[Federal Register Volume 59, Number 111 (Friday, June 10, 1994)] [Unknown Section] [Page 0] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 94-12295] [[Page Unknown]] [Federal Register: June 10, 1994] DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1, 20, and 25 [PS-26-93] RIN 1545-AR56 Actuarial Tables Exceptions AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking. ----------------------------------------------------------------------- SUMMARY: This document contains proposed amendments to the income, estate, and gift tax regulations under the Internal Revenue Code relating to exceptions to the use of standard valuation tables for valuing annuities, interests for life or a term of years, and remainder or reversionary interests. These amendments are necessary in order to provide guidance consistent with court decisions that call for deviation from the use of standard valuation tables in valuing those interests. The proposed regulations would apply in valuing all interests that would, but for the exceptions, be valued under section 7520 of the Code. DATES: Written comments and requests for a public hearing must be received by August 9, 1994. ADDRESSES: Send submissions to: CC:DOM:CORP:T:R ([PS-26-93]), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, submissions may be hand delivered to: CC:DOM:CORP:T:R ([PS-26-93]), room 5228, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. FOR FURTHER INFORMATION CONTACT: William L. Blodgett, telephone (202) 622-3090 (not a toll-free number). SUPPLEMENTARY INFORMATION: Background This document contains proposed regulations (26 CFR 1.7520-3(b), 20.7520-3(b), and 25.7520-3(b)) for the valuation of certain partial interests in property under section 7520 of the Internal Revenue Code (Code), as added by section 5031 of the Technical and Miscellaneous Revenue Act of 1988, when the use of standard actuarial tables would produce unreasonable results. The regulations are proposed to be effective for valuation dates occurring after the date the regulations are published as final regulations in the Federal Register. Explanation of Provisions Section 7520(a), which is effective after April 30, 1989, provides that the value of annuities, interests for life or a term of years, and remainder or reversionary interests is to be determined under tables published by the IRS based on an interest rate equal to 120 percent of the applicable Federal mid-term rate (rounded to the nearest two-tenths of one percent) in effect under section 1274(d)(1) for the month in which the valuation date falls. Section 7520(b) provides that section 7520 shall not apply for purposes of any provision specified in regulations. The Conference Report to the Technical and Miscellaneous Revenue Act of 1988, H.R. Conf. Rep. No. 1104, 100th Cong., 2d Sess. 113 (1988), 1988-3 C.B. 603, explains that section 7520 does not apply to ``situations specified in Treasury regulations.'' The IRS has never attempted to include in the regulations all of the different actuarial factors that could apply to the many different kinds of vested and contingent annuity, income, and remainder interests that can arise in tax administration. The actuarial tables that have been set forth in the regulations from time to time have listed only those factors that are most frequently needed by taxpayers. Generally, these actuarial tables have included the one-life annuity, income, and remainder factors for ages 0 through 109 and the term-certain annuity, income, and remainder factors for periods of 1 through 60 years. These one-life and term-certain factors are often referred to in this notice of proposed rulemaking as ``standard actuarial factors'' or ``standard section 7520 actuarial factors.'' Other standard actuarial factors that are less frequently needed by taxpayers are included in tables that have been separately published by the IRS from time to time and that may be purchased from the Government Printing Office. The tables in these books include two-life actuarial factors, as well as many one-life factors and term-certain factors not found in the regulations tables. These publications also include a number of examples that illustrate how to compute special section 7520 actuarial factors such as the annuity, income, or remainder factor for a period limited to the lesser of a term certain or a lifetime. Special actuarial factors have for many years been referred to as such in the regulations. See, for example, Sec. 20.2055-2(f)(5). Other special section 7520 actuarial factors that may apply to more unusual situations may be computed by the taxpayer or, upon request, by the Internal Revenue Service for the taxpayer, by using actuarial methods consistent with those used to compute the standard section 7520 actuarial factors that appear in the tables in the regulations and in the Service's publications. Examples of these more unusual situations include an annuity payable for more than two lives, a right to income for a term certain or until the prior death of the first to die of two individuals, and the right to receive a remainder after a term certain if an individual survives the term. In calculating a standard section 7520 actuarial factor, certain assumptions are made. For all standard section 7520 actuarial factors in the single-life and term-certain tables in Sec. 20.2031-7(d), the interest rate for enjoyment or the postponement of enjoyment is the applicable section 7520 rate. In the case of a life annuity, income, or remainder factor, the basis for mortality rates for measuring lives is the data in Table 80 CNSMT. However, in unusual situations, where special section 7520 actuarial factors must be computed, one or more alternative assumptions may be appropriate. For example, if the actual income is known to be below applicable standards, the section 7520 interest rate may not be used to project the trust income yield. Similarly, if a measuring life is classified as terminally ill, the standard mortality data from Table 80 CNSMT may not be used as the mortality basis. But, even though one or both of these exceptions is applicable in a case, the section 7520 interest rate will ordinarily be used to discount the value of the right to any postponed enjoyment. In cases requiring the valuation of ordinary annuities, income interests, and remainder and reversionary interests, the courts have consistently recognized the need to use the standard actuarial factors prescribed by the regulations. See Ithaca Trust v. United States, 279 U.S. 151 (1929). However, the courts have recognized that the use of the standard actuarial factors is inappropriate in certain cases. Robinette v. Helvering, 318 U.S. 184 (1943) (reversionary interest with several interdependent contingencies); Stark v. United States, 477 F.2d 131 (8th Cir. 1973), cert. denied, 414 U.S. 975 (1973) (closely held stock that was not publicly traded and paid no dividends); O'Reilly v. Commissioner, 973 F.2d 1403 (8th Cir. 1992), rem'd, T.C.M. 1994-61 (disparity between .2 percent yield and 10 percent tables produced unrealistic and unreasonable result); and Commissioner v. Estate of Sternberger, 348 U.S. 187 (1955) (charitable bequest that would occur only if decedent's unmarried daughter died without issue surviving her and her mother). In addition, the courts have held that the standard actuarial factors cannot be used if the measuring life is terminally ill. Estate of McLendon v. Commissioner, T.C.M. 1993-459; Estate of Jennings v. Commissioner, 10 T.C. 323 (1948); and Estate of Denbigh v. Commissioner, 7 T.C. 387 (1946). See Rev. Rul. 80-80, 1980-1 C.B. 194, which provides that, in cases where the individual's death is imminent, the taxpayer may not use standard actuarial factors prescribed by the regulations. See also, Carter v. United States, 921 F.2d 63 (5th Cir. 1991), where the court