Sec. 25.2701-3 Determination of amount of gift.

(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 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.

(2) Definitions.

The following definitions apply for purposes of this section.

(1) Step 1 -- Valuation of family-head interest.

(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.

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 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 section 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.

(5) Adjustment in Step 2.

(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 --

(2) Junior equity interest.

For purposes of paragraph (c)(1) of this section, junior equity interest means common stock 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.

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 section 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 follows --

Step 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 X $800 (the section 2701 value of A's preferred stock, computed under the "lower of" rule of section 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 furnished 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 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 X $1,000). The balance of A's preferred stock is valued under section 2701 at $400,000 (500 shares X $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 under Step 4 is the same as in Example 1. Thus, the amount of the gift is $480,000.

EXAMPLE 3. Corporation X has outstanding 1,000 shares of $1,000 par value non-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 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 family-held 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 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 1 value 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 (250/1,000 X $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 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 the difference is $83,333. If the section 2701 value of the applicable retained interested were $100,000, the Step 4 adjustment would have been a $33,333 reduction for consideration received ((250/750) x $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 X $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 would have been involved in the exchange. Thus, the amount of the gift is $666,667.