[Federal Register Volume 69, Number 142 (Monday, July 26, 2004)]
[Proposed Rules]
[Pages 44476-44480]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-16593]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 25

[REG-163679-02]
RIN 1545-BB72


Qualified Interests

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: These proposed regulations amend the regulations under the 
gift tax special valuation rules to provide that a unitrust amount or 
annuity payable for a specified term of years to the grantor, or to the 
grantor's estate if the grantor dies prior to the expiration of the 
term, is a qualified interest for the specified term. The proposed 
regulations also clarify that the exception treating a spouse's 
revocable successor interest as a retained qualified interest applies 
only if the spouse's annuity or unitrust interest, standing alone, 
would constitute a qualified interest that meets the requirements of 
Sec.  25.2702-3(d)(3), but for the grantor's revocation power. This 
document also provides a notice of a public hearing on these proposed 
regulations.

DATES: Written and electronic comments must be received by October 21, 
2004. Outlines of topics to be discussed at the public hearing 
scheduled for October 28, 2004, must be received by October 7, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-163679-02), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
163679-02), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
electronic comments directly to the IRS Internet site at http://www.irs.gov/regs or via the Federal eRulemaking Portal at http://www.regulations.gov (indicate IRS and REG-163679-02). The public 
hearing will be held in the auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Juli Ro Kim, (202) 622-3090; concerning submissions of comments, the 
hearing, and/or to be placed on the building access list to attend the 
hearing, Guy Traynor, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Section 2702 provides special rules for valuing gifts in trust when 
the donor or an applicable family member retains an interest in the 
trust. If the retained interest is not a qualified interest, the 
retained interest is valued at zero, and the amount of the gift is the 
entire value of the transferred property. If the retained interest is a 
qualified interest, the retained interest is valued under section 7520 
using prescribed actuarial tables and interest rates, and the amount of 
the gift is the value of the transferred property reduced by the value 
of the retained interest. Under section 2702(b), a qualified interest 
is: (1) An interest that consists of a right to receive fixed amounts 
payable not less frequently than annually (a qualified annuity 
interest); (2) an interest that consists of a right to receive amounts 
that are payable at least annually and are a fixed percentage of the 
net fair market value of the trust assets determined annually (a 
qualified unitrust interest); and (3) a right to receive a 
noncontingent remainder interest if all other interests in the trust 
are qualified annuity or unitrust interests (a qualified remainder 
interest). Under Sec.  25.2702-3(d)(3) of the Gift Tax Regulations, the 
qualified annuity or unitrust interest must be payable, ``for the life 
of the term holder, for a specified term of years, or for the shorter 
(but not longer) of those periods.'' Under Sec.  25.2702-2(a)(5) the 
retention of a power to revoke a qualified annuity interest (or 
unitrust interest) of the transferor's spouse is treated as the 
retention of a qualified annuity interest (or unitrust interest).
    These qualified interest requirements were the subject of 
litigation in two cases (described more fully below) before the United 
States Tax Court and, on appeal in one case, the Ninth Circuit Court of 
Appeals. These proposed regulations are being issued to clarify the 
existing regulations with respect to the issues raised in the cases and 
to revise an example in the regulations that the Tax Court held to be 
invalid.

[[Page 44477]]

Walton v. Commissioner

    In Walton v. Commissioner, 115 T.C. 589 (2000), the Tax Court 
considered a situation similar to that presented in Example 5 of Sec.  
25.2702-3(e). In this example, A transfers property to an irrevocable 
trust, retaining the right to receive a unitrust amount for 10 years. 
If A dies within the 10-year term, the unitrust amount is to be paid to 
A's estate for the balance of the term. The example concludes that A's 
interest is a qualified unitrust interest to the extent of the right to 
receive the unitrust amount for 10 years or until A's prior death. The 
example also concludes, however, that the unitrust amount payable to 
A's estate if A dies within the term of the trust is not a qualified 
interest.
    In Example 6 of Sec.  25.2702-3(e), the facts are the same as in 
Example 5, except that, if A dies within the 10-year term, the unitrust 
amount will be paid to A's estate for an additional 35 years. The 
example concludes that the result is the same as in Example 5; that is, 
A's interest is a qualified unitrust interest to the extent of the 
right to receive the unitrust amount for 10 years or until A's prior 
death.
    In Walton, the grantor established a grantor retained annuity trust 
(GRAT), pursuant to which the grantor was to receive an annuity for a 
term of 2 years. If the grantor died before the expiration of the 2-
year term, the annuity was to be paid to the grantor's estate for the 
balance of the term. Upon expiration of the 2-year term, the trust 
corpus was to be distributed to a designated remainder beneficiary. 
After considering the legislative history and purpose of section 2702, 
the court held that Example 5 is an unreasonable interpretation and 
invalid extension of section 2702. The court concluded that a retained 
annuity payable for a specified term of years to the grantor, or to the 
grantor's estate if the grantor dies prior to expiration of the term, 
is a qualified interest under section 2702 for the specified term of 
years.