refused to ascribe value to an income interest for purposes of the section 2013 credit where death of the measuring life was simultaneous with that of the decedent. In Shapiro v. Commissioner, T.C. Memo 1993-483 (1993), the Tax Court allowed the taxpayer to improperly value an annuity with a standard one-life annuity actuarial factor from Table A in Sec. 20.2031-7(f) in a situation in which the annuity could have exhausted the fund from which the annuity was to be paid before the death of the annuitant. The Internal Revenue Service believes that the annuity factor that should have been used in this case is a special annuity factor for the right to receive annual payments for 4 years or until the prior death of the annuitant. See Rev. Rul. 77-454, 1977-2 C.B. 351. See also Moffett v. Commissioner, 269 F.2d 738 (4th Cir. 1959), and United States v. Dean, 224 f.2d 26 (1st Cir. 1955). Therefore, the Service will not follow the result in Shapiro. Sections 1.7520-3(a), 20.7520-3(a), and 25.7520-3(a) set forth specific Code sections that are exempt from the valuation rules of section 7520. The proposed regulations contained in this notice describe other areas in which the valuation methodology applicable to standard and special section 7520 actuarial factors is not to be used. Generally, if the interest in property that is to be valued is not an ordinary annuity, income interest, or remainder interest, the standard annuity, income, and remainder factors in the tables of factors set forth in the regulations and IRS publications cannot be used. In some cases in which the standard factors from the regulations and publications tables cannot be used, a special factor may be computed by the taxpayer or by the Service upon the request of the taxpayer. In other cases where standard or special factors may not be used, the property interest may be valued using other valuation techniques. Depending upon the facts and circumstances, a property interest that cannot be valued using the standard or special section 7520 factors may have no ascertainable value. The proposed regulations establish two primary tests to determine whether the fair market value of the interest is computed by use of the standard section 7520 actuarial factors found in the regulations and IRS publications. The first test is whether the instrument of transfer provides the beneficiary with the degree of beneficial enjoyment that is consistent with the type of property interest that the standard valuation tables are designed to measure. In this regard, the rights of an annuity beneficiary must be adequately defined and, if the annuity is payable from a group of assets, the value of the assets must be sufficient to support all of the annuity payments. Similarly, the rights of an income beneficiary must be consistent with the rights of an outright owner of the property interest for the same period of time, and the rights of a remainder or reversionary beneficiary must be protected against invasion or erosion of the corpus. The second test in the proposed regulations addresses the mortality component of the transferred interest. The Internal Revenue Service previously addressed this issue in Rev. Rul. 66-307, 1966-2 C.B. 429, and Rev. Rul 80-80. Rev. Rul. 66-307 set forth the rule that the value of a life or remainder interest would be determined by taking into account the health of the life tenant if it was known on the valuation date that the life tenant was afflicted with a fatal and incurable disease in its advanced stages and that the life tenant could not survive for more than a brief period of time. Rev. Rul. 80-80 clarified the ``brief period'' test in Rev. Rul. 66-307, and stated that the standard life actuarial factors are to be applied to value the interest unless death is clearly imminent. In the view of the Service, because the test for determining whether death is imminent set forth in Rev. Rul. 66-307 and Rev. Rul. 80-80 does not satisfactorily quantify the probability of death occurring within 1 year from the valuation date, this test may permit the use of standard actuarial factors in inappropriate situations. These regulations propose to explicitly quantify the applicable standard for purposes of applying this test. Under the proposed regulations, if an individual who is a measuring life of the interest being transferred is known to be terminally ill, the mortality test of the proposed regulations is not satisfied and a special section 7502 actuarial factor, rather than a standard actuarial factor must be used in valuing the interest. Terminal illness is defined in the proposed regulations as an incurable illness or other deteriorating physical condition that would substantially reduce a person's life expectancy to the extent that there is at least a 50 percent probability that the individual will not survive for more than 1 year from the valuation date. Exceptions are made in the regulations for special situations under sections 2013, 2037, and 2042. In the case of the simultaneous death of the transferor and an individual who is the measuring life of a property interest, the proposed regulations specifically preclude use of the standard factors in the tables to value that interest. This is pertinent in determining the previously taxed property credit under section 2013 and reaffirms the position of the Fifth Circuit in the Carter case. Special Analyses It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure 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, an initial Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Comments and Requests for a Public Hearing Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments that are submitted timely (preferably a signed original and eight copies) to the Internal Revenue Service. In particular, the Service invites comments on whether the proposed definition of terminal illness adequately deals with certain illnesses that are known to cause death in a short period of time but are often diagnosed more than 1 year before death. All comments will be available for public inspection and copying. A public hearing may be scheduled if requested in writing by a person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the hearing will be published in the Federal Register. Drafting Information The principal author of these proposed regulations is William L. Blodgett, Office of Assistant Chief Counsel (Passthroughs and Special Industries), Internal Revenue Service. However, other personnel from the IRS and Treasury Department participated in their development. List of Subjects 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 20 Estate taxes, Reporting and recordkeeping requirements. 