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Oct 1991

Estate tax freezes - in terms you can use with a client who is a candidate. (Personal Financial Planning)

by Rottenstreich, Zvi

    Abstract- New rules for Chapter 14 have affected estate planning through its substitution of the estate freezing clauses of Internal Revenue Code Sec. 2036(c). These rules, as contained in the Omnibus Budget Reconciliation Act of 1990, are applicable to partnership or corporation transfers of interest by a member of the family even when there is the option to retain distribution, liquidation, put, or call that would influence the significance of the interest transferred. The rules for Chapter 14 also provide for a trust's transfer to a family member. Examples are considered for these transfers, both for those outright and those in trust.

RRA 90 had major impact on estate planning by retroactively repealing the estate freeze provisions of IRC Sec. 2036(c) and substituting in its place a new Chapter 14. To best understand the effect of this change, we should review where we were before its enactment.


Prior to 1987 a technique called an "estate freeze" was popular. Generally, under this technique, there would be a recapitalization of a closely held corporation (although this concept could also be used with a partnership). The stock would be split into two classes. The preferred shares representing the then-value of the company would be retained by the older generation and the common would go to a younger generation. The preferred shareholders would retain voting control and, thus, still be in a position to run the business. This had the effect of freezing the value of the company in the preferred stock and transferring future appreciation to the younger generation (and out of the estate of the older generation). This was not bad from the government's standpoint because the transfer of the common stock to the younger generation was subject to current gift tax. The problem in the government's view was that the preferred stock was often given rights (such as a noncumulative dividend feature or a set redemption price), and, based on these rights, most, if not all, of the value of the company at the time of transfer was attributed to the preferred stock. Consequently, the value of the common stock, on which the gift tax was paid, amounted to little or nothing. Furthermore, the dividends were never intended to be declared nor was the redemption feature ever intended to be used.

To curb abuse in this area, Sec. 2036(c) was added to the law in 1987. Under Sec. 2036(c), a retention of an income interest, coupled with a transfer of disproportionate share of the potential future appreciation, was treated as if the transferred interest had been retained. This had the effect of keeping the future appreciation in the estate of the transferor, thereby subjecting it to eventual estate tax. The problem with Sec. 2036(c) was that it was too broad. It not only covered the perceived abuse areas, but included many more estate planning techniques such as grantor retained income trusts (GRITs), joint purchases and buy- sell agreements. Also, the calculations required to determine if Sec. 2036(c) applied were complicated. Small business owners who were concerned about their ability to pass their business onto future generations, along with their business advisors and other professionals, successfully pressured Congress to retroactively repeal Sec. 2036(c) and enact the current Chapter 14 of the IRC.

Outright Transfers

The new rules apply to situations where a family member transfers an interest in a partnership or corporation which is controlled by the family to another family member, while retaining either a right to a distribution based on stock ownership (or ownership of a partnership interest) or a liquidation, put, call, or conversion right which would affect the value of the transferred interest. Control is defined as 50% of the voting power or value of the stock or 50% of the capital or profits interest in the partnership. Family includes a spouse, a lineal descendant, the spouse's lineal descendants and a spouse of a lineal descendant.

The whole theory of valuing the transferred interest upon which gift tax is paid has now been changed. Rather than valuing the interest that is transferred, the new approach is to subtract the value of the interest retained from the value of the entire entity in order to determine the value of the gift. Furthermore, the new provisions set a floor and a ceiling for the value of the retained interest. Unless the retained interest includes a right to receive cumulative dividends at a fixed market rate (or the equivalent for a partnership interest) the retained interest will be valued at zero.

This would mean that a current gift tax would be due based on the transfer of the full value of the entity. Even if the retained interest includes such a right, the common stock being transferred cannot be valued at less than 10% of the value of all the stock interests combined plus any indebtedness to the transferor. Since the potential for abuse is limited, these rules do not apply to transfers where the market value for the retained interest is readily ascertainable or the transferred interest is of the same class as the retained interest.