Schott v. Commissioner

    As noted above, Sec.  25.2702-2(a)(5) provides that the retention 
of a power to revoke a qualified annuity interest (or unitrust 
interest) of the transferor's spouse is treated as the retention by the 
transferor of a qualified annuity interest (or unitrust interest). 
Section 25.2702-2(d)(1), Examples 6 and 7 illustrate the application of 
this rule.
    In Example 6 of Sec.  25.2702-2(d)(1), A transfers property to an 
irrevocable trust, retaining the right to receive the income for 10 
years. Upon the expiration of 10 years, the income of the trust is 
payable to A's spouse for 10 years, if living. Upon expiration of the 
spouse's interest, the trust terminates and the trust corpus is payable 
to A's child. A retains the right to revoke the spouse's interest. 
Because A has made a completed gift of the remainder interest, the 
transfer of property to the trust is not incomplete as to all interests 
in the property and section 2702 applies. A's power to revoke the 
spouse's term interest is treated as a retained interest for purposes 
of section 2702. The example concludes that, because neither one of the 
interests retained by A (that is, A's income interest and the spouse's 
revocable income interest) is a qualified interest, the amount of the 
gift is the fair market value of the property transferred to the trust.
    In Example 7 of Sec.  25.2702-2(d)(1), the facts are the same as in 
Example 6, except that both the term interest retained by A and the 
interest transferred to A's spouse (subject to A's right of revocation) 
are qualified annuity or unitrust interests. The example concludes that 
the amount of the gift is the fair market value of the property 
transferred to the trust reduced by the value of both A's qualified 
interest and the qualified interest transferred to A's spouse (subject 
to A's power to revoke).
    In Schott v. Commissioner, T.C.M. 2001-110, rev'd and remanded 319 
F. 3d 1203 (9th Cir. 2003), the GRAT at issue provided for fixed 
annuity payments to the grantor for a 15-year term, or until the 
grantor's prior death. If the grantor died prior to the end of the 15-
year term and the grantor's spouse survived the grantor, then the 
annuity was to be paid to the spouse for the balance of the 15-year 
term. The grantor retained the right to revoke the spouse's interest. 
The Tax Court, relying on its earlier opinion in Cook v. Commissioner, 
115 T.C. 15 (2000), aff'd 269 F. 3d 854 (7th Cir. 2001), concluded that 
the successor spousal interest was not a qualified interest, and thus, 
that the successor spousal interest must be valued at zero. The court 
noted that the term of the revocable spousal interest was contingent 
upon the death of the grantor and thus was not fixed and ascertainable 
under the governing instrument as required by Sec.  25.2702-3(d)(3). 
Further, because the revocable spousal interest was deemed to be an 
interest retained by the grantor, the possibility existed that the 
retained annuity interest could extend beyond the life of the term 
holder (the grantor) but for less than the specified 15-year term, 
which is not consistent with the requirement in Sec.  25.2702-3(d)(3) 
that the qualified annuity or unitrust interest be payable ``for the 
life of the term holder, for a specified term of years, or for the 
shorter (but not longer) of those periods.'' The Tax Court, following 
its opinion in Cook, distinguished the Schott GRAT from Sec.  25.2702-
2(d)(1), Example 7, because, in the Court's view, in Example 7, the 
spouse or the estate of the spouse would receive the annuity regardless 
of whether the spouse was living at the end of the grantor's initial 
10-year term. Thus, the court viewed the spouse's interest in Example 7 
as a noncontingent interest for a fixed term of years. In contrast, the 
Schott spousal interest would pass to the spouse only if the grantor 
died within the term of the trust and the spouse was living when the 
grantor died.
    However, on appeal, the Ninth Circuit concluded that the Schott 
spousal interest was a qualified interest. The Ninth Circuit 
distinguished Cook because the revocable spousal interest in Cook was 
also contingent upon the grantor and the spouse being married to each 
other at the grantor's death, which could not be accounted for by an 
annuity table. Further, the Ninth Circuit rejected the Commissioner's 
contention that a spousal interest contingent on the death of the 
grantor lacks the fixed term required by the regulations. Rather, the 
court stated that every annuity given to a person, if living, is 
contingent on that person's survival. The court also stated that the 
present value of the spouse's interest (even if dependent on the 
grantor's death prior to expiration of the specified term) can be 
ascertained using the actuarial tables.

