Td 8395

1992-1 C.B. 316; T.D. 8395; 1992 IRB LEXIS 2002
Special Valuation Rules
US Internal Revenue Service
January 1992
Reporter
1992 IRB LEXIS 2002 *; 1992-1 C.B. 316; T.D. 8395

Treasury Decision 8395

Subject Matter
Section 2701.-Special Valuation Rules in Case of Transfers of Certain Interests in Corporations or Partnerships

Applicable Sections
26 CFR 25.2701-0: Table of contents. (Also Sections 2702, 2703, 2704.) Internal Revenue Service 26 CFR Parts
20, 25, 301 and 602
[*1]

Core Terms
gift, holder, transferor, personal residence, annuity, liquidate, partnership, equity interest, fair market value, elect,
entity, term interest, lapse, family member, valuation, spouse, preferred stock, common stock, unitrust, remainder
interest, terminate, transfer of property, voting rights, right to receive, taxable event, stock, annual, family-held, zero,
indirect

Text
AGENCY:
Internal Revenue Service, Treasury.
ACTION:
Final Regulations.
SUMMARY:
This document contains final regulations relating to chapter 14 of the Internal Revenue Code as enacted in the
Omnibus Budget Reconciliation Act of 1990, Pub. L. 101-508, 104 Stat. 1388. These regulations provide special
valuation rules for purposes of the Federal estate and gift taxes imposed under chapters 11 and 12 of the Code. In
addition these regulations provide rules involving lapsing rights and other transactions that are treated as completed
transfers under chapter 14.

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EFFECTIVE DATES:
These regulations are effective as of January 28, 1992.
SUPPLEMENTARY INFORMATION:
A. Paperwork Reduction Act
The collection of information contained in these final regulations has been reviewed and approved by the Office of
Management and Budget in accordance with the requirements of the Paperwork Reduction Act of 1980 (44 U.S.C.
3504 (h)) under control numbers 1545-1241 and 1545-1273. The [*2] estimated average annual burden per
respondent is 20 minutes.
These estimates approximate the average time expected to be necessary for the collection of information. They are
based upon the information available to the Internal Revenue Service. Individual respondents may require more or
less time, depending on their particular circumstances.
Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be
sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer T:FP, Washington, D.C. 20224, and to
the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of
Information and Regulatory Affairs, Washington, D.C. 20503.
B. Background
April 9, 1991 proposed regulations
On April 9, 1991, a Notice of Proposed Rulemaking (PS-92-90 [1991-1 C.B. 998]) relating to the special valuation
rules of sections 2701 through 2703 of the Internal Revenue Code was published in the Federal Register (56 FR
14321). These sections, along with section 2704, were enacted as chapter 14 of the Code in the Omnibus Budget
Reconciliation Act of 1990, Pub. L. 101-508 [1991-2 C.B. 481]. The Internal Revenue Service [*3] received written
comments on the proposed regulations and, on September 20, 1991, held a public hearing on those regulations.
After consideration of the comments received and the statements made at the public hearing, the proposed
regulations are revised and adopted as final regulations by this Treasury decision.
September 11, 1991 proposed regulations
On September 11, 1991, a Notice of Proposed Rulemaking (PS-30-91 [1991-2 C.B. 1118]) relating to additional
special valuation rules under chapter 14 was published in the Federal Register (56 FR 46244). This notice
proposed rules under sections 2701 and 2702 regarding adjustments to mitigate double taxation. Rules under
section 2704 of the Internal Revenue Code were also proposed. The Internal Revenue Service received written
comments from the public on the proposed regulations and, on November 1, 1991, held a public hearing concerning
the regulations. After consideration of the comments received and the statements made at the public hearing, the
proposed regulations, other than proposed §25.2701-5 (relating to adjustments to mitigate double taxation), are
revised and adopted as final regulations by this Treasury decision. An amendment [*4] to proposed §25.2701-5 is
proposed by a Notice of Proposed Rulemaking published elsewhere in ∗ ∗ ∗ [PS-30-91, page 1239, this Bulletin].
The following discusses the more significant comments received on the proposed regulations and the reasons for
accepting or rejecting those comments in the final regulations.
C. Section 2701
Scope of section 2701
Several commentators urged that the definition of "transfer" should be restricted. In response to this comment, the
final regulations clarify the situations in which a "capital structure transaction" will be treated as a transfer subject to
section 2701. Generally, if an individual receives an applicable retained interest in connection with a redemption,
recapitalization, or other change in the capital structure of an entity, the transaction is subject to section 2701 if the
other conditions of that section are met. In addition, if an individual holding an applicable retained interest
surrenders a senior equity interest in a corporation or partnership and the fair market value of an applicable retained
interest already held by that individual increases, the transaction is potentially subject to section 2701. Similarly, if

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an individual surrenders [*5] a junior equity interest while a member of the individual's family holds a junior equity
interest, and the individual or an applicable family member simultaneously holds an applicable retained interest, the
transaction is potentially subject to section 2701.
The final regulations also clarify the application of section 2701 to the transfer of an interest held indirectly through a
trust. As proposed, the rule could unfairly subject an individual to section 2701. The final regulations narrow the
application of the rule to circumstances where (1) the indirectly-held property would have been includible in the
gross estate of the individual if the individual had died at the time of the termination, or (2) the indirectly-held
property is in a trust as to which the individual is considered the owner under the grantor trust rules. Seesections
671 through 678.
The final regulations provide that in determining whether a class of interest is proportional to another class,
differences between classes attributable to non-lapsing provisions necessary to comply with partnership allocation
requirements of the Internal Revenue Code ( e.g., section 704 (b)) are treated as non-lapsing differences with
[*6] respect to limitations on liability.
In response to comments regarding the exception for proportionate transfers in §25.2701-1 (c) (4), the final
regulations provide that the exception is available to the extent the transfer results in the required proportionate
reduction in the holdings of the transferor and applicable family members. The final regulations clarify that this
exception applies only with respect to a transfer by a single individual.
Valuation of applicable retained interests
The final regulations clarify that, for purposes of section 2701, a payment that is contingent as to time or amount is
not a guaranteed payment of a fixed amount.
The final regulations adopt the recommendation of one commentator that a right to receive a specific amount
payable at death should qualify as a mandatory payment right.
Responding to several comments, the final regulations clarify that voting rights that confer an ability to compel
liquidation are not valued at zero but instead are valued without regard to the ability to compel liquidation or, if the
holder's rights are valued under the "lower of" valuation rule, in a manner consistent with the assumptions of that
rule.
Several commentators [*7] suggested that partial elections be allowed under §25.2701-2 (c) (2). The final
regulations adopt this suggestion.
The subtraction method of valuation
Comments variously suggested that the proposed subtraction method of valuation is too restrictive, acceptable as
written, or lacking in necessary specificity.
The valuation of a closely-held business interest is one of the most difficult administrative problems presented by
the transfer tax system and courts have varied widely on the applicability of the subtraction method in that process.
Some commentators argue that section 2701 does not require use of a subtraction method. They argue, contrary to
the conference report reference to "present law principles," that there are no such present law principles. Other
commentators suggest that section 2701 should apply only if (and to the extent) a subtraction method would be
appropriate under present law.
These and similar comments are based on the premise that section 2701 operates within the general framework of
section 2512 of the Internal Revenue Code, i.e., that the special valuation rules are to be used to determine the
value of the transferred property which, in turn, measures the amount [*8] of the gift. They ignore the operative
language of section 2701 that the amount of the gift is to be determined by valuing certain retained rights under the
special rules in section 2701. If use of the subtraction method is not required by section 2701, valuation of retained
rights would have no bearing on the amount of the gift. That interpretation would cause section 2701 to be a nullity

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in that the valuation of retained rights cannot affect the amount of the gift other than by subtraction from a pretransfer aggregate value.
The Treasury Department and the Service do not believe that section 2701 was intended to be a nullity or merely
an appendix to section 2512, but rather that chapter 14 provides an independent set of rules intended to ensure
more accurate gift tax valuation.
Present gift tax regulations provide a subtraction method for determining the amount of the gift if a donor retains an
interest in the transferred property. In such a case, the amount of the gift is the value of the entire property less the
value of the donor's retained interest. See§25.2512-5 (a) (1) (i). The proposed regulations paralleled that rule.
Although the Treasury Department and the Service believe [*9] that the subtraction method set forth in the April 9,
1991, proposed regulations is the appropriate method for determining the amount of the gift under section 2701,
changes have been made, in response to comments, to the specific methodology set forth in the proposed
regulations.
The 3-step method of valuation outlined in §25.2701-3 of the proposed regulations is modified as follows. In Step 1,
only the interests held by the individuals whose holdings are taken into account in determining "control" under
§25.2701-2 (b) (5) ("family-held interests") are valued. The family-held interests are valued as if held by a single
individual. Thus, the final regulations substantially simplify the valuation procedure by eliminating unnecessary
valuations with respect to the entire entity and unrelated parties. By providing for a single-shareholder assumption
in valuing the family-held interests in Step 1, the final regulations adopt the position of several commentators that
the minority discount with respect to the transferred interest is appropriately applied at the end of the section 2701
valuation process rather than at the beginning. Steps 2 and 3 (including the special adjustment in Step 2)
[*10] remain basically unchanged. However, Step 2 provides a rule that has the effect of allocating any "control
premium" reflected in the value determined in Step 1 among the corresponding family-held interests on a pro rata
basis. The final regulations add Step 4 to the valuation methodology. In Step 4, adjustments are made to the total
amount of the gift to reflect consideration received for the transfer, appropriate discounts, and the value of certain
retained interests if the property is transferred in trust. Consistent with the position of the regulations that section
2701 does not affect the value of the transferred property and the legislative history indicating that chapter 14 does
not affect minority discounts otherwise available under the law in effect before enactment of chapter 14, any
minority discount taken in Step 4 generally is limited to the amount that would have been available under chapter 12
with respect to the transfer if section 2701 had not been applicable.
Minimum value rule
The final regulations clarify that, in applying the minimum value rule, the value of any junior equity interest is not
less than a pro rata portion of 10 percent of the sum of the value of all [*11] equity interests including indebtedness
to the transferor and applicable family members determined without regard to guarantees and qualified deferred
compensation.
Accumulated qualified payments
The final regulations permit a qualified payment to be made in the form of a debt instrument, the term of which does
not exceed four years, that bears compound interest at a rate no less than the appropriate discount rate payable
from the due date of the qualified payment.
Adjustment to mitigate double taxation
In response to numerous comments, proposed §25.2701-5 is being substantially modified by a Notice of Proposed
Rulemaking published elsewhere in ∗ ∗ ∗ [PS-30-91, page 1239, this Bulletin]. Rather than provide a credit against
the Federal estate tax as contained in the September 11 proposed regulations, the revised proposed regulations
provide for a reduction to a decedent's adjusted taxable gifts. In general, the amount of the reduction is the lesser
of: (1) the amount by which the transferor's taxable gifts were increased as a result of the application of section
2701, and (2) the increase in the decedent's gross estate (or adjusted taxable gifts) attributable to the portion of the
value [*12] of the applicable retained interest that was subject to gift tax at the time of the initial transfer. The
limitation in the regulation assures that aggregate value includible in the decedent's transfer tax base is the sum of:

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(1) the value (on the date of the section 2701 transfer) of the family-held applicable retained interests allocable to
the transferred subordinate equity interests, and (2) the value (as of the date the interest is subsequently
transferred by the transferor) of the transferor's portion of family-held applicable retained interests not previously
subject to tax.
Under certain circumstances, the transferor's spouse is treated as the transferor. The reduction is otherwise not
assignable or transferable.
Indirect ownership
Several comments were received regarding the indirect ownership rules in §25.2701-6. Most of these comments
arose from concern over the definition of transfer that included the transfer of any indirectly-held interest. The
revision to the definition of transfer discussed above generally makes changes to the indirect ownership rules
unnecessary. Other suggested changes were rejected because of the additional complexity that would be
introduced into these [*13] rules.
Effect on other Internal Revenue Code sections
Some commentators argued that determining the amount of a gift under section 2701 necessarily affects the results
under other provisions of the Internal Revenue Code (such as the determination of basis under section 1015) that
are based on the value of the transferred property. As discussed above, the final regulations reject the argument
that section 2701 determines the value of the transferred property.
D. Section 2702
Exceptions
The final regulations provide that section 2702 does not apply to the transfer of an interest in trust if the only interest
in the trust, other than the remainder interest or a qualified annuity or unitrust interest, is an interest qualifying for
the charitable deduction under section 2522 (a charitable lead trust).
Other commentators recommended exceptions for lapses of "Crummey" powers and for certain transfers of annuity
or unitrust interests. Those changes are made.
Retained rights
Several commentators requested that the application of section 2702 to retained powers be clarified. In response,
the final regulations provide that an "interest" includes a power if retention of the power prevents the transfer
[*14] of an interest in property from being a completed gift under chapter 12. Without this rule, section 2702 could
be avoided merely by retaining a power over a term income interest rather than the income interest itself.
In response to one comment, the final regulations provide that section 2702 does not apply if the only retained
interest is as a permissible recipient of income.
Tangible property exception
Several commentators suggested eliminating the evidentiary requirement necessary to qualify for valuation under
the special rule for certain tangible property. This change is not made. Without a standard such as that set forth in
the proposed regulations ( e.g., actual evidence of rentals) against which proffered appraisals can be tested, the
likelihood of significant over-valuations is very high. On the other hand, the recommendation that the burden of
proof be placed on the transferor rather than the term holder is adopted in the final regulations.
One commentator suggested that depreciable property should qualify for the tangible property exception. This
recommendation was not adopted. Generally, the use or non-use of such property during the term would affect the
value of the property [*15] passing to the remainder beneficiary, and thus, the property would not come within the
statutory exception. Congress intended, in enacting this exception, to provide limited relief to a class of property the
value of which would not be affected by use or non-use.
As suggested by commentators, the rule regarding valuation of the unexpired portion of a term interest at the time
of a conversion is expanded and clarified.

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One commentator requested that the regulations permit a term interest in property that ceases to qualify for the
tangible property exception to be converted to a qualified unitrust interest rather than a qualified annuity interest.
This is not done, primarily because of the complexity involved in determining the appropriate amount of the unitrust
payment.
In response to one comment, the final regulations clarify that the date on which tangible property is deemed to be
converted as the result of an addition or improvement is the date on which the addition or improvement is
commenced.
Qualified interests
The final regulations clarify that a cumulative power of withdrawal does not meet the requirements of a qualified
interest. Congress clearly intended that retained interests [*16] that are given value at the time of the transfer must
reflect amounts that will actually be paid to the term holder. Section 2702 could be avoided if powers of withdrawal
are considered qualified interests.
In response to comments requesting that increases in the annuity and unitrust amounts be permitted throughout the
term, the final regulations provide flexibility to taxpayers by permitting the annuity or unitrust amount to be 120
percent of the annuity or unitrust amount paid for the preceding year. The proposed regulations prohibited
increases to prevent transferors from "zeroing out" a gift while still effectively transferring the appreciation on all the
property during the term to the remainder beneficiary, ( e.g., by providing for a balloon payment in the final year of
the term). The Treasury Department and the Service believe that such a result would be inconsistent with the
principles of section 2702. The final regulations, with minimal complexity, strike a balance between the
government's policy concerns and taxpayers' desire for planning flexibility.
In response to a comment, the final regulations permit the payment of the greater (but not the lesser) of an annuity
or unitrust [*17] amount. In that case, the retained interest is valued at the higher of the values of the two interests.
Commentators suggested allowing additional contributions to a trust from which a qualified annuity interest is
payable. This is not done. Without this prohibition, additional contributions would arguably pass to the remainder
beneficiary under certain circumstances without appropriate transfer taxes being paid.
Commentators suggested that commutation of qualified interests be permitted. This change is not made.
Commutation ( i.e., the prepayment of the term holder's interest) shifts the risk of a decline in interest rates from the
remainder beneficiaries to the term holder. Therefore, a commuted term interest may not ultimately yield the same
value to the term holder as the annuity or unitrust interest originally retained by the transferor. Congress intended in
enacting section 2702, that a term interest would be valued at an amount greater than zero, only if the form of the
term interest insures that the holder actually receives the value attributed to the interest. Allowing commutation
would be inconsistent with this intent.
Joint purchases
In response to another comment, the limit [*18] on the amount the term holder is considered to transfer in a joint
purchase is clarified.
Personal residence trusts
The final regulations adopt the suggestion of commentators that an individual be permitted in certain circumstances
to hold term interests in more than two personal residence trusts (or qualified personal residence trusts).
The final regulations make no changes in the definition of personal residence. Since the transfer in trust of a
personal residence arguably presents the same opportunity for valuation abuse that Congress sought to prevent by
enactment of section 2702, the Treasury Department and the Service believe that Congress intended the personal
residence exception to be a narrow exception to enable transferors to pass the family home, whether the principal
residence or a vacation home, to younger members of the family. Therefore, the most recent Congressional
statutory expression of what constitutes a personal residence, as found in section 163 (h), is most pertinent in this
situation. That provision defines personal residence as the principal residence and one other residence.

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The final regulations address the concern of one commentator by permitting a single trust [*19] to be used to hold
the interests of both spouses in a personal residence under certain circumstances.
The final regulations permit personal residence trusts to hold (for two years) proceeds payable as a result of
damage, destruction or involuntary conversion of the personal residence. However, consistent with the explicit
statutory language requiring that the only property in the trust be a residence, the final regulations continue to
prohibit the holding of any other assets by the trust, including proceeds from the sale of the personal residence.
Qualified personal residence trusts
Because of the restrictive statutory limitations on a personal residence trust, the safe harbor for a qualified personal
residence trust is retained with slight modifications.
The final regulations clarify that a qualified personal residence trust must distribute any income to the term holder
not less frequently than annually.
Commentators generally proposed that the regulations explicitly permit certain actions during the term of the trust.
These comments were not adopted because the regulations are intended only to set out governing instrument
requirements. The suggestion of one commentator that, upon termination [*20] of the term interest, any cash in the
trust be permitted to be used to pay unpaid expenses and termination expenses, was adopted.
The final regulations revise the provisions concerning cessation of use of the residence as a personal residence in
several respects. First, the governing instrument must require either that the trust be terminated (and all trust assets
distributed to the term holder) or that the term interest be converted to a qualified annuity interest. The trustee may
be given the sole discretion to select between those two options. Under the final regulations, the distribution or
conversion must occur within 30 days of the date on which the trust ceases to be a qualified personal residence
trust. The final regulations also permit excess sale proceeds not reinvested in a new personal residence to be
converted to a qualified annuity interest.
Finally, one commentator requested that, upon cessation of use as a personal residence, the interest of the term
holder be permitted to convert to a qualified unitrust interest. This is not done because of the complexity in
determining the appropriate unitrust amount.
Adjustment to mitigate double taxation
Comments were received suggesting [*21] that adjustments be permitted in situations not covered by the proposed
regulations. None of these proposed changes are included in the final regulations. Section 2702 does not require
an adjustment to mitigate double taxation. The final regulations intend relief only if the retained interest itself is
taxed in a transfer subsequent to the original transfer to which section 2702 applied.
The final regulations provide that a reduction in adjusted taxable gifts is available if a term interest is included in the
transferor's gross estate solely by reason of section 2033.
In response to one comment, the final regulations clarify the interaction of §25.2702-6 and section 2001.
E. Section 2703
Exceptions
The final regulations provide that perpetual restrictions on the use of real property that qualified for either the gift or
estate tax charitable deduction are not subject to section 2703. The specific reference to section 170 (h) is deleted.
As suggested by several commentators, the final regulations expand the exception in the proposed regulations for
rights and restrictions among unrelated parties. The final regulations provide that a right or restriction is not
disregarded if more than 50 [*22] percent by value of the property subject to the right or restriction is owned by
persons who are not family members of the transferor. "Member of the family" is defined by cross-reference to
§25.2701-2 (b) (5) and also includes any other individual who is the natural object of the transferor's bounty.

