prior to his death was $59 million. They also stipulated that due to lapsing of the right to liquidate, the value of the interest was only $33 million. Because the Tax Court held that a prospective purchaser would not acquire the right to liquidate, the value of the interest for estate tax purposes was the lower figure.
Congress enacted Sec. 2704 to prevent the Harrison case result in the future. The lapse of a voting or liquidation right in a family- controlled corporation results in a transfer by gift or an inclusion in the gross estate. The amount of the transfer is the excess of the value immediately before the lapse over the value immediately after. The rules do not specifically affect minority discounts or other discounts available under present law; they will apply to voting rights retained through voting trusts or irrevocable proxies.
The new freeze rules will probably not totally eliminate valuation litigation such as Estate of Newhouse v. Commissioner, 92 T.C. __ No. 14. At issue was the value of decedent's voting and nonvoting common shares in light of substantial voting preferred stock held by other family members. Expert witnesses differed in their opinion as to what a willing buyer would pay for decedent's interest in light of the corporate uncertainties.
The new law will obviously be a hurdle in creating the diverse corporate interests found in Newhouse. The restrictions will have to be taken into account and dealt with under Sec. 2701. But valuation may still be difficult. Discounts for items such as minority interest, lack of marketability and loss of a key employee will continue to be major issues.
Interests in Trust
Again, the value of the remainder interest is the value of the entire property reduced by the value of the income interests. However, if the income interest is not a "qualified interest," it is valued at zero. A qualified interest is the right to receive fixed amounts payable not less frequently than annually or any interest to receive a fixed percentage of the fair market value of the trust property which payment is to be made not less frequently than annually. These amounts are valued under Sec. 7520 (i.e., using the Applicable Federal Rate).
These rules may sound familiar as they are essentially the same as the unitrust and annuity trust rules contained in the charitable remainder trust portion of the IRC. Under the rules, if a grantor retains all of the income from the transferred property for a period of years (as in a GRIT), he or she has made a present gift of the entire value of the property. The rules do not apply to a transfer which is incomplete under the gift tax rules or to a transfer of an interest in a residence.
The statute indicates that the retention of a life estate and transfer of a remainder interest will be treated as a transfer in trust. Also, a joint purchase of property will be treated as a purchase by the income holder followed by a transfer of the remainder interest to the remainderman.
While the new rules as they effect freezes are somewhat beneficial to taxpayers, the rules regarding trusts are much more restrictive. GRITs will remain of benefit only with respect to property that is expected to appreciate, and personal residences. Indeed, the use of GRITs for residences may be the most significant benefit available under the new statute. Holding a residence in a grantor trust will not eliminate the right to rollover gain on sale under IRC Sec. 1034 (Rev. Rul. 66-159) or the right to the $125,000 exclusion for a taxpayer over the age of 55 (Rev. Rul. 85-45).
CREATING A RESIDENCE GRIT
A personal residence is not included within the new rules relating to transfers to trusts. Consequently, such a residence can be used to fund a GRIT, essentially without restrictions.
The donor would convey the property to a trust, retaining the right to use the property for a fixed period. The longer the retention period, the larger is the value of the retention and consequently the smaller the full value of the gift of the remainder. However, if the transferor dies during the retention period, the full value of the property is included in the taxable estate.
The value of the retained interest is determined pursuant to IRS formula, and interest rates are determined under Sec. 7520. A 10-year income interest (using a 10% interest rate) is valued at about 61.5% so that the value of the gift is about 38.5%.
The taxpayer can further depress the value of the remainder by providing a reversion to the grantor's estate if the taxpayer does not survive the retention period. This discount becomes larger as the age of the donor increases.
For example, Mrs. Ivana, a 72-year-old married woman, owns a residence worth $1 million. She may transfer it to a 10-year GRIT, passing the remainder to her children in 10 years. On that basis, she has made a gift of about $385,000. If she further provides that the property reverts to her estate if she does not survive 10 years, the value of the remainder (now contingent) drops to about 22.4%. On this basis, she has made a present transfer in the amount of $224,000. If Mrs. Ivana survives the 10-year period, $1 million of property will have been passed to her children using only $224,000 of her unified credit equivalent. If she dies within the 10-year period, the full value of the property is included in her estate.
The addition of the reversion to her estate in the trust does not create any additional tax and would allow the property to then be bequeathed by will to her husband, if he survives, thus restoring a marital deduction.