Explanation of Provisions

Walton v. Commissioner

    In Notice 2003-72 (2003-44 I.R.B. 964) (released October 15, 2003), 
the IRS announced that it will follow the Walton decision. Consistent 
with Notice 2003-72, the proposed regulations revise Example 5 and 
Example 6 of Sec.  25.2702-3(e) to conform to the Walton decision. 
Under the examples as revised, a unitrust amount payable for a 
specified term of years to the grantor, or to the grantor's estate if 
the grantor dies prior to the expiration of the term, is a qualified 
interest for the specified term. Thus, in Example 5, the interest of A 
(and A's estate) to receive the unitrust amount for a specified term of 
10 years in all events is a qualified interest. Similarly, in Example 
6, the unitrust interest, to the extent payable to either A or A's 
estate for a 10-year period in all events, is a qualified interest for 
a 10-year term. However, in Example 6, the interest of A's estate to 
receive the unitrust amount after the 10-year period

[[Page 44478]]

for the remaining balance of the additional 35-year term if A dies 
within the 10-year period, is a contingent interest that is not fixed 
or ascertainable at the creation of the interest and, therefore, is not 
a qualified interest.
    The result in Example 6, in which only a discrete portion of the 
grantor's retained 35-year unitrust interest (specifically, that 
portion payable in all events for a 10-year term) is a qualified 
interest, does not change the result in Example 1 of Sec.  25.2702-
3(e). In Example 1, A retains the right to receive an annuity for a 10-
year term, or until A's prior death. If A dies prior to the expiration 
of the 10-year term, the entire trust corpus reverts to A's estate. The 
example concludes that the estate's contingent reversion is valued at 
zero, notwithstanding that, economically, this reversion of the entire 
trust corpus includes the equivalent value of the annuity that would be 
payable for the balance of the 10-year term. The Tax Court in Walton 
addressed Example 1, noting that, in the case of a reversion, even 
though the equivalent of the term annuity's value would be payable to 
the grantor or the grantor's estate in all events, Congress was 
entitled to require that interests be cast in one of three specified 
forms to receive the favorable treatment afforded qualified interests. 
The Court stated ``* * * the Commissioner is equally justified in 
assigning a zero value to reversionary interests outside the scope of 
the statutory definition and refusing to consider whether such 
interests can have the practical effect of a different form of interest 
not chosen by the grantor. See Sec.  25.2702-3(e), Example (1), Gift 
Tax Regs.'' Walton, 115 T.C. at 602. Thus, in Example 1, the reversion, 
even though including the equivalent value of an annuity payable for 
the balance of the 10-year term, is not in a qualified form prescribed 
by the statute and is, therefore, not a qualified interest to any 
extent. On the other hand, in Example 6 of Sec.  25.2702-3(e), the 
retained interest is in the form of a unitrust interest and, therefore, 
is a qualified interest to the extent payable to A or A's estate for a 
10-year period in all events.