26 CFR Part 25 Gift taxes, Reporting and recordkeeping requirements. Proposed Amendments to the Regulations Accordingly, 26 CFR parts 1, 20 and 25 are proposed to be amended as follows: PART 1--INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.7520-3 is amended by adding the text of paragraph (b) to read as follows: Sec. 1.7520-3 Limitation on the application of section 7520. * * * * * (b) Other limitations on the application of section 7520-- (1) In general--(i) Ordinary beneficial interests. For purposes of this section: (A) An ordinary annuity interest is the right to receive a fixed dollar amount at the end of each year during one or more measuring lives or for some other defined period. A standard section 7520 annuity factor for an ordinary annuity interest represents the present worth of the right to receive $1.00 per year for a defined period, using the interest rate prescribed under section 7520 for the appropriate month. If an annuity interest is payable more often than annually or is payable at the beginning of each period, a special adjustment must be made in any computation with a standard section 7520 annuity factor. (B) An ordinary income interest is the right to receive the income from, or the use of, property during one or more measuring lives or for some other defined period. A standard section 7520 income factor for an ordinary income interest represents the present worth of the right to receive the income from $1.00 for a defined period, using the interest rate prescribed under section 7520 for the appropriate month. (C) An ordinary remainder or reversionary interest is the right to receive an interest in property at the end of one or more measuring lives or for some other defined period. A standard section 7520 remainder factor for an ordinary remainder or reversionary interest represents the present worth of the right to receive $1.00 at the end of a defined period, using the interest rate prescribed under section 7520 for the appropriate month. (ii) Certain restricted beneficial interests. A restricted beneficial interest is an annuity, income, remainder, or reversionary interest that is subject to a contingency, power, or other restriction, whether the restriction is provided for by the terms of the trust, will, or other governing instrument or is caused by other circumstances. In general, a standard section 7520 annuity, income, or remainder factor may not be used to value a restricted beneficial interest. However, a special section 7520 annuity, income, or remainder factor may be used to value a restricted beneficial interest under some circumstances. See Example 2 in Sec. 1.7520-3(b)(4), which illustrates a situation where a special section 7520 actuarial factor is needed to take into account the shorter life expectancy of the terminally ill measuring life. See Sec. 1.7520-1(c) for requesting a special factor from the Internal Revenue Service. (iii) Other beneficial interests. If, under the provisions of Sec. 1.7520-3(b), the interest rate and mortality components prescribed under section 7520 are not applicable in determining the value of any annuity, income, remainder, or reversionary interest, the actual fair market value of the interest (determined without regard to section 7520) is based on all of the facts and circumstances if and to the extent permitted by the Internal Revenue Code provision applicable to the property interest. (2) Provisions of governing instrument and other limitations on source of payment--(i) Annuities. A standard section 7520 annuity factor is not to be used to determine the present value of an annuity for a specified term of years or the life of one or more individuals unless the effect of the trust, will, or other governing instrument is to ensure that the annuity will be paid for the entire defined period. In the case of an annuity payable from a trust or other limited fund, the annuity is not considered payable for the entire defined period if, considering the applicable section 7520 interest rate, the annuity is expected to exhaust the fund before the last possible annuity payment is made in full. For this purpose, it must be assumed that it is possible for each measuring life to survive until age 110, because every standard section 7520 life annuity factor is calculated on the basis of that assumption. If it is determined that the trust or other fund from which an annuity is to be paid may exhaust before the end of the defined period of the annuity, it will be necessary to calculate a special section 7520 annuity factor that takes into account the facts and circumstances that may exhaust the trust or fund. (ii) Income and similar interests--(A) Beneficial enjoyment. A standard section 7520 income factor for an ordinary income interest is not to be used to determine the present value of an income or similar interest in trust for a term of years or for the life of one or more individuals unless the effect of the trust, will, or other governing instrument is to provide the income beneficiary with that degree of beneficial enjoyment of the property during the term of the income interest that the principles of the law of trusts accord to a person who is unqualifiedly designated as the income beneficiary of a trust for a similar period of time. This degree of beneficial enjoyment is provided only if it was the transferor's intent, as manifested by the provisions of the governing instrument and the surrounding circumstances, that the trust provide an income interest for the income beneficiary during the specified period of time that is consistent with the value of the trust corpus and with its preservation. In determining whether a trust arrangement evidences that intention, the treatment required or permitted with respect to individual items must be considered in relation to the entire system provided for in the administration of the subject trust. Similarly, in determining the present value of the right to use tangible property (whether or not in trust) for one or more measuring lives or other specified period of time, the interest rate component prescribed under section 7520 and Sec. 1.7520-1 is not to be used unless, during the specified period, the beneficiary is entitled to that degree of use, possession, and enjoyment of the property that an outright owner would be entitled to exercise during a similar period of time. (B) Diversions of income and corpus. A standard section 7520 income factor for an ordinary income interest is not to be used to value an income interest or similar interest in property for a term of years or for one or more measuring lives if-- (1) The trust, will, or other governing instrument requires or permits the beneficiary's income or other enjoyment to be withheld, diverted, or accumulated for another person's benefit without the consent of the income beneficiary; or (2) The governing instrument requires or permits trust corpus to be withdrawn from the trust for another person's benefit during the income beneficiary's term of enjoyment without the consent of and accountability to the income beneficiary for such diversion. (iii) Remainder and reversionary interests. A standard section 7520 remainder interest factor for an ordinary remainder or reversionary interest is not to be used to determine the present value of a remainder or reversionary interest (whether in trust or otherwise) unless, consistent with the preservation and protection that the law of trusts would provide for a person who is unqualifiedly designated as the remainder beneficiary of a trust for a similar duration, the effect of the administrative and dispositive provisions for the interest or interests that precede the remainder or reversionary interest is to assure that the property will be adequately preserved and protected from erosion, invasion, depletion, or damage until the remainder or reversionary interest takes effect in possession and enjoyment. This degree of preservation and protection is provided only if it was the transferor's intent, as manifested by the provisions of the arrangement and the surrounding circumstances, that the entire disposition provide the remainder or reversionary beneficiary with an undiminished interest in the property transferred. (iv) Pooled income fund interests. In general, pooled income funds are created and administered to achieve a special rate of return. A beneficial interest in a pooled income fund is not ordinarily valued using a standard section 7520 income or remainder interest factor. The present value of a beneficial interest in a pooled income fund is determined according to rules and special remainder factors prescribed in Sec. 1.642(c)-6. (3) Mortality component. The mortality component prescribed under section 7520 is not to be used to determine the present value of an annuity, income interest, remainder interest, or reversionary interest if an individual who is a measuring life for the interest dies or is terminally ill at the time of the transaction. For purposes of this paragraph (b)(3), an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50 percent probability that the individual will die within 1 year. (4) Examples. The provisions of this paragraph (b) are illustrated by the following examples: Example 1.