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One comment asked that the final regulations specifically state that a right of first refusal among family member coowners of a business is never disregarded if the right can be exercised only by matching the price offered by an
outside purchaser. The Treasury Department and the Service do not believe that every such restriction necessarily
meets the tests of section 2703.
Substantial Modification
The final regulations clarify when a transfer to a family member of an interest in property that is subject to a right or
restriction is a substantial modification of the right or restriction. The final regulations provide that the addition of a
family member in a generation no lower than the lowest generation occupied by persons already party to the right or
restriction is not a substantial modification.
Other Issues
One commentator requested that the final regulations define the term "natural [*23] objects of the bounty." The
final regulations do not provide a definition of this term. This concept has long been part of the transfer tax system
and cannot be reduced to a simple formula or specific classes of relationship. The class of persons who may be the
objects of an individual's bounty is not necessarily limited to persons related by blood or marriage.
In response to a comment, the final regulations clarify that if property is subject to multiple rights or restrictions,
each separate right or restriction is tested independently. Whether separate provisions constitute separate rights or
restrictions or are integral elements of a single right or restriction depends on the facts and circumstances in the
particular case.
An example is added to the final regulations to clarify that a lease is a right or restriction with respect to the use of
property that is disregarded in certain circumstances.
F. Section 2704
Lapsing rights
One set of comments was received regarding section 2704. The commentator argued that applying section 2704
(a) to a transfer of a voting interest that results in the termination of a liquidation right with respect to an interest
other than the transferred interest [*24] was inappropriate in some cases. In response to that comment, the final
regulations limit the scope of the rule to situations where the transferred interest is senior to the interest as to which
the liquidation right terminates.
The final regulations clarify the exception for the lapse of liquidation rights valued under section 2701 is provided to
mitigate double taxation.
As suggested by the commentator, the final regulations provide that a lapse of a liquidation right that occurs solely
by reason of a change in State law is not treated as a lapse subject to section 2704 (a). A recommendation that the
final regulations create an exception for any lapse occurring by reason of State law is not adopted because
shareholders or partners are free to alter the rules otherwise applicable under State law.
Applicable restrictions
The final regulations expand the exception for certain commercially reasonable restrictions on liquidation imposed
with respect to debt to include certain commercially reasonable restrictions on liquidation imposed in connection
with the issuance of equity.
The commentator suggested that the ability to liquidate be determined under State law without regard to any
provisions [*25] in the governing instrument regarding liquidation (whether or not the provisions would be more
restrictive than the State law that would otherwise apply). Adopting that rule would be inconsistent with the purpose
of section 2704 (b) which is intended to determine the value of property by reference to actual ability to liquidate
without regard to restrictions that will lapse or can be removed.
Special Analyses
These rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is
not required. Although this Treasury decision was preceded by a notice of proposed rule-making that solicited

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public comments, the notice was not required by 5 U.S.C. 553 since the regulations proposed in that notice and
adopted by this Treasury decision are interpretative. Therefore, a final Regulatory Flexibility Analysis is not required
by the Regulatory Flexibility Act (5 U.S.C. chapter 6). Pursuant to section 7805 (f) of the Internal Revenue Code,
the proposed regulations were sent to the Chief Counsel for Advocacy for Small Business Administration for
comment on their impact on small business.
∗∗∗
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 20, [*26] 25, 301 and 602 are amended as follows:
PART 20-ESTATE TAX; ESTATES OF DECEDENTS DYING AFTER AUGUST 16, 1954
Paragraph 1. The authority citation for part 20 continues to read, in part:
Authority: Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805 ∗ ∗ ∗
Par. 2. Section 20.0-2 is amended by removing the last sentence in paragraph (b) (5) and adding the following
in its place:
§20.0-2 General description of tax.
∗∗∗
(b)∗ ∗ ∗
(5)∗ ∗ ∗ Sections 25.2701-5 and 25.2702-6 of this chapter contain rules that provide additional adjustments
to mitigate double taxation in cases where the amount of the decedent's gift was previously determined
under the special valuation provisions of sections 2701 and 2702. For a detailed explanation of the credits
against tax, see sections 2011 through 2016 and the regulations thereunder.
∗∗∗
Par. 3. Section 20.2031-2 is amended by adding a sentence to the end of paragraph (h) and adding a new
paragraph (j) to read as follows:
§20.2031-2 Valuation of stocks and bonds.
∗∗∗
(h)∗ ∗ ∗ See section 2703 and the regulations at §25.2703 of this chapter for special rules involving options
and agreements (including contracts to purchase) entered into (or substantially modified after) October
[*27] 8, 1990.
∗∗∗
(j) Application of chapter 14. See section 2701 and the regulations at §25.2701 of this chapter for special
rules for valuing the transfer of an interest in a corporation and for the treatment of unpaid qualified
payments at the death of the transferor or an applicable family member. See section 2704 (b) and the
regulations at §25.2704-2 of this chapter for special valuation rules involving certain restrictions on
liquidation rights created after October 8, 1990.
Par. 4. Section 20.2031-3 is amended by adding three new sentences to the end to read as follows:
§20.2031-3 Valuation of interests in businesses.
∗∗∗
∗ ∗ ∗ See section 2701 and the regulations at §25.2701 of this chapter for special rules for valuing the
transfer of an interest in a partnership and for the treatment of unpaid qualified payments at the death of
the transferor or an applicable family member. See section 2703 and the regulations at §25.2703 of this
chapter for special rules involving options and agreements (including contracts to purchase) entered into

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(or substantially modified after) October 8, 1990. See section 2704 (b) and the regulations at §25.2704-2
of this chapter for special valuation rules [*28] involving certain restrictions on liquidation rights created
after October 8, 1990.
PART 25-GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954
Par. 5. The authority for part 25 continues to read, in part:
Authority: Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805 ∗ ∗ ∗
Par. 6. Section 25.0-1 is amended by adding a new sentence to the end of paragraph (c) (1) and by revising
paragraph (c) (2) to read as follows:
§25.0-1 Introduction.
∗∗∗
(c)∗ ∗ ∗
(1)∗ ∗ ∗ Sections 25.2701-5 and 25.2702-6 contain rules that provide additional adjustments to mitigate
double taxation where the amount of the transferor's property was previously determined under the special
valuation provisions of sections 2701 and 2702.
(2) Transfer. Subchapter B of chapter 12 and chapter 14 of the Internal Revenue Code pertain to the
transfers which constitute the making of gifts and the valuation of those transfers. The regulations pursuant
to subchapter B are set forth in §§25.2511-1 through 25.2518-3. The regulations pursuant to chapter 14
are set forth in §§25.2701-1 through 25.2704-3.
∗∗∗
Par. 7. Section 25.2502-1 is amended by adding a new sentence to the end c paragraph (a) (3) to read as
follows:
§25.2502-1 Rate of Tax.
(a)∗ ∗ ∗
(3)∗ [*29] ∗ ∗ See §25.2702-6 for an adjustment to the total amount of an individual's taxable gifts where
the individual's current taxable gifts include the transfer of certain interests in trust that were previously
valued under the provisions of section 2702.
∗∗∗
Par. 8. Section 25.2512-1 is amended by adding two new sentences to the end to read as follows:
§25.2512-1 Valuation of property; in general.
∗ ∗ ∗ See section 2701 and the regulations at §25.2701 for special rules for valuing transfers of an interest
in a corporation or a partnership and for the treatment of unpaid qualified payments at the subsequent
transfer of an applicable retained interest by the transferor or by an applicable family member. See section
2704 (b) and the regulations at §25.2704-2 for special valuation rules where an interest in property is
subject to an applicable restriction.
Par. 9. Section 25.2512-5 is amended by adding a new sentence to paragraph (a) (1) (i) immediately after the
sixth sentence to read as follows:
§25.2512-5 Valuation of annuities, life estates, terms for years, remainders, and reversions
transferred after November 30, 1983.
(a) In general. (1) (i)∗ ∗ ∗ See section 2702 and the regulations at §25.2702 [*30] for special rules for
valuing transfers of interests in trust after October 8, 1990. ∗ ∗ ∗
Par. 10. Section 25.2512-8 is amended by adding a sentence to the end to read as follows:

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§25.2512-8 Transfers for insufficient consideration.
∗ ∗ ∗ See also sections 2701, 2702, 2703 and 2704 and the regulations at §§25.2701-0 through 25.2704-3
for special rules for valuing transfers of business interests, transfers in trust, and transfers pursuant to
options and purchase agreements.
Par. 11. A new undesignated centerheading and new §§25.2701-through 25.2701-8, 25.2702-0 through
25.2702-7, 25.2703-1 and 25.2703-2 and 25.2704-1 through 25.2704-3 are added to read as follows:
SPECIAL VALUATION RULES
§25.2701-0 Table of contents.
This section lists the major paragraphs contained in §§25.2701-1 through 25.2701-8.
§25.2701-1 Special valuation rules in the case of transfers of certain interests in corporations and
partnerships.
(a) In general.
(1) Scope of section 2701.
(2) Effect of section 2701.
(3) Example.
(b) Transfers and other triggering events.
(1) Completed transfers.
(2) Transactions treated as transfers.
(3) Excluded transactions.
(c) Circumstances in which section 2701 does not apply.
(1) Marketable transferred [*31] interests.
(2) Marketable retained interests.
(3) Interests of the same class.
(4) Proportionate transfers.
(d) Family definitions.
(1) Member of the family.
(2) Applicable family member.
(3) Relationship by adoption.
(e) Examples.
§25.2701-2 Special valuation rules for applicable retained interests.
(a) In general.
(1) Valuing an extraordinary payment right.
(2) Valuing a distribution right.
(3) Special rule for valuing a qualified payment right held in conjunction with an extraordinary payment
right.
(4) Valuing other rights.
(5) Example.
(b) Definitions.
(1) Applicable retained interest.
(2) Extraordinary payment right.
(3) Distribution right.

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1992 IRB LEXIS 2002, *31
(4) Rights that are not extraordinary payment rights or distribution rights.
(5) Controlled entity.
(6) Qualified payment right.
(c) Qualified payment elections.
(1) Election to treat a qualified payment right as other than a qualified payment right.
(2) Election to treat other distribution rights as qualified payment rights.
(3) Elections irrevocable.
(4) Treatment of certain payments to applicable family members.
(5) Time and manner of elections.
(d) Examples.
§25.2701-3 Determination of amount of gift.
(a) Overview.
(1) In general.
(2) Definitions.
(b) [*32] Valuation methodology.
(1) Step 1-Valuation of family-held interests.
(2) Step 2-Subtract the value of senior equity interests.
(3) Step 3-Allocate the remaining value among the transferred interests and other family-held subordinate
equity interests.
(4) Step 4-Determine the amount of the gift.
(5) Adjustment in Step 2.
(c) Minimum value rule.
(1) In general.
(2) Junior equity interest.
(3) Indebtedness.
(d) Examples.
§25.2701-4 Accumulated qualified payments.
(a) In general.
(b) Taxable event.
(1) In general.
(2) Exception.
(3) Individual treated as interest holder.
(c) Amount of increase.
(1) In general.
(2) Due date of qualified payments.
(3) Appropriate discount rate.
(4) Application of payments.
(5) Payment.
(6) Limitation.
(d) Taxpayer election.
(1) In general.
(2) Limitation not applicable.

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1992 IRB LEXIS 2002, *32
(3) Time and manner of election.
(4) Example.
§25.2701-5 Adjustments to mitigate double taxation. [Reserved].
§25.2701-6 Indirect holding of interests.
(a) In general.
(1) Attribution to individuals.
(2) Corporations.
(3) Partnerships.
(4) Estates, trusts, and other entities.
(5) Multiple attribution.
(b) Examples.
§25.2701-7 Separate interests.
§25.2701-8 Effective dates.
§25.2701-1 Special valuation rules in the case of transfers of certain interests in corporations and
partnerships.
(a) [*33] In general-(1) Scope of section 2701. Section 2701 provides special valuation rules to determine
the amount of the gift when an individual transfers an equity interest in a corporation or partnership to a
member of the individual's family. For section 2701 to apply, the transferor or an applicable family member
(as defined in paragraph (d) (2) of this section) must, immediately after the transfer, hold an applicable
retained interest (a type of equity interest defined in §25.2701-2 (b) (1)). If certain subsequent payments
with respect to the applicable retained interest do not conform to the assumptions used in valuing the
interest at the time of the initial transfer, §25.2701-4 provides a special rule to increase the individual's
later taxable gifts or taxable estate.
(2) Effect of section 2701. If section 2701 applies to a transfer, the amount of the transferor's gift, if any, is
determined using a subtraction method of valuation (described in §25.2701-3). Under this method, the
amount of the gift is determined by subtracting the value of any family-held applicable retained interests
and other non-transferred equity interests from the aggregate value of family-held interests in the
[*34] corporation or partnership (the "entity"). Generally, in determining the value of any applicable
retained interest held by the transferor or an applicable family member(i) Any put, call, or conversion right, any right to compel liquidation, or any similar right is valued at zero if the
right is an "extraordinary payment right" (as defined in §25.2701-2 (b) (2));
(ii) Any distribution right in a controlled entity ( e.g., a right to receive dividends) is valued at zero unless the
right is a "qualified payment right" (as defined in §25.2701-2 (b) (6)); and
(iii) Any other right (including a qualified payment right) is valued as if any right valued at zero did not exist but
otherwise without regard to section 2701.
(3) Example. The following example illustrates rules of this paragraph (a).
Example. A, an individual, holds all the outstanding stock of S Corporation. A exchanges A's shares in
S for 100 shares of 10-percent cumulative preferred stock and 100 shares of voting common stock A
transfers the common stock to A's child. Section 2701 applies to the transfer because A has
transferred an equity interest (the common stock) to a member of A's family, and immediately
thereafter holds an applicable [*35] retained interest (the preferred stock). A's preferred stock is
valued under the rules of section 2701. A's gift is determined under the subtraction method by

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subtracting the value of A's preferred stock from the value of A's interest in S immediately prior to the
transfer.
(b) Transfers and other triggering events-(1) Completed transfers. Section 2701 applies to determine the
existence and amount of any gift, whether or not the transfer would otherwise be a taxable gift under
chapter 12 of the Internal Revenue Code. For example, section 2701 applies to a transfer that would not
otherwise be a gift under chapter 12 because it was a transfer for full and adequate consideration.
(2) Transactions treated as transfers-(i) In general. Except as provided in paragraph (b) (3) of this section,
for purposes of section 2701, transfer includes the following transactions:
(A) A contribution to the capital of a new or existing entity;
(B) A redemption, recapitalization, or other change in the capital structure of an entity (a "capital structure
transaction"), if(1) The transferor or an applicable family member receives an applicable retained interest in the capital
structure transaction;
(2) The transferor [*36] or an applicable family member holding an applicable retained interest before the
capital structure transaction surrenders an equity interest that is junior to the applicable retained
interest (a "subordinate interest") and receives property other than an applicable retained interest; or
(3) The transferor or an applicable family member holding an applicable retained interest before the capital
structure transaction surrenders an equity interest in the entity (other than a subordinate interest) and
the fair market value of the applicable retained interest is increased; or
(C) The termination of an indirect holding in an entity (as defined in §25.2701-6) (or a contribution to capital by
an entity to the extent an individual indirectly holds an interest in the entity) if(1) The property is held in a trust as to which the indirect holder is treated as the owner under subchapter J
of chapter 1 of the Internal Revenue Code; or
(2) If the termination (or contribution) is not treated as a transfer under paragraph (b) (2) (i) (C) ( 1) of this
section, to the extent the value of the indirectly-held interest would have been included in the value of
the indirect holders gross estate for Federal estate [*37] tax purposes if the indirect holder died
immediately prior to the termination.
(ii) Multiple attribution. For purposes of paragraph (b) (2) (i) (C) of this section, if the transfer of an indirect
holding in property is treated as a transfer with respect to more than one indirect holder, the transfer is
attributed in the following order:
(A) First, to the indirect holder(s) who transferred the interest to the entity (without regard to section 2513);
(B) Second, to the indirect holder(s) possessing a presently exercisable power to designate the person who
shall possess or enjoy the property;
(C) Third, to the indirect holder(s) presently entitled to receive the income from the interest;
(D) Fourth, to the indirect holder(s) specifically entitled to receive the interest at a future date; and
(E) Last, to any other indirect holder(s) proportionally.
(3) Excluded transactions. For purposes of section 2701, a transfer does not include the following
transactions:
(i) A capital structure transaction, if the transferor, each applicable family member, and each member of the
transferor's family holds substantially the same interest after the transaction as that individual held before
the transaction. For this [*38] purpose, common stock with non-lapsing voting rights and nonvoting
common stock are interests that are substantially the same;
(ii) A shift of rights occurring upon the execution of a qualified disclaimer described in section 2518; and

Page 15 of 58
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(iii) A shift of rights occurring upon the release, exercise, or lapse of a power of appointment other than a
general power of appointment described in section 2514, except to the extent the release, exercise, or
lapse would otherwise be a transfer under chapter 12.
(c) Circumstances in which section 2701 does not apply. To the extent provided, section 2701 does not
apply in the following cases:
(1) Marketable transferred interests. Section 2701 does not apply if there are readily available market
quotations on an established securities market for the value of the transferred interests.
(2) Marketable retained interests. Section 25.2701-2 does not apply to any applicable retained interest if there
are readily available market quotations on an established securities market for the value of the applicable
retained interests.
(3) Interests of the same class. Section 2701 does not apply if the retained interest is of the same class of
equity as the transferred interest [*39] or if the retained interest is of a class that is proportional to the
class of the transferred interest. A class is the same class as (or is proportional to the class of) the
transferred interest if the rights are identical (or proportional) to the rights of the transferred interest, except
for non-lapsing differences in voting rights (or, for a partnership, non-lapsing differences with respect to
management and limitations on liability). For purposes of this section, non-lapsing provisions necessary to
comply with partnership allocation requirements of the Internal Revenue Code ( e.g., section 704 (b)) are
non-lapsing differences with respect to limitations on liability. A right that lapses by reason of Federal or
State law is treated as a non-lapsing right unless the Secretary determines, by regulation or by published
revenue ruling, that it is necessary to treat such a right as a lapsing right to accomplish the purposes of
section 2701. An interest in a partnership is not an interest in the same class as the transferred interest if
the transferor or applicable family members have the right to alter the liability of the transferee.
(4) Proportionate transfers. Section 2701 does not [*40] apply to a transfer by an individual to a member of the
individual's family of equity interests to the extent the transfer by that individual results in a proportionate
reduction of each class of equity interest held by the individual and all applicable family members in the
aggregate immediately before the transfer. Thus, for example, section 2701 does not apply if P owns 50
percent of each class of equity interest in a corporation and transfers a portion of each class to P's child in
a manner that reduces each interest held by P and any applicable family members, in the aggregate, by 10
percent even if the transfer does not proportionately reduce P's interest in each class. See §25.2701-6
regarding indirect holding of interests.
(d) Family definitions-(1) Member of the family. A member of the family is, with respect to any transferor(i) The transferor's spouse;
(ii) Any lineal descendant of the transferor or the transferor's spouse; and
(iii) The spouse of any such lineal descendant.
(2) Applicable family member. An applicable family member is, with respect to any transferor(i) The transferor's spouse;
(ii) Any ancestor of the transferor or the transferor's spouse; and
(iii) The spouse of [*41] any such ancestor.
(3) Relationship by adoption. For purposes of section 2701, any relationship by legal adoption is the same
as a relationship by blood.
(e) Examples. The following examples illustrate provisions of this section:
Example 1. P, an individual, holds all the outstanding stock of X Corporation. Assume the fair market
value of P's interest in X immediately prior to the transfer is $1.5 million. X is recapitalized so that P
holds 1,000 shares of $1,000 par value preferred stock bearing an annual cumulative dividend of $100

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per share (the aggregate fair market value of which is assumed to be $1 million) and 1,000 shares of
voting common stock. P transfers the common stock to P's child. Section 2701 applies to the transfer
because P has transferred an equity interest (the common stock) to a member of P's family and
immediately thereafter holds an applicable retained interest (the preferred stock). P's right to receive
annual cumulative dividends is a qualified payment right and is valued for purposes of section 2701 at
its fair market value of $1,000,000. The amount of P's gift, determined using the subtraction method of
§25.2701-3, is $500,000 ($1,500,000 minus $1,000,000).
Example [*42] 2. The facts are the same as in Example 1. except that the preferred dividend right is
non-cumulative. Under §25.2701-2, P's preferred dividend right is valued at zero because it is a
distribution right in a controlled entity, but is not a qualified payment right. All of P's other rights in the
preferred stock are valued as if P's dividend right does not exist but otherwise without regard to
section 2701. The amount of P's gift, determined using the subtraction method, is $1,500,000
($1,500,000 minus $0). P may elect, however, to treat the dividend right as a qualified payment right
as provided in §25.2701-2 (c) (2).
§25.2701-2 Special valuation rules for applicable retained interests.
(a) In general. In determining the amount of a gift under §25.2701-3, the value of any applicable retained
interest (as defined in paragraph (b) (1) of this section) held by the transferor or by an applicable family
member is determined using the rules of chapter 12, with the modifications prescribed by this section. See
§25.2701-6 regarding the indirect holding of interests.
(1) Valuing an extraordinary payment right. Any extraordinary payment right (as defined in paragraph (b)
(2) of this section) is [*43] valued at zero.
(2) Valuing a distribution right. Any distribution right (as defined in paragraph (b) (3) of this section) in a
controlled entity is valued at zero, unless it is a qualified payment right (as defined in paragraph (b) (6) of
this section). Controlled entity is defined in paragraph (b) (5) of this section.
(3) Special rule for valuing a qualified payment right held in conjunction with an extraordinary payment
right. If an applicable retained interest confers a qualified payment right and one or more extraordinary
payment rights, the value of all these rights is determined by assuming that each extraordinary payment
right is exercised in a manner that results in the lowest total value being determined for all the rights, using
a consistent set of assumptions and giving due regard to the entity's net worth, prospective earning power,
and other relevant factors (the "lower of" valuation rule). See §§20.2031-2 (f) and 20.2031-3 for rules
relating to the valuation of business interests generally.
(4) Valuing other rights. Any other right (including a qualified payment right not subject to the prior
paragraph) is valued as if any right valued at zero does not exist and as if any [*44] right valued under the
lower of rule is exercised in a manner consistent with the assumptions of that rule but otherwise without
regard to section 2701. Thus, if an applicable retained interest carries no rights that are valued at zero or
under the lower of rule, the value of the interest for purposes of section 2701 is its fair market value.
(5) Example. The following example illustrates rules of this paragraph (a).
Example. P, an individual, holds all 1,000 shares of X Corporation's $1,000 par value preferred stock
bearing an annual cumulative dividend of $100 per share and holds all 1,000 shares of X's voting
common stock. P has the right to put all the preferred stock to X at any time for $900,000. P transfers
the common stock to P's child and immediately thereafter holds the preferred stock. Assume that at
the time of the transfer, the fair market value of X is $1,500,000, and the fair market value of P's
annual cumulative dividend right is $1,000,000. Because the preferred stock confers both art
extraordinary payment right (the put right) and a qualified payment right ( i.e., the right to receive
cumulative dividends), the lower of rule applies and the value of these rights is [*45] determined as if
the put right will be exercised in a manner that results in the lowest total value being determined for