Schott v. Commissioner

    The proposed regulations also clarify when a revocable spousal 
interest is a qualified interest.
    Sections 2702(a)(3)(A)(i) and (B) confirm that the valuation rules 
of section 2702 do not apply to a gift that is incomplete. Section 
25.2702-2(a)(5) provides a regulatory exception to this statutory rule 
by providing that the retention of a power to revoke a qualified 
annuity or unitrust interest of the transferor's spouse is a qualified 
interest. The annuity or unitrust interest payable to the transferor's 
spouse must be a qualified interest to meet this exception. Thus, the 
regulatory exception focuses on the spouse's annuity or unitrust 
interest and applies only if that interest is a qualified interest as 
described in Sec.  25.2702-3(d).
    The references to ``term holder'' in Sec.  25.2702-3(d)(3) or 
``holder of the qualified * * * interest'' in Sec.  25.2702-3(b) and 
(c) refer to the person to whom the annuity or unitrust interest is 
payable during the fixed term. In the case of a revocable successor 
interest held by the transferor's spouse, although the spouse's 
interest (if qualified) is valued as a retained qualified interest of 
the transferor and may thus be deducted from the total value of the 
assets transferred in computing the taxable gift under section 2702, 
the spouse is the holder during the period when an interest is payable 
to the spouse. Thus, each qualified interest must meet the fixed 
duration requirements of Sec.  25.2702-3(d)(3), and each holder's 
separate interest must be valued as a single life annuity or unitrust 
interest.
    In addition to the requirement that a qualified interest be for a 
fixed term, payment of the interest cannot be contingent on any event 
other than the survival of the term holder (subject to the transferor's 
retained right of revocation). A revocable spousal interest is 
contingent, and therefore not a qualified interest, if the spouse will 
not receive any payments if the transferor survives the fixed term 
during which the transferor is the holder.
    Section 25.2702-2(d)(1), Example 7, illustrates the revocable 
spousal interest exception. In Example 7, beginning at the expiration 
of a 10-year term, the spouse's annuity is payable to the spouse for 10 
years or until the spouse's prior death. Thus, the spouse's annuity in 
the example meets the requirements of Sec.  25.2702-3(d)(3), that the 
term of the annuity must be for either the life of the holder (the 
spouse), for a specified term of years, or for the shorter but not the 
longer of these two periods and, assuming the spouse survives until the 
commencement of his or her interest, the spouse will receive that 
interest in all events (subject to the transferor's retained right of 
revocation). In contrast, in Schott, the spouse's annuity does not meet 
the requirements of Sec.  25.2702-3(d)(3) because the spousal annuity 
is payable, if at all, only if the grantor dies prior to the 
termination of the term of the trust and, if payable at all, is payable 
for a period that depends on the length of the unexpired portion of the 
trust's term when the grantor dies.
    The proposed regulations clarify that the revocable spousal 
interest exception applies only if the spouse's interest, standing 
alone, would constitute a qualified interest that meets the 
requirements of Sec.  25.2702-3(d)(3), but for the grantor's revocation 
power.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
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) does not apply to these proposed regulations, and 
because these proposed regulations do not impose a collection of 
information on small entities, the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis 
is not required. Pursuant to section 7805(f) of the Internal Revenue 
Code, the proposed regulations will be submitted to the Small Business 
Administration for comment on their impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely (in the 
manner described in ADDRESSES of this preamble) to the IRS. The IRS and 
the Treasury Department request comments on the clarity of the proposed 
regulations and how they may be made easier to understand. All comments 
will be available for public inspection and copying.
    A public hearing has been scheduled for October 28, 2004, at 10 
a.m. in the auditorium, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. In addition, all visitors must present 
photo identification to enter the building. Because of access 
restrictions, visitors will not be admitted beyond the immediate 
entrance area more than 30 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit comments by 
October 21, 2004, and submit an outline of the

[[Page 44479]]

topics to be discussed and the time to be devoted to each topic (signed 
original and eight (8) copies) by October 7, 2004.
    A period of 10 minutes will be allotted to each person for making 
comments. An agenda showing the scheduling of the speakers will be 
prepared after the deadline for receiving outlines has passed. Copies 
of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is Juli Ro Kim, 
Office of the Associate Chief Counsel (Passthroughs and Special 
Industries), IRS. Other personnel from the IRS and the Treasury 
Department participated in their development. If you have any questions 
concerning these proposed regulations, please contact Ms. Kim at (202) 
622-3090.

List of Subjects in 26 CFR Part 25

    Gift taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 25 is proposed to be amended as follows:

PART 25--Gift Tax; GIFTS MADE AFTER DECEMBER 31, 1954

    Paragraph 1. The authority citation for part 25 continues to read, 
in part, as follows:

    Authority: 25 U.S.C. 7805 * * *

    Par. 2. In Sec.  25.2702-0, the table is amended as follows:
    1. The entries for Sec.  25.2702-2(a)(5) through Sec.  25.2702-
2(a)(9) are redesignated as Sec.  25.2702-2(a)(6) through Sec.  
25.2702-2(a)(10), respectively.
    2. A new entry for Sec.  25.2702-2(a)(5) is added.
    3. The entries for Sec.  25.2702-3(d)(2) through Sec.  25.2702-
3(d)(4) are redesignated as Sec.  25.2702-3(d)(3) through Sec.  
25.2702-3(d)(5), respectively.
    4. A new entry for Sec.  25.2702-3(d)(2) is added.
    5. An entry for Sec.  25.2702-3(d)(6) is added.
    The additions read as follows:


Sec.  25.2702-0  Table of contents.

