or contingency to occur. Such divisions do not refer to remainder The regulation does not answer the question whether an interest for the shorter of life or a term of years is a term interest. This important issue should be resolved by statute rather than by regulation. The reason why the personal residence exception in section 2701(a)(4)(B) applies only when the residence is the sole asset of the trust is unclear. Since any other asset transferred to the trust will be subject to Chapter 14, what is the problem with other assets? Also, if the other assets were transferred to the trust after the residence was transferred, such assets would be valued for gift tax purposes under Chapter 14. 2. Failure to Pay Annuity or Unitrust Amount as Gift Pursuant to section 2701(c), if payment of the entire annuity or unitrust amount from a trust for a calendar year is not made within 65 days of the close of that year, the grantor is deemed to have made a gift on the last day of the year equal to the underpayment. This result is incorrect when a unitrust amount payable to the grantor is involved because the grantor retains a unitrust interest in the amount of the gift. An incorrect result is also produced under section 2701(c) when a preferred shareholder is also a common shareholder. He should not be deemed to have made a gift to the extent that the value of his common shares are increased by the failure to pay the preferred dividend. Similarly, if a charity is a common shareholder a gift tax charitable deduction should be allowed as to its share of the gift. If the underpayment is later satisfied, any gift tax paid by the grantor is treated as a payment for the later year and the amount of the underpayment is excluded from taxable gifts for the purpose of determining the grantor's gift or estate tax. Treating the gift tax paid as a payment for the later year should not cause the application of IRC Sec. 2035(c) as a result of such treatment. However, clarification on the point would be helpful. 3. Gift or Estate Tax Treatment of Other Retained Interests Section 2701(e) is captioned "Adjustment in Value of Other Specially Valued Retained Rights" and relates to a right under a specially valued retained interest, which is defined in section 2703(e) (2) as any retained interest valued under section 2701(a)(2)(A) or (B). This would include any contingent principal interest in a GRIT whose value is determined to be zero pursuant to (A). Section 2701(e)(1) directs that as to any specially valued retained interest, other than a QFP, for purposes of determining (i) whether any transfer of such right is a gift (and the amount of such gift) or (ii) the amount includible in the gross estate of the transferor "by reason of such right" the amount otherwise treated as the value of such right shall be reduced by the amount of the increase in any prior taxable gift as a result in valuing such right at zero. As a result, the later transfer by gift or inclusion in the gross estate is reduced.3/ If the grantor of a GRIT with a contingent principal interest assigns this interest, section 2701(e)(1) prevents a further gift being made, but this does not cause a reduction in the gift previously made when the GRIT was created. Thus, no tax benefit can result from the assignment. The reduction of the amount includible in the gross estate when the grantor dies during the term of his retained interests may prevent a change in basis pursuant to IRC Sec. 1014, which may be harmful or helpful. The result turns upon the effect of the words "by reason of such right." Inclusion would also result because of the retention of the annuity amount or unitrust amount, and this would 3/ The Section needs to be revised to encompass Chapter 13 transfers. - 7 seem to negate the effect of section 2701(e)(1). This ambiguity should be eliminated. Also, the effect of the reduction of the gross estate is unnecessary because the same result occurs under IRC Sec. 2001(b); the gift resulting from the disallowance of a reduction for the value of the contingent principal interest is not an "adjusted taxable gift." 4. Joint Purchases and Consideration Under section 2703(d)(1), the transfer of an interest in property with respect to which there is one or more term interests is treated as a transfer of an interest in a trust. A "term interest" is defined in section 2703(d)(3) as a life interest in property or an interest in property for a term of years. Section 2703(d)(2), captioned "Joint Purchases," provides that if members of the same family acquire interests in property in which one or more term interests exist the person (or persons) acquiring the term interest shall be treated as having acquired the entire property and then transferred to the other persons the "interests acquired" by them. The meaning of the quoted words is uncertain. What is meant is that for purposes of section 2701(a)(1) the person with the term interest is deemed to have created a trust with the entire property. Under the proposed statute, if A and B purchased property for 100, with A supplying 75 and having a life interest and B supplying 25 and being entitled to the property at A's death, A is deemed to have made a gift of 100 since A's interest is not an annuity amount or a unitrust amount. Presumably B's 25 is an offset against the gift to reduce it to 75, but this point is not clear because Chapter 14 does not refer to consideration except in section 2701(a)(4)(A) which has previously been discussed. Section 2703(d)(2) does not apply to B. Under section 2701(a)(1), B seems to make a gift of 25. This result is, of course, wrong and points up again the necessity of a consideration provision in Chapter 