Page 17 of 58
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the rights (in this case, by assuming that the put will be exercised immediately). The value of P's
preferred stock is $900,000 (the lower of $1,000,000 or $900,000). The amount of the gift is $600,000
($1,500,000 minus $900,000).
(b) Definitions-(1) Applicable retained interest. An applicable retained interest is any equity interest in a
corporation or partnership with respect to which there is either(i) An extraordinary payment right (as defined in paragraph (b) (2) of this section), or
(ii) In the case of a controlled entity (as defined in paragraph (b) (5) of this section), a distribution right (as
defined in paragraph (b) (3) of this section).
(2) Extraordinary payment right. Except as provided in paragraph (b) (4) of this section, an extraordinary
payment right is any put, call, or conversion right, any right to compel liquidation, or any similar right, the
exercise or nonexercise of which affects the value of the transferred interest. A call right includes any
warrant, option, or other right to acquire one or more equity interests.
(3) Distribution right. A distribution [*46] right is the right to receive distributions with respect to an equity
interest. A distribution right does not include(i) Any right to receive distributions with respect to an interest that is of the same class as, or a class that is
subordinate to, the transferred interest;
(ii) Any extraordinary payment right; or
(iii) Any right described in paragraph (b) (4) of this section.
(4) Rights that are not extraordinary payment rights or distribution rights. Mandatory payment rights,
liquidation participation rights, rights to guaranteed payments of a fixed amount under section 707 (c), and
non-lapsing conversion rights are neither extraordinary payment rights nor distribution rights.
(i) Mandatory payment right. A mandatory payment right is a right to receive a payment required to be
made at a specific time for a specific amount. For example, a mandatory redemption right in preferred
stock requiring that the stock be redeemed at its fixed par value on a date certain is a mandatory payment
right and therefore not an extraordinary payment right or a distribution right. A right to receive a specific
amount on the death of the holder is a mandatory payment right.
(ii) Liquidation participation rights. [*47] A liquidation participation right is a right to participate in a
liquidating distribution. If the transferor, members of the transferor's family, or applicable family members
have the ability to compel liquidation, the liquidation participation right is valued as if the ability to compel
liquidation(A) Did not exist, or
(B) If the lower of rule applies, is exercised in a manner that is consistent with that rule.
(iii) Right to a guaranteed payment of a fixed amount under section 707 (c). The right to a guaranteed
payment of a fixed amount under section 707 (c) is the right to a guaranteed payment (within the meaning
of section 707 (c)) the amount of which is determined at a fixed rate (including a rate that bears a fixed
relationship to a specified market interest rate). A payment that is contingent as to time or amount is not a
guaranteed payment of a fixed amount.
(iv) Non-lapsing conversion right-(A) Corporations. A non-lapsing conversion right, in the case of a
corporation, is a non-lapsing right to convert an equity interest in a corporation into a fixed number or a
fixed percentage of shares of the same class as the transferred interest (or into an interest that would be of
the same [*48] class but for non-lapsing differences in voting rights), that is subject to proportionate
adjustments for changes in the equity ownership of the corporation and to adjustments similar to those
provided in section 2701 (d) for unpaid payments.

Page 18 of 58
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(B) Partnerships. A non-lapsing conversion right, in the case of a partnership, is a non-lapsing right to
convert an equity interest in a partnership into a specified interest (other than an interest represented by a
fixed dollar amount) of the same class as the transferred interest (or into an interest that would be of the
same class but for non-lapsing differences in management rights or limitations on liability) that is subject to
proportionate adjustments for changes in the equity ownership of the partnership and to adjustments
similar to those provided in section 2701 (d) for unpaid payments.
(C) Proportionate adjustments in equity ownership. For purposes of this paragraph (b) (4), an equity
interest is subject to proportionate adjustments for changes in equity ownership if, in the case of a
corporation, proportionate adjustments are required to be made for splits, combinations, reclassifications,
and similar changes in capital stock, or, in [*49] the case of a partnership, the equity interest is protected
from dilution resulting from changes in the partnership structure.
(D) Adjustments for unpaid payments. For purposes of this paragraph (b) (4), an equity interest is subject
to adjustments similar to those provided in section 2701 (d) if it provides for(1) Cumulative payments;
(2) Compounding of any unpaid payments at the rate specified in §25.2701-4 (c) (2); and
(3) Adjustment of the number or percentage of shares or the size of the interest into which it is convertible to
take account of accumulated but unpaid payments.
(5) Controlled entity-(i) In general. For purposes of section 2701, a controlled entity is a corporation or
partnership controlled, immediately before a transfer, by the transferor, applicable family members, and
any lineal descendants of the parents of the transferor or the transferor's spouse. See §25.2701-6
regarding indirect holding of interests.
(ii) Corporations-(A) In general. In the case of a corporation, control means the holding of at least 50
percent of the total voting power or total fair market value of the equity interests in the corporation.
(B) Voting rights. Equity interests that carry no right to [*50] vote other than on liquidation, merger, or a
similar event are not considered to have voting rights for purposes of this paragraph (b) (5) (ii). Generally,
a voting right is considered held by an individual to the extent that the individual, either alone or in
conjunction with any other person, is entitled to exercise (or direct the exercise of) the right. However, if an
equity interest carrying voting rights is held in a fiduciary capacity, the voting rights are not considered held
by the fiduciary, but instead are considered held by each beneficial owner of the interest and by each
individual who is a permissible recipient of the income from the interest. A voting right does not include a
right to vote that is subject to a contingency that has not occurred, other than a contingency that is within
the control of the individual holding the right.
(iii) Partnerships. In the case of any partnership, control means the holding of at least 50 percent of either
the capital interest or the profits interest in the partnership. Any right to a guaranteed payment under
section 707 (c) of a fixed amount is disregarded in making this determination. In addition, in the case of a
limited partnership, [*51] control means the holding of any equity interest as a general partner. See
§25.2701-2 (b) (4) (iii) for the definition of a right to a guaranteed payment of a fixed amount under section
707 (c).
(6) Qualified payment right-(i) In general. A qualified payment right is a right to receive qualified payments.
A qualified payment is a distribution that is(A) A dividend payable on a periodic basis (at least annually) under any cumulative preferred stock, to the
extent such dividend is determined at a fixed rate;
(B) Any other cumulative distribution payable on a periodic basis (at least annually) with respect to an equity
interest, to the extent determined at a fixed rate or as a fixed amount; or
(C) Any distribution right for which an election has been made pursuant to paragraph (c) (2) of this section.

Page 19 of 58
1992 IRB LEXIS 2002, *51
(ii) Fixed rate. For purposes of this section, a payment rate that bears a fixed relationship to a specified
market interest rate is a payment determined at a fixed rate.
(c) Qualified payment elections-(1) Election to treat a qualified payment right as other than a qualified
payment right. Any transferor holding a qualified payment right may elect to treat all rights held by the
transferor of [*52] the same class as rights that are not qualified payment rights. An election may be a
partial election, in which case the election must be exercised with respect to a consistent portion of each
payment right in the class as to which the election has been made.
(2) Election to treat other distribution rights as qualified payment rights. Any individual may elect to treat a
distribution right held by that individual in a controlled entity as a qualified payment right. An election may
be a partial election, in which case the election must be exercised with respect to a consistent portion of
each payment right in the class as to which the election has been made. An election under this paragraph
(c) (2) will not cause the value of the applicable retained interest conferring the distribution right to exceed
the fair market value of the applicable retained interest (determined without regard to section 2701). The
election is effective only to the extent(i) Specified in the election, and
(ii) That the payments elected are permissible under the legal instrument giving rise to the right and are
consistent with the legal right of the entity to make the payment.
(3) Elections irrevocable. Any election [*53] under paragraph (c) (1) or (c) (2) of this section is revocable
only with the consent of the Commissioner.
(4) Treatment of certain payments to applicable family members. Any payment right described in
paragraph (b) (6) of this section held by an applicable family member is treated as a payment right that is
not a qualified payment right unless the applicable family member elects (pursuant to paragraph (c) (2) of
this section) to treat the payment right as a qualified payment right. An election may be a partial election, in
which case the election must be exercised with respect to a consistent portion of each payment right in the
class as to which the election has been made.
(5) Time and manner of elections. Any election under paragraph (c) (1) or (c) (2) of this section is made by
attaching a statement to the Form 709, Federal Gift Tax Return, filed by the transferor on which the
transfer is reported. An election filed after the time of the filing of the Form 709 reporting the transfer is not
a valid election. An election filed as of April 6, 1992, for transfers made prior to its publication is effective.
The statement must(i) Set forth the name, address, and taxpayer identification [*54] number of the electing individual and of the
transferor, if different;
(ii) If the electing individual is not the transferor filing the return, state the relationship between the individual
and the transferor;
(iii) Specifically identify the transfer disclosed on the return to which the election applies;
(iv) Describe in detail the distribution right to which the election applies;
(v) State the provision of the regulation under which the election is being made; and
(vi) If the election is being made under paragraph (c) (2) of this section(A) State the amounts that the election assumes will be paid, and the times that the election assumes the
payments will be made;
(B) Contain a statement, signed by the electing individual, in which the electing individual agrees that(1) If payments are not made as provided in the election, the individual's subsequent taxable gifts or
taxable estate will, upon the occurrence of a taxable event (as defined in §25.2704 (b)), be
increased by an amount determined under §25.2701-4 (c), and

Page 20 of 58
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(2) The individual will be personally liable for any increase in tax attributable thereto.
(d) Examples. The following examples illustrate provisions of this section:
Example 1. On March [*55] 30, 1991, P transfers non-voting common stock of X Corporation to P's
child, while retaining $100 par value voting preferred stock bearing a cumulative annual dividend of
$10. Immediately before the transfer, P held 100 percent of the stock. Because X is a controlled entity
(within the meaning of paragraph (b) (5) of this section), P's dividend right is a distribution right that is
subject to section 2701. See §25.2701-2 (b) (3). Because the distribution right is an annual cumulative
dividend, it is a qualified payment right. See §25.2701-2 (b) (6).
Example 2. The facts are the same as in Example 1. except that the dividend right is non-cumulative.
P's dividend right is a distribution right in a controlled entity, but is not a qualified payment right
because the dividend is non-cumulative. Therefore, the non-cumulative dividend right is valued at zero
under §25.2701-2 (a) (2). If the corporation were not a controlled entity, P's dividend right would be
valued without regard to section 2701.
Example 3. The facts are the same as in Example 1. Because P holds sufficient voting power to
compel liquidation of X, P's right to participate in liquidation is an extraordinary payment right under
[*56] paragraph (b) (2) of this section. Because P holds an extraordinary payment right in conjunction
with a qualified payment right (the right to receive cumulative dividends), the lower of rule applies.
Example 4. The facts are the same as in Example 1, except that immediately before the transfer, P,
applicable family members of P, and members of P's family, hold 60 percent of the voting rights in X.
Assume that 80 percent of the vote is required to compel liquidation of any interest in X. P's right to
participate in liquidation is not an extraordinary payment right under paragraph (b) (2) of this section,
because P and P's family cannot compel liquidation of X. P's preferred stock is an applicable retained
interest that carries no rights that are valued under the special valuation rules of section 2701. Thus,
in applying the valuation method of §25.2701-3, the value of P's preferred stock is its fair market value
determined without regard to section 2701.
Example 5. L holds 10-percent non-cumulative preferred stock and common stock in a corporation
that is a controlled entity. L transfers the common stock to L's child. L holds no extraordinary payment
rights with respect to the preferred [*57] stock. L elects under paragraph (c) (2) of this section to treat
the non-cumulative dividend right as a qualified payment right consisting of the right to receive a
cumulative annual dividend of 5 percent. Under §25.2701-2 (c) (2), the value of the distribution right
pursuant to the election is the lesser of(A) The fair market value of the right to receive a cumulative 5-percent dividend from the corporation, giving due
regard to the corporation's net worth, prospective earning power, and dividend-paying capacity; or
(B) The value of the distribution right determined without regard to section 2701 and without regard to the terms
of the qualified payment election.
§25.2701-3 Determination of amount of gift.
(a) Overview-(1) In general. The amount of the gift resulting from any transfer to which section 2701
applies is determined by a subtraction method of valuation. Under this method, the amount of the transfer
is determined by subtracting the values of all family-held senior equity interests from the fair market value
of all family-held interests in the entity determined immediately before the transfer. The values of the
senior equity interests held by the transferor and applicable family [*58] members generally are
determined under section 2701. Other family-held senior equity interests are valued at their fair market
value. The balance is then appropriately allocated among the transferred interests and other family-held
subordinate equity interests. Finally, certain discounts and other appropriate reductions are provided, but
only to the extent permitted by this section.

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1992 IRB LEXIS 2002, *58
(2) Definitions. The following definitions apply for purposes of this section.
(i) Family-held. Family-held means held (directly or indirectly) by an individual described in §25.2701-2 (b)
(5) (i).
(ii) Senior equity interest. Senior equity interest means an equity interest in the entity that carries a right to
distributions of income or capital that is preferred as to the rights of the transferred interest.
(iii) Subordinate equity interest. Subordinate equity interest means an equity interest in the entity as to
which an applicable retained interest is a senior equity interest.
(b) Valuation methodology. The following methodology is used to determine the amount of the gift when
section 2701 applies.
(1) Step 1-Valuation of family-held interests-(i) In general. Except as provided in paragraph (ii) of this Step
[*59] 1, determine the fair market value of all family-held equity interests in the entity immediately after the
transfer. The fair market value is determined by assuming that the interests are held by one individual,
using a consistent set of assumptions.
(ii) Special rule for contributions to capital. In the case of a contribution to capital, determine the fair market
value of the contribution.
(2) Step 2-Subtract the value of senior equity interests-(i) In general. If the amount determined in Step 1 is
not determined under the special rule for contributions to capital, from that value subtract the following
amounts:
(A) An amount equal to the sum of the fair market value of all family-held senior equity interests (other than
applicable retained interests held by the transferor or applicable family members) and the fair market value
of any family-held equity interests of the same class or a subordinate class to the transferred interests held
by persons other than the transferor, members of the transferor's family, and applicable family members of
the transferor. The fair market value of an interest is its pro rata share of the fair market value of all familyheld senior equity interests of [*60] the same class (determined, immediately after the transfer, as if all
family-held senior equity interests were held by one individual); and
(B) The value of all applicable retained interests held by the transferor or applicable family members (other than
an interest received as consideration for the transfer) determined under §25.2701-2, taking into account
the adjustment described in paragraph (b) (5) of this section.
(ii) Special rule for contributions to capital. If the value determined in Step 1 is determined under the
special rule for contributions to capital, subtract the value of any applicable retained interest received in
exchange for the contribution to capital determined under §25.2701-2.
(3) Step 3-Allocate the remaining value among the transferred interests and other family-held subordinate
equity interests. The value remaining after Step 2 is allocated among the transferred interests and other
subordinate equity interests held by the transferor, applicable family members, and members of the
transferor's family. If more than one class of family-held subordinate equity interest exists, the value
remaining after Step 2 is allocated, beginning with the most senior class of subordinate [*61] equity
interest, in the manner that would most fairly approximate their value if all rights valued under section 2701
at zero did not exist (or would be exercised in a manner consistent with the assumptions of the rule of
§25.2702-2 (a) (4), if applicable). If there is no clearly appropriate method of allocating the remaining value
pursuant to the preceding sentence, the remaining value (or the portion remaining after any partial
allocation pursuant to the preceding sentence) is allocated to the interests in proportion to their fair market
values determined without regard to section 2701.
(4) Step 4-Determine the amount of the gift-(i) In general. The amount allocated to the transferred interests
in Step 3 is reduced by the amounts determined under this paragraph (b) (4).

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1992 IRB LEXIS 2002, *61
(ii) Reduction for minority or similar discounts. Except as provided in §25.2701-3 (c), if the value of the
transferred interest (determined without regard to section 2701) would be determined after application of a
minority or similar discount with respect to the transferred interest, the amount of the gift determined under
section 2701 is reduced by the excess, if any, of(A) A pro rata portion of the fair market value [*62] of the family-held interests of the same class (determined
as if all voting rights conferred by family-held equity interests were held by one person who had no interest
in the entity other than the family-held interests of the same class, but otherwise without regard to section
2701), over
(B) The value of the transferred interest (without regard to section 2701).
(iii) Adjustment for transfers with a retained interest. If the value of the transferor's gift (determined without
regard to section 2701) would be reduced under section 2702 to reflect the value of a retained interest, the
value determined under section 2701 is reduced by the same amount.
(iv) Reduction for consideration. The amount of the transfer (determined under section 2701) is reduced by
the amount of consideration in money or money's worth received by the transferor, but not in excess of the
amount of the gift (determined without regard to section 2701). The value of consideration received by the
transferor in the form of an applicable retained interest in the entity is determined under section 2701
except that, in the case of a contribution to capital, the Step 4 value of such an interest is zero.
(5) Adjustment in Step [*63] 2-(i) In general. For purposes of paragraph (b) (2) of this section, if the
percentage of any class of applicable retained interest held by the transferor and by applicable family
members (including any interest received as consideration for the transfer) exceeds the family interest
percentage, the excess is treated as a family-held interest that is not held by the transferor or an
applicable family member.
(ii) Family interest percentage. The family interest percentage is the highest ownership percentage
(determined on the basis of relative fair market values) of family-held interests in(A) Any class of subordinate equity interest; or
(B) All subordinate equity interests, valued in the aggregate.
(c) Minimum value rule-(1) In general. If section 2701 applies to the transfer of an interest in an entity, the
value of a junior equity interest is not less than its pro-rata portion of 10 percent of the sum of(i) The total value of all equity interests in the entity, and
(ii) The total amount of any indebtedness of the entity owed to the transferor and applicable family members.
(2) Junior equity interest. For purposes of paragraph (c) (1) of this section, junior equity interest means
common stock [*64] or, in the case of a partnership, any partnership interest under which the rights to
income and capital are junior to the rights of all other classes of partnership interests. Common stock
means the class or classes of stock that, under the facts and circumstances, are entitled to share in the
reasonably anticipated residual growth in the entity.
(3) Indebtedness-(i) In general. For purposes of paragraph (c) (1) of this section, indebtedness owed to the
transferor (or an applicable family member) does not include(A) Short-term indebtedness incurred with respect to the current conduct of the entity's trade or business (such
as amounts payable for current services);
(B) Indebtedness owed to a third party solely because it is guaranteed by the transferor or an applicable family
member; or
(C) Amounts permanently set aside in a qualified deferred compensation arrangement, to the extent the
amounts are unavailable for use by the entity.