--Annuity funded with unproductive property. The taxpayer transfers corporation stock worth $1,000,000 to a trust. The trust provides for a 6 percent ($60,000 per year) annuity in cash or other property to be paid to a charitable organization for 25 years and for the remainder to be distributed to the donor's child. The trust specifically authorizes, but does not require, the trustee to retain the shares of stock. The section 7520 interest rate for the month of the transfer is 8.2 percent. The corporation has paid no dividends on this stock during the past 5 years, and there is no indication that this policy will change in the near future. Under applicable state law, the corporation is considered to be a sound investment for a trust with diversified investments because the corporation's practice of retaining its earnings has caused the value of the corporation stock to grow commensurately each year. Considering the 6 percent annuity payout rate and the 8.2 percent section 7520 interest rate, the trust corpus is considered sufficient to pay this annuity for the entire 25-year term of the trust, or even indefinitely. Thus, though the trust assets not likely to earn dividend income during the term of the trust, the assets would be assumed to appreciate at the rate of 8.2 percent per year if there were no income. Therefore, the trust's sole investment in this corporation is not expected to adversely affect the interest of either the annuitant or the remainder beneficiary. Although it appears that neither beneficiary would be able to compel the trustee to make the trust corpus produce investment income, the annuity interest in this case is considered to be an ordinary annuity interest, and the standard section 7520 annuity factor may be used to determine the present value of the annuity. In this case, the section 7520 annuity factor would represent the right to receive $1.00 per year for a term of 25 years. Example 2.--Terminal illness. The taxpayer transfers property worth $1,000,000, to a charitable remainder unitrust described in section 664(d)(2) and Sec. 1.664-3. The trust provides for a fixed- percentage 7 percent unitrust benefit (each annual payment is equal to 7 percent of the trust assets as valued at the beginning of each year) to be paid quarterly to an individual beneficiary for life and for the remainder to be distributed to a charitable organization. At the time the trust is created, the individual beneficiary is age 60 and has been diagnosed with an incurable illness and there is at least a 50 percent probability of the individual dying within 1 year. Because there is at least a 50 percent probability that this beneficiary will die within 1 year, the standard section 7520 unitrust remainder factor for a person age 60 from the valuation tables may not be used to determine the present value of the charitable remainder interest. Instead, a special unitrust remainder factor must be computed that is based on the section 7520 interest rate and that takes into account the projection of the individual beneficiary's actual life expectancy. (5) Additional limitations. Section 7520 does not apply to the extent provided by the Internal Revenue Service in revenue rulings or revenue procedures. (6) Effective date. The provisions of paragraph (b) of this section are effective with respect to transactions after the date these regulations are published as final regulations in the Federal Register. PART 20--ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16, 1954 Par. 3. The authority citation for part 20 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 4. Section 20.7520-3 is amended by adding the text of paragraph (b) to read as follows: Sec. 20.7520-3 Limitation on the application of section 7520. * * * * * (b) Other limitations on the application of section 7520--(1) In general--(i) Ordinary beneficial interests. For purposes of this section: (A) An ordinary annuity interest is the right to receive a fixed dollar amount at the end of each year during one or more measuring lives or for some other defined period. A standard section 7520 annuity factor for an ordinary annuity interest represents the present worth of the right to receive $1.00 per year for a defined period, using the interest rate prescribed under section 7520 for the appropriate month. If an annuity interest is payable more often than annually or is payable at the beginning of each period, a special adjustment must be made in any computation with a standard section 7520 annuity factor. (B) An ordinary income interest is the right to receive the income from or the use of property during one or more measuring lives or for some other defined period. A standard section 7520 income factor for an ordinary income interest represents the present worth of the right to receive the income from $1.00 for a defined period, using the interest rate prescribed under section 7520 for the appropriate month. (C) An ordinary remainder or reversionary interest is the right to receive an interest in property at the end of one or more measuring lives or for some other defined period. A standard section 7520 remainder factor for an ordinary remainder or reversionary interest represents the present worth of the right to receive $1.00 at the end of a defined period, using the interest rate prescribed under section 7520 for the appropriate month. (ii) Certain restricted beneficial interests--A restricted beneficial interest is an annuity, income, remainder, or reversionary interest that is subject to any contingency, power, or other restriction, whether the restriction is provided for by the terms of the trust, will, or other governing instrument or is caused by other circumstances. In general, a standard section 7520 annuity, income, or remainder factor may not be used to value a restricted beneficial interest. However, a special section 7520 annuity, income, or remainder factor may be used to value a restricted beneficial interest under some circumstances. See Example 4 in Sec. 20.7520-3(b)(2)(iv) and Example 2 in Sec. 20.7520-3(b)(4), which illustrate situations where special section 7520 actuarial factors are needed to take into account limitations on beneficial interests. See Sec. 20.7520-1(c) for requesting a special factor from the Internal Revenue Service. (iii) Other beneficial interests. If, under the provisions of Sec. 20.7520-3(b), the interest rate and mortality components prescribed under section 7520 are not applicable in determining the value of any annuity, income, remainder, or reversionary interest, the actual fair market value of the interest (determined without regard to section 7520) is based on all of the facts and circumstances if and to the extent permitted by the Code provision applicable to the property interest. (2) Provisions of governing instrument and other limitations on source of payment--(i) Annuities. A standard section 7520 annuity factor is not to be used to determine the present value of an annuity for a specified term of years or the life of one or more individuals unless the effect of the trust, will, or other governing instrument is to ensure that the annuity will be paid for the entire defined period. In the case of an annuity payable from a trust or other limited fund, the annuity is not considered payable for the entire defined period if, considering the applicable section 7520 interest rate, the annuity is expected to exhaust the fund before the last possible annuity payment is made in full. For this purpose, it must be assumed that it is possible for each measuring life to survive until age 110, because every standard