What Are the Section 2701 Special Valuation Rules?

Internal Revenue Code Chapter 14 contains special valuation rules to prevent the undervaluation of assets transferred between family members for federal tax purposes. These rules ensure that when an interest in a family-controlled business is gifted to a younger generation, the value is not artificially suppressed by the transferor retaining certain rights.

The provisions under Section 2701 establish a framework for valuing these transfers that deviates from the standard “willing buyer-willing seller” test. This method often results in a higher valuation for the transferred interest. The rules target specific transactions within closely-held corporations and partnerships.

Circumstances Triggering Special Valuation Rules

Section 2701 valuation rules are not applied to all intra-family transactions and are triggered only when a specific set of conditions is met. The first condition is a transfer of an equity interest in a corporation or partnership. A “transfer” is broad and includes actions beyond a simple gift, such as contributions to a new entity, recapitalizations, or redemptions.

A second requirement is that the transfer must be made to a “member of the transferor’s family.” For the purposes of Section 2701, this group includes the transferor’s spouse, their lineal descendants like children and grandchildren, and the spouses of those lineal descendants.

The final element is that the transferor or an “applicable family member” must hold an “applicable retained interest” in the entity immediately after the transfer. An applicable family member includes the transferor’s spouse and any ancestor of the transferor or their spouse. The interest they retain must be an “applicable retained interest,” which involves either a distribution right in a controlled entity or an extraordinary payment right, such as a liquidation, put, call, or conversion right.

The Subtraction Method of Valuation

When a transaction triggers Section 2701, the transferred interest is valued for gift tax purposes using the “subtraction method.” This process calculates the gift’s value by first valuing the entire entity and then subtracting the value of interests retained by senior family members. The result is the value assigned to the interests transferred to the younger generation, which differs from simply appraising the fair market value of the gifted shares.

At the heart of the subtraction method is the “zero-value rule,” which dictates that certain retained rights are assigned a value of zero. Discretionary distribution rights or extraordinary payment rights, like the power to force liquidation, are valued at zero unless they meet strict criteria. By assigning a zero value to these retained rights, their value is effectively shifted to the transferred interests, increasing the total value of the taxable gift.

To illustrate, imagine a parent owns all the stock in a family corporation valued at $5 million. The parent recapitalizes the company into $4 million of preferred stock and $1 million of common stock. The parent then gifts the common stock to their child while retaining the preferred stock, which holds a discretionary dividend right. Under Section 2701, because the dividend right is discretionary, the retained preferred stock is valued at zero, resulting in a taxable gift of $5 million.

A minimum valuation rule also applies. The value of the gifted junior equity interests cannot be less than 10% of the sum of the total value of all equity in the entity plus any debt the entity owes to the transferor and applicable family members. This rule prevents the value of the common equity from being reduced to an insignificant amount, ensuring a baseline level of gift tax is applied.

Valuation Rules for Trusts and Agreements

Section 2702 governs transfers of interests in trusts to a family member. If the person making the transfer retains an interest in the trust, that retained interest is valued at zero for gift tax purposes unless it is a “qualified interest.” A qualified interest is a right to receive a fixed annuity payment, as in a Grantor Retained Annuity Trust (GRAT), or a payment based on a fixed percentage of the trust’s value.

Section 2703 addresses the effect of certain agreements on valuation. For estate and gift tax valuation, any option, agreement, or right to acquire property for less than its fair market value is disregarded, which includes most buy-sell agreements in family businesses. An agreement is respected for valuation only if it is a bona fide business arrangement, not a device to transfer property for less than full consideration, and its terms are comparable to similar arm’s-length transactions.

Section 2704 deals with the treatment of lapsing rights and restrictions. If an individual and their family control an entity, the lapse of a voting or liquidation right is treated as a taxable transfer. For example, if a parent holds a voting right that expires upon their retirement, that lapse is considered a gift to the other owners whose interests are enhanced. This prevents families from using lapsing rights to pass value to the next generation without incurring transfer tax.

Statutory Exceptions to Valuation Rules

The Internal Revenue Code provides several exceptions where the special valuation rules do not apply, carving out situations where the potential for valuation abuse is considered low. One of the most significant exceptions is for interests for which market quotations are readily available on an established securities market. If a stock is publicly traded, its value is determined by the market, and the Section 2701 rules are unnecessary.

Another exception applies when the retained interest is of the same class as the transferred interest. For instance, if a parent gifts shares of common stock to a child while retaining other shares of the same class of common stock, Section 2701 does not apply. This exception also covers interests that are proportionally the same, such as those with non-lapsing differences in voting rights. A transfer that results in a proportionate reduction of each class of equity held by the transferor and their family is also excluded.

The rules also provide an exception for retained rights to receive “qualified payments.” A right to a cumulative, preferred dividend that is payable on a periodic basis at a fixed rate is considered a qualified payment. This type of retained interest is not valued at zero but on its own merits, which prevents its value from being shifted to the transferred interest. A payment is considered timely if made within four years of its due date.