[Federal Register Volume 59, Number 86 (Thursday, May 5, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-10727]


[[Page Unknown]]

[Federal Register: May 5, 1994]


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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