What happens if the retention period expires and the transferor wishes to continue to live in the residence? While there should not be a binding written obligation in existence, there is no reason why the transferor could not pay a fair rent to the children for the use of the property after the retention period.
Buy-sell agreements were also used to some extent as estate-freezing devices. Although courts carefully scrutinized arrangements between related parties, the agreements were honored if they fixed a price, were bona fide, had a valid business purpose and were not disguised testamentary dispositions.
Because of comments in the Committee Reports accompanying Sec. 2036(c), the IRS in Notice 89-99 determined that Sec. 2036(c) applied to buy-sell agreements, so that in most instances the IRS would be able to include the excess of the fair market value over the agreement price in the estate. The new statute brings us back to prior law.
To prevent abuses, the new statute provides that for transfer tax purposes, the value of property is determined without regard to any option, agreement or other right to acquire or use property at less than fair market value or any restriction on the right to sell or use the property.
The agreement will be respected only if it is 1) a bona-fide business arrangement, 2) not a device to transfer property to members of the decedent's family for less than fair market value, and 3) the terms are comparable to those that could have been entered into in an arm's length agreement.
In adopting these rules, Congress rejected an earlier proposal that would have required the price to be reasonable both at time of establishment and time of exercise and would have required an actual sale at that price. A carefully drawn buy-sell agreement should be part of every close corporation's valuation strategy. Even if not binding on the IRS, it is evidence as to what the parties agreed.
Statute of Limitations
If a gift arises under Sec. 2701 and the gift is not shown on a gift tax return, the statute of limitations does not begin to run. There is an exception for any item disclosed on the return (or in a statement attached to the return) in a manner adequate to apprise the IRS of the nature of such item.
Under prior law, if a gift tax return was filed and a tax was, in fact, paid, assessments of gift tax would be time-barred. Such was the result in Boatmen's First National Bank of Kansas City v. U.S., 705 F. Supp. 1407 (W.D. Mo. 1988), where the District Court denied a later IRS revaluation. However, the Tax Court has held that prior taxable gifts could be adjusted ultimately in the computation of estate tax due, thus boosting the tax bracket significantly. Estate of Frederick Smith, 94 T.C. No. 55 (1990).
Under the new law, in the absence of a return or of inadequate disclosure on the return, the IRS can assess the gift tax for the year in which the gift was made plus interest plus penalties at any time. Thus, the stakes for not reporting have been considerably increased.
Valuing Recapitalization After RRA 90
In RRA 90, Congress also seemingly codified the result of Rev. Rul. 83-119 by a specific amendment to Sec. 305(c). This change was in the new Act's corporate provisions, not the estate freeze provisions. Further, Congress provided that in valuing the redemption premium, the computation must be made using the Original Issue Discount rules of Sec. 1274.
WHAT WILL HAPPEN?
While RRA 90 represents minor simplification, it is doubtful that small partnerships and corporations will rush to do freezes. First of all, many small corporations have become S corporations and can have only one class of stock. The income and estate tax benefits provided by an S corporation may outweigh the potential freeze benefit. Second, the dividend rate that the preferred will have to pay, in most cases, will be too high for the corporation to afford, or it may cause the older owner's interest to increase at a higher rate than the junior equity will increase.
In today's market, a preferred stock would probably command a dividend of at least 12%. The corporation will likely be unable to part with that capital. Or that rate may be higher than the corporation's rate of growth.
The advantage of GRITs has also been considerably diminished because one may only value the actual income stream retained by the Grantor, not a hypothetical income stream based on the IRS tables.
AND FINALLY THE STATE DILEMMA
Although the purpose of this article has been to focus on federal changes, practitioners must be conscious of state and local tax effects especially in states whose laws do not conform with the federal.
New York, for example, recently adopted legislation (effective May 25, 1990) incorporating IRC Sec. 2036(c) by reference. Thus, at this point in time, IRC Sec. 2036(c) applies at the state level, but new Secs. 2701 to 2704 do not.
Hopefully, the state legislature will retroactively repeal the 1990 legislation and incorporate the new federal legislation. Otherwise the result for practitioners will be chaos.
Laurence Keiser, LLM, CPA, is a partner in the New York City and White Plains law firm of Greenfield Eisenberg Stein & Senior, specializing in tax planning, litigation, estate planning and administration.
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