The proposed regulations to Internal Revenue Code Section 2704, while generally retroactive to restrictions created after Oct. 8, 1990, apply only to lapses and transfers occurring on or after the date the proposed regulations are published as final regulations. The only exception, outlined in my prior article, is that the new rule on disregard restrictions only applies to transfers occurring 30 or more days after the date the proposed regulations are published as final regulations. Thus, one obvious planning technique would be to transfer, either by gift or by sale (including sales to a trust that’s “defective” for income tax purposes), affected interests before the date the proposed regulations become final. This would appear to include even interests that are newly created after the date of the proposed regulations.
Sales to a defective trust should be effective under the grandfathering sections of the proposed regulations despite the fact that grantor/seller will continue to be a holder of the entity interest for purposes of determining whether the grantor/seller and members of their family were or are in control of the entity.1 That’s because the relevant lapse or transfer of the interest to or for the benefit of a member of the transferor’s family will have occurred prior to the date the regulations become final, which is all that’s required under the proposed regulations’ grandfathering rules. No lapse of rights in the interest or transfer of the interest occurs on or after the date the regulations become final.
Use of an Incomplete Gift Trust
Assuming the proposed regulations will eventually be finalized and upheld in substantially their current form, all future lapsing rights and restrictions on liquidation will need to somehow fall within their cracks. Here’s a planning idea that shouldn’t only avoid the proposed regulations, but also IRC Section 2704 completely.
The client first establishes and funds an irrevocable trust in which he retains no interest other than the exclusive lifetime and testamentary power to determine all distributions of principal or income to other persons, including the client’s descendants. Because there’s no completed gift on the establishment of the trust,2 the rules of IRC Section 2702 don’t apply.3 To avoid having the client considered the owner of any trust assets for Section 2704 purposes, the trust document is drafted to eliminate any ability to distribute trust income or principal to or for the benefit of the client. The trust serves the additional important business purpose of insulating the trust assets from creditor attack in most states.
According to the proposed regulations, “[a]n individual, the individual’s estate, and members of the individual’s family are treated as also holding any interest held indirectly by such person through a corporation, partnership, trust, or other entity under the rules contained in §25.2701-6.”4 As applied to estates and trusts, Treasury Regulations Section 25.2701-6(a)(4)(i) includes the following attribution rules (emphasis supplied):
A person is considered to hold an equity interest held by or for an estate or trust to the extent the person's beneficial interest therein may be satisfied by the equity interest held by the estate or trust, or the income or proceeds thereof, assuming the maximum exercise of discretion in favor of the person. A beneficiary of an estate or trust who cannot receive any distribution with respect to an equity interest held by the estate or trust, including the income therefrom or the proceeds from the disposition thereof, is not considered the holder of the equity interest. Thus, if stock held by a decedent's estate has been specifically bequeathed to one beneficiary and the residue of the estate has been bequeathed to other beneficiaries, the stock is considered held only by the beneficiary to whom it was specifically bequeathed. However, any person who may receive distributions from a trust is considered to hold an equity interest held by the trust if the distributions may be made from current or accumulated income from or the proceeds from the disposition of the equity interest, even though under the terms of the trust the interest can never be distributed to that person. This paragraph applies to any entity that is not classified as a corporation, an association taxable as a corporation, or a partnership for federal income tax purposes.
Also according to the regulations, “[a] person holds a beneficial interest in a trust or an estate so long as the person may receive distributions from the trust or estate other than payments for full and adequate consideration.”5 The grantor may not receive distributions from the type of “incomplete gift” trust described above.
The regulations add that “[a]n individual holds as equity interest held by or for a trust if the individual is considered an owner of the trust (a “grantor trust”) under subpart E, part 1, subchapter J of the Internal Revenue Code (relating to grantors and others treated as substantial owners).”6 It’s therefore also necessary to structure transfers to the irrevocable trust, and the trust instrument itself, so that it doesn’t run afoul of IRC Section 674, relating to powers to control beneficial enjoyment.
The easiest Section 674 exception to use will typically be the one found in Section 674(b)(5)(A), a power to distribute corpus “to or for a beneficiary or beneficiaries or to or for a class of beneficiaries (whether or not income beneficiaries) provided that the power is limited by a reasonably definite standard which is set forth in the trust instrument.” Remembering that “a reasonably definite standard” isn’t the same as an “ascertainable standard” applicable in the federal estate and gift tax context, if the trust document requires that all trust accounting income is to be added to corpus, and that corpus can only be distributed as the grantor (in a non-fiduciary capacity) directs for the education, support, maintenance or health of a beneficiary, for a beneficiary’s reasonable support and comfort or to enable a beneficiary to maintain their accustomed standard of living7, the grantor shouldn’t be treated as an owner of any portion of the trust under subchapter J.
The gift should also be incomplete for federal gift tax purposes, in accordance with Treas. Regs. Section 25.2511-2(c): “A gift is also incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of beneficiaries as between themselves, unless the power is a fiduciary power limited by a fixed or ascertainable standard” (emphasis supplied). One issue to bear in mind is that if the grantor only has one child and no other descendants, it will be necessary to broaden the class of permissible beneficiaries and/or remaindermen of the trust (other than the grantor or the grantor’s spouse, or their respective estates, creditors or creditors of their estates), to satisfy the requirements of this section of the regulations.
