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ESTATE AND GIFT TAX

The federal and estate gift tax is one of the major impediments to the continuity of small businesses and independent business. The impact of estate taxes frequently forces sale or liquidation of small businesses in order to pay the tax liability. If this does not occur because the business has the resources to provide the fund to pay the tax, the business must operate with much less capital. This in itself hinders the expansion or continuity of small business. Even if the estate qualifies for installment payment of the tax, the tax presents a serious ongoing charge against the future after corporate tax earnings of the business. Estate and gift taxes raise very little net revenue. These taxes produce approximately two percent of total federal revenues, while the cost of administering estate and gift tax laws are reported to be approximately 85 percent of these revenues. They are very disruptive to the continuity of small businesses, in addition to creating a number of other undesirable economic consequences. The repeal of estate and gift taxes would be the ideal solution in solving the problem of maintaining continuity in small family held businesses. Given revenue and social considerations, however, it is recommended that estate and gift tax laws be amended significantly. The specific recommendations relating to this area of the tax law are:

1. Adoption of President Reagan's revised tax cut proposals and the bipartisan tax reduction program

We strongly endorse the following provisions included in the Bipartisan Tax Reduction Program:

(a) An increase in the credit against the unified estate and gift tax which when phased in by 1985 will correspond to an estate tax exclusion of $600,000; (b) An increase in the marital deduction so that it will be unlimited effective January 1, 1982—the marital deduction is now limited to one-half of the adjusted gross estate;

(c) An increase of the annual gift tax exclusions from $3,000 to $10,000 per donee, effective January 1, 1982.

2. Enact reduction of estate tax rates

We recommend that the estate tax rates be immediately reduced to correspond with the individual tax relief included in the Bipartisan Tax Reduction Program. A three-year tax cut is essential calling for across-the-board rate reductions of 5 percent on October 1, 1981, with additional reductions of 10 percent on July 1, 1982 and 10 percent on July 1, 1983. The top marginal estate and gift rate should be lowered from 70 percent to a maximum of 50 percent by July 1, 1983.

3. Adopt special valuation rules for closely held businesses

We recommend that the executor of an estate should be given an election to value the business interest at either its current fair market value or at the decedent's original cost basis. For purposes of the provision, an interest in a closely held business would be defined in the same manner as under the present provisions relating to extensions of time for paying estate taxes.

If the estate or the decedent's heirs dispose of their interest in the business within 10 years after the decedent's death, the estate tax benefits will be recaptured in a manner similar to the manner in which the benefits of special use valuation are recaptured under present law. Recapture would not occur on distributions from the estate to the decedent's heirs or on transfers between members of the decedent's family.

4. Adopt special rules for stock redemption and installment payment of estate taxes for owners of closely held businesses

Much costly estate planning could be minimized if the percentage tests in IRS Code Sections 303 (stock redemptions) and 6166 and 6166A (deferred payment of estate tax) were eliminated or reduced sustantially. In an effort to insure that an estate will be able to meet the present percentage tests, liquid assets often are removed from the estate-a move which may be contrary to sound continuity of ownership planning. An estate in which the value of the closely held business (or businesses) included in the estate exceeds 35 percent of the value of the gross estate or 50 percent of the taxable estate would be eligible for payment of the estate tax over 15 years, with interest only payable over the first five years.

5. Encourage employee ownership by allowing deductible gifts to employee stock ownership plans (ESOP)

SBU recommends that stockholders who make a gift or bequest of company stock to an ESOP be allowed a charitable contribution deduction for purposes of gift and

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estate tax so long as the ESOP does not allocate any portion of the contributed stock to the contributing stockholders, a 25 percent stockholder, or relatives of the stockholders.

We recommend notwithstanding Employee Retirement Income Security Act (ERISA) limitations on deductible corporate contributions to an ESOP, that a corporation be allowed an employee retirement plan deduction equal to the payments required to service the ESOP's debt for the purchase of stock.

6. Provide a faster and less costly means of resolving valuation disputes

Small business frequently is faced with difficult valuation problems in confrontation with the IRS. SBU recommends that these taxpayers have the right to waive their administrative and judicial rights and demand that the IRS submit the valuation to binding arbitration if the IRS agent or his supervisors