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appreciation in the corporation at a
reduced gift tax cost without giving up Planning in this area involves avoiding the
control of the business operations.
Sec. 2701 rules entirely or structuring the
Understanding stock freezes
and the Sec. 2701 rules transaction so that the retained interests
Under current rules, the retained pre- are assigned qualified payment rights with
ferred stock would be assigned a value of a substantial value.
zero, unless certain requirements are met
(Sec. 2701(a)(3)(A)). The gifted inter-
est (usually common stock) would be
assigned the entire value of the corpora- conversion rights, must meet certain 25% of its face value. Then, A will gift
tion. This could create a gift tax liability requirements. In general, they must call all of his common stock to B.
for the donor. for a periodic dividend payment on cu- This transaction is subject to Sec.
The valuation provisions of Sec. mulative preferred stock payable at least 2701 for the following reasons. The
2701 apply when there is a transfer of a annually at a fixed rate (Sec. 2701(c)(3) stock transferred to B is a junior equity
junior equity interest in a business to a (A); Regs. Sec. 25.2701-2(b)(6)). interest because the preferred stock has
family member and, immediately after Planning in this area involves avoid- dividend and liquidation rights senior
the transfer, the transferor holds an ing the Sec. 2701 rules entirely or to the common stock and B is a family
applicable retained interest (Regs. Sec. structuring the transaction so that the member. Also, X is a controlled entity
25.2701-1(a)(1)). In general, the provi- retained interests are assigned qualified because A, directly or indirectly, owns
sions tend to shift a major portion of the payment rights with a substantial value. over 50% of the stock. Because A’s pre-
value of the corporation to the interest ferred stock is entitled to distributions
that has been gifted, making the typical Example 1. Recapitalizing a corpora- from X, A has an applicable retained
estate freeze transaction much less at- tion with preferred stock: A owns interest (Regs. Sec. 25.2701-2(b)(1)).
tractive. The following definitions help 100% of the common stock of X Using cumulative preferred stock
to understand these provisions. Corp. A is 50 years old and would with annual dividend rights at a fixed
■ Junior equity interest: Common stock like to turn control of X over to his rate increases the value of A’s retained
in which the rights to income or son, B. However, B does not have preferred stock interest and decreases the
capital (e.g., dividend or liquidation funds to purchase the stock, and amount of the gift to B. For instance, A’s
rights) are subordinate to the rights X does not have funds to redeem preferred stock calls for annual cumula-
of all other classes of stock (Sec. the stock. X’s common stock has tive dividend payments of 25% of its
2701(a)(4)(B)(i)). a par value of $200,000 and a fair face value, yielding an annual payment
■ Family member: The transferor’s market value (FMV) of $1.5 mil- of $25,000 ($100,000 × 25%). Therefore,
spouse, any descendant of the trans- lion, but A believes the value will be A’s retained preferred stock interest is
feror or transferor’s spouse, and the greater than $12 million in the next valued based on the present value of this
spouse of any descendant (Regs. Sec. five years. stream of payments over his remaining
25.2701-1(d)(1)). life expectancy. If this valuation equals
■ Applicable retained interest: Includes A would like to remain active in the $500,000, the value of the common
an equity interest in a controlled business. While X represents a major stock gifted to B would be reduced to
entity for which there is a distribu- portion of his planned retirement in- $1 million ($1.5 million total FMV less
tion right. come stream, A wants to keep as much $500,000 allocated to preferred stock).
If the interest retained by the donor of the future increase in value of X’s There may be other discounts, such as
or applicable family members is as- stock out of his estate as possible. for lack of marketability, that would re-
signed certain distribution rights, the A chooses to recapitalize X by re- duce the value of the gift even further.
retained interest may have some value ceiving one share of voting preferred A’s gift of all of his common stock
based on these rights (Sec. 2701(a)(3) stock for each share of common stock shifts the future appreciation in the
(B)). However, these distribution rights, he owns. (This is a tax-free stock divi- value of X to B. The dividend payments,
such as extraordinary payment rights, dend under Sec. 305(a).) The preferred along with some reasonable salary, will
mandatory payment rights, liquida- stock will have a face value of $100,000 provide A with a stream of income to
tion payment rights, and nonlapsing and be entitled to an annual dividend of build funds for his retirement.

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