Page 23 of 58
1992 IRB LEXIS 2002, *64
(ii) Leases. A lease of property is not indebtedness, without regard to the length of the lease term, if the
lease payments represent full and adequate consideration for use of the property. Lease payments are
considered full and adequate consideration if a good [*65] faith effort is made to determine the fair rental
value under the lease and the terms of the lease conform to the value so determined. Arrearages with
respect to a lease are indebtedness.
(d) Examples. The application of the subtraction method described in this section is illustrated by the
following examples:
Example 1. Corporation X has outstanding 1,000 shares of $1,000 par value voting preferred stock,
each share of which carries a cumulative annual dividend of 8 percent and a right to put the stock to X
for its par value at any time. In addition, there are outstanding 1,000 shares of non-voting common
stock. A holds 600 shares of the preferred stock and 750 shares of the common stock. The balance of
the preferred and common stock is held by B, a person unrelated to A. Because the preferred stock
confers both a qualified payment right and an extraordinary payment right, A's rights are valued under
the "lower of" rule of §25.2701-2 (a) (3). Assume that A's rights in the preferred stock are valued at
$800 per share under the "lower of" rule (taking account of A's voting rights). A transfers all of A's
common stock to A's child. The method for determining the amount of A's gift is as [*66] followsStep 1: Assume the fair market value of all the family-held interests in X, taking account of A's
control of the corporation, is determined to be $1 million.
Step 2: From the amount determined under Step 1, subtract $480,000 (600 shares × $800 (the
section 2701 value of A's preferred stock, computed under the "lower of rule of §25.2701-2 (a)
(3))).
Step 3: The result of Step 2 is a balance of $520,000. This amount is fully allocated to the 750
shares of family-held common stock.
Step 4: Because no consideration was received for the transfer, the adjustment under Step 4 is
limited to the amount of any appropriate minority or similar discount. Before the application of
Step 4 the amount of A's gift is $520,000.
Example 2. The facts are the same as in Example 1, except that prior to the transfer A holds only
50 percent of the common stock and B holds the remaining 50 percent. Assume that the fair
market value of A's 600 shares of preferred stock is $600,000.
Step 1: Assume that the result of this step (determining the value of the family-held interest) is
$980,000.
Step 2: From the amount determined under Step 1, subtract $500,000 ($400,000, the value of
500 shares of A's preferred [*67] stock determined under section 2701 plus $100,000, the fair
market value of A's other 100 shares of preferred stock determined without regard to section
2701 pursuant to the valuation adjustment determined under paragraph (b) (5) of this section).
The adjustment in step 2 applies in this example because A's percentage ownership of the
preferred stock (60 percent) exceeds the family interest percentage of the common stock (50
percent). Therefore, 100 shares of A's preferred stock are valued at fair market value, or
$100,000 (100 × $1,000). The balance of A's preferred stock is valued under section 2701 at
$400,000 (500 shares × $800). The value of A's preferred stock for purposes of section 2701
equals $500,000 ($100,000 plus $400,000).
Step 3: The result of Step 2 is $480,000 ($980,000 minus $500,000) which is allocated to the
family-held common stock. Because A transferred all of the family-held subordinate equity
interests, all of the value determined under Step 2 is allocated to the transferred shares.
Step 4: The adjustment in Step 4 is the same as in Example 1. Thus, the amount of the gift is
$480,000.

Page 24 of 58
1992 IRB LEXIS 2002, *67
Example 3. Corporation X has outstanding 1,000 shares of $1,000 par value non-voting
[*68] preferred stock, each share of which carries a cumulative annual dividend of 8 percent and a
right to put the stock to X for its par value at any time. In addition, there are outstanding 1,000 shares
of voting common stock. A holds 600 shares of the preferred stock and 750 shares of the common
stock. The balance of the preferred and common stock is held by B. a person unrelated to A. Assume
further that steps one through three, as in Example 1, result in $520,000 being allocated to the familyheld common stock and that A transfers only 75 shares of A's common stock. The transfer fragments
A's voting interest. Under Step 4, an adjustment is appropriate to reflect the fragmentation of A's
voting rights. The amount of the adjustment is the difference between 10 percent (75⁄
750) of the fair market value of A's common shares and the fair market value of the transferred
shares, each determined as if the holder thereof had no other interest in the corporation.
Example 4. On December 31, 1990, the capital structure of Y corporation consists of 1,000 shares of
voting common stock held three-fourths by A and one-fourth by A's child, B. On January 15, 1991, A
transfers 250 shares of common stock [*69] to Y in exchange for 300 shares of nonvoting, noncumulative 8% preferred stock with a section 2701 value of zero. Assume that the fair market value of
Y is $1,000,000 at the time of the exchange and that the exchange by A is for full and adequate
consideration in moneys' worth. However, for purposes of section 2701, if a subordinate equity
interest is transferred in exchange for an applicable retained interest, consideration in the exchange is
determined with reference to the section 2701 value of the senior interest. Thus, A is treated as
transferring the common stock to the corporation for no consideration. Immediately after the transfer,
B is treated as holding one-third (250⁄
750) of the common stock and A is treated as holding two-thirds (500⁄
750). The amount of the gift is determined as follows:
Step 1. Because Y is held exclusively by A and B, the Step 1value is $1,000,000.
Step 2. The result of Step 2 is $1,000.000 ($1,000,000 − 0).
Step 3. The amount allocated to the transferred common stock is $250,000 (250⁄
1000 × $1,000,000). That amount is further allocated in proportion to the respective holdings of A
and B in the common stock ($166,667 and $83,333, respectively).
Step 4. There [*70] is no Step 4 adjustment because the section 2701 value of the consideration
received by A was zero and no minority discount would have been involved in the exchange.
Thus, the amount of the gift is $83,333. If the section 2701 value of the applicable retained
interest were $100,000, The Step 4 adjustment would have been a $33,000 reduction for
consideration received ((250⁄
750) × $100,000).
Example 5. The facts are the same as in Example 4, except that on January 6, 1992, when the fair
market value of Y is still $1,000.000, A transfers A's remaining 500 shares of common stock to Y in
exchange for 2500 shares of preferred stock. The second transfer is also for full and adequate
consideration in money or money's worth. The result of Step 2 is the same - $1,000,000.
Step 3. The amount allocated to the transferred common stock is $666,667 (500⁄
750 × $1,000,000). Since A holds no common stock immediately after the transfer, A, is treated as
transferring the entire interest to the other shareholder (B). Thus, $666,667 is fully allocated to the
shares held by B.
Step 4. There is no Step 4 adjustment because the section 2701 value of the consideration received
by A was zero and no minority discount [*71] would have been involved in the exchange. Thus, the
amount of the gift is $666,667.
§25.2701-4 Accumulated qualified payments.

Page 25 of 58
1992 IRB LEXIS 2002, *71
(a) In general. If a taxable event occurs with respect to any applicable retained interest conferring a
distribution right that was previously valued as a qualified payment right (a "qualified payment interest"),
the taxable estate or taxable gifts of the individual holding the interest are increased by the amount
determined under paragraph (c) of this section.
(b) Taxable event-(1) In general. Except as otherwise provided in this section, taxable event means the
transfer of a qualified payment interest, either during life or at death, by the individual in whose hands the
interest was originally valued under section 2701 (the "interest holder") or by any individual treated
pursuant to paragraph (b) (3) of this section in the same manner as the interest holder. Except as provided
in paragraph (a) (2) of this section, any termination of an individual's rights with respect to a qualified
payment interest is a taxable event. Thus, for example, if an individual is treated as indirectly holding a
qualified payment interest held by a trust, a taxable event occurs on [*72] the earlier of(i) The termination of the individual's interest in the trust (whether by death or otherwise), or
(ii) The termination of the trust's interest in the qualified payment interest (whether by disposition or otherwise).
(2) Exception. If, at the time of a termination of an individual's rights with respect to a qualified payment
interest, the value of the property would be includible in the individual's gross estate for Federal estate tax
purposes if the individual died immediately after the termination, a taxable transfer does not occur until the
earlier of(i) The time the property would no longer be includible in the individual's gross estate (other than by reason of
section 2035), or
(ii) The death of the individual.
(3) Individual treated as interest holder-(i) In general. If a taxable event involves the transfer of a qualified
payment interest by the interest holder (or an individual treated as the interest holder) to an applicable
family member of the individual who made the transfer to which section 2701 applied (other than the
spouse of the individual transferring the qualified payment interest), the transferee applicable family
member is treated in the same manner as the [*73] interest holder with respect to late or unpaid qualified
payments first due after the taxable event. Thus, for example, if an interest holder transfers during life a
qualified payment interest to an applicable family member, that transfer is a taxable event with respect to
the interest holder whose taxable gifts are increased for the year of the transfer as provided in paragraph
(c) of this section. The transferee is treated thereafter in the same manner as the interest holder with
respect to late or unpaid qualified payments first due after the taxable event.
(ii) Transfers to spouse-(A) In general. If an interest holder (or an individual treated as the interest holder)
transfers a qualified payment interest, the transfer is not a taxable event to the extent a marital deduction
is allowed with respect to the transfer under sections 2056, 2106 (a) (3), or 2523 or, in the case of a
transfer during the individual's lifetime, to the extent the spouse furnishes consideration for the transfer.
If this exception applies, the transferee spouse is treated as if he or she were the holder of the interest
from the date the transferor spouse acquired the interest. If the deduction for a transfer [*74] to a spouse
is allowable under section 2056 (b) (8) or 2523 (g) (relating to charitable remainder trusts), the transferee
spouse is treated as the holder of the entire interest passing to the trust.
(B) Marital bequests. If the selection of property with which a marital bequest is funded is discretionary, a
transfer of a qualified payment interest will not be considered a transfer to the surviving spouse unless(1) The marital bequest is funded with the qualified payment interest before the due date for filing the
decedent's Federal estate tax return (including extensions actually granted) (the "due date"), or
(2) The executor(i) Files a statement with the return indicating the extent to which the marital bequest will be funded with the
qualified payment interest, and

Page 26 of 58
1992 IRB LEXIS 2002, *74
(ii) Before the date that is one year prior to the expiration of the period of limitations on assessment of the
Federal estate tax, notifies the District Director having jurisdiction over the return of the extent to which
the bequest was funded with the qualified payment interest (or the extent to which the qualified
payment interest has been permanently set aside for that purpose).
(C) Purchase by the surviving spouse. For [*75] purposes of this section, the purchase (before the date
prescribed for filing the decedent's estate tax return, including extensions actually granted) by the surviving
spouse (or a trust described in section 2056 (b) (7)) of a qualified payment interest held (directly or
indirectly) by the decedent immediately before death is considered a transfer with respect to which a
deduction is allowable under section 2056 or section 2106 (a) (3), but only to the extent that the deduction
is allowed to the estate. For example, assume that A bequeaths $50,000 to A's surviving spouse, B, in a
manner that qualifies for deduction under section 2056, and that subsequent to A's death B purchases a
qualified payment interest from A's estate for $200,000, its fair market value. The economic effect of the
transaction is the equivalent of a bequest by A to B of the qualified payment interest, one-fourth of which
qualifies for the marital deduction. Therefore, for purposes of this section, one-fourth of the qualified
payment interest purchased by B ($50,000 ÷ $200,000) is considered a transfer of an interest with respect
to which a deduction is allowed under 2056. If the purchase by the surviving spouse [*76] is not made
before the due date of the decedent's return, the purchase of the qualified payment interest will not be
considered a bequest for which a marital deduction is allowed unless the executor(1) Files a statement with the return indicating the qualified payment interests to be purchased by the surviving
spouse (or a trust described in section 2056 (b) (7)), and
(2) Before the date that is one year prior to the expiration of the period of limitations on assessment of the
Federal estate tax, notifies the District Director having jurisdiction over the return that the purchase of the
qualified payment interest has been made (or that the funds necessary to purchase the qualified payment
interest have been permanently set aside for that purpose).
(c) Amount of increase-(1) In general. Except as limited by paragraph (c) (6) of this section, the amount of
the increase to an individual's taxable estate or taxable gifts is the excess, if any, of(i) The sum of(A) The amount of qualified payments payable during the period beginning on the date of the transfer to
which section 2701 applied (or, in the case of an individual treated as the interest holder, on the date
the interest of the prior [*77] interest holder terminated) and ending on the date of the taxable event;
and
(B) The earnings on those payments, determined hypothetically as if each payment were paid on its due
date and reinvested as of that date at a yield equal to the appropriate discount rate (as defined below);
over
(ii) The sum of(A) The amount of the qualified payments actually paid during the same period;
(B) The earnings on those payments, determined hypothetically as if each payment were reinvested as of
the date actually paid at a yield equal to the appropriate discount rate; and
(C) To the extent required to prevent double inclusion, by an amount equal to the sum of(1) The portion of the fair market value of the qualified payment interest solely attributable to any right
to receive unpaid qualified payments determined as of the date of the taxable event;
(2) The fair market value of any equity interest in the entity received by the individual in lieu of qualified
payments and held by the individual at the taxable event, and
(3) The amount by which the individual's aggregate taxable gifts were increased by reason of the failure
of the individual to enforce the right to receive qualified payments.

Page 27 of 58
1992 IRB LEXIS 2002, *77
(2) Due date of qualified [*78] payments. With respect to any qualified payment, the "due date" is that
date specified in the governing instrument as the date on which payment is to be made. If no date is
specified in the governing instrument, the due date is the last day of each calendar year.
(3) Appropriate discount rate. The appropriate discount rate is the discount rate that was applied in
determining the value of the qualified payment right at the time of the transfer to which section 2701
applied.
(4) Application of payments. For purposes of this section, any payment of an unpaid qualified payment is
applied in satisfaction of unpaid qualified payments beginning with the earliest unpaid qualified payment.
Any payment in excess of the total of all unpaid qualified payments is treated as a prepayment of future
qualified payments.
(5) Payment. For purposes of this paragraph (c), the transfer of a debt obligation bearing compound
interest from the due date of the payment at a rate not less than the appropriate discount rate is a qualified
payment if the term of the obligation (including extensions) does not exceed four years from the date
issued. A payment in the form of an equity interest in the entity is not a [*79] qualified payment. Any
payment of a qualified payment made (or treated as made) either before or during the four-year period
beginning on the due date of the payment but before the date of the taxable event is treated as having
been made on the due date.
(6) Limitation-(i) In general. The amount of the increase to an individual's taxable estate or taxable gifts is
limited to the applicable percentage of the excess, if any, of(A) The sum of(1) The fair market value of all outstanding equity interests in the entity that are subordinate to the
applicable retained interest, determined as of the date of the taxable event without regard to any
accrued liability attributable to unpaid qualified payments; and
(2) Any amounts expended by the entity to redeem or otherwise acquire any such subordinate interest
during the period beginning on the date of the transfer to which section 2701 applied (or, in the case of
an individual treated as an interest holder, on the date the interest of the prior interest holder
terminated) and ending on the date of the taxable event (reduced by any amounts received on the
resale or issuance of any such subordinate interest during the same period); over
(B) The fair [*80] market value of all outstanding equity interests in the entity that are subordinate to the
applicable retained interest, determined as of the date of the transfer to which section 2701 applied (or, in
the case of an individual treated as an interest holder, on the date the interest of the prior interest holder
terminated).
(ii) Computation of limitation. For purposes of computing the limitation applicable under this paragraph (c)
(6), the aggregate fair market value of the subordinate interests in the entity are determined without regard
to §25.2701-3 (c).
(iii) Applicable percentage. The applicable percentage is determined by dividing the number of shares or
units of the applicable retained interest held by the interest holder (or an individual treated as the interest
holder) on the date of the taxable event by the total number of such shares or units outstanding on the
same date. If an individual holds applicable retained interests in two or more classes of interests, the
applicable percentage is equal to the largest applicable percentage determined with respect to any class.
For example, if T retains 40 percent of the class A preferred and 60 percent of the class B preferred in a
[*81] corporation, the applicable percentage with respect to T's holdings is 60 percent.
(d) Taxpayer election-(1) In general. An interest holder (or individual treated as an interest holder) may
elect to treat as a taxable event the payment of an unpaid qualified payment occurring more than four
years after its due date. Under this election, the increase under paragraph (c) of this section is determined
only with respect to that payment and all previous payments for which an election was available but not

Page 28 of 58
1992 IRB LEXIS 2002, *81
made. Payments for which an election applies are treated as having been paid on their due dates for
purposes of subsequent taxable events. The election is revocable only with the consent of the
Commissioner.
(2) Limitation not applicable. If a taxable event occurs by reason of an election described in paragraph (d)
(1) of this section, the limitation described in paragraph (c) (6) of this section does not apply.
(3) Time and manner of election-(i) Timely-filed returns. The election may be made by attaching a
statement to a Form 709, Federal Gift Tax Return, filed by the recipient of the qualified payment on a
timely basis for the year in which the qualified payment is received. In that case, [*82] the taxable event is
deemed to occur on the date the qualified payment is received.
(ii) Election on late returns. The election may be made by attaching a statement to a Form 709, Federal
Gift Tax Return, filed by the recipient of the qualified payment other than on a timely basis for the year in
which the qualified payment is received. In that case, the taxable event is deemed to occur on the first day
of the month immediately preceding the month in which the return is filed. If an election, other than an
election on a timely return, is made after the death of the interest holder, the taxable event with respect to
the decedent is deemed to occur on the later of(A) The date of the recipient's death, or
(B) The first day of the month immediately preceding the month in which the return is filed.
(iii) Requirements of statement. The statement must(A) Provide the name, address, and taxpayer identification number of the electing individual and the interest
holder, if different;
(B) Indicate that a taxable event election is being made under paragraph (d) of this section;
(C) Disclose the nature of the qualified payment right to which the election applies, including the due dates of
the payments, [*83] the dates the payments were made, and the amounts of the payments;
(D) State the name of the transferor, the date of the transfer to which section 2701 applied, and the discount
rate used in valuing the qualified payment right; and
(E) State the resulting amount of increase in taxable gifts.
(4) Example. The following example illustrates the rules of this paragraph (d).
Example. A holds cumulative preferred stock that A retained in a transfer to which section 2701
applied. No dividends were paid in years 1 through 5 following the transfer. In year 6, A received a
qualified payment that, pursuant to paragraph (c) (3) of this section, is considered to be in satisfaction
of the unpaid qualified payment for year 1. No election was made to treat that payment as a taxable
event. In year 7, A receives a qualified payment that, pursuant to paragraph (c) (4) of this section, is
considered to be in satisfaction of the unpaid qualified payment for year 2. A elects to treat the
payment in year 7 as a taxable event. The election increases A's taxable gifts in year 7 by the amount
computed under paragraph (c) of this section with respect to the payments due in both year 1 and
year 2. For purposes of any [*84] future taxable events, the payments with respect to years 1 and 2
are treated as having been made on their due dates.
§25.2701-5 Adjustments to mitigate double taxation. [Reserved]
§25.2701-6 Indirect holding of interests.
(a) In general-(1) Attribution to individuals. For purposes of section 2701, an individual is treated as holding
an equity interest to the extent the interest is held indirectly through a corporation, partnership, estate,
trust, or other entity. If an equity interest is treated as held by a particular individual in more than one

Page 29 of 58
1992 IRB LEXIS 2002, *84
capacity, the interest is treated as held by the individual in the manner that attributes the largest total
ownership of the equity interest. An equity interest held by a lower-tier entity is attributed to higher-tier
entities in accordance with the rules of this section. For example, if an individual is a 50-percent
beneficiary of a trust that holds 50 percent of the preferred stock of a corporation, 25 percent of the
preferred stock is considered held by the individual under these rules.
(2) Corporations. A person is considered to hold an equity interest held by or for a corporation in the
proportion that the fair market value of the stock [*85] the person holds bears to the fair market value of all
the stock in the corporation (determined as if each class of stock were held separately by one individual).
This paragraph applies to any entity classified as a corporation or as an association taxable as a
corporation for federal income tax purposes.
(3) Partnerships. A person is considered to hold an equity interest held by or for a partnership in the
proportion that the fair market value of the larger of the person's profits interest or capital interest in the
partnership bears to the total fair market value of the corresponding profits interests or capital interests in
the partnership, as the case may be (determined as if each class were held by one individual). This
paragraph applies to any entity classified as a partnership for federal income tax purposes.
(4) Estates, trusts and other entities-(i) In general. 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 [*86] 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.
(ii) Special rules-(A) Property is held by a decedent's estate if the property is subject to claims against the
estate and expenses of administration.
(B) A person holds [*87] a beneficial interest in a trust or an estate so long as the person may receive
distributions from the trust or the estate other than payments for full and adequate consideration.
(C) An individual holds an 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). However, if an individual is treated as the owner of
only a fractional share of a grantor trust because there are multiple grantors, the individual holds each
equity interest held by the trust, except to the extent that the fair market value of the interest exceeds the
fair market value of the fractional share.
(5) Multiple attribution-(i) Applicable retained interests. If this section attributes an applicable retained
interest to more than one individual in a class consisting of the transferor and one or more applicable
family members, the interest is attributed within that class in the following order(A) If the interest is held in a grantor trust, to the individual treated as the holder thereof;
(B) To the transferor;
(C) To the transferor's [*88] spouse; or
(D) To each applicable family member on a pro rata basis.

