[Code of Federal Regulations]
[Title 26, Volume 14]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR25.2704-1]

[Page 670-672]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 25_GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954--Table of Contents
 
Sec.  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 
holder's gross estate.
    (2) Definitions. The following definitions apply for purposes of 
this section.
    (i) Control. Control has the meaning given it in Sec.  25.2701-
2(b)(5).
    (ii) Member of the family. Member of the family has the meaning 
given it in Sec.  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 Sec.  
25.2701-3(a)(2)(iii).
    (3) Certain temporary 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

[[Page 671]]

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 to the transferred interest is a lapse of a liquidation 
right with respect to the subordinate interest.
    (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) 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 Sec.  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 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 nonlapsing) was $100X. The value of that interest 
immediately after death would have been $90X if the voting rights had 
been nonlapsing. 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 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 \1/2\ 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

[[Page 672]]

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 owns 84 percent of the single outstanding class of 
stock of Corporation Y. The by-laws 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 3\1/3\ 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 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 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 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, 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 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.

[T.D. 8395, 57 FR 4274, Feb. 4, 1992]