Consider this Example

XYZ Company is owned 100% by B, who wishes to transfer ownership to his daughter C. A recapitalization of XYZ takes place whereby B receives common stock as well as preferred stock in exchange for his stock in XYZ. XYZ is valued at $1 million. B transfers all the common to C. Under the new rules, if the preferred stock does not have a cumulative dividend feature its value will be zero. Thus, B will have made a gift of $1 million to C. If the preferred pays an 8% cumulative dividend, then the value of B's preferred would be based on the discounted value of his receiving $80,000 a year for his life expectancy. If this amounted to $400,000 then the value of the gift to C would be $600,000 ($1 million value of XYZ less $400,000 value retained by B). However, even if the value of B's preferred stock were $920,000, the value of the gift of the common stock could not be less than 10% of the value of all the stock (or $100,000 in this example). Thus, care should be taken in setting the dividend rate on the preferred so that it is not higher than necessary to reduce the value of the current gift. Furthermore, the amount of current federal gift tax payable will be reduced by any remaining unified credit available to the transferor.

Transfers In Trust

Other provisions of the new rules deal with transfers in trust to a family member. If the transferor retains other than a qualified interest, the retained interest is valued at zero resulting in a gift tax value equal to the full value of the interest transferred. A qualified interest is: 1) the right to receive at least annually either, a) a fixed amount grantor retained annuity trust (GRAT); or b) a fixed percentage of the fair market value of the trust grantor retained unitrust (GRUT); or 2) a non-contingent remainder interest where all other trust interests are either GRATs or GRUTs. Thus, although the period of the trust is no longer limited to 10 years as it was under Sec. 2036(c), since the value of the retained interest is now to be computed using an interest rate of 120% of the federal midterm rate, the size of the gift to the remainderman will increase.

Another Example

For example, Mother sets up a trust with income to her for 10 years and the remainder to her son. If all of the income is to be paid to Mother, then it is not a qualified interest (since it is not for a fixed dollar amount or a fixed percentage of the trust) and thus Mother has made a gift of the entire trust to her son. If, however, the trust specifies that Mother is to receive $20,000 a year (or Mother is to receive 5% of the fair market value of the trust each year), then there is a qualified interest. The result is that the value of Mother's retained interest is the discounted value of her right to receive the $20,000 for 10 years (or the value of her right to receive the 5% of the fair market value for 10 years) and the balance of the value of the trust is considered a gift to her son.

There are exceptions to these rules. A trust which contains a residence which is used as a personal residence by the holder of the term interest is not covered. Also, for a trust composed of tangible property, if the non-exercise of rights under a term interest would substantially affect the value of the remainder, then the value of the term interest would not be zero but would be whatever the holder of that interest can prove an unrelated third party would pay for it. Finally, a joint purchase is treated as a purchase of the entire property by the term interest holder and then a transfer of the remainder in exchange for the consideration provided by the purchaser of the remainder interest. As a result, the gift, if any, is the difference between the value of the remainder interest and the consideration furnished by the remainderman.

Rights and Restrictions

Certain rights and restrictions on the use or sale of the property are disregarded (in determining the value of the retained interests) unless they are bona fide business transactions not entered into to effect a transfer at less than full consideration and their terms are similar to other arm's-length transactions between unrelated parties. The lapse of voting or liquidation rights is treated as a transfer, if the individual holding the rights and the members of his family control the entity both before and after the lapse. The value of the transfer is the difference in value of the interest held by the individual before the lapse and after the lapse.

The effective date of Chapter 14 is for transfers after October 8, 1990. Unless adequate disclosure is made on the gift tax return to alert the IRS to the fact that Chapter 14 may apply, the statute of limitations does not begin to run. Furthermore, states have not yet incorporated these new provisions into law and thus old Sec. 2036(c) still exists. There is however, movement in the state legislatures to repeal Sec. 2036(c).

While Chapter 14 is a welcome replacement for Sec. 2036(c), it is still a very complex area of the law. Some planning tools have been restricted while others have been revived. As always, it remains important to plan for the transfer of property and family businesses to future generations. Where substantial appreciation in assets is expected, there are still tax savings opportunities to be attained even after the enactment of Chapter 14.

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