* * * * *


Sec.  25.2702-2  Definitions and valuation rules.

    (a) * * *
    (5) Holder.
* * * * *


Sec.  25.2702-3  Qualified interests.

* * * * *
    (d) * * *
    (2) Contingencies.
* * * * *
    (6) Use of debt obligations to satisfy the annuity or unitrust 
payment obligation.
* * * * *
    Par. 3. Section 25.2702-2 is amended as follows:
    1. Paragraphs (a)(5) through (a)(9) are redesignated as paragraphs 
(a)(6) through (a)(10), respectively.
    2. A new paragraph (a)(5) is added.
    3. In redesignated paragraph (a)(6), the second sentence is removed 
and two sentences are added in its place.
    4. In paragraph (d)(1), Example 6 and Example 7 are removed.
    5. In paragraph (d)(2), introducing text, the phrase ``Examples 8-
10'' is revised to read ``Examples 6 through 8''.
    6. In paragraph (d)(2), Examples 8, 9 and 10 are redesignated 
Examples 6, 7 and 8, respectively.
    The additions read as follows:


Sec.  25.2702-2  Definitions and valuation rules.

    (a) * * *
    (5) Holder. The holder is the person to whom the annuity or 
unitrust interest is payable during the fixed term of that interest. 
References to holder shall also include the estate of that person.
    (6) * * * If a transferor retains a power to revoke a qualified 
annuity interest or qualified unitrust interest of the transferor's 
spouse, then the revocable qualified annuity or unitrust interest of 
the transferor's spouse is treated as a retained qualified interest of 
the transferor. In order for the transferor to be treated as having 
retained a qualified interest under the preceding sentence, the 
interest of the transferor's spouse (the successor holder) must be an 
interest that meets the requirements of a qualified annuity interest in 
accordance with Sec.  25.2702-3(b) and (d), or a qualified unitrust 
interest in accordance with Sec.  25.2702-3(c) and (d), but for the 
transferor's retained power to revoke the interest.
* * * * *
    Par. 4. Section 25.2702-3 is amended as follows:
    1. Paragraphs (d)(2) through (d)(5) are redesignated as paragraphs 
(d)(3) through (d)(6), respectively.
    2. A new paragraph (d)(2) is added.
    3. In redesignated paragraph (d)(4), the first two sentences are 
revised.
    4. Redesignated paragraph (d)(5) is revised.
    5. In paragraph (e), Example 5, the last sentence is revised.
    6. In paragraph (e), Example 6, the last sentence is removed and 
two new sentences are added in its place.
    7. In paragraph (e), new Example 8 and new Example 9 are added.
    The revisions and additions read as follows:


Sec.  25.2702-3  Qualified interests.

* * * * *
    (d) * * *
    (2) Contingencies. A holder's qualified interest must be payable in 
any event to or for the benefit of the holder for the fixed term of 
that interest. Thus, payment of the interest cannot be subject to any 
contingency other than either the survival of the holder until the 
commencement, or throughout the term, of that holder's interest, or, in 
the case of a revocable interest described in Sec.  25.2702-2(a)(6), 
the transferor's right to revoke the qualified interest of that 
transferor's spouse.
* * * * *
    (4) Term of the annuity or unitrust interest. The governing 
instrument must fix the term of the annuity or unitrust and the term of 
the interest must be fixed and ascertainable at the creation of the 
trust. The term must be for the life of the holder, for a specified 
term of years, or for the shorter (but not the longer) of those 
periods. * * *
    (5) Commutation. The governing instrument must prohibit commutation 
(prepayment) of the interest of the holder.
* * * * *
    (e) * *

    *Example 5. * * * The interest of A (and A's estate) to receive 
the unitrust amount for the specified term of 10 years in all events 
is a qualified unitrust interest for a term of 10 years.
    Example 6. * * * As in Example 5, the interest of A (and A's 
estate) to receive the unitrust amount for a specified term of 10 
years in all events is a qualified unitrust interest for a term of 
10 years. However, the right of A's estate to continue to receive 
the unitrust amount after the expiration of the 10-year term if A 
dies within that 10-year period is not fixed and ascertainable at 
the creation of the interest and is not a qualified unitrust 
interest.
* * * * *
    Example 8. A transfers property to an irrevocable trust, 
retaining the right to receive an annuity equal to 6 percent of the 
initial net fair market value of the trust property for 10 years, or 
until A's prior death. At the expiration of the 10-year term, or on 
A's death prior to the expiration of the 10-year term, the annuity 
is to be paid to B, A's spouse, if then living, for 10 years or 
until B's prior death. A retains the right to revoke B's interest. 
Upon expiration of B's interest (or if A revokes B's interest, or if 
B predeceases A, then on the expiration of A's interest), the trust 
terminates and the trust corpus is payable to A's child. Because A 
has made a completed gift of the remainder interest, the transfer of 
property to the trust

