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statement attached to the return, in a manner adequate

to apprise the Secretary of the nature and amount of such item."

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(c) TECHNICAL AMENDMENT.-Subsection (d) of sec

5 tion 6501 is amended by striking "3 years" and inserting “3

6

years (6 years

in case of any tax imposed by chapter 12 with 7 respect to a transfer of property the value of which is deter

8 mined under section 2701)".

9 (d) EFFECTIVE DATE.-The amendments made by this 10 section shall apply to gifts after

O

SUMMARY OF DISCUSSION DRAFT

Repeal of Present Estate Freeze Rules

Section 2036 (c) would be repealed retroactively.

Replacement Proposal

The replacement provision targets specific valuation abuses that were of concern in the enactment of section 2036 (c). These abuses generally involved overvaluation of retained rights which, in a family context, were unlikely to be exercised. The provision abandons the approach of section 2036(c), which taxes future appreciation in value by including previously transferred property in the transferor's gross estate. Instead, the new provision attempts to value more accurately the various interests at the time of the transfer. No effective date is specified for the provision.

The Basic Rule

The new provision would generally apply to transfers of an interest in a corporation, partnership, or trust to a family member. The rules would not apply if the transferor and his family owned less than 10% of the corporation, partnership, or trust.

In determining whether a gift has been made, and the amount of the gift, the following rights which the transferor (or a member of his family) retained would be valued:

1. Rights to Receive Qualified Fixed Payments.

Rights to receive qualified fixed payments ("QFPs") would be valued as described below. QFPs from a corporation or partnership would include a cumulative preferred dividend (payable on a periodic basis and at a fixed rate), or any other payment or distribution which is fixed both as to time and amount.

For trusts, a QFP would be a fixed amount payable at least annually, an amount payable at least annually which is a fixed percentage of the trust's assets (valued annually), or a non-contingent remainder interest if all the other interests in the trust are QFPs.

QFPS would include payments under a debt instrument or a
lease (if fixed as to time and amount). QFPS could have a
variable interest rate, if the rate were tied to a
specified market rate. Payments (except from a trust)
subject to a life contingency would not be QFPs.
Employment agreements would not be affected by these
rules.

To provide flexibility in structuring transactions, taxpayers could elect to treat certain payments as QFPs.

Specifically, non-cumulative preferred stock dividends,
and partnership distributions which are contingent on cash
flow or income, could be treated as QFPs.

2. Voting Rights.

Voting rights would be valued without regard to these new
rules. Thus, minority discounts and control premiums
(where applicable) would not be affected.

3. Rights in Same or Junior Class.

If the transferred interest is of the same class as the interest retained (for example, where common stock is transferred and common stock of the same class retained), these rules would not apply. These rules would also not apply if the retained interest were junior to the transferred interest (for example, where preferred stock is transferred and common stock retained).

No other rights would be given value.

This treatment

is designed to ensure that discretionary rights which are likely not to be exercised in an arm's length manner cannot be used to understate the value of the property transferred.

How OFPS Are Valued

In valuing QFPs, taxpayers would be allowed two favorable assumptions, which would increase the value of the retained interest (and correspondingly reduce the value of the residual gift): (1) that the QFPs will be paid as provided in the instrument; and (2) that QFPs under instruments without a fixed termination or redemption date will be paid in

perpetuity.

Generally, as under present law, QFPs from corporations or partnerships would be valued by determining the value of the income stream, using appropriate market discount rates. Taxpayers would be free to set the rate of the QFP at whatever rate they wished. For example, if preferred stock with a par value of $1,000 carried an 8% cumulative dividend, and 8% was the appropriate market rate, the value of the stock would be approximately $1,000 (its par value). On the other hand, the taxpayer could choose a 4% dividend rate, but if the appropriate market rate were 8%, the value of the stock would be less than par value.

In the case of trusts, QFPs would be valued (as under current law) according to the appropriate Treasury tables.

These special rules could not reduce the value of the common stock of a corporation or the non-preferred interests of

a partnership below a minimum value. Thus, the total value of the common stock or non-preferred partnership interests could not be less than 20% of the sum of the total equity in the corporation or partnership and any debt which the corporation or partnership owed to the transferor or members of his family. This minimum value is intended to reflect the "option value" of the right of the common stock or non-preferred interest to future appreciation.

Deemed Gift If OFPs Not Made

When the initial transfer is made, the transferor receives the benefit of a favorable assumption that QFPS will be paid when they are due. The corollary to this favorable assumption is that if a QFP is not paid, the transferor will be treated as making a gift of the unpaid QFP.

To provide maximum flexibility for corporations and partnerships, this "deemed gift" rule does not apply if the QFP is paid within 3 years after the year in which the QFP was due. Trusts are allowed to make QFPS within 65 days after the end of the trust tax year in which the QFP was due. In addition, the "deemed gift" rule will not apply to any QFP payable by a corporation or partnership which is not paid, if the instrument under which the payment is to be made provides that the unpaid QFP will bear compound interest at the discount rate used to determine the value of the initial gift.

To prevent double tax, a QFP which is treated as a deemed gift will not be taken into account in valuing the instrument under which it was payable if the instrument is subsequently transferred. In addition, if a QFP which gave rise to a "deemed gift" is later paid, any gift tax paid on the "deemed gift" would be creditable or refundable.

Dispositions of Interests Valued Under These Special Rules

To prevent double tax, if any rights which were previously valued at zero are later transferred (by gift or upon death), the value of the later transfer will be reduced by the amount by which the original gift had been increased because these rights were valued at zero.

If a right to receive QFPs had previously been valued under these special rules, and that right is later disposed of, there may be an additional deemed gift (or an additional amount included in the transferor's estate). This rule is designed to ensure that valuation assumptions which the transferor used initially are applied consistently in subsequent transfers.

This additional gift would result if (but only if) the value of the transferred QFP rights (at the time of the

transfer) determined under these special valuation rules exceeds the value of the rights determined without regard to these special rules. The amount of the additional gift (or estate inclusion) would be such excess. This rule would not apply to transfers to spouses, and the spouse would be treated as if he or she were the original transferor.

Special Exception for Insolvency and Bankruptcy

In addition to the rule which allows payments of QFPS to be missed if compound interest is provided, there is a special insolvency/bankruptcy exception to the deemed gift rules. For example, the three-year grace period for deemed gifts is extended by the period of insolvency or bankruptcy, QFPs which are discharged in bankruptcy are not treated as deemed gifts, and no deemed gift occurs if the transferor transfers his retained interest during insolvency or bankruptcy (unless the IRS can show tax avoidance motives).

Term Interests

The retention of a term interest (including a life estate) in property would be treated the same as the retention of an interest in trust. For example, if a person owned property and transferred a remainder interest in the property while retaining a term interest, the trust rules would apply. This treatment is to prevent the form of the transfer from determining its tax consequences.

For the same reason, a joint purchase of property would be treated as an acquisition of the entire property by the holder of the term interest, followed by a transfer of the remainder interest. The trust and term interest rules would not apply to transfers of interests in a personal residence to be used by the holder of the term interest.

Another special rule would apply to certain term interests not in trust. The rule would apply if the term interest was not a QFP, and if the term interest was in tangible property where the non-exercise of the term-holder's rights with regard to that property would not substantially affect the value of the property passing to the holder of the remainder interest. In that case, the value of the term interest would not be zero, but instead would be the amount for which the term interest could be sold to an unrelated third party (not determined under the Treasury tables). For example, the rule could apply to the joint purchase of a painting or undeveloped real estate (the value of which primarily reflects future development potential). On the other hand, the rule would not apply to a joint purchase of depletable property.