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(ii) Subordinate equity interests. If this section attributes a subordinate equity interest to more than one
individual in a class consisting of the transferor, applicable family members, and members of the
transferor's family, the interest is attributed within that class in the following order(A) To the transferee;
(B) To each member of the transferor's family on a pro rata basis;
(C) If the interest is held in a grantor trust, to the individual treated as the holder thereof;
(D) To the transferor;
(E) To the transferor's spouse; or
(F) To each applicable family member on a pro rata basis.
(b) Examples. The following examples illustrate the provisions of this section:
Example 1. A, an individual, holds 25 percent by value of each class of stock of Y Corporation.
Persons unrelated to A hold the remaining stock. Y holds 50 percent of the stock of Corporation X.
Under paragraph (a) (2) of this section, Y's interests in X are attributed proportionately to the
shareholders of Y. Accordingly, A is considered to hold a 12.5 percent (25 percent x 50 percent)
interest in X.
Example 2. Z Bank's authorized capital consists of 100 shares of [*89] common stock and 100
shares of preferred stock. A holds 60 shares of each (common and preferred) and A's child, B, holds
40 shares of common stock. Z holds the balance of its own preferred stock, 30 shares as part of a
common trust fund it maintains and 10 shares permanently set aside to satisfy a deferred obligation.
For purposes of section 2701, A holds 60 shares of common stock and 66 shares of preferred stock in
Z, 60 shares of each class directly and 6 shares of preferred stock indirectly (60 percent of the 10
shares set aside to fund the deferred obligation).
Example 3. An irrevocable trust holds a 10 percent general partnership interest in Partnership Q. Onehalf of the trust income is required to be distributed to O Charity. The other one-half of the income is to
be distributed to D during D's life and thereafter to E for such time as E survives D. D holds one-half of
the trust's interest in Q by reason of D's present right to receive one-half of the trust's income, and E
holds one-half of the trust's interest in Q by reason of E's future right to receive one-half of the trust's
income. Nevertheless, no family member is treated as holding more than one-half of the trust's
interest [*90] in Q because at no time will either D or E actually hold, in the aggregate, any right with
respect to income or corpus greater than one-half.
Example 4. An irrevocable trust holds a 10 percent general partnership interest in partnership M. Onehalf of the trust income is to be paid to D for D's life. The remaining income may, in the trustee's
discretion, be accumulated or paid to or for the benefit of a class that includes D's child F, in such
amounts as the trustee determines. On the death of the survivor of D and F, the trust corpus is
required to be distributed to O Charity, The trust's interest in M is held by the trust's beneficiaries to
the extent that present and future income or corpus may be distributed to them. Accordingly, D holds
one-half of the trust's interest in M because D is entitled to receive one-half of the trust income
currently. F holds the entire value of the interest because F is a member of the class eligible to receive
the entire trust income for such time as F survives D. See paragraph (a) (5) of this section for rules
applicable in the case of multiple attribution.
Example 5. The facts are the same as in Example 4, except that all the income is required to [*91] be
paid to 0 Charity for the trust's initial year. The result is the same as in Example 4.
§25.2701-7 Separate interests.

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The Secretary may, by regulation, revenue ruling, notice, or other document of general application,
prescribe rules under which an applicable retained interest is treated as two or more separate interests for
purposes of section 2701. In addition, the Commissioner may, by ruling issued to a taxpayer upon request,
treat any applicable retained interest as two or more separate interests as may be necessary and
appropriate to carry out the purposes of section 2701.
§25.2701-8 Effective dates.
Sections 25.2701-1 through 25.2701-4 and §§25.2701-6 and 25.2701-7 are effective as of January 28,
1992. For transfers made prior to January 28, 1992, taxpayers may rely on any reasonable interpretation
of the statutory provisions. For these purposes, the provisions of the proposed regulations and the final
regulations are considered a reasonable interpretation of the statutory provisions.
§25.2702-0 Table of Contents.
This section lists the major paragraphs contained in §§25.2702-1 through 25.2702-7.
§25.2702-1 Special valuation rules in the case of transfers of interests in trust.
(a) [*92] Scope of section 2702.
(b) Effect of section 2702.
(c) Exceptions to section 2702.
(1) Incomplete gift.
(2) Personal residence trust.
(3) Charitable remainder trust.
(4) Pooled income fund.
(5) Charitable lead trust.
(6) Certain assignments of remainder interests.
(7) Certain property settlements.
§25.2702-2 Definitions and valuation rules.
(a) Definitions.
(1) Member of the family.
(2) Transfer in trust.
(3) Retained.
(4) Interest.
(5) Qualified interest.
(6) Qualified annuity interest.
(7) Qualified unitrust interest.
(8) Qualified remainder interest.
(9) Governing instrument.
(b) Valuation of retained interests.
(1) In general.
(2) Qualified interest.
(c) Valuation of a term interest in certain tangible property.
(1) In general.
(2) Tangible property subject to rule.
(3) Evidence of value of property.
(4) Conversion of property.

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(5) Additions or improvements to property.
(d) Examples.
§25.2702-3 Qualified interests.
(a) In general.
(b) Special rules for qualified annuity interests.
(1) Payment of annuity amount.
(2) Incorrect valuations of trust property.
(3) Computation of annuity amount in certain circumstances.
(4) Additional contributions prohibited.
(c) Special rules for qualified unitrust interests.
(1) Payment [*93] of unitrust amount.
(2) Incorrect valuations of trust property.
(3) Computation of unitrust amount in certain circumstances.
(d) Requirements applicable to qualified annuity interests and qualified initrust interests.
(1) In general.
(2) Amounts payable to other persons.
(3) Term of the annuity or unitrust interest.
(4) Commutation.
(e) Examples.
(f) Qualified remainder interest.
(1) Requirements.
(2) Remainder interest.
(3) Examples.
§25.2702-4 Certain property treated as held in trust.
(a) In general.
(b) Leases.
(c) Joint purchases.
(d) Examples.
§25.2702-5 Personal residence trusts.
(a) In general.
(b) Personal residence trust.
(1) In general.
(2) Personal residence.
(3) Qualified proceeds.
(c) Qualified personal residence trust.
(1) In general.
(2) Personal residence.
(3) Income of the trust.
(4) Distributions from the trust to other persons.
(5) Assets of the trust.
(6) Commutation.
SARA COVINGTON

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(7) Cessation of use as a personal residence.
(8) Disposition of trust assets on cessation as qualified personal residence trust.
(d) Examples.
§25.2702-6 Reduction in taxable gifts.
(a) Transfers of retained interests in trust.
(1) Inter vivos transfers.
(2) Testamentary transfers.
(3) Gift splitting.
(b) Amount of reduction.
(1) [*94] In general.
(2) Treatment of annual exclusion.
(3) Overlap with section 2001.
(c) Examples.
§25.2702-7 Effective dates.
§25.2702-1 Special valuation rules in the case of transfers of interests in trust.
(a) Scope of section 2702. Section 2702 provides special rules to determine the amount of the gift when
an individual makes a transfer in trust to (or for the benefit of) a member of the individual's family and the
individual or an applicable family member retains an interest in the trust. Section 25.2702-4 treats certain
transfers of property as transfers in trust. Certain transfers, including transfers to a personal residence
trust, are not subject to section 2702. See paragraph (c) of this section. Member of the family is defined in
§25.2702-2 (a) (1). Applicable family member is defined in §25.2701-1 (d) (2).
(b) Effect of section 2702. If section 2702 applies to a transfer, the value of any interest in the trust
retained by the transferor or any applicable family member is determined under §25.2702-2 (b). The
amount of the gift, if any, is then determined by subtracting the value of the interests retained by the
transferor or any applicable family member from the value of the transferred [*95] property. If the retained
interest is not a qualified interest (as defined in §25.2702-3), the retained interest is generally valued at
zero, and the amount of the gift is the entire value of the property.
(c) Exceptions to section 2702. Section 2702 does not apply to the following transfers.
(1) Incomplete gift. A transfer no portion of which would be treated as a completed gift without regard to
any consideration received by the transferor. If a transfer is wholly incomplete as to an undivided fractional
share of the property transferred (without regard to any consideration received by the transferor), for
purposes of this paragraph the transfer is treated as incomplete as to that share.
(2) Personal residence trust. A transfer in trust that meets the requirements of §25.2702-5.
(3) Charitable remainder trust. A transfer in trust if the remainder interest in the trust qualifies for deduction
under section 2522.
(4) Pooled income fund. A transfer of property to a pooled income fund (as defined in section 642 (c) (5)).
(5) Charitable lead trust. A transfer in trust if the only interest in the trust, other than the remainder interest
or a qualified annuity or unitrust interest, is an interest [*96] that qualifies for deduction under section
2522.

Page 34 of 58
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(6) Certain assignments of remainder interests. The assignment of a remainder interest if the only retained
interest of the transferor or an applicable family member is as the permissible recipient of distributions of
income in the sole discretion of an independent trustee (as defined in section 674 (c)).
(7) Certain property settlements. A transfer in trust if the transfer of an interest to a spouse is deemed to
be for full and adequate consideration by reason of section 2516 (relating to certain property settlements)
and the remaining interests in the trust are retained by the other spouse.
§25.2702-2 Definitions and valuation rules.
(a) Definitions. The following definitions apply for purposes of section 2702 and the regulations thereunder.
(1) Member of the family. With respect to any individual, member of the family means the individual's
spouse, any ancestor or lineal descendant of the individual or the individual's spouse, any brother or sister
of the individual, and any spouse of the foregoing.
(2) Transfer in trust. A transfer in trust includes a transfer to a new or existing trust and an assignment of
an interest in an existing trust. [*97] Transfer in trust does not include(i) The exercise, release or lapse of a power of appointment over trust property that is not a transfer under
chapter 12; or
(ii) The execution of a qualified disclaimer (as defined in section 2518).
(3) Retained. Retained means held by the same individual both before and after the transfer in trust. In the
case of the creation of a term interest, any interest in the property held by the transferor immediately after
the transfer is treated as held both before and after the transfer.
(4) Interest. An interest in trust includes a power with respect to a trust if the existence of the power would
cause any portion of a transfer to be treated as an incomplete gift under chapter 12.
(5) Qualified interest. Qualified interest means a qualified annuity interest, a qualified unitrust interest, or a
qualified remainder interest. 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).
(6) Qualified annuity interest. Qualified annuity interest means an interest that meets all the requirements
of §25.2702-3 (b) and (d).
(7) Qualified [*98] unitrust interest. Qualified unitrust interest means an interest that meets all the
requirements of §25.2702-3 (c) and (d).
(8) Qualified remainder interest. Qualified remainder interest means an interest that meets all the
requirements of §25.2702-3 (f).
(9) Governing instrument. Governing instrument means the instrument or instruments creating and
governing the operation of the trust arrangement.
(b) Valuation of retained interests-(1) In general. Except as provided in paragraphs (b) (2) and (c) of this
section, the value of any interest retained by the transferor or an applicable family member is zero.
(2) Qualified interest. The value of a qualified annuity interest and a qualified remainder interest following a
qualified annuity interest are determined under section 7520. The value of a qualified unitrust interest and
a qualified remainder interest following a qualified unitrust interest are determined as if they were interests
described in section 664.
(c) Valuation of a term interest in certain tangible property- (1) In general. If section 2702 applies to a
transfer in trust of tangible property described in paragraph (c) (2) of this section ("tangible property"), the

Page 35 of 58
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value of a [*99] retained term interest (other than a qualified interest) is not determined under section
7520 but is the amount the transferor establishes as the amount a willing buyer would pay a willing seller
for the interest, each having reasonable knowledge of the relevant facts and neither being under any
compulsion to buy or sell. If the transferor cannot reasonably establish the value of the term interest
pursuant to this paragraph (c) (1), the interest is valued at zero.
(2) Tangible property subject to rule-(i) In general. Except as provided in paragraph (c) (2) (ii) of this
section, paragraph (c) (1) of this section applies only to tangible property(A) For which no deduction for depreciation or depletion would be allowable if the property were used in a trade
or business or held for the production of income; and
(B) As to which the failure to exercise any rights under the term interest would not increase the value of the
property passing at the end of the term interest.
(ii) Exception for de minimis amounts of depreciable property. In determining whether property meets the
requirements of this paragraph (c) (2) at the time of the transfer in trust, improvements that would
otherwise cause the [*100] property not to qualify are ignored if the fair market value of the improvements,
in the aggregate, do not exceed 5 percent of the fair market value of the entire property.
(3) Evidence of value of property. The best evidence of the value of any term interest to which this
paragraph (c) applies is actual sales or rentals that are comparable both as to the nature and character of
the property and the duration of the term interest. Little weight is accorded appraisals in the absence of
such evidence. Amounts determined under section 7520 are not evidence of what a willing buyer would
pay a willing seller for the interest.
(4) Conversion of property-(i) In general. Except as provided in paragraph (c) (4) (iii) of this section, if a
term interest in property is valued under paragraph (c) (1) of this section, and during the term the property
is converted into property a term interest in which would not qualify for valuation under paragraph (c) (1) of
this section, the conversion is treated as a transfer for no consideration for purposes of chapter 12 of the
value of the unexpired portion of the term interest.
(ii) Value of unexpired portion of term interest. For purposes of paragraph (c) (4) [*101] (i) of this section,
the value of the unexpired portion of a term interest is the amount that bears the same relation to the value
of the term interest as of the date of conversion (determined under section 7520 using the rate in effect
under section 7520 on the date of the original transfer and the fair market value of the property as of the
date of the original transfer) as the value of the term interest as of the date of the original transfer
(determined under paragraph (c) (1) of this section) bears to the value of the term interest as of the date of
the original transfer (determined under section 7520).
(iii) Conversion to qualified annuity interest. The conversion of tangible property previously valued under
paragraph (c) (1) of this section into property a term interest in which would not qualify for valuation under
paragraph (c) (1) of this section is not a transfer of the value of the unexpired portion of the term interest if
the interest thereafter meets the requirements of a qualified annuity interest. The rules of §25.2702-5 (d)
(8) (including governing instrument requirements) apply for purposes of determining the amount of the
annuity payment required to be made and the [*102] determination of whether the interest meets the
requirements of a qualified annuity interest.
(5) Additions or improvements to property-(i) Additions or improvements substantially affecting nature of
property. If an addition or improvement is made to property a term interest in which was valued under
paragraph (c) (1) of this section, and the addition or improvement affects the nature of the property to such
an extent that the property would not be treated as property meeting the requirements of paragraph (c) (2)
of this section if the property had included the addition or improvement at the time it was transferred, the
entire property is deemed, for purposes of paragraph (c) (4) of this section, to convert (effective as of the
date the addition or improvement is commenced) into property a term interest in which would not qualify
for valuation under paragraph (c) (1) of this section.

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(ii) Other additions or improvements. If an addition or improvement is made to property, a term interest in
which was valued under paragraph (c) (1) of this section, and the addition or improvement does not affect
the nature of the property to such an extent that the property would not be treated as property
[*103] meeting the requirements of paragraph (c) (2) of this section if the property had included the
addition or improvement at the time it was transferred, the addition or improvement is treated as an
additional transfer (effective as of the date the addition or improvement is commenced) subject to
§25.2702-2 (b) (1).
(d) Examples. (1) The following examples illustrate the rules of §25.2702-1 and §25.2702-2. Each example
assumes that all applicable requirements of those sections not specifically described in the example are
met.
Example 1. A transfers property to an irrevocable trust, retaining the right to receive the income of the
trust for 10 years. On the expiration of the 10-year term, the trust is to terminate and the trust corpus
is to be paid to A's child. However, if A dies during the 10-year term, the entire trust corpus is to be
paid to A's estate. Each retained interest is valued at zero because it is not a qualified interest. Thus,
the amount of A's gift is the fair market value of the property transferred to the trust.
Example 2. A transfers property to an irrevocable trust, retaining a 10-year annuity interest that meets
the requirements set forth in §25.2702-3 for a qualified [*104] annuity interest. Upon expiration of the
10-year term, the trust is to terminate and the trust corpus is to be paid to A's child. The amount of A's
gift is the fair market value of the property transferred to the trust less the value of the retained
qualified annuity interest determined under section 7520.
Example 3. D transfers property to an irrevocable trust under which the income is payable to D's
spouse for life. Upon the death of D's spouse, the trust is to terminate and the trust corpus is to be
paid to D's child. D retains no interest in the trust. Although the spouse is an applicable family member
of D under section 2702, the spouse has not retained an interest in the trust because the spouse did
not hold the interest both before and after the transfer. Section 2702 does not apply because neither
the transferor nor an applicable family member has retained an interest in the trust. The result is the
same whether or not D elects to treat the transfer as a transfer of qualified terminable interest property
under section 2056 (b) (7).
Example 4. A transfers property to an irrevocable trust, under which the income is to be paid to A for
life. Upon termination of the trust, the trust [*105] corpus is to be distributed to A's child. A also
retains certain powers over principal that cause the transfer to be wholly incomplete for federal gift tax
purposes. Section 2702 does not apply because no portion of the transfer would be treated as a
completed gift.
Example 5. The facts are the same as in Example 4, except that the trust is divided into separate
fractional shares and A's retained powers apply to only one of the shares. Section 2702 applies
except with respect to the share of the trust as to which A's retained powers cause the transfer to be
an incomplete gift.
Example 6. A transfers property to an irrevocable trust, retaining the right to receive the income for 10
years. Upon 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 the transfer of property to the
trust is not incomplete as to all interests in the property ( i.e., A has made a completed gift of the
remainder interest), section 2702 applies. A's power to revoke the spouse's term interest is treated
[*106] as a retained interest for purposes of section 2702. Because no interest retained by A is a
qualified interest, the amount of the gift is the fair market value of the property transferred to the trust.
Example 7. 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

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unitrust interests. 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 value of the qualified interest transferred to
A's spouse (subject to A's power to revoke).
(2) The following facts apply for Examples 8-10 (examples illustrating §25.2702-2 (c) - tangible property
exception):
Facts. A transfers a painting having a fair market value of $2,000,000 to A's child, B, retaining the use
of the painting for 10 years. The painting does not possess an ascertainable useful life. Assume that
the painting would not be depreciable if it were used in a trade or business or held for the production
of income. Assume that the value of A's term interest, determined under section 7520, is $1,220,000,
and [*107] that A establishes that a willing buyer of A's interest would pay $500,000 for the interest.
Example 8. A's term interest is not a qualified interest under §25.2702-3. However, because of the
nature of the property, A's failure to exercise A's rights with regard to the painting would not be
expected to cause the value of the painting to be higher than it would otherwise be at the time it
passes to B. Accordingly, A's interest is valued under §25.2702-2 (c) (1) at $500,000. The amount of
A's gift is $1,500,000, the difference between the fair market value of the painting and the amount
determined under §25.2702-2 (c) (1).
Example 9. Assume that the only evidence produced by A to establish the value of A's 10-year term
interest is the amount paid by a museum for the right to use a comparable painting for 1 year. A
asserts that the value of the 10-year term is 10 times the value of the 1-year term. A has not
established the value of the 10-year term interest because a series of short-term rentals the aggregate
duration of which equals the duration of the actual term interest does not establish what a willing
buyer would pay a willing seller for the 10-year term interest. However, the value [*108] of the 10year term interest is not less than the value of the 1-year term because it can be assumed that a
willing buyer would pay no less for a 10-year term interest than a 1-year term interest.
Example 10. Assume that after 24 months A and B sell the painting for $2,000,000 and invest the
proceeds in a portfolio of securities. A continues to hold an income interest in the securities for the
duration of the 10-year term. Under §25.2702-2 (c) (4) the conversion of the painting into a type of
property a term interest in which would not qualify for valuation under §25.2702-2 (c) (1) is treated as
a transfer by A of the value of the unexpired portion of A's original term interest, unless the property is
thereafter held in a trust meeting the requirements of a qualified annuity interest. Assume that the
value of A's remaining term interest in $2,000,000 (determined under section 7520 using the section
7520 rate in effect on the date of the original transfer) is $1,060,000. The value of the unexpired
portion of A's interest is $434,426, the amount that bears the same relation to $1,060,000 as
$500,000 (the value of A's interest as of the date of the original transfer determined under paragraph
[*109] (c) (1) of this section) bears to $1,220,000 (the value of A's interest as of the date of the
original transfer determined under section 7520).
§25.2702-3 Qualified interests.
(a) In general. This section provides rules for determining if an interest is a qualified annuity interest, a
qualified unitrust interest, or a qualified remainder interest.
(b) Special rules for qualified annuity interests. An interest is a qualified annuity interest only if it meets the
requirements of this paragraph and paragraph (d) of this section.
(1) Payment of annuity amount-(i) In general. A qualified annuity interest is an irrevocable right to receive a
fixed amount. The annuity amount must be payable to (or for the benefit of) the holder of the annuity
interest for each taxable year of the term. A right of withdrawal, whether or not cumulative, is not a
qualified annuity interest. The annuity payment may be made after the close of the taxable year, provided

Page 38 of 58
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the payment is made no later than the date by which the trustee is required to file the Federal income tax
return of the trust for the taxable year (without regard to extensions).
(ii) Fixed amount. A fixed amount means(A) A stated dollar amount payable [*110] periodically, but not less frequently than annually, but only to the
extent the amount does not exceed 120 percent of the stated dollar amount payable in the preceding year;
or
(B) A fixed fraction or percentage of the initial fair market value of the property transferred to the trust, as finally
determined for federal tax purposes, payable periodically but not less frequently than annually, but only to
the extent the fraction or percentage does not exceed 120 percent of the fixed fraction or percentage
payable in the preceding year.
(iii) Income in excess of the annuity amount. An annuity interest does not fail to be a qualified annuity
interest merely because the trust permits income in excess of the amount required to pay the annuity
amount to be paid to or for the benefit of the holder of the qualified annuity interest. Nevertheless, the right
to receive the excess income is not a qualified interest and is not taken into account in valuing the qualified
annuity interest.
(2) Incorrect valuations of trust property. If the annuity is stated in terms of a fraction or percentage of the
initial fair market value of the trust property, the governing instrument must contain provisions meeting
[*111] the requirements of §1.664-2 (a) (1) (iii) of this chapter (relating to adjustments for any incorrect
determination of the fair market value of the property in the trust).
(3) Computation of annuity amount in certain circumstances. The governing instrument must contain
provisions meeting the requirements of §1.664-2 (a) (1) (iv) of this chapter (relating to the computation of
the annuity amount in the case of short taxable years and the last taxable year of the term).
(4) Additional contributions prohibited. The governing instrument must prohibit additional contributions to
the trust.
(c) Special rules for qualified unitrust interests. An interest is a qualified unitrust interest only if it meets the
requirements of this paragraph and paragraph (d) of this section.
(1) Payment of unitrust amount-(i) In general. A qualified unitrust interest is an irrevocable right to receive
payment periodically, but not less frequently than annually, of a fixed percentage of the net fair market
value of the trust assets, determined annually. For rules relating to computation of the net fair market value
of the trust assets see §25.2522 (c)-3 (c) (2) (vii). The unitrust amount must be payable to (or for
[*112] the benefit of) the holder of the unitrust interest for each taxable year of the term. A right of
withdrawal, whether or not cumulative, is not a qualified unitrust interest. The unitrust payment may be
made after the close of the taxable year, provided that the payment is made no later than the date by
which the trustee is required to file the Federal income tax return of the trust for the year (without regard to
extensions).
(ii) Fixed percentage. A fixed percentage is a fraction or percentage of the net fair market value of the trust
assets, determined annually, payable periodically but not less frequently than annually, but only to the
extent the fraction or percentage does not exceed 120 percent of the fixed fraction or percentage payable
in the preceding year.
(iii) Income in excess of unitrust amount. A unitrust interest does not fail to be a qualified unitrust interest
merely because the trust permits income in excess of the amount required to pay the unitrust amount to be
paid to or for the benefit of the holder of the qualified unitrust interest. Nevertheless, the right to receive the
excess income is not a qualified interest and is not taken into account in valuing the qualified
[*113] unitrust interest.

