I had intended to write a simple blog entry about taxable estate gifts and transfers, but I wound up circling the rabbit hole of IRC Section 2701. Section 2701, titled “Special valuation rules in case of transfers of certain interests in corporations or partnerships,” sets forth valuation rules for gifts of certain interests in closely held family businesses. The provision focuses on the valuation of retained interests in family limited partnerships, LLCs and other appreciation shifting mechanisms. By extension, Section 2701 provides guidance in determining the extent of taxable gifts of other “junior” interests in the same entities.

Lifetime transfers have two basic advantages over transfers at death. First, they freeze the value of assets at their current level for transfer tax purposes and remove future appreciation from the taxpayer’s estate. The other advantage of lifetime transfers is that the gift tax has a lower effective rate than the estate tax. While the estate tax is imposed on the full value of the taxable estate, the gift tax is imposed only on the value of the property that the donee actually receives after the gift tax has been paid.

From a valuation perspective, the first point makes the most sense. For example, a gift of property that has the same value on the donor’s death as it had on the date of the gift does not produce estate tax savings, since the gift and estate tax rates are identical. On the other hand, if the property appreciates substantially in value after the gift, the entire appreciation in value escapes taxation in the donor’s estate. Thus, the straightforward estate planning game plan is to transfer potential appreciation in the value of real property from the owner’s estate to a younger generation. If the transferred property appreciates, none of its appreciated value will be included in the transferor’s estate.

So how does all of this get us to the Special Valuation Rules, under Section 2701? For clarification, we use the following excerpts from Gerald J. Robinson’s, “Estate and Family Planning for Real Estate:”

The special valuation rules are basically gift tax valuation provisions designed to deter abusive estate freeze transfers by imposing an increased gift tax at the time of the transfer. The target of the rules is under-valuations of gifts of stock or partnership interests to family members. The weapons used to attack this target are special valuation provisions that increase the amount of the taxable gift when an individual transfers an equity interest in a corporation or partnership to a family member and retains specified interests.

Two events generally must occur to trigger application of the statute. First, the transferor must transfer an equity interest in a corporation or partnership to a family member. Second, the transferor or an “applicable family member” must hold, immediately after the transfer, an “applicable retained interest.” I.R.C. § 2701(a)(1). If these two events occur and the special valuation rules become applicable, the retained interest may be valued at zero, so that the value of the transferred interest is increased for gift tax purposes, perhaps dramatically. Reg. § 25.2701-1(a), 25.2701-2(a).

The regulations, under §2701 prescribe a four-step procedure for applying the subtraction method to value a gift to which the statute applies. First, the fair market value of all family-held equity interests in the entity is determined as if all such interests were held by one individual. Second, from such fair market value, the fair market value of all family-held senior equity interests (generally preferred interests) is subtracted. Third, the value remaining after step 2 is allocated among the transferred interests and other family-held subordinate equity interests. Fourth, the amount allocated to the transferred interests in step 3 is reduced for minority interest or similar discounts and any consideration paid to the transferor. See Reg. § 25.27013(b).

[1] Jerry A. Kasner, Benton C. Strauss, Michael S. Strauss, Post-Mortem Tax Planning. “Valuation of Estate Assets, Generally'” current through 2013

[2] Ibid