section 7520 annuity factor is calculated on the basis of that assumption. If it is determined that the trust or other fund from which an annuity is to be paid may exhaust before the end of the defined period of the annuity, it will be necessary to calculate a special section 7520 annuity factor that takes into account the facts and circumstances that may exhaust the trust or fund. (ii) Income and Similar Interests--(A) Beneficial enjoyment. A standard section 7520 income factor for an ordinary income interest is not to be used to determine the present value of an income or similar interest in trust for a term of years, or for the life of one or more individuals, unless the effect of the trust, will, or other governing instrument is to provide the income beneficiary with that degree of beneficial enjoyment of the property during the term of the income interest that the principles of the law of trusts accord to a person who is unqualifiedly designated as the income beneficiary of a trust for a similar period of time. This degree of beneficial enjoyment is provided only if it was the transferor's intent, as manifested by the provisions of the governing instrument and the surrounding circumstances, that the trust provide an income interest for the income beneficiary during the specified period of time that is consistent with the value of the trust corpus and with its preservation. In determining whether a trust arrangement evidences that intention, the treatment required or permitted with respect to individual items must be considered in relation to the entire system provided for in the administration of the subject trust. Similarly, in determining the present value of the right to use tangible property (whether or not in trust) for one or more measuring lives or other specified period of time, the interest rate component prescribed under section 7520 and Sec. 20.7520-1 is not to be used unless, during the specified period, the beneficiary is entitled to that degree of use, possession, and enjoyment of the property that an outright owner would be entitled to exercise during a similar period of time. (B) Diversions of income and corpus. A standard section 7520 income factor for an ordinary income interest is not to be used to value an income interest or similar interest in property for a term of years, or for one or more measuring lives, if-- (1) The trust, will, or other governing instrument requires or permits the beneficiary's income or other enjoyment to be withheld, diverted, or accumulated for another person's benefit without the consent of the income beneficiary; or (2) The governing instrument requires or permits trust corpus to be withdrawn from the trust for another person's benefit without the consent of the income beneficiary during the income beneficiary's term of enjoyment and without accountability to the income beneficiary for such diversion. (iii) Remainder and reversionary interests. A standard section 7520 remainder interest factor for an ordinary remainder or reversionary interest is not to be used to determine the present value of a remainder or reversionary interest (whether in trust or otherwise) unless, consistent with the preservation and protection that the law of trusts would provide for a person who is unqualifiedly designated as the remainder beneficiary of a trust for a similar duration, the effect of the administrative and dispositive provisions for the interest or interests that precede the remainder or reversionary interest is to assure that the property will be adequately preserved and protected from erosion, invasion, depletion, or damage until the remainder or reversionary interest takes effect in possession and enjoyment. This degree of preservation and protection is provided only if it was the transferor's intent, as manifested by the provisions of the arrangement and the surrounding circumstances, that the entire disposition provide the remainder or reversionary beneficiary with an undiminished interest in the property transferred. (iv) Pooled income fund interests. In general, pooled income funds are created and administered to achieve a special rate of return. A beneficial interest in a pooled income fund is not ordinarily valued using a standard section 7520 income or remainder interest factor. The present value of a beneficial interest in a pooled income fund is determined according to rules and special remainder factors prescribed in Sec. 1.642(c)-6 of this chapter (Income Tax Regulations). (v) Examples. The provisions of this paragraph (b)(2) are illustrated by the following examples: Example 1.--Unproductive property. The decedent's will provides for a bequest of corporation stock to a trust under the terms of which all of the trust income is payable to the decedent's child for life. After the death of the life income beneficiary, the trust is to terminate and the trust property is to be distributed to the decedent's grandchild. The trust specifically authorizes, but does not require, the trustee to retain the shares of stock. The corporation has paid no dividends on this stock during the past 5 years, and there is no indication that this policy will change in the near future. Under applicable state law, the corporation is considered to be an adequately sound growth investment for a trust with diversified investments because the corporation's practice of retaining its earnings has caused the value of the corporation stock to increase commensurately each year. The facts and circumstances, including applicable state law, indicate that the life income beneficiary would not be able to compel the trustee to make the trust corpus productive in conformity with the requirements for a lifetime trust income interest under applicable local law. Therefore, the life income interest in this case is considered nonproductive. Consequently, the income interest may not be valued actuarially under this section. Example 2.--Beneficiary's right to make trust productive. The facts are the same as in Example 1, except that the trustee is not specifically authorized to retain the shares of stock. Further, the terms of the trust specifically provide that the life income beneficiary may require the trustee to make the trust corpus productive consistent with income yield standards for trusts under applicable state law. Under that law, the minimum rate of income that a productive trust may produce is substantially below the section 7520 interest rate for the month of the decedent's death. In this case, because the income beneficiary has the right to compel the trustee to make the trust productive for purposes of applicable local law during the beneficiary's lifetime, the income interest is considered an ordinary income interest for purposes of this paragraph, and the standard section 7520 life income interest factor may be used to determine the present value of the income interest. Example 3.--Discretionary invasion of corpus. The decedent transfers property to a trust under the terms of which all of the trust income is to be paid to the decedent's child for life and the remainder of the trust is to be distributed to a grandchild. The trust authorizes the trustee without restriction to distribute corpus to the decedent's surviving spouse for the spouse's comfort and happiness. In this case, because the trustee's power to invade trust corpus is unrestricted, the exercise of the power could result in the termination of the income interest at any time. Consequently, the income interest is not considered an ordinary income interest for purposes of this paragraph, and may not be valued actuarially under this section. Example 4.