[[Page 44480]]

is not incomplete as to all interests in the property and section 
2702 applies. A's annuity interest (A's right to receive the annuity 
for 10 years, or until A's prior death) is a retained interest that 
is a qualified annuity interest under paragraphs (b) and (d) of this 
section. In addition, because A has retained the power to revoke B's 
interest, B's interest is treated as an interest retained by A for 
purposes of section 2702. B's successive annuity interest otherwise 
satisfies the requirements for a qualified interest contained in 
paragraph (d) of this section, but for A's power to revoke. The term 
of B's interest is specified in the governing instrument and is 
fixed and ascertainable at the creation of the trust, and B's right 
to receive the annuity is contingent only on B's survival, and A's 
power to revoke. Following the expiration of A's interest, the 
annuity is to be paid for a 10-year term or for B's (the successor 
holder's) life, whichever is shorter. Accordingly, A is treated as 
retaining B's revocable qualified annuity interest pursuant to Sec.  
25.2702-2(a)(6). Because both A's interest and B's interest are 
treated as qualified interests retained by A, the value of the gift 
is the value of the property transferred to the trust less the value 
of both A's qualified interest and B's qualified interest (subject 
to A's power to revoke), each valued as a single-life annuity. 
Further, if A revokes B's interest prior to the commencement of that 
interest, A is treated as making a completed gift at that time to 
A's child. The amount of the gift would be the present value of B's 
interest determined under section 7520 and the applicable 
regulations, as of the date the interest is revoked. See Sec.  
25.2511-2(b) and (f).
    Example 9. (i) A transfers property to an irrevocable trust, 
retaining the right to receive 6 percent of the initial net fair 
market value of the trust property for 10 years, or until A's prior 
death. If A survives the 10-year term, the trust terminates and the 
trust corpus is payable to A's child. If A dies prior to the 
expiration of the 10-year term, the annuity is payable to B, A's 
spouse, if then living, for the balance of the 10-year term, or 
until B's prior death. A retains the right to revoke B's interest. 
Upon expiration of B's interest (or upon A's death if A revokes B's 
interest), the trust terminates and the trust corpus is payable to 
A's child. As is the case in Example 8, A's retained annuity 
interest (A's right to receive the annuity for 10 years, or until 
A's prior death) is a qualified annuity interest under paragraphs 
(b) and (d) of this section. However, B's interest does not meet the 
requirements of paragraph (d) of this section. The term of B's 
annuity is not fixed and ascertainable at the creation of the trust, 
because it is not payable for the life of B, a specified term of 
years, or for the shorter of those periods. Rather, B's annuity is 
payable for an unspecified period that will depend upon the number 
of years left in the original term after A's death. Further, B's 
annuity is payable only if A dies prior to the expiration of the 10-
year term. Thus, payment of B's annuity is not dependent solely on 
B's survival, but rather is dependent on A's failure to survive.
    (ii) Accordingly, the amount of the gift is the fair market 
value of the property transferred to the trust reduced by the value 
of A's qualified interest (A's right to receive the stated annuity 
for 10 years or until A's prior death). B's interest is not a 
qualified interest and is thus valued at zero under section 2702.

* * * * *
    Par. 5. Section 25.2702-7 is amended to add two new sentences at 
the end of that section. The addition reads as follows:


Sec.  25.2702-7  Effective dates.

    * * * Section 25.2702-2(a)(5), the second and third sentences of 
Sec.  25.2702-2(a)(6), Sec.  25.2702-3(d)(2), the first two sentences 
of Sec.  25.2702-3(d)(4), the last sentence of Sec.  25.2702-3(e), 
Example 5, the last two sentences of Sec.  25.2702-3(e), Example 6, and 
Sec.  25.2702-3(e), Examples 8 and 9, are effective for trusts created 
on or after July 26, 2004. However, the Internal Revenue Service will 
not challenge any prior application of the changes to Examples 5 and 6 
in Sec.  25.2702-3(e).

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-16593 Filed 7-23-04; 8:45 am]
BILLING CODE 4830-01-P