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(2) Incorrect valuations of trust property. The governing instrument must contain provisions meeting the
requirements of §1.664-3 (a) (1) (iii) of this chapter (relating to the incorrect determination of the fair
market value of the property in the trust).
(3) Computation of unitrust amount in certain circumstances. The governing instrument must contain
provisions meeting the requirements of §1.664-3 (a) (1) (v) of this chapter (relating to the computation of
the unitrust amount in the case of short taxable years and the last taxable year of the term).
(d) Requirements applicable to qualified annuity interests and qualified unitrust interests-(1) In general. To
be a qualified annuity or unitrust interest, an interest must be a qualified annuity interest in every respect or
a qualified unitrust interest in every respect. For example, if the interest consists of the right to receive
each year a payment equal to the lesser of a fixed amount of the initial trust assets or a fixed percentage
of the annual value of the trust assets, the interest is not a qualified interest. If, however, the interest
consists of the right to receive each year a payment equal to the greater [*114] of a stated dollar amount
or a fixed percentage of the initial trust assets or a fixed percentage of the annual value of the trust assets,
the interest is a qualified interest that is valued at the greater of the two values. To be a qualified interest,
the interest must meet the definition of and function exclusively as a qualified interest from the creation of
the trust.
(2) Amounts payable to other persons. The governing instrument must prohibit distributions from the trust
to or for the benefit of any person other than the holder of the qualified annuity or unitrust interest during
the term of the qualified interest.
(3) Term of the annuity or unitrust interest. The governing instrument must fix the term of the annuity or
unitrust interest. The term must be for the life of the term holder, for a specified term of years, or for the
shorter (but not the longer) of those periods. Successive term interests for the benefit of the same
individual are treated as the same term interest.
(4) Commutation. The governing instrument must prohibit commutation (prepayment) of the interest of the
term holder.
(e) Examples. The following examples illustrate the rules of paragraphs (b), (c), and (d) [*115] of this
section. Each example assumes that all applicable requirements for a qualified interest are met unless
otherwise specifically stated.
Example 1. A transfers property to an irrevocable trust, retaining the right to receive the greater of
$10,000 or the trust income in each year for a term of 10 years. Upon expiration of the 10-year term,
the trust is to terminate and the entire trust corpus is to be paid to A's child, provided that if A dies
within the 10-year term the trust corpus is to be paid to A's estate. A's annual payment right is a
qualified annuity interest to the extent of the right to receive $10,000 per year for 10 years or until A's
prior death, and is valued under section 7520 without regard to the right to receive any income in
excess of $10,000 per year. The contingent reversion is valued at zero. The amount of A's gift is the
fair market value of the property transferred to the trust less the value of the qualified annuity interest.
Example 2. U transfers property to an irrevocable trust, retaining the right to receive $10,000 in each
of years 1 through 3, $12,000 in each of years 4 through 6, and $15,000 in each of years 7 through
10. The interest is a qualified [*116] annuity interest to the extent of U's right to receive $10,000 per
year in years 1 through 3, $12,000 in years 4 through 6, $14,400 in year 7, and $15,000 in years 8
through 10, because those amounts represent the lower of the amount actually payable each year or
an amount that does not exceed 120 percent of the stated dollar amount for the preceding year.
Example 3. S transfers property to an irrevocable trust, retaining the right to receive $50,000 in each
of years 1 through 3 and $10,000 in each of years 4 through 10. S's entire retained interest is a
qualified annuity interest.

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Example 4. R transfers property to an irrevocable trust retaining the right to receive annually an
amount equal to the lesser of 8 percent of the initial fair market value of the trust property or the trust
income for the year. R's annual payment right is not a qualified annuity interest to any extent because
R does not have the irrevocable right to receive a fixed amount for each year of the term.
Example 5. A transfers property to an irrevocable trust, retaining the right to receive 5 percent of the
net fair market value of the trust property, valued annually, for 10 years. If A dies within the 10-year
term, [*117] the unitrust amount is to be paid to A's estate for the balance of the term. A's interest is a
qualified unitrust interest to the extent of the right to receive the unitrust payment for 10 years or until
A's prior death.
Example 6. The facts are the same as in Example5, 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 result is the same as in
Example 5. because the 10-year term is the only term that is fixed and ascertainable at the creation of
the interest.
Example 7. B transfers property to an irrevocable trust retaining the right to receive annually an
amount equal to 8 percent of the initial fair market value of the trust property for 10 years. Upon
expiration of the 10-year term, the trust is to terminate and the entire trust corpus is to be paid to B's
child. The governing instrument provides that income in excess of the annuity amount may be paid to
B's child in the trustee's discretion. B's interest is not a qualified annuity interest to any extent because
a person other than the individual holding the term interest may receive distributions from the trust
during the term.
(f) Qualified remainder interest-(1) [*118] Requirements. An interest is a qualified remainder interest only
if it meets all of the following requirements:
(i) It is a qualified remainder interest in every respect.
(ii) It meets the definition of and functions exclusively as a qualified interest from the creation of the interest.
(iii) It is non-contingent. For this purpose, an interest is non-contingent only if it is payable to the beneficiary or
the beneficiary's estate in all events.
(iv) All interests in the trust, other than non-contingent remainder interests, are qualified annuity interests or
qualified unitrust interests. Thus, an interest is a qualified remainder interest only if the governing
instrument does not permit payment of income in excess of the annuity or unitrust amount to the holder of
the qualified annuity or unitrust interest.
(2) Remainder interest. Remainder interest is the right to receive all or a fractional share of the trust
property on termination of all or a fractional share of the trust. Remainder interest includes a reversion. A
transferor's right to receive an amount that is a stated or pecuniary amount is not a remainder interest.
Thus, the right to receive the original value of the trust corpus (or [*119] a fractional share) is not a
remainder interest.
(3) Examples. The following examples illustrate rules of this paragraph (f). Each example assumes that all
applicable requirements of a qualified interest are met unless otherwise specifically stated.
Example 1. A transfers property to an irrevocable trust. The income of the trust is payable to A's child
for life. On the death of A's child, the trust is to terminate and the trust corpus is to be paid to A. A's
remainder interest is not a qualified remainder interest because the interest of A's child is neither a
qualified annuity interest nor a qualified unitrust interest.
Example 2. The facts are the same as in Example 1, except that A's child has the right to receive the
greater of the income of the trust or $10,000 per year. A's remainder interest is not a qualified
remainder interest because the right of A's child to receive income in excess of the annuity amount is
not a qualified interest.

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Example 3. A transfers property to an irrevocable trust. The trust provides a qualified annuity interest
to A's child for 12 years. An amount equal to the initial value of the trust corpus is to be paid to A at
the end of that period and the balance [*120] is to be paid to A's grandchild. A's interest is not a
qualified remainder interest because the amount A is to receive is not a fractional share of the trust
property.
Example 4. U transfers property to an irrevocable trust. The trust provides a qualified unitrust interest
to U's child for 15 years, at which time the trust terminates and the trust corpus is paid to U or, if U is
not then living, to U's child. Because U's remainder interest is contingent, it is not a qualified
remainder interest.
§25.2702-4 Certain property treated as held in trust.
(a) In general. For purposes of section 2702, a transfer of an interest in property with respect to which
there are one or more term interests is treated as a transfer in trust. A term interest is one of a series of
successive (as contrasted with concurrent) interests. Thus, a life interest in property or an interest in
property for a term of years is a term interest. However, a term interest does not include a fee interest in
property merely because it is held as a tenant in common, a tenant by the entireties, or a joint tenant with
right of survivorship.
(b) Leases. A leasehold interest in property is not a term interest to the extent the [*121] lease is for full
and adequate consideration (without regard to section 2702). A lease will be considered for full and
adequate consideration if, under all the facts and circumstances as of the time the lease is entered into or
extended, a good faith effort is made to determine the fair rental value of the property and the terms of the
lease conform to the value so determined.
(c) Joint purchases. Solely for purposes of section 2702, if an individual acquires a term interest in
property and, in the same transaction or series of transactions, one or more members of the individual's
family acquire an interest in the same property, the individual acquiring the term interest is treated as
acquiring the entire property so acquired, and transferring to each of those family members the interests
acquired by that family member in exchange for any consideration paid by that family member. For
purposes of this paragraph (c), the amount of the individual's gift will not exceed the amount of
consideration furnished by that individual for all interests in the property.
(d) Examples. The following examples illustrate rules of this section:
Example 1. A purchases a 20-year term interest in an apartment [*122] building and A's child
purchases the remainder interest in the property. A and A's child each provide the portion of the
purchase price equal to the value of their respective interests in the property determined under section
7520. Solely for purposes of section 2702, A is treated as acquiring the entire property and
transferring the remainder interest to A's child in exchange for the portion of the purchase price
provided by A's child. In determining the amount of A's gift, A's retained interest is valued at zero
because it is not a qualified interest.
Example 2. K holds rental real estate valued at $100,000. K sells a remainder interest in the property
to K's child, retaining the right to receive the income from the property for 20 years. Assume the
purchase price paid by K's child for the remainder interest is equal to the value of the interest
determined under section 7520. K's retained interest is not a qualified interest and is therefore valued
at zero. K has made a gift in the amount of $100,000 less the consideration received from K's child.
Example 3. G and G's child each acquire a fifty percent undivided interest as tenants in common in an
office building. The interests of [*123] G and G's child are not term interests to which section 2702
applies.

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Example 4. B purchases a life estate in property from R, B's grandparent, for $100 and B's child
purchases the remainder interest for $50. Assume that the value of the property is $300, the value of
the life estate determined under section 7520 is $250 and the value of the remainder interest is $50. B
is treated as acquiring the entire property and transferring the remainder interest to B's child.
However, the amount of B's gift is $100, the amount of consideration ($100) furnished by B for B's
interest.
Example 5. H and W enter into a written agreement relative to their marital and property rights that
requires W to transfer property to an irrevocable trust, the terms of which provide that the income of
the trust will be paid to H for 10 years. On the expiration of the 10-year term, the trust is to terminate
and the trust corpus is to be paid to W. H and W divorce within two years after the agreement is
entered into. Pursuant to section 2516, the transfer to H would otherwise be deemed to be for full and
adequate consideration. Section 2702 does not apply to the acquisition of the term interest by H
because no member [*124] of H's family acquired an interest in the property in the same transaction
or series of transactions. The result would not be the same if, on the termination of H's interest in the
trust, the trust corpus were distributable to the children of H and W rather than W.
§25.2702-5 Personal residence trusts.
(a) In general. Section 2702 does not apply to a transfer in trust meeting the requirements of this section.
A transfer in trust meets the requirements of this section only if the trust is a personal residence trust (as
defined in paragraph (b) of this section). A trust meeting the requirements of a qualified personal residence
trust (as defined in paragraph (c) of this section) is treated as a personal residence trust. A trust of which
the term holder is the grantor that otherwise meets the requirements of a personal residence trust (or a
qualified personal residence trust) is not a personal residence trust (or a qualified personal residence trust)
if, at the time of transfer, the term holder of the trust already holds term interests in two trusts that are
personal residence trusts (or qualified personal residence trusts) of which the term holder was the grantor.
For this purpose, trusts [*125] holding fractional interests in the same residence are treated as one trust.
(b) Personal residence trust-(1) In general. A personal residence trust is a trust the governing instrument of
which prohibits the trust from holding, for the original duration of the term interest, any asset other than
one residence to be used or held for use as a personal residence of the term holder and qualified
proceeds (as defined in paragraph (b) (3) of this section). A residence is held for use as a personal
residence of the term holder so long as the residence is not occupied by any other person (other than the
spouse or a dependent of the term holder) and is available at all times for use by the term holder as a
personal residence. A trust does not meet the requirements of this section if, during the original duration of
the term interest, the residence may be sold or otherwise transferred by the trust or may be used for a
purpose other than as a personal residence of the term holder. Expenses of the trust whether or not
attributable to trust principal may be paid directly by the term holder of the trust.
(2) Personal residence-(i) In general. For purposes of this paragraph (b), a personal residence [*126] of a
term holder is either(A) The principal residence of the term holder (within the meaning of section 1034);
(B) One other residence of the term holder (within the meaning of section 280A (d) (1) but without regard to
section 280A (d) (2)); or
(C) An undivided fractional interest in either.
(ii) Additional property. A personal residence may include appurtenant structures used by the term holder
for residential purposes and adjacent land not in excess of that which is reasonably appropriate for
residential purposes (taking into account the residence's size and location). The fact that a residence is
subject to a mortgage does not affect its status as a personal residence. The term personal residence
does not include any personal property ( e.g., household furnishings).

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(iii) Use of residence. A residence is a personal residence only if its primary use is as a residence of the
term holder when occupied by the term holder. The principal residence of the term holder will not fail to
meet the requirements of the preceding sentence merely because a portion of the residence is used in an
activity meeting the requirements of section 280A (c) (1) or (4) (relating to deductibility of expenses related
[*127] to certain uses), provided that such use is secondary to use of the residence as a residence. A
residence is not used primarily as a residence if it is used to provide transient lodging and substantial
services are provided in connection with the provision of lodging ( e.g. a hotel or a bed and breakfast). A
residence is not a personal residence if, during any period not occupied by the term holder, its primary use
is other than as a residence.
(iv) Interests of spouses in the same residence. If spouses hold interests in the same residence (including
community property interests), the spouses may transfer their interests in the residence (or a fractional
portion of their interests in the residence) to the same personal residence trust, provided that the
governing instrument prohibits any person other than one of the spouses from holding a term interest in
the trust concurrently with the other spouse.
(3) Qualified proceeds. Qualified proceeds means the proceeds payable as a result of damage to, or
destruction or involuntary conversion (within the meaning of section 1033) of, the residence held by a
personal residence trust, provided that the governing instrument requires that the proceeds
[*128] (including any income thereon) be reinvested in a personal residence within two years from the
date on which the proceeds are received.
(c) Qualified personal residence trust-(1) In general. A qualified personal residence trust is a trust meeting
all the requirements of this paragraph (c). These requirements must be met by provisions in the governing
instrument, and these governing instrument provisions must by their terms continue in effect during the
existence of any term interest in the trust.
(2) Personal residence-(i) In general. For purposes of this paragraph (c), a personal residence of a term
holder is either(A) The principal residence of the term holder (within the meaning of section 1034);
(B) One other residence of the term holder (within the meaning of section 280A (d) (1) but without regard to
section 280A (d) (2)); or
(C) An undivided fractional interest in either.
(ii) Additional property. A personal residence may include appurtenant structures used by the term holder
for residential purposes and adjacent land not in excess of that which is reasonably appropriate for
residential purposes (taking into account the residence's size and location). The fact that a residence is
subject [*129] to a mortgage does not affect its status as a personal residence. The term personal
residence does not include any personal property ( e.g., household furnishings).
(iii) Use of residence. A residence is a personal residence only if its primary use is as a residence of the
term holder when occupied by the term holder. The principal residence of the term holder will not fail to
meet the requirements of the preceding sentence merely because a portion of the residence is used in an
activity meeting the requirements of section 280A (c) (1) or (4) (relating to deductibility of expenses related
to certain uses), provided that such use is secondary to use of the residence as a residence. A residence
is not used primarily as a residence if it is used to provide transient lodging and substantial services are
provided in connection with the provision of lodging ( e.g. a hotel or a bed and breakfast). A residence is
not a personal residence if, during any period not occupied by the term holder, its primary use is other than
as a residence. A residence is not a personal residence if, during any period not occupied by the term
holder, its primary use is other than as a residence.
(iv) Interests of [*130] spouses in the same residence. If spouses hold interests in the same residence
(including community property interests), the spouses may transfer their interests in the residence (or a

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fractional portion of their interests in the residence) to the same qualified personal residence trust,
provided that the governing instrument prohibits any person other than one of the spouses from holding a
term interest in the trust concurrently with the other spouse.
(3) Income of the trust. The governing instrument must require that any income of the trust be distributed
to the term holder not less frequently than annually.
(4) Distributions from the trust to other persons. The governing instrument must prohibit distributions of
corpus to any beneficiary other than the transferor prior to the expiration of the retained term interest.
(5) Assets of the trust-(i) In general. Except as otherwise provided in paragraphs (c) (5) (ii) and (c) (8) of
this section, the governing instrument must prohibit the trust from holding, for the entire term of the trust,
any asset other than one residence to be used or held for use (within the meaning of paragraph (c) (7) (i)
of this section) as a personal residence of [*131] the term holder (the "residence").
(ii) Assets other than personal residence. Except as otherwise provided, the governing instrument may
permit a qualified personal residence trust to hold the following assets (in addition to the residence) in the
amounts and in the manner described in this paragraph (c) (5) (ii):
(A) Additions of cash for payment of expenses, etc.- (1) Additions. The governing instrument may permit
additions of cash to the trust, and may permit the trust to hold additions of cash in a separate account, in
an amount which, when added to the cash already held in the account for such purposes, does not exceed
the amount required:
(i) For payment of trust expenses (including mortgage payments) already incurred or reasonably expected
to be paid by the trust within six months from the date the addition is made;
(ii) For improvements to the residence to be paid by the trust within six months from the date the addition is
made; and
(iii) For purchase by the trust of the initial residence, within three months of the date the trust is created,
provided that no addition may be made for this purpose, and the trust may not hold any such addition,
unless the trustee has previously entered [*132] into a contract to purchase that residence; and
(iv) For purchase by the trust of a residence to replace another residence, within three months of the date
the addition is made, provided that no addition may be made for this purpose, and the trust may not
hold any such addition, unless the trustee has previously entered into a contract to purchase that
residence.
(2) Distributions of excess cash. If the governing instrument permits additions of cash to the
trust pursuant to paragraph (c) (5) (ii) (A) ( 1) of this section, the governing instrument must
require that the trustee determine, not less frequently than quarterly, the amounts held by the
trust for payment of expenses in excess of the amounts permitted by that paragraph and must
require that those amounts be distributed immediately thereafter to the term holder. In
addition, the governing instrument must require, upon termination of the term holder's interest
in the trust, any amounts held by the trust for the purposes permitted by paragraph (c) (5) (ii)
(A) ( 1) of this section that are not used to pay trust expenses due and payable on the date of
termination (including expenses directly related to termination) be distributed [*133] outright to
the term holder within 30 days of termination.
(B) Improvements. The governing instrument may permit improvements to the residence to be added to the
trust and may permit the trust to hold such improvements, provided that the residence, as improved, meets
the requirements of a personal residence.
(C) Sale proceeds. The governing instrument may permit the sale of the residence and may permit the trust to
hold proceeds from the sale of the residence, in a separate account.
(D) Insurance and insurance proceeds. The governing instrument may permit the trust to hold one or more
policies of insurance on the residence. In addition, the governing instrument may permit the trust to hold, in

Page 45 of 58
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a separate account, proceeds of insurance payable to the trust as a result of damage to or destruction of
the residence. For purposes of this paragraph, amounts (other than insurance proceeds payable to the
trust as a result of damage to or destruction of the residence) received as a result of the involuntary
conversion (within the meaning of section 1033) of the residence are treated as proceeds of insurance.
(6) Commutation. The governing instrument must prohibit commutation (prepayment) of the term
[*134] holder's interest.
(7) Cessation of use as a personal residence-(i) In general. The governing instrument must provide that a
trust ceases to be a qualified personal residence trust if the residence ceases to be used or held for use as
a personal residence of the term holder. A residence is held for use as a personal residence of the term
holder so long as the residence is not occupied by any other person (other than the spouse or a
dependent of the term holder) and is available at all times for use by the term holder as a personal
residence. See §25.2702-5 (c) (8) for rules governing disposition of assets of a trust as to which the trust
has ceased to be a qualified personal residence trust.
(ii) Sale of personal residence. The governing instrument must provide that the trust ceases to be a
qualified personal residence trust upon sale of the residence if the governing instrument does not permit
the trust to hold proceeds of sale of the residence pursuant to paragraph (c) (5) (ii) (C) of this section. If the
governing instrument permits the trust to hold proceeds of sale pursuant to that paragraph, the governing
instrument must provide that the trust ceases to be a qualified personal [*135] residence trust with respect
to all proceeds of sale held by the trust not later than the earlier of(A) The date that is two years after the date of sale;
(B) The termination of the term holder's interest in the trust; or
(C) The date on which a new residence is acquired by the trust.
(iii) Damage to or destruction of personal residence-(A) In general. The governing instrument must provide
that, if damage or destruction renders the residence unusable as a residence, the trust ceases to be a
qualified personal residence trust on the date that is two years after the date of damage or destruction (or
the date of termination of the term holder's interest in the trust, if earlier) unless, prior to such date(1) Replacement of or repairs to the residence are completed; or
(2) A new residence is acquired by the trust.
(B) Insurance proceeds. For purposes of this paragraph (C) (7) (iii), if the governing instrument permits the
trust to hold proceeds of insurance received as a result of damage to or destruction of the residence
pursuant to paragraph (c) (5) (ii) (D) of this section, the governing instrument must contain provisions
similar to those required by paragraph (c) (7) (ii) of this section.
(8) [*136] Disposition of trust assets on cessation as personal residence trust-(i) In general. The
governing instrument must provide that, within 30 days after the date on which the trust has ceased to be a
qualified personal residence trust with respect to certain assets, either(A) The assets be distributed outright to the term holder;
(B) The assets be converted to and held for the balance of the term holder's term in a separate share of the
trust meeting the requirements of a qualified annuity interest; or
(C) In the trustee's sole discretion, the trustee may elect to comply with either paragraph (c) (8) (i) (A) or (B)
pursuant to their terms.
(ii) Requirements for conversion to a qualified annuity interest-(A) Governing instrument requirements. For
assets subject to this paragraph (c) (8) to be converted to and held as a qualified annuity interest, the
governing instrument must contain all provisions required by §25.2702-3 with respect to a qualified annuity
interest.