--Limited invasion of corpus. The decedent bequeaths property to a trust under the terms of which all of the trust income is to be paid to the decedent's child for life and the remainder is to be distributed to the decedent's grandchild. The trust authorizes the child to withdraw up to $5,000 per year from the trust corpus. In this case, the child's power to invade trust corpus is limited to an ascertainable amount each year. Annual invasions of any amount would be expected to progressively diminish the property from which the child's income is paid. Consequently, the income interest is not considered an ordinary income interest for purposes of this paragraph, and the standard section 7520 income interest factor may not be used to determine the present value of the income interest. Nevertheless, the present value of the child's income interest is ascertainable by making a special actuarial calculation that would take into account not only the initial value of the trust corpus, the section 7520 interest rate for the month of the transfer, and the mortality component for the child's age, but also the assumption that the trust corpus will decline at the rate of $5,000 each year during the child's lifetime. The child's right to receive an amount not in excess of $5,000 per year may be separately valued in this instance and, assuming the trust corpus would not exhaust before the child would attain age 110, would be considered an ordinary annuity interest. Example 5.--Power to consume. The decedent devises a life estate in 3 parcels of real estate to the surviving spouse with the remainder to a child. The decedent also confers upon the spouse an unrestricted power to consume the property, which includes the right to sell part or all of the property and to use the proceeds for the spouse's support, comfort, happiness, and other purposes. Any portion of the property or its sale proceeds remaining at the death of the surviving spouse is to vest by operation of law in the child at that time. In this case, the surviving spouse's power to consume the corpus is unrestricted, and the exercise of the power could entirely exhaust the remainder interest during the life of the spouse. Consequently, the remainder interest is not considered an ordinary remainder interest for purposes of this paragraph and may not be valued actuarially under this section. (3) Mortality component--(i) Terminal illness cases. Except as provided in paragraph (b)(3)(ii) of this section, the mortality component prescribed under section 7520 is not to be used to determine the present value of an annuity, income interest, remainder interest, or reversionary interest if an individual who is a measuring life dies or is terminally ill at the time of the decedent's death. For purposes of this paragraph (b)(3), an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50 percent probability that the individual will die within 1 year. (ii) Exceptions. If, in the case of the allowance of the credit for tax on a prior transfer under section 2013, the tax in the transferor's estate was finally determined without regard to the fact that one or more measuring lives were terminally ill at the time of the transferor's death, the value of any transferred interest dependent on any of those lives shall be determined for purposes of section 2013 without regard to the fact that those measuring lives were terminally ill. In addition, the value of a decedent's reversionary interest under section 2037(b) or 2042(2) shall be determined without regard to the physical condition of the decedent immediately before death. (4) Examples. The provisions of paragraph (b)(3) of this section are illustrated by the following examples: Example 1.--Simultaneous deaths. The decedent's will establishes a trust to pay income to the decedent's surviving spouse for life. The will provides that, upon the spouse's death, or if the spouse fails to survive the decedent, the trust property is to pass to the decedent's children. The decedent and the decedent's spouse die simultaneously in an accident under circumstances in which it was impossible to determine who survived the other. Applicable state law presumes that the decedent died first with the result that the property interest is considered to have passed in trust for the benefit of the spouse for life, after which the remainder is to be distributed to the decedent's children. Therefore, the spouse's life income interest may not be valued under this section. Example 2.--Terminal illness. The decedent bequeaths $1,000,000 to a trust under the terms of which the trustee is to pay $103,000 per year to a charitable organization during the life of the decedent's child. Upon the death of the child, the remainder in the trust is to be distributed to the decedent's grandchild. The child, who is age 60, has been diagnosed with an incurable illness, and there is at least a 50 percent probability of the child dying within 1 year. The section 7520 interest rate for the month of the decedent's death is 10.6 percent. The standard life annuity factor for a person age 60 (7.4230) may not be used to determine the present value of the charitable organization's annuity interest because there is at least a 50 percent probability that the measuring life will die within 1 year. Instead, a special section 7520 annuity factor must be computed that takes into account the projection of the child's actual life expectancy. (5) Additional Limitations. Section 7520 does not apply to the extent provided by the Internal Revenue Service in revenue rulings or revenue procedures. (6) Effective date. The provisions of this paragraph (b) are effective with respect to estates of decedents dying after the date these regulations are published as final regulations in the Federal Register. PART 25--GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954 Par. 5. The authority citation for part 25 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 6. Section 25.7520-3 is amended by adding the text of paragraph (b) to read as follows: Sec. 25.7520-3 Limitation on the application of section 7520. * * * * * (b) Other limitations on the application of section 7520--(1) In general--(i) Ordinary beneficial interests. For purposes of this section: (A) An ordinary annuity interest is the right to receive a fixed dollar amount at the end of each year during one or more measuring lives or for some other defined period. A standard section 7520 annuity factor for an ordinary annuity interest represents the present worth of the right to receive $1.00 per year for a defined period, using the interest rate prescribed under section 7520 for the appropriate month. If an annuity interest is payable more often than annually or is payable at the beginning of each period, a special adjustment must be made in any computation with a standard section 7520 annuity factor. (B) An ordinary income interest is the right to receive the income from or the use of property during one or more measuring lives or for some other defined period. A standard section 7520 income factor for an ordinary income interest represents the present worth of the right to receive the income from $1.00 for a defined period, using the interest rate prescribed under section 7520 for the appropriate month. However, in the case of certain gifts made after October 8, 1990, if the donor does not retain a qualified annuity, unitrust, or reversionary interest, the value of any interest retained by the donor is considered to be zero if the remainder beneficiary is a member of the donor's family. See Sec. 25.2702-2. (C) An ordinary remainder or reversionary interest is the right to receive an interest in property at the end of one or more measuring lives or for some other defined period. A standard section 7520 remainder factor for an ordinary remainder or reversionary interest represents the present worth of the right to receive $1.00 at the end of a defined period, using the interest rate prescribed under section 7520 for the appropriate month. (ii) Certain restricted beneficial