14, as is acknowledged by the Joint Committee pamphlet (JCS-13-90). IV. BUY-SELL AGREEMENTS; OPTIONS; SECTION 2702 A. In General; Policy Issues Section 2702(a) would create the general rule that for gift, estate and generation-skipping transfer tax purposes the value of any property would be determined without regard to any of the following rights held by a member of the family of the transferor or decedent: (1) Any option (or agreement) to acquire the property at a price less than the fair market value of such property (determined without regard to the option or agreement) as of the time the option (or rights under the agreement) are exercised. (2) Any right of first refusal (or similar right) with respect to such property. (3) Any right to use such property pursuant to a lease. Subsection (b) creates an exception to the general rule if: (1) the property is sold pursuant to such option or agreement, (2) the price at which such property is so sold is determined pursuant to a formula which (A) was reviewed no more than 3 years before such sale, and (B) at the time of such review, was reasonably expected to produce a price which would approximate the fair market value of such property as of the time of such sale, and (3) such property does not have a readily ascertainable market value 8 and such property is not resold before the date 6 months after the date of the death of the decedent (or the transfer in the case of a transfer subject to tax under chapter 12 or 13) to a person not related (within the meaning of section 267) to the decedent or transferor (as the case may be). Leaving aside the technical problems with the exception discussed below, its formulation presents a serious practical problem. Aggressive IRS estate tax agents will simply take the position in audits that the formula price was not reasonably expected to produce an approximately fair market value price. The only way for the exception to work in a uniform manner would be for the IRS National Office to describe formulas which would meet the test. The application of section 2702 is unclear when the shareholders' agreement requires a sale to the company (redemption) and some of the other shareholders are members of the decedent's family and other shareholders are not members of his family. Section 2703(c) provides that a redemption is treated as a transfer of an interest in the corporation. The effect of sections 2702(a) and 2703(c) appear to be that for shareholders who are members of a decedent's family the agreement is ignored for estate tax purposes but for shareholders who are not members of the decedent's family the agreement price may be binding for estate tax purposes. Such a bifurcated approach is undesirable. Also, a related provision (section 2703(a)(2)) states that if any transfer of property would be treated as a gift for gift tax purposes without regard to Chapter 14, the transferee shall be treated as if such transferee were a member of the transferor's family. As a result, if the execution of a shareholders' agreement among siblings (who under section 2703(a)(1) are not members of each other's family) involves a gift, section 2702(a) would apply. This is a bad policy decision. The law regarding whether entering into a buy-sell agreement constitutes a gift from one or more shareholders to other shareholders is uncertain. However, the IRS position is clearly that a gift can result. The IRS Action on Decision CC1985-008 dealing with Estate of Orville B. Littick. 31 T.C. 181 (1958), acq. 1959-2 Cum. Bull. 5, and recommending acquiescence in result only, states: Substantial disparity in the life expectancies of the contracting We disagree with the policy decision in section 2703(a) to ignore a right of first refusal for gift, estate and Chapter 13 valuation purposes. Such a right is commonly used, even among shareholders who are members of the same family, and does depress somewhat the value of the affected interest. However, the IRS is free to contend under current law that the creation of such a right is a gift. If concern exists on this point, the Discussion Draft could so state. An "early to complete" gift tax rule is desirable for a right of first refusal. If this is not done, a potential marital deduction disallowance issue could be created at a shareholder's death for the difference between the value of the stock determined with and without the first refusal right. 9 B. Technical Comments 1. Options The application of sections 2701 and 2702 concerning options is uncertain. Suppose T grants his daughter D an option exercisable within ten years to purchase 100 shares of AT&T stock at its fair market value when the option is granted. Under Chapter 12, this would be a gift. Section 2702(a) directs that the value of T's stock for gift, estate and Chapter 13 tax purposes is determined without regard to the option, if it is at a price less than the fair market value at the time the option is exercised. When the option is granted, it is uncertain whether this test is met. Nevertheless, the intent seems to be for the section to apply and, if it does, the stock has the same value before and after the grant of the option. Therefore, T has made no transfer with any value for gift tax purposes. In any case, the initial gift would be no larger than under the law without the section. If T dies with the option in effect, the estate tax value of the stock will be determined without regard to the option, as would be the case if T gave the stock to a third party subject to D's option. However, if D exercised the option while T is alive, after the stock has appreciated, section 2702 does not apply because it only determines value. The exercise of the