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(B) Effective date of annuity. The governing instrument must provide that the right of the term holder to
receive the annuity amount begins on the date of sale of the residence, the date of damage to or
destruction of the residence, [*137] or the date on which the residence ceases to be used or held for use
as a personal residence, as the case may be ("the cessation date"). Notwithstanding the preceding
sentence, the governing instrument may provide that the trustee may defer payment of any annuity
amount otherwise payable after the cessation date until the date that is 30 days after the assets are
converted to a qualified annuity interest under paragraph (c) (8) (i) (B) of this section ("the conversion
date"); provided that any deferred payment must bear interest from the cessation date at a rate not less
than the section 7520 rate in effect on the cessation date. The governing instrument may permit the
trustee to reduce aggregate deferred annuity payments by the amount of income actually distributed by the
trust to the term holder during the deferral period.
(C) Determination of annuity amount-(1) In general. The governing instrument must require that the
annuity amount be no less than the amount determined under this paragraph (C).
(2) Entire trust ceases to be a qualified personal residence trust. If, on the conversion date, the assets of
the trust do not include a residence used or held for use as a personal residence, [*138] the annuity may
not be less than an amount determined by dividing the lesser of the value of all interests retained by the
term holder (as of the date of the original transfer or transfers) or the value of all the trust assets (as of the
conversion date) by an annuity factor determined(i) For the original term of the term holder's interest; and
(ii) At the rate used in valuing the retained interest at the time of the original transfer.
(3) Portion of trust continues as qualified personal residence trust. If, on the conversion date, the assets of
the trust include a residence used or held for use as a personal residence, the annuity must not be less
than the amount determined under paragraph (c) (8) (ii) (C) (2) of this section multiplied by a fraction. The
numerator of the fraction is the excess of the fair market value of the trust assets on the conversion date
over the fair market value of the assets as to which the trust continues as a qualified personal residence
trust, and the denominator of the fraction is the fair market value of the trust assets on the conversion date.
(d) Examples. The following examples illustrate rules of this section. Each example assumes that all
applicable [*139] requirements of a personal residence trust (or qualified personal residence trust) are
met unless otherwise stated.
Example 1. C maintains C's principal place of business in one room of C's principal residence. The
room meets the requirements of section 280A (c) (1) for deductibility of expenses related to such use.
The residence is a personal residence.
Example 2. L owns a vacation condominium that L rents out for six months of the year, but which is
treated as L's residence under section 280A (d) (1) because L occupies it for at least 18 days per
year. L provides no substantial services in connection with the rental of the condominium. L transfers
the condominium to an irrevocable trust, the terms of which meet the requirements of a qualified
personal residence trust. L retains the right to use the condominium during L's lifetime. The trust is a
qualified personal residence trust.
Example 3. W owns a 200-acre farm. The farm includes a house, barns, equipment buildings, a silo,
and enclosures for confinement of farm animals. W transfers the farm to an irrevocable trust, retaining
the use of the farm for 20 years, with the remainder to W's child. The trust is not a personal residence
[*140] trust because the farm includes assets not meeting the requirements of a personal residence.
Example 4. A transfers A's principal residence to an irrevocable trust, retaining the right to use the
residence for a 20-year term. The governing instrument of the trust does not prohibit the trust from
holding personal property. The trust is not a qualified personal residence trust.

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Example 5. T transfers a personal residence to a trust that meets the requirements of a qualified
personal residence trust, retaining a term interest in the trust for 10 years. During the period of T's
retained term interest, T is forced for health reasons to move to a nursing home. T's spouse continues
to occupy the residence. If the residence is available at all times for T's use as a residence during the
term (without regard to T's ability to actually use the residence), the residence continues to be held for
T's use and the trust does not cease to be a qualified personal residence trust. The residence would
cease to be held for use as a personal residence of T if the trustee rented the residence to an
unrelated party, because the residence would no longer be available for T's use at all times.
Example 6. T transfers [*141] T's personal residence to a trust that meets the requirements of a
qualified personal residence trust, retaining the right to use the residence for 12 years. On the date
the residence is transferred to the trust, the fair market value of the residence is $100,000. After 6
years, the trustee sells the residence, receiving net proceeds of $250,000, and invests the proceeds
of sale in common stock. After an additional eighteen months, the common stock has paid $15,000 in
dividends and has a fair market value of $260,000. On that date, the trustee purchases a new
residence for $200,000. On the purchase of the new residence, the trust ceases to be a qualified
personal residence trust with respect to any amount not reinvested in the new residence. The
governing instrument of the trust provides that the trustee, in the trustee's sole discretion, may elect
either to distribute the excess proceeds or to convert the proceeds into a qualified annuity interest.
The trustee elects the latter option. The amount of the annuity is the amount of the annuity that would
be payable if no portion of the sale proceeds had been reinvested in a personal residence multiplied
by a fraction. The numerator of [*142] the fraction is $60,000 (the amount remaining after
reinvestment) and the denominator of the fraction is $260,000 (the fair market value of the trust assets
on the conversion date). The obligation to pay the annuity commences on the date of sale, but
payment of the annuity that otherwise would have been payable luring the period between the date of
sale and the date on which the trust ceased to be a qualified personal residence trust with respect to
the excess proceeds may be deferred until 30 days after the date on which the new residence is
purchased. Any amount deferred must bear compound interest from the date the annuity is payable at
the section 7520 rate in effect on the date of sale. The $15,000 of income distributed to the term
holder during that period may be used to reduce the annuity amount payable with respect to that
period if the governing instrument so provides and thus reduce the amount on which compound
interest is computed.
§25.2702-6 Reduction in taxable gifts.
(a) Transfers of retained interests in trust-(1) Inter vivos transfers. If an individual subsequently transfers
by gift an interest in trust previously valued (when held by that individual) under §25.2702-2 (b)
(1) [*143] or (c), the individual is entitled to a reduction in aggregate taxable gifts. The amount of the
reduction is determined under paragraph (b) of this section. Thus, for example, if an individual transferred
property to an irrevocable trust, retaining an interest in the trust that was valued at zero under §25.2702-2
(b) (1), and the individual later transfers the retained interest by gift, the individual is entitled to a reduction
in aggregate taxable gifts on the subsequent transfer. For purposes of this section, aggregate taxable gifts
means the aggregate sum of the individual's taxable gifts for the calendar year determined under section
2502 (a) (1).
(2) Testamentary transfers. If either(i) A term interest in trust is included in an individual's gross estate solely by reason of section 2033, or
(ii) A remainder interest in trust is included in an individual's gross estate, and the interest was previously
valued (when held by that individual) under §25.2702-2 (b) (1) or (c), the individual's estate is entitled to a
reduction in the individual's adjusted taxable gifts in computing the Federal estate tax payable under
section 2001. The amount of the reduction is determined under paragraph [*144] (b) of this section.

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1992 IRB LEXIS 2002, *144
(3) Gift splitting on subsequent transfer. If an individual who is entitled to a reduction in aggregate taxable
gifts (or adjusted taxable gifts) subsequently transfers the interest in a transfer treated as made one-half by
the individual's spouse under section 2513, the individual may assign one-half of the amount of the
reduction to the consenting spouse. The assignment must be attached to the Form 709 on which the
consenting spouse reports the split gift.
(b) Amount of reduction-(1) In general. The amount of the reduction in aggregate taxable gifts (or adjusted
taxable gifts) is the lesser of(i) The increase in the individual's taxable gifts resulting from the interest being valued at the time of the initial
transfer under §25.2702-2 (b) (1) or (c); or
(ii) The increase in the individual's taxable gifts (or gross estate) resulting from the subsequent transfer of the
interest.
(2) Treatment of annual exclusion. For purposes of determining the amount under paragraph (b) (1) (ii) of
this section, the exclusion under section 2503 (b) applies first to transfers in that year other than the
transfer of the interest previously valued under §25.2702-2 (b) (1) or (c).
(3) Overlap [*145] with section 2001. Notwithstanding paragraph (b) (1) of this section, the amount of the
reduction is reduced to the extent section 2001 would apply to reduce the amount of an individual's
adjusted taxable gifts with respect to the same interest to which paragraph (b) (1) of this section would
otherwise apply.
(c) Examples. The rules of this section are illustrated by the following examples. The following facts apply
for Examples 1-4:
(1) Facts. In 1992, X transferred property to an irrevocable trust retaining the right to receive the trust
income for life. On the death of X, the trust is to terminate and the trust corpus is to be paid to X's
child, C. X's income interest had a value under section 7520 of $40,000 at the time of the transfer,
however, because X's retained interest was not a qualified interest, it was valued at zero under
§25.2702-2 (b) (1) for purposes of determining the amount of X's gift. X's taxable gifts in 1992 were
therefore increased by $40,000. In 1993, X transfers the income interest to C for no consideration.
Example 1. Assume that the value under section 7520 of the income interest on the subsequent
transfer to C is $30,000. If X makes no other gifts to C in [*146] 1993, X is entitled to a reduction in
aggregate taxable gifts of $20,000, the lesser of the amount by which X's taxable gifts were increased
as a result of the income interest being valued at zero on the initial transfer ($40,000) or the amount
by which X's taxable gifts are increased as a result of the subsequent transfer of the income interest
($30,000 minus $10,000 annual exclusion).
Example 2. Assume that in 1993, 4 months after, X transferred the income interest to C, X transferred
$5,000 cash to C. In determining the increase in taxable gifts occurring on the subsequent transfer,
the annual exclusion under section 2503 (b) is first applied to the cash gift. X is entitled to a reduction
in aggregate taxable gifts of $25,000, the lesser of the amount by which X's taxable gifts were
increased as a result of the income interest being valued at zero on the initial transfer ($40,000) or the
amount by which X's taxable gifts are increased as a result of the subsequent transfer of the income
interest ($25,000 (($30,000 + $5,000) − $10,000 annual exclusion).
Example 3. Assume that the value under section 7520 of the income interest on the subsequent
transfer to C is $55,000. X is entitled [*147] to reduce aggregate taxable gifts by $40,000, the lesser
of the amount by which X's taxable gifts were increased as a result of the income interest being
valued at zero on the initial transfer ($40,000) or the amount by which X's taxable gifts are increased
as a result of the subsequent transfer of the income interest ($55,000 minus $10,000 annual exclusion
= $45,000).

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Example 4. Assume that X and X's spouse, S, split the subsequent gift to C. X is entitled to assign
one-half the reduction to S. If the assignment is made, each is entitled to reduce aggregate taxable
gifts by $17,500, the lesser of their portion of the increase in taxable gifts on the initial transfer by
reason of the application of section 2702 ($20,000) and their portion of the increase in taxable gifts on
the subsequent transfer of the retained interest ($27,500 − $10,000 annual exclusion).
Example 5. In 1992, A transfers property to an irrevocable trust, retaining the right to receive the trust
income for 10 years. On the expiration of the 10-year term, the trust is to terminate and the trust
corpus is to be paid to A's child, B. Assume that A's term interest has a value under section 7520 of
$20,000 at the [*148] time of the transfers however, because A's retained interest was not a qualified
interest, it was valued at zero under §25.2702-2 (b) (1) for purposes of determining the amount of A's
gift. Assume also that A and A's spouse, S, split the gift of the remainder interest under section 2513.
In 1993, A transfers A's term interest to D, A's other child, for no consideration. A is entitled to reduce
A's aggregate taxable gifts on the transfer. Assume that A and S also split the subsequent gift to D,
and that A dies one month after making the subsequent transfer of the term interest and S dies six
months later. The gift of the term interest is included in A's gross estate under section 2035 (d) (2). To
the extent S's taxable gifts are reduced pursuant to section 2001 (e), S is entitled to no reduction in
aggregate or adjusted taxable gifts under this section.
Example 6. T transfers property to an irrevocable trust retaining the power to direct the distribution of
trust income for 10 years among T's descendants in whatever shares T deems appropriate. On the
expiration of the 10-year period, the trust corpus is to be paid in equal shares to T's children. T's
transfer of the remainder interest [*149] is a completed gift. Because T's retained interest is not a
qualified interest, it is valued at zero under §25.2702-2 (b) (1) and the amount of T's gift is the fair
market value of the property transferred to the trust. The distribution of income each year is not a
transfer of a retained interest in trust. Therefore, T is not entitled to reduce aggregate taxable gifts as
a result of the distributions of income from the trust.
Example 7. The facts are the same as in Example 6, except that after 3 years T exercises the right to
direct the distribution of trust income by assigning the right to the income for the balance of the term to
T's child, C. The exercise is a transfer of a retained interest in trust for purposes of this section. T is
entitled to reduce aggregate taxable gifts by the lesser of the increase in taxable gifts resulting from
the application of section 2702 to the initial transfer or the increase in taxable gifts resulting from the
transfer of the retained interest in trust.
Example 8. In 1992, V purchases an income interest for 10 years in property in the same transaction
or series of transactions in which G, V's child, purchases the remainder interest in the same property.
[*150] V dies in 1997 still holding the term interest, the value of which is includible in V's gross estate
under section 2033. V's estate would be entitled to a reduction in adjusted taxable gifts in the amount
determined under paragraph (b) of this section.
§25.2702-7 Effective dates.
Sections 25.2702-1 through 25.2702-6 are effective as of January 28, 1992.With respect to transfers to
which section 2702 applied made prior to January 28, 1992, taxpayers may rely on any reasonable
interpretation of the statutory provisions. For these purposes, the provisions of the proposed regulations
and the final regulations are considered a reasonable interpretation of the statutory provisions.
§25.2703-1 Property subject to restrictive arrangements.
(a) Disregard of rights or restrictions-(1) In general. For purposes of subtitle B (relating to estate, gift, and
generation-skipping transfer taxes), the value of any property is determined without regard to any right or
restriction relating to the property.
(2) Right or restriction. For purposes of this section, right or restriction means-

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(i) Any option, agreement, or other right to acquire or use the property at a price less than fair market value
(determined [*151] without regard to the option, agreement, or right); or
(ii) Any restriction on the right to sell or use the property.
(3) Agreements, etc, containing rights or restrictions. A right or restriction may be contained in a
partnership agreement, articles of incorporation, corporate bylaws, a shareholders' agreement, or any
other agreement. A right or restriction may be implicit in the capital structure of an entity.
(4) Qualified easements. A perpetual restriction on the use of real property that qualified for a charitable
deduction under either section 2522 (d) of section 2055 (f) of the Internal Revenue Code is not treated as
a right or restriction.
(b) Exceptions-(1) In general. This section does not apply to any right or restriction satisfying the following
three requirements(i) The right or restriction is a bona fide business arrangement;
(ii) The right or restriction is not a device to transfer property to the natural objects of the transferor's bounty for
less than full and adequate consideration in money or money's worth; and
(iii) At the time the right or restriction is created, the terms of the right or restriction are comparable to similar
arrangements entered into by persons in an arm's [*152] length transaction.
(2) Separate requirements. Each of the three requirements described in paragraph (b) (1) of this section
must be independently satisfied for a right or restriction to meet this exception. Thus, for example, the
mere showing that a right or restriction is a bona fide business arrangement is not sufficient to establish
that the right or restriction is not a device to transfer property for less than full and adequate consideration.
(3) Exception for certain rights or restrictions. A right or restriction is considered to meet each of the three
requirements described in paragraph (b) (1) of this section if more than 50 percent by value of the property
subject to the right or restriction is owned directly or indirectly (within the meaning of §25.2701-6) by
individuals who are not members of the transferor's family. In order to meet this exception, the property
owned by those individuals must be subject to the right or restriction to the same extent as the property
owned by the transferor. For purposes of this section, members of the transferor's family include the
persons described in §25.2701-2 (b) (5) and any other individual who is a natural object of the transferor's
[*153] bounty. Any property held by a member of the transferor's family under the rules of §25.2701-6
(without regard to §25.2701-6 (a) (5)) is treated as held only by a member of the transferor's family.
(4) Similar arrangement-(i) In general. A right or restriction is treated as comparable to similar
arrangements entered into by persons in an arm's length transaction if the right or restriction is one that
could have been obtained in a fair bargain among unrelated parties in the same business dealing with
each other at arm's length. A right or restriction is considered a fair bargain among unrelated parties in the
same business if it conforms with the general practice of unrelated parties under negotiated agreements in
the same business. This determination generally will entail consideration of such factors as the expected
term of the agreement, the current fair market value of the property, anticipated changes in value during
the term of the arrangement, and the adequacy of any consideration given in exchange for the rights
granted.
(ii) Evidence of general business practice. Evidence of general business practice is not met by showing
isolated comparables. If more than one valuation method [*154] is commonly used in a business, a right
or restriction does not fail to evidence general business practice merely because it uses only one of the
recognized methods. It is not necessary that the terms of a right or restriction parallel the terms of any
particular agreement. If comparables are difficult to find because the business is unique, comparables from
similar businesses may be used.