interests. A restricted beneficial interest is an annuity, income, remainder, or reversionary interest that is subject to any contingency, power, or other restriction, whether the restriction is provided for by the terms of the trust, will, or other governing instrument or is caused by other circumstances. In general, a standard section 7520 annuity, income, or remainder factor may not be used to value a restricted beneficial interest. However, a special section 7520 annuity, income, or remainder factor may be used to value a restricted beneficial interest under some circumstances. See Examples 3, 4, and 5 in Sec. 25.7520-3(b)(2)(iv) and the Example in Sec. 25.7520-3(b)(4), which illustrate situations in which special section 7520 actuarial factors are needed to take into account limitations on beneficial interests. See Sec. 25.7520-1(c) for requesting a special factor from the Internal Revenue Service. (iii) Other beneficial interests. If, under the provisions of Sec. 25.7520-3(b), the interest rate and mortality components prescribed under section 7520 are not applicable in determining the value of any annuity, income, remainder, or reversionary interest, the actual fair market value of the interest (determined without regard to section 7520) is based on all of the facts and circumstances if and to the extent permitted by the Internal Revenue Code provision applicable to the property interest. (2) Provisions of governing instrument and other limitations on source of payment--(i) Annuities. A standard section 7520 annuity factor is not to be used to determine the present value of an annuity for a specified term of years or the life of one or more individuals unless the effect of the trust, will, or other governing instrument is to ensure that the annuity will be paid for the entire defined period. In the case of an annuity payable from a trust or other limited fund, the annuity is not considered payable for the entire defined period if, considering the applicable section 7520 interest rate, the annuity is expected to exhaust the fund before the last possible annuity payment is made in full. For this purpose, it must be assumed that it is possible for each measuring life to survive until age 110, because every standard section 7520 annuity factor is calculated on the basis of that assumption. If it is determined that the trust or other fund from which an annuity is to be paid may exhaust before the end of the defined period of the annuity, it will be necessary to calculate a special section 7520 annuity factor that takes into account the facts and circumstances that may exhaust the trust or fund. (ii) Income and similar interests--(A) Beneficial enjoyment. A standard section 7520 income factor for an ordinary income interest is not to be used to determine the present value of an income or similar interest in trust for a term of years, or for the life of one or more individuals, unless the effect of the trust, will, or other governing instrument is to provide the income beneficiary with that degree of beneficial enjoyment of the property during the term of the income interest that the principles of the law of trusts accord to a person who is unqualifiedly designated as the income beneficiary of a trust for a similar period of time. This degree of beneficial enjoyment is provided only if it was the transferor's intent, as manifested by the provisions of the governing instrument and the surrounding circumstances, that the trust provide an income interest for the income beneficiary during the specified period of time that is consistent with the value of the trust corpus and with its preservation. In determining whether a trust arrangement evidences that intention, the treatment required or permitted with respect to individual items must be considered in relation to the entire system provided for in the administration of the subject trust. Similarly, in determining the present value of the right to use tangible property (whether or not in trust) for one or more measuring lives or other specified period of time, the interest rate component prescribed under section 7520 and Sec. 25.7520-1 is not to be used unless, during the specified period, the beneficiary is entitled to that degree of use, possession, and enjoyment of the property that an outright owner would be entitled to exercise during a similar period of time. (B) Diversions of income and corpus. A standard section 7520 income factor for an ordinary income interest is not to be used to value an income interest or similar interest in property for a term of years, or for one or more measuring lives, if-- (1) The trust, will, or other governing instrument requires or permits the beneficiary's income or other enjoyment to be withheld, diverted, or accumulated for another person's benefit without the consent of the income beneficiary; or (2) The governing instrument requires or permits trust corpus to be withdrawn from the trust for another person's benefit without the consent of the income beneficiary during the income beneficiary's term of enjoyment and without accountability to the income beneficiary for such diversion. (iii) Remainder and reversionary interests. A standard section 7520 remainder interest factor for an ordinary remainder or reversionary interest is not to be used to determine the present value of a remainder or reversionary interest (whether in trust or otherwise) unless, consistent with the preservation and protection that the law of trusts would provide for a person who is unqualifiedly designated as the remainder beneficiary of a trust for a similar duration, the effect of the administrative and dispositive provisions for the interest or interests that precede the remainder or reversionary interest is to assure that the property will be adequately preserved and protected from erosion, invasion, depletion, or damage until the remainder or reversionary interest takes effect in possession and enjoyment. This degree of preservation and protection is provided only if it was the transferor's intent, as manifested by the provisions of the arrangement and the surrounding circumstances, that the entire disposition provide the remainder or reversionary beneficiary with an undiminished interest in the property transferred. (iv) Pooled income fund interests. In general, pooled income funds are created and administered to achieve a special rate of return. A beneficial interest in a pooled income fund is not ordinarily valued using a standard section 7520 income or remainder interest factor. The present value of a beneficial interest in a pooled income fund is determined according to rules and special remainder factors prescribed in Sec. 1.642(c)-6 of this chapter (Income Tax Regulations). (v) Examples. The provisions of this paragraph (b)(2) are illustrated by the following examples: Example 1.--Unproductive property. The donor transfers corporation stock to a trust under the terms of which all of the trust income is payable to a child for life. After the death of the life income beneficiary, the trust is to terminate and the trust property is to be distributed to a grandchild. The trust specifically authorizes, but does not require, the trustee to retain the shares of stock. The corporation has paid no dividends on this stock during the past 5 years, and there is no indication that this policy will change in the near future. Under applicable state law, the corporation is considered to be an adequately sound growth investment for a trust with diversified investments because the corporation's practice of retaining its earnings has caused the value of the corporation stock to increase commensurately each year. The facts and circumstances, including applicable state law, indicate that the income beneficiary would not have the legal right to compel the trustee to make the trust corpus productive in conformity with the requirements for a lifetime trust income interest under applicable local law. Therefore, the life income interest in this case is considered nonproductive. Consequently, the income interest may not be valued actuarially under this section. Example 2.