Adjustments Under Special Valuation Rules

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 25 and 602

[TD 8536]

RIN 1545-AM86

Adjustments Under Special Valuation Rules

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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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, DC 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, DC 20503.

Background

Proposed Regulations

Proposed Sec. 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 Sec. 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 Sec. 25.2701-0, table of contents entries are added

under Sec. 25.2701-5 to read as follows:

Sec. 25.2701-0 Table of contents.

* * * * *

Sec. 25.2701-5 Adjustments to mitigate double taxation.

(a) Reduction of transfer tax base.

(1) In general.

(2) Federal gift tax modification.

(3) Federal estate tax modification.

(4) Section 2701 interest.

(b) Amount of reduction.

(c) Duplicated amount.

(1) In general.

(2) Transfer tax value--in general.

(3) Special transfer tax value rules.

(d) Examples.

(e) Computation of reduction if initial transfer is split under

section 2513.

(1) In general.

(2) Transfers during joint lives.

(3) Transfers at or after death of either spouse.

(f) Examples.

(g) Double taxation otherwise avoided.

(h) Effective date.

* * * * *

Par. 3. In Sec. 25.2701-1, paragraph (a)(1) is amended by adding a

sentence at the end to read as follows:

Sec. 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 Sec. 25.2701-5 to read as follows:

Sec. 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 Sec. 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 Sec. 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 Sec. 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

Sec. 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 Sec. 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

Sec. 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 Sec. 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 Sec. 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:

Sec. 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 Sec. 602.101(c) is amended by adding the

following citation in numerical order to read as follows:

25.2701-5

1545-1273

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

Approved: April 18, 1994.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 94-10727 Filed 5-4-94; 8:45 am]

BILLING CODE 4830-01-U