Page 51 of 58
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(5) Multiple rights or restrictions. If property is subject to more than one right or restriction described in
paragraph (a) (2) of this section, the failure of a right or restriction to satisfy the requirements of paragraph
(b) (1) of this section does not cause any other right or restriction to fail to satisfy those requirements if the
right or restriction otherwise meets those requirements. Whether separate provisions are separate rights or
restrictions, or are integral parts of a single right or restriction, depends on all the facts and circumstances.
(c) Substantial modification of a right or restriction-(1) In general. A right or restriction that is substantially
modified is treated as a right or restriction created on the date of the modification. Any discretionary
modification of a right or [*155] restriction, whether or not authorized by the terms of the agreement, that
results in other than a de minimis change to the quality, value, or timing of the rights of any party with
respect to property that is subject to the right or restriction is a substantial modification. If the terms of the
right or restriction require periodic updating, the failure to update is presumed to substantially modify the
right or restriction unless it can be shown that updating would not have resulted in a substantial
modification. The addition of any family member as a party to a right or restriction (including by reason of a
transfer of property that subjects the transferee family member to a right or restriction with respect to the
transferred property) is considered a substantial modification unless the addition is mandatory under the
terms of the right or restriction or the added family member is assigned to a generation (determined under
the rules of section 2651 of the Internal Revenue Code) no lower than the lowest generation occupied by
individuals already party to the right or restriction.
(2) Exceptions. A substantial modification does not include(i) A modification required by the terms of [*156] a right or restriction;
(ii) A discretionary modification of an agreement conferring a right or restriction if the modification does not
change the right or restriction;
(iii) A modification of a capitalization rate used with respect to a right or restriction if the rate is modified in a
manner that bears a fixed relationship to a specified market interest rate; and
(iv) A modification that results in an option price that more closely approximates fair market value.
(d) Examples. The following examples illustrate the provisions of this section:
Example 1. T dies in 1992 owning title to Black-acre. In 1991, T and T's child entered into a lease with
respect to Blackacre. At the time the lease was entered into, the terms of the lease were not
comparable to leases of similar property entered into among unrelated parties. The lease is a
restriction on the use of the property that is disregarded in valuing the property for Federal estate tax
purposes.
Example 2. T and T's child, C, each own 50 percent of the outstanding stock of X corporation. T and C
enter into an agreement in 1987 providing for the disposition of stock held by the first to die at the time
of death. The agreement also provides certain [*157] restrictions with respect to lifetime transfers. In
1992, as permitted (but not required) under the agreement, T transfers one-half of T's stock to T's
spouse, S. S becomes a party to the agreement between T and C by reason of the transfer. The
transfer is the addition of a family member to the right or restriction. However, it is not a substantial
modification of the right or restriction because the added family member would be assigned to a
generation under section 2651 of the Internal Revenue Code no lower than the generation occupied
by C.
Example 3. The facts are the same as in Example 2. In 1993, the agreement is amended to reflect a
change in the company's name and a change of address for the company's registered agent. These
changes are not a substantial modification of the agreement conferring the right or restriction because
the right or restriction has not changed.
§25.2703-2 Effective date.

Page 52 of 58
1992 IRB LEXIS 2002, *157
Section 25.2703-1 applies to any right or restriction created or substantially modified after October 8, 1990,
and is effective as of January 28, 1992. With respect to transfers occurring prior to January 28, 1992, and
for purposes of determining whether an event occurring prior to January [*158] 28, 1992, constitutes a
substantial modification, taxpayers may rely on any reasonable interpretation of the statutory provisions.
For these purposes, the provisions of the proposed regulations and the final regulations are considered a
reasonable interpretation of the statutory provisions.
§25.2704-1 Lapse of certain rights.
(a) Lapse treated as transfer-(1) In general. The lapse of a voting right or a liquidation right in a corporation
or partnership (an "entity") is a transfer by the individual directly or indirectly holding the right immediately
prior to its lapse (the "holder") to the extent provided in paragraphs (b) and (c) of this section. 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. The amount of the transfer is determined under paragraph (d) of this section. If the
lapse of a voting right or a liquidation right occurs during the holder's lifetime, the lapse is a transfer by gift.
If the lapse occurs at the holder's death, the lapse is a transfer includible in the corporation
(2) Definitions. The following definitions apply for purposes of this section.
(i) Control. Control has the [*159] meaning given it in §25.27012 (b) (5).
(ii) Member of the family. Member of the family has the meaning given it in §25.2702-2 (a) (1).
(iii) Directly or indirectly held. An interest is directly or indirectly held only to the extent the value of the
interest would have been includible in the gross estate of the individual if the individual had died
immediately prior to the lapse.
(iv) Voting right. Voting right means a right to vote with respect to any matter of the entity. In the case of a
partnership, the right of a general partner to participate in partnership management is a voting right. The
right to compel the entity to acquire all or a portion of the holder's equity interest in the entity by reason of
aggregate voting power is treated as a liquidation right and is not treated as a voting right.
(v) Liquidation right. Liquidation right means a right or ability to compel the entity to acquire all or a portion
of the holder's equity interest in the entity, including by reason of aggregate voting power, whether or not
its exercise would result in the complete liquidation of the entity.
(vi) Subordinate. Subordinate has the meaning given it in §25.2701-3 (a) (2) (iii).
(3) Certain temporary [*160] lapses. If a lapsed right may be restored only upon the occurrence of a future
event not within the control of the holder or members of the holder's family, the lapse is deemed to occur
at the time the lapse becomes permanent with respect to the holder, i.e. either by a transfer of the interest
or otherwise.
(4) Source of right or lapse. A voting right or a liquidation right may be conferred by and may lapse by
reason of a State law, the corporate charter or bylaws, an agreement, or other means.
(b) Lapse of voting right. A lapse of a voting right occurs at the time a presently exercisable voting right is
restricted or eliminated.
(c) Lapse of liquidation right-(1) In general. A lapse of a liquidation right occurs at the time a presently
exercisable liquidation right is restricted or eliminated. Except as otherwise provided, a transfer of an
interest that results in the lapse of a liquidation right is not subject to this section if the rights with respect to
the transferred interest are not restricted or eliminated. However, a transfer that results in the elimination of
the transferor's right or ability to compel the entity to acquire an interest retained by the transferor that is
subordinate [*161] to the transferred interest is a lapse of a liquidation right with respect to the
subordinate interest.

Page 53 of 58
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(2) Exceptions. Section 2704 (a) does not apply to the lapse of a liquidation right under the following
circumstances.
(i) Family cannot obtain liquidation value-(A) In general. Section 2704 (a) does not apply to the lapse of a
liquidation right to the extent the holder (or the holder's estate) and members of the holder's family cannot
immediately after the lapse liquidate an interest that the holder held directly or indirectly and could have
liquidated prior to the lapse.
(B) Ability to liquidate. Whether an interest can be liquidated immediately after the lapse is determined
under the State law generally applicable to the entity, as modified by the governing instruments of the
entity, but without regard to any restriction described in section 2704 (b). Thus, if, after any restriction
described in section 2704 (b) [*162] is disregarded, the remaining requirements for liquidation under the
governing instruments are less restrictive than the State law that would apply in the absence of the
governing instruments, the ability to liquidate is determined by reference to the governing instruments.
(ii) Rights valued under section 2701. Section 2704 (a) does not apply to the lapse of a liquidation right
previously valued under section 2701 to the extent necessary to prevent double taxation (taking into
account any adjustment available under §25.2701-5).
(iii) Certain changes in State law. Section 2704 (a) does not apply to the lapse of a liquidation right that
occurs solely by reason of a change in State law. For purposes of this paragraph, a change in the
governing instrument of an entity is not a change in State law.
(d) Amount of transfer. The amount of the transfer is the excess, if any, of(1) The value of all interests in the entity owned by the holder immediately before the lapse (determined
immediately after the lapse as if the lapsed right was nonlapsing); over
(2) The value of the interests described in the preceding paragraph immediately after the lapse (determined as
if all such interests were held by [*163] one individual).
(e) Application to similar rights. [RESERVED]
(f) Examples. The following examples illustrate the provisions of this section:
Example 1. Prior to D's death, D owned all the preferred stock of Corporation Y and D's children
owned all the common stock. At that time, the preferred stock had 60 percent of the total voting power
and the common stock had 40 percent. Under the corporate by-laws, the voting rights of the preferred
stock terminated on D's death. The value of D's interest immediately prior to D's death (determined as
if the voting rights were non-lapsing) was $100X. The value of that interest immediately after death
would have been $90X if the voting rights had been non-lapsing. The decrease in value reflects the
loss in value resulting from the death of D (whose involvement in Y was a key factor in Y's
profitability). Section 2704 (a) applies to the lapse of voting rights on D's death. D's gross estate
includes an amount equal to the excess, if any, of $90X over the fair market value of the preferred
stock determined after the lapse of the voting rights.
Example 2. Prior to D's death, D owned all the preferred stock of Corporation Y. The preferred stock
and the [*164] common stock each carried 50 percent of the total voting power of Y. D's children
owned 40 percent of the common stock and unrelated parties own the remaining 60 percent. Under
the corporate by-laws, the voting rights of the preferred stock terminate on D's death. Section 2704 (a)
does not apply to the lapse of D's voting rights because members of D's family do not control Y after
the lapse.
Example 3. The by-laws of Corporation Y provide that the voting rights of any transferred shares of
the single outstanding class of stock are reduced to 1⁄

Page 54 of 58
1992 IRB LEXIS 2002, *164
2 vote per share after the transfer but are fully restored to the transferred shares after 5 years. D
owned 60 percent of the shares prior to death and members of D's family owned the balance. On D's
death, D's shares pass to D's children and the voting rights are reduced pursuant to the by-laws.
Section 2704 (a) applies to the lapse of D's voting rights. D's gross estate includes an amount equal to
the excess, if any, of the fair market value of D's stock (determined immediately after D's death as
though the voting rights had not been reduced and would not be reduced) over the stock's fair market
value immediately after D's death.
Example 4. D [*165] owns 84 percent of the single outstanding class of stock of Corporation Y. The
bylaws require at least 70 percent of the vote to liquidate Y. D gives one-half of D's stock in equal
shares to D's three children (14 percent to each). Section 2704 (a) does not apply to the loss of D's
ability to liquidate Y, because the voting rights with respect to the corporation are not restricted or
eliminated by reason of the transfer.
Example 5. D and D's two children, A and B, are partners in Partnership X. Each has a 31⁄
3 percent general partnership interest and a 30 percent limited partnership interest. Under State law, a
general partner has the right to participate in partnership management. The partnership agreement
provides that when a general partner withdraws or dies, X must redeem the general partnership
interest for its liquidation value. Also, under the agreement any general partner can liquidate the
partnership. A limited partner cannot liquidate the partnership and a limited partner's capital interest
will be returned only when the partnership is liquidated. A deceased limited partner's interest
continues as a limited partnership interest. D dies, leaving his limited partnership interest [*166] to
D's spouse. Because of a general partner's right to dissolve the partnership, a limited partnership
interest has a greater fair market value when held in conjunction with a general partnership interest
than when held alone. Section 2704 (a) applies to the lapse of D's liquidation right because after the
lapse, members of D's family could liquidate D's limited partnership interest. D's gross estate includes
an amount equal to the excess of the value of all D's interests in X immediately before D's death
(determined immediately after D's death but as though the liquidation right had not lapsed and would
not lapse) over the fair market value of all D's interests in X immediately after D's death.
Example 6. The facts are the same as in Example 5, except that under the partnership agreement D is
the only general partner who holds a unilateral liquidation right. Assume further that the partnership
agreement contains a restriction described in section 2704 (b) that prevents D's family members from
liquidating D's limited partnership interest immediately after D's death. Under State law, in the
absence of the restriction in the partnership agreement, D's family members could liquidate the
[*167] partnership. The restriction on the family's ability to liquidate is disregarded and the amount of
D's gross estate is increased by reason of the lapse of D's liquidation right.
Example 7. D owns all the stock of Corporation X, consisting of 100 shares of non-voting preferred
stock and 100 shares of voting common stock. Under the by-laws, X can only be liquidated with the
consent of at least 80 percent of the voting shares. D transfers 30 shares of common stock to D's
child. The transfer is not a lapse of a liquidation right with respect to the common stock because the
voting rights that enabled D to liquidate prior to the transfer are not restricted or eliminated. The
transfer is not a lapse of a liquidation right with respect to the retained preferred stock because the
preferred stock is not subordinate to the transferred common stock.
Example 8. D owns all of the single class of stock of Corporation Y. D recapitalizes Y, exchanging D's
common stock for voting common stock and non-voting, non-cumulative preferred stock. The
preferred stock carries a right to put the stock for its par value at any time during the next 10 years. D
transfers the common stock to D's grandchild in a transfer [*168] subject to section 2701. In
determining the amount of D's gift under section 2701, D's retained put right is valued at zero. D's
child, C, owns the preferred stock when the put right lapses. Section 2704 (a) applies to the lapse,

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without regard to the application of section 2701, because the put right was not valued under section
2701 in the hands of C.
Example 9. A and A's two children are equal general and limited partners in Partnership Y. Under the
partnership agreement, each general partner has a right to liquidate the partnership at any time.
Under State law that would apply in the absence of contrary provisions in the partnership agreement,
the death or incompetency of a general partner terminates the partnership. However, the partnership
agreement provides that the partnership does not terminate on the incompetence or death of a
general partner, but that an incompetent partner cannot exercise rights as a general partner during
any period of incompetency. A partner's full rights as general partner are restored if the partner
regains competency. A becomes incompetent. The lapse of A's voting right on becoming incompetent
is not subject to section 2704 (a) because it may be restored [*169] to A in the future. However, if A
dies while incompetent, a lapse subject to section 2704 (a) is deemed to occur at that time because
the lapsed right cannot thereafter be restored to A.
§25.2704-2 Transfers subject to applicable restrictions.
(a) In general. If an interest in a corporation or partnership (an "entity") is transferred to or for the benefit of
a member of the transferor's family, any applicable restriction is disregarded in valuing the transferred
interest. This section applies only if the transferor and members of the transferor's family control the entity
immediately before the transfer. For the definition of control, see §25.2701-2 (b) (5). For the definition of
member of the family, see §25.2702-2 (a) (1).
(b) Applicable restriction defined. An [*170] applicable restriction is a limitation on the ability to liquidate
the entity (in whole or in part) that is more restrictive than the limitations that would apply under the State
law generally applicable to the entity in the absence of the restriction. A restriction is an applicable
restriction only to the extent that either the restriction by its terms will lapse at any time after the transfer, or
the transferor (or the transferor's estate) and any members of the transferor's family can remove the
restriction immediately after the transfer. Ability to remove the restriction is determined by reference to the
State law that would apply but for a more restrictive rule in the governing instruments of the entity. See
§25.2704-1 (c) (1) (B) for a discussion of the term "State law." An applicable restriction does not include a
commercially reasonable restriction on liquidation imposed by an unrelated person providing capital to the
entity for the entity's trade or business operations whether in the form of debt or equity. An unrelated
person is any person whose relationship to the transferor, the transferee, or any member of the family of
either is not described in section 267 (b) of the Internal Revenue Code, [*171] provided that for purposes
of this section the term "fiduciary of a trust" as used in section 267 (b) does not include a bank as defined
in section 581 of the Internal Revenue Code. A restriction imposed or required to be imposed by Federal
or State law is not an applicable restriction. An option, right to use property, or agreement that is subject to
section 2703 is not an applicable restriction.
(c) Effect of disregarding an applicable restriction. If an applicable restriction is disregarded under this
section, the transferred interest is valued as if the restriction does not exist and as if the rights of the
transferor are determined under the State law that would apply but for the restriction. For example, an
applicable restriction with respect to preferred stock will be disregarded in determining the amount of a
transfer of common stock under section 2701.
(d) Examples. The following examples illustrate the provisions of this section:
Example 1. D owns a 76 percent interest and each of D's children, A and B, owns a 12 percent
interest in General Partnership X. The partnership agreement requires the consent of all the partners
to liquidate the partnership. Under the State law that [*172] would apply in the absence of the
restriction in the partnership agreement, the consent of partners owning 70 percent of the total
partnership interests would be required to liquidate X. On D's death, D's partnership interest passes to
D's child, C. The requirement that all the partners consent to liquidation is an applicable restriction.

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Because A, B and C (all members of D's family), acting together after the transfer, can remove the
restriction on liquidation, D's interest is valued without regard to the restriction; i.e., as though D's
interest is sufficient to liquidate the partnership.
Example 2. D owns all the preferred stock in Corporation X. The preferred stock carries a right to
liquidate X that cannot be exercised until 1999. D's children, A and B, own all the common stock of X.
The common stock is the only voting stock. In 1994, D transfers the preferred stock to D's child, A.
The restriction on D's right to liquidate is an applicable restriction that is disregarded. Therefore, the
preferred stock is valued as though the right to liquidate were presently exercisable.
Example 3. D owns 60 percent of the stock of Corporation X. The corporate by-laws provide that the
corporation [*173] cannot be liquidated for 10 years after which time liquidation requires approval by
60 percent of the voting interests. In the absence of the provision in the by-laws, State law would
require approval by 80 percent of the voting interests to liquidate X. D transfers the stock to a trust for
the benefit of D's child, A, during the 10-year period. The 10-year restriction is an applicable restriction
and is disregarded. Therefore, the value of the stock is determined as if the transferred block could
currently liquidate X.
Example 4. D and D's children, A and B, are partners in Limited Partnership Y. Each has a 3.33
percent general partnership interest and a 30 percent limited partnership interest. Any general partner
has the right to liquidate the partnership at any time. As part of a loan agreement with a lender who is
related to D, each of the partners agree that the partnership may not be liquidated without the lender's
consent while any portion of the loan remains outstanding. During the term of the loan agreement, D
transfers one-half of both D's partnership interests to each of A and B. Because the lender is a related
party, the requirement that the lender consent to liquidation [*174] is an applicable restriction and the
transfers of D's interests are valued as if such consent were not required.
Example 5. D owns 60 percent of the preferred and 70 percent of the common stock in Corporation X.
The remaining stock is owned by individuals unrelated to D. The preferred stock carries a put right
that cannot be exercised until 1999. In 1995, D transfers the common stock to D's child in a transfer
that is subject to section 2701. The restriction on D's right to liquidate is an applicable restriction that
is disregarded in determining the amount of the gift under section 2701.
§25.2704-3 Effective date.
Section 25.2704-1 applies to lapses occurring after January 28, 1992, of rights created after October 8,
1990. Section 25.2704-2 applies to transfers occurring after January 28, 1992, of property subject to
applicable restrictions created after October 8, 1990. In determining whether a voting right or a liquidation
right has lapsed prior to that date, and for purposes of determining whether the lapse is subject to section
2704 (a), taxpayers may rely on any reasonable interpretation of the statutory provisions. For transfers of
interests occurring before January 28, 1992, taxpayers [*175] may rely on any reasonable interpretation
of the statutory provisions in determining whether a restriction is an applicable restriction that must be
disregarded in determining the value of the transferred interest. For these purposes, the provisions of the
proposed regulations and the final regulations are considered a reasonable interpretation of the statutory
provisions.
PART 301-PROCEDURE AND ADMINISTRATION
Par. 12. The authority for part 301 continues to read, in part:
Authority: Sec 7805, I.R.C. 1954; 68A Stat. 917; 26 U.S.C. 7805 ∗ ∗ ∗
Par. 13. In §301.6501 (c)-1, new paragraph (e) is added in the appropriate place to read as follows:
§301.6501 (c)-1 Exceptions to general period of limitations on assessment and collection.
∗∗∗

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(e) Certain gifts not shown on return-(1) In general. If any transfer of property subject to the special
valuation rules of section 2701 or section 2702, or if the occurrence of any taxable event described in
section §25.2701-4 of this chapter, is not adequately shown on a return of tax imposed by chapter 12
of subtitle B of the Internal Revenue Code (without regard to section 2503 (b)), any tax imposed by
chapter 12 of subtitle B of the Code on the transfer [*176] or resulting from the taxable event may be
assessed, or a proceeding in court for the collection of the appropriate tax may be begun without
assessment, at any time.
(2) Adequately shown. A transfer of property valued under the rules of section 2701 or section 2702 or
any taxable event described in §25.2701-4 of this chapter will be considered adequately shown on a
return of tax imposed by chapter 12 of subtitle B of the Internal Revenue Code only if, with respect to
the entire transaction or series of transactions (including any transaction that affected the transferred
interest) of which the transfer (or taxable event) was a part, the return provides:
(i) A description of the transactions, including a description of transferred and retained interests and the method
(or methods) used to value each;
(ii) The identity of, and relationship between, the transferor, transferee, all other persons participating in the
transactions, and all parties related to the transferor holding an equity interest in any entity involved in the
transaction; and
(iii) A detailed description (including all actuarial factors and discount rates used) of the method used to
determine the amount of the gift arising from [*177] the transfer (or taxable event), including, in the case of
an equity interest that is not actively traded, the financial and other data used in determining value.
Financial data should generally include balance sheets and statements of net earnings, operating results,
and dividends paid for each of the 5 years immediately before the valuation date.
(3) Effective date. The provisions of this paragraph (e) are effective as of January 28, 1992. In
determining whether a transfer or taxable event is adequately shown on a gift tax return filed prior to
that date, taxpayers may rely on any reasonable interpretation of the statutory provisions. For these
purposes, the provisions of the proposed regulations and the final regulations are considered a
reasonable interpretation of the statutory provisions.
PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 14. The authority for part 602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 15. The table of OMB Control Numbers in §602.101 is amended by adding the following citations:
§25.2701-2

5145-1241

§25.2701-4

5145-1241

§25.2702-6

5145-1273

§301.6501 (c)-1

5145-1241.

Fred T. Goldberg, Jr.,
Commissioner of Internal Revenue.
Approved [*178] January 2, 1992.
Kenneth W. Gideon,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on January 28, 1992, 4:11 p.m., and published in the issue of the
Federal Register for February 4, 1992, 57 F.R. 4250 as corrected by 57 F.R. 11264)

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