Demystifying the Qualified Payment Right: Structuring and Administering a §2701-Compliant Entity

Estate planners use special business entities to help families pass on their wealth without paying high taxes. They often create these entities with two types of ownership: one that gets a guaranteed return on their investment (preferred interests) and one that gets any extra profits (common interests). Older family members can give the common interests to younger family members without paying taxes, as long as the preferred interests are set up in a specific way. This can get complicated because of a tax rule called I.R.C. §2701. But if the preferred return is set up properly, it can avoid this tax rule. It’s important to make sure everything is set up correctly to avoid tax problems. I.R.C. §2701 applies when a parent transfers ownership in a family business to their child, and the parent still holds some ownership in the business. If the parent has certain rights to get money out of the business, the value of the gift to the child is calculated by subtracting the value of the parent’s remaining ownership from the value before the gift. Any rights the parent has to get money from the business are considered to be worth nothing for this calculation. This rule is meant to make sure that parents can’t give their kids a business but still keep the valuable parts for themselves. A Qualified Payment Right (QPR) is a specific type of distribution right that helps to avoid a tax rule called the zero-value rule. This rule can make it harder to transfer certain types of assets as gifts without facing gift tax. A QPR is a right to receive regular payments that are either a fixed amount or determined at a fixed rate, like a 7 percent annual return. Because the amount of the payments is fixed and required to be made at least once a year, it’s easier to figure out the value of the QPR for tax purposes. This can make it easier to transfer the asset as a gift without owing gift tax. In simple terms, if a distribution right doesn’t fit neatly into a certain definition, the person who owns it can choose to treat it as a Qualified Payment Right (QPR) or not. This choice is permanent and must be made when reporting the transfer on a gift tax return. If the right is treated as a QPR, its value will be based on normal principles of valuation, but if not, it will be valued at zero. However, even if it’s treated as a QPR, there may still be a gift if the preferred return is lower than what it would be in a normal transaction. To figure out the proper preferred return for a qualified payment right (QPR), a qualified appraiser needs to do a valuation appraisal. They look at factors like the security of the preferred return, the company’s earnings and assets, and the business environment. There’s also a special rule for valuing the preferred interest if it includes an extra payment right. This rule makes sure that the holder of the preferred interest doesn’t have any extra rights that could add value to it, which could cause tax issues. If you’re transferring shares of a company to family members, the value of the gift can’t be less than 10% of the total value of the company’s equity and any money it owes to you or your family. It’s important to pay the agreed-upon amounts on time to avoid tax issues. If the trust agreement doesn’t say when payments are due, they’re due at the end of each year. If a payment is made within four years of when it’s due, it’s considered on time. You can also use a debt obligation to pay, as long as it has interest and is paid off within four years. This means you can defer the payment for up to eight years without any tax problems. If someone owes money to another person and doesn’t pay on time, they have to pay interest on the late payment. If the person who is supposed to get the money transfers it to someone who is not their spouse or family member, they have to pay even more money as a penalty. But once the money is transferred, the penalty does not apply anymore. If the person receiving the QPR interest is the QPR interest holder’s spouse, they won’t have to pay taxes on the transfer. But if the spouse later gives away the interest, they will have to pay taxes on it. If the person receiving the QPR interest is a family member, they will have to pay taxes on it. The QPR interest holder can choose to pay taxes on any unpaid payments after four years. This choice is made when they file their gift tax return. A person named A has a partnership interest in a company, and they didn’t receive any money for five years. Then they got some money in the sixth year, and more in the seventh year. They had to pay tax on the money they got in the seventh year, and it increased the amount of gifts they have to pay taxes on. The tax amount is figured out by assuming the money was paid on time and earning interest. In simple terms, the tax adjustment amount is calculated by looking at the payments made by the person who received the gift and comparing it to what they should have received based on the original value of the gift. There are rules in place to limit how much the tax adjustment amount can increase, and it’s important for estate planners to carefully set up these types of entities to avoid unexpected gift tax consequences. I.R.C. §2701 is a complex tax law that deals with transferring interests in businesses to family members. It defines who qualifies as family members and sets rules for valuing these transfers. It also has regulations for certain types of payments and elections that can affect the value of the transfer. The law aims to prevent people from undervaluing these transfers for tax purposes. If you want to learn more about this law and how to plan for it, you can read articles by Nathan R. Brown. These are references to specific sections of tax regulations and codes. They are used by attorneys who specialize in tax and estate planning to help their clients with their financial and legal matters. The attorneys mentioned, Nathan R. Brown and John F. DeStefano, work for a law firm in Boca Raton and help people with their taxes and estate planning. This information was submitted by the Tax Law Section of The Florida Bar.

Source: https://www.floridabar.org/the-florida-bar-journal/demystifying-the-qualified-payment-right-structuring-and-administering-a-2701-compliant-entity/