A principal requirement of Section 2704(a) is that: “the individual holding such right immediately before the lapse and members of such individual’s family hold, both before and after the lapse, control of the entity.” Similarly, a primary requirement of Section 2704(b) is that “the transferor and members of the transferor’s family hold, immediately before the transfer, control of the entity.” As a consequence of the IRS’ above-outlined trust attribution rules, if a corporate or partnership interest is owned inside the type of incomplete gift trust described above, for Section 2704 purposes, no portion of the interest is owned by the grantor of the trust. The Section 2704(a) lapsing rules and the Section 2704(b) applicable and disregarded restriction rules therefore can’t apply when a transfer of the interests is deemed made by the grantor, either for gift tax purposes as a result of the lapse, exercise or release of the grantor’s retained powers or for estate tax purposes as a result of a completed transfer of an interest included in the grantor’s gross under IRC Section 2038.
The individual’s spouse shouldn’t be a beneficiary of the trust under this formulation, because the application of IRC Section 677 could then render the grantor an owner of the trust under subchapter J. However, either the individual or the individual’s spouse should be able to receive bona fide loans from the trust, since fair market value loans wouldn’t constitute a beneficial interest in the trust.8 The drafter would only need to be careful not to violate any of the defective loan provisions of IRC Section 675.
It may be postulated: If a partial exercise or release (and therefore a completed gift) occurs during the grantor’s lifetime, Section 2702 applies. However, Section 2702(d) provides: “In the case of a transfer of an income or remainder interest with respect to a specified portion of the property in a trust, only such portion shall be taken into account in applying this section to such transfer.” (Emphasis supplied) Under the above-described incomplete gift trust arrangement, neither the grantor nor any applicable family member will have retained any interest in the transferred portion, and therefore Section 2702 doesn’t apply to the deemed transfer or to the remaining portion of the trust in which the grantor hasn’t made a completed gift.
Treas. Regs. Section 25.2511-2(f) also makes clear that “[t]he relinquishment or termination of a power to change the beneficiaries of transferred property, occurring otherwise than by the death of the donor (the statute being confined to transfers by living donors) is regarded as the event which completes the gift and causes the tax to apply.” Section 2702 therefore can’t apply at the death of the grantor, since the section only applies to lifetime gifts.
What does this all mean for Section 2704 purposes and the proposed regulations? It means simply that if the corporation or partnership arrangement contemplated by Section 2704 and the proposed and final Section 2704 regulations is established by a trust in which the grantor owns no ability to receive distributions of either income or principal, Sections 2704(a) and (b) can’t apply to gifts or estate tax inclusion with respect to the grantor’s interest in the trust. Thus, although there will still be a taxable gift by the grantor when he exercises or releases his retained rights, or estate tax inclusion when his retained rights lapse at death, the valuation of the gifts of the included interest shouldn’t be limited by the rules under Section 2704, because the interests aren’t considered owned by the grantor for purposes of determining the requisite Section 2704 concurrent control in the grantor and their family.
Of course, efforts should be made to avoid any potential step-transaction argument stemming from situations in which, for example, the client transfers his entity interest to the incomplete gift trust, and then follows the transfer up shortly thereafter by exercising his retained power to direct that trust assets be distributed for the trust beneficiaries’ reasonable support and comfort, or the client transfers his interest to the incomplete gift trust in contemplation of death.9 Subject to the step-transaction doctrine, the mere exercise or release of the client’s retained powers within three years of his death shouldn't run afoul of the IRS’ proposed rule treating a lapse of a voting or liquidation rights that results from a transfer that occurs within three years of the decedent’s death as a lapse which occurs on the date of the transferor’s death. The reason for this conclusion is that, immediately before the exercise or release of the client’s retained powers (that is , the transfer which potentially resulted in the loss of voting or liquidation rights), the client and his family didn't hold control of the entity.10
Endnotes
1. Internal Revenue Code Section 2704(c)(3); Treasury Regulations Section 25.2701-6(a)(4)(ii)(C).
2. Treas. Regs. Section 25.2511-2(f).
3. IRC Section 2702(a)(3)(A)(i).
4. Proposed Regulations Section 25.2704-2(d).
5. Treas. Regs. Section 25.2701-6(a)(4)(ii)(B).
6. Treas. Regs. Section 25.2701-6(a)(4)(ii)(C).
7. Treas. Regs. Section 1.674(b)-1(b)(5)(i).
8. Treas. Regs. Section 25.2701-6(a)(4)(ii)(B).
9. Note the distinction between the latter situation and Internal Revenue Service's proposed rule for transfers within three years of the transferor’s death that result in the lapse of a voting or liquidation right. In the latter situation, no transfer occurs during the decedent’s lifetime.
10. Treas. Regs. Section 25.2704-1(a)(1). (“This section applies only if the entity is controlled by the holder and members of the holder’s family immediately before and after the lapse.”)