A potential issue with the type of incomplete gift trust discussed in my previous article, entitled “Strategies to Prepare for Implementation of Proposed 2704 Regulations,” arises because the IRS has attempted to add regulations that change the law so that no longer must the control of the entity immediately before the lapse or transfer be in the hands of the transferor and members of their family, as required by both Internal Revenue Code Section 2704(a) and 2704(b), but instead control immediately before the transfer need only be in “the transferor and/or members of the transferor’s family.”1 The Conference Committee Report that accompanied the passage of IRC Section 2704 in 1990 was very specific in including the requirement that control of the corporation or partnership immediately before the lapse or transfer be in “the transferor and family members,”2 and included this concurrent arrangement in all three of its examples illustrating the application of IRC Section 2704(a) and 2704(b):
Example 6—Parent and Child control a corporation. Parent’s stock has a voting right that lapses on Parent’s death. Under the conference agreement, Parent’s stock is valued for Federal estate tax purposes as if the voting right of the parent’s stock were nonlapsing.
Example 7—Father and Child each own general and limited interests in a partnership. The general partnership interest carries with it the right to liquidate the partnership; the limited partnership interest has no such right. The liquidation right associated with the general partnership interest lapses after 10 years. Under the conference agreement, there is a gift at the time of the lapse equal to the excess of (1) the value of Father’s partnership interests determined as if he held the right to liquidate over (2) the value of such interests determined as if he did not hold such right.
Example 8—Mother and Son are partners in a two-person partnership. The partnership agreement provides that the partnership cannot be terminated. Mother dies and leaves her partnership interest to Daughter. As the sole partners, Daughter and Son acting together could remove the restriction on partnership termination. Under the conference agreement, the value of Mother’s partnership interest in her estate is determined without regard to the restriction. Such value would be adjusted to reflect any appropriate fragmentation discount.3
The Internal Revenue Service has clearly exceeded its regulatory authority by changing the Congressionally-imposed “and” to an IRS-imposed “and/or.” Congress granted the IRS certain regulatory authority in Section 2704(b)(4):
The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.
Congress thus gave the IRS authority to disregard other restrictions, which the IRS clearly has done by proposing new Treasury Regulations Section 25.2704-3, but Congress didn’t grant the IRS authority to make other unilateral changes to the IRC, which it clearly has also done by changing the key concurrent word “and” to the concurrent or disjunctive phrase “and/or.”
Evidence that Congress knew how to employ the concurrent and disjunctive “and/or” concept can be found in the separate IRC Section 2704(b)(2)(B)(ii), which deals with the situation after the transfer: “The transferor or any member of the transferor’s family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction.” (emphasis supplied) The IRS itself has also demonstrated that it understands the difference between the “immediately before” and “after” sections and the use of the word “and” versus the phrase “and/or,” by choosing to employ the following language in proposed regulation Section 25.2704-2(b)(1): “. . . if, after the transfer, that limitation either lapses or may be removed by the transferor, the transferor’s estate, and/or any member of the transferor’s family, either alone or collectively.” (emphasis supplied)
The preamble to the proposed regulations likewise illustrates that the IRS recognizes that Congress intended the word “and” to mean concurrent ownership only (emphasis supplied):
The legislative history of section 2704 states that the provision is intended, in part, to prevent results similar to that in Estate of Harrison v. Commissioner, T.C. Memo. 1987-8 . . . In Harrison, the decedent and two of his children each held a general partner interest in a partnership immediately before the decedent’s death. . . .
Finally, note that the IRS’ current “immediately before” regulations do not employ the proposed “and/or” wording, but rather track the Code’s “and” wording.4 Thus, for whatever the reasons, the decision was apparently made to change the concurrent word “and” to the concurrent and disjunctive phrase “and/or.”
Impermissible Change in IRC
Assume A owns 100 percent of a corporation and gifts 25 percent each to his three children, taking a minority interest discount for each of the three separate gifts (the transfer resulting in the lapse of voting and liquidation rights). A dies two years later owning the remaining 25 percent interest in the corporation, with no evidence that the transfer two years earlier was in contemplation of A’s death. In this situation, when only A controlled the corporation immediately before the lapse of the voting and liquidation rights (that is, the date A transferred the 25 percent interest each to A’s three children), when there’s no evidence that the transfer two years earlier was in contemplation of A’s death, does the IRS have authority to unilaterally impose a new three-year rule treating the resulting lapse of the voting and liquidation rights as occurring at A’s death, for purposes of IRC Section 2704(a)?
This question is relevant because immediately before the actual lapse date, only A was in control of the corporation, while at the time of A’s death (that is, the “deemed” lapse date, under the proposed regulations), both A and A’s children controlled the corporation. The IRS’ only regulatory authority under Section 2704(a)(3) is to “apply this subsection to rights similar to voting and liquidation rights.” (emphasis supplied) But the rights at issue here aren’t rights “similar to” voting and liquidation rights; they are voting and liquidation rights. Considering a resulting lapse of voting and liquidation rights as a transfer under Section 2704(a) under the IRS’ general grant of authority to render reasonable interpretations of the IRC isn’t the issue, because such a construction of the IRC is at least arguable; deeming the lapse to have occurred at death, however, is a problem, because this construction constitutes an impermissible change in the IRC.
Therefore, if the IRS’ proposed “three-year rule” is ultimately determined to constitute an invalid exercise of the IRS’ regulatory power, lifetime gifts of minority interests by a transferor who is the sole owner of the entity, even if made within three years of the transferor’s death, would not be subject to IRC Section 2704(a), because of the balance of the proposed regulations which do not tax other “resulting” lapses, and would not be subject to IRC Section 2704(b), because there is no applicable restriction on the transferor’s ability to liquidate the entity or the transferor’s interest therein, at the time of the gifts. If the gifts are made more than three years before the transferor's death, and again assuming the transferor is the sole owner of the entity at the time, none of Section 2704 would apply regardless of the validity of the proposed regulations.
1. Proposed Regulations Section 25.2704-2(a). Prop. Reg. Section 25.2704-1(a)(1).
2. Conference Committee Report at p. 158. (emphasis supplied).
3. Ibid., at pp. 157-158. (emphasis supplied).
4. Treasury Regulations Section 25.2704-1(a)(1). Treas. Reg. Section 25.2704-2(a).