option will not be a gift under Chapter 12. Does Section 2701 apply to the grant of the option? Stated another way, does the section make the gift upon grant of the option any greater than it would be without the section? In contrast to section 2702, section 2701 applies only if the stock is in a "10% owned entity," which is defined in section 2703(e)(1). This would occur only if the shares subject to the option are treated as a "trust." Section 2703(d) states that certain property is treated as held in trust, and the words "term interest" can be read to cover an option. Of course, if the shares subject to the option are in a corporation and 10 percent or more of the value of its stock is owned by T, section 2701 would apply. Are the exceptions in section 2701(a)(2)(C) applicable? They are: (i) Any instrument of the same class as the transferred (ii) Voting rights. (iii) Any instrument none of the rights under which have a preference over any rights under the transferred interest. Arguably (i) or (iii) could apply, but the language does not "fit" well with the case being considered. If section 2701(a) does apply, the stock seems to have a zero value, and the grant of the option is a gift of the full value of the stock. 2. Special Rule Read literally, the section 2702(b) exception would not apply when no review occurs within the 3 year period even though if the review had taken place the formula in effect would have satisfied the other requirements of this exception. This result is wrong. The use of the word "reviewed" suggests that the "formula" used is continued. A new formula could be used. The word "established" would be preferable. Also, when the sale occurs as a result of death, the 3 year period should be measured by death rather than the actual sale date. The use of the words "readily ascertainable market value" is imprecise. As to stock, a reference to traded on a securities exchange or in the over-the-counter market would be preferable. See IRC Sec. 6166(b)(7) (B). It is unclear whether the reference to the quoted words is made as of the date of sale or at some earlier date. The reference should be to the time of the establishment of the protected formula. 3. Other - 10 We are puzzled by (3) in section 2702(a). Suppose a parent is leasing a residence owned by a child at a rent above the "going rate." The child can then transfer the residence to his child (a grandchild of the parent) without having the amount of the gift reflect the high rent. Why? An exception needs to be created for cases where the formula establishment process cannot be effectuated because of the incompetency of a major shareholder or shareholders. The definition of "family" in section 2703(a) (1) seems faulty. To illustrate, assume a shareholders' agreement exists and requires a sale to the company, except that a transfer to a QTIP trust is permitted, and a shareholder has children by a prior marriage and a second spouse and leaves shares to a QTIP trust for his spouse. At the death of the surviving spouse a sale to the company occurs when the other shareholders are children of the spouse who created the QTIP. Such children are not members of the surviving spouse's family. V. TRANSITION RULES A. Trusts The Discussion Draft does not address transition issues, but rather states "The amendments made by this section shall apply in the case of transfers after These issues will, of course, have to be dealt with. An important issue is whether Statutory GRITs which are created after March 22 and before a tax writing committee approves a change in current law will be "protected." Fairness requires a yes answer, but obvious concern exists on the point. In this connection, a grantor cannot now create a GRIT using a retained annuity or unitrust amount because neither one can satisfy the Statutory GRIT requirements as a result of the limitation on principal interests. We recognize that an effective date in the future and a retroactive repeal of IRC Sec. 2036(c) would create a window of opportunity for trusts to be established before that date which would be subject to neither the new law nor the old law. The window could, of course, be closed by retaining the provisions of IRC Sec. 2036(c)(6), but this would have the undesirable effect of perpetuating and having to interpret a provision for a small number of cases. The indirect administrative cost of doing so would appear to be more than the possible gain in tax revenues. B. "Old" Freezes Current law provides that for purposes of the effective date of IRC Sec. 2036(c) with respect to property transferred prior to December 18, 1987, the failure to exercise a right of conversion, or the failure to pay dividends or the failure to exercise other rights specified in regulations, will not be treated as a transfer under IRC Sec. 2036(c). The Discussion Draft does not contain such a provision. As a result, for example, the failure to pay the full amount of a noncumulative dividend on preferred stock, could result in a gift under the Draft if, as seems likely, that failure is considered to be a "transfer of an interest" in the issuing corporation. This is unfair. The policy consideration which led to the exclusion from IRC Sec. 2036(c) also applies to the application of the Draft. The failure to have the gift determined under the Draft does not mean no gift has been made, but only that the applicable statute is in Chapter 12 rather than Chapter 14. C. "Old" Buy-Sell Agreements Section 2702 is harsher than current law because it applies to agreements now in effect which are not thereafter changed. Existing agreements should be governed by current law absent an amendment which reduces the purchase price. |