Rethinking Section 2702

Abstract

In 1990, Congress added chapter 14 to the Code to address several gift and estate tax avoidance techniques that flourished under prior law. In general, those avoidance techniques involved fragmenting beneficial ownership into separate interests to facilitate transferring the underlying property in several stages. A donor utilizing one of these techniques initially transferred one interest while retaining another interest in the same property. Eventually, the interest retained in the initial transfer lapsed or was disposed of in a subsequent transfer. Especially where the underlying property was held in a closely-held business entity or family trust, the respective interests could be tailored to shift value from donor to donee in ways that proved extremely difficult to detect or measure. Chapter 14 responds by adopting special valuation rules for certain types of transactions to ensure that such value shifts are included in the transfer tax base.
Section 2702 of the Code applies to split-interest arrangements involving successive beneficial interests representing present and future rights to possess or enjoy the underlying property. When a donor transfers one interest to a family member while retaining another interest, the special valuation rules of section 2702 assign a value of zero to the retained interest unless it meets various statutory requirements. Since the value of the transferred interest is determined by subtracting the value of the retained interest from the value of the underlying property, section 2702 produces a correspondingly high value for the transferred interest, which is reflected in the donor's gift tax base.
For example, a parent who gratuitously transfers a remainder to a child while retaining an income interest for a limited term makes a completed gift of only the remainder. If the special valuation rules assign a zero value to the income interest, the donor makes a taxable gift of the full value of the underlying property. If the parent subsequently disposes of the retained interest in a transfer that attracts a gift or estate tax, a problem of double taxation may arise. The section 2702 regulations address this problem by providing a corrective adjustment at the time of the subsequent transfer.