--Beneficiary's right to make trust productive. The facts are the same as in Example 1, except that the trustee is not specifically authorized to retain the shares of corporation stock. Further, the terms of the trust specifically provide that the life income beneficiary may require the trustee to make the trust corpus productive consistent with income yield standards for trusts under applicable state law. Under that law, the minimum rate of income that a productive trust may produce is substantially below the section 7520 interest rate on the valuation date. In this case, because the income beneficiary has the right to compel the trustee to make the trust productive for purposes of applicable local law during the beneficiary's lifetime, the income interest is considered an ordinary income interest for purposes of this paragraph, and the standard section 7520 life income factor may be used to determine the value of the income interest. However, in the case of gifts made after October 8, 1990, if the donor was the life income beneficiary, the value of the income interest would be considered to be zero in this situation. See Sec. 25.2702-2. Example 3.--Annuity trust funded with unproductive property. The donor, who is age 60, transfers corporation stock worth $1,000,000 to a trust. The trust will pay a 6 percent ($60,000 per year) annuity in cash or other property to the donor for 10 years or until the donor's prior death. Upon the termination of the trust, the trust property is to be distributed to the donor's child. The section 7520 rate for the month of the transfer is 8.2 percent. The corporation has paid no dividends on the stock during the past 5 years, and there is no indication that this policy will change in the near future. Under applicable state law, the corporation is considered to be a sound investment for a trust with diversified investments because the corporation's practice of retaining its earnings has caused the value of the corporation stock to grow commensurately each year. Considering the 6 percent annuity payout rate and the 8.2 percent section 7520 interest rate, the trust corpus is considered sufficient to pay this annuity for the entire 10-year term of the trust, or even indefinitely. Thus, though the trust assets not likely to earn dividend income during the term of the trust, the assets would be assumed to appreciate at the rate of 8.2 percent per year if there were no income. Therefore, the trust's sole investment in this corporation is not expected to adversely affect the interest of either the annuity beneficiary or the remainder beneficiary. The trust specifically authorizes, but does not require, the trustee to retain the shares of stock. Although it appears that neither beneficiary would be able to compel the trustee to make the trust corpus produce investment income, the annuity interest in this case is considered to be an ordinary annuity interest, and a section 7520 annuity factor may be used to determine the present value of the annuity. In this case, the section 7520 annuity factor would represent the right to receive $1.00 per year for a term of 10 years or the prior death of a person age 60. Example 4.--Unitrust funded with unproductive property. The facts are the same as in Example 3, except that the donor has retained a unitrust interest equal to 7 percent of the value of the trust property, valued as of the beginning of each year. Although the trust corpus is nonincome producing, the present value of the donor's retained unitrust interest may be determined by using the section 7520 unitrust factor for a term of years or a prior death. Example 5.--Eroding corpus in an annuity trust. The donor, who is age 60 and in normal health, transfers property worth $1,000,000 to a trust. The trust will pay a 10 percent ($100,000 per year) annuity to a charitable organization for the life of the donor, and the remainder is to be distributed to the donor's child. The section 7520 rate for the month of the transfer is 6.8 percent. Because the 10 percent annuity payout rate exceeds the 6.8 percent income and growth rate that the trust is expected to experience each year, the annuity payout must be assumed to progressively erode the corpus. Using an interest rate of 6.8 percent, an annuity payout of $100,000 per year will exhaust a $1,000,000 trust corpus in 18 years. The final payment at the end of the 18th year will consist of a partial payment of $32,712. Under section 7520, the standard life annuity factors are based on the assumption that any person may survive until age 110. This means that the standard life annuity factor for age 60 (9.8585) takes into account the separate probabilities that a person age 60 may survive to receive each of 50 different annuity payments. However, in the present case, because of the eroding corpus, the person age 60 can be assumed to receive no more than 17 $100,000 annuity payments, regardless of how long that person might survive. Therefore, the standard life annuity factor for a person age 60 (9.8585) is not applicable in this case, and special section 7520 annuity factors that take into account the 18-year limitation on the annuity payout must be used. The special annuity factor for the present value of the right to receive $1.00 per year for 17 years or until the prior death of a person age 60 is $8.6121, and the special factor for the present value of the right to receive $1.00 in 18 years if a person age 60 survives is $.1836. The present value of the charitable annuity interest is $867,269 ($100,000 X 8.6121 plus $32,712 X .1836). (3) Mortality component. The mortality component prescribed under section 7520 is not to be used to determine the present value of an annuity, income interest, remainder interest, or reversionary interest if an individual who is a measuring life dies or is terminally ill at the time the gift is completed. For purposes of this paragraph (b)(3), an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50 percent probability that the individual will die within 1 year. (4) Example. The provisions of paragraph (b)(3) of this section are illustrated by the following example: Example.--Terminal illness. The donor transfers property worth $1,000,000 to a child in exchange for the child's promise to pay the donor $103,000 per year for the donor's life. The donor is age 60 but has been diagnosed with an incurable illness and has at least a 50 percent probability of dying within 1 year. The section 7520 interest rate for the month of the transfer is 10.6 percent, and the standard annuity factor at that interest rate for a person age 60 in normal health is 7.4230. Thus, if the donor were not terminally ill, the present value of the annuity would be $764,569 ($103,000 X 7.4230). Because there is at least a 50 percent probability that the donor will not survive for 1 more year, the standard section 7520 annuity factor may not be used to determine the present value of the donor's annuity interest. Instead, a special section 7520 annuity factor must be computed that takes into account the projection of the donor's actual life expectancy. (5) Additional limitations. Section 7520 does not apply to the extent provided by the Internal Revenue Service in revenue rulings or revenue procedures. (6) Effective date. The provisions of this paragraph are effective with respect to gifts made after [the date these regulations are published as final regulations in the Federal Register]. Margaret Milner Richardson, Commissioner of Internal Revenue. [FR Doc. 94-12295 Filed 6-9-94; 8:45 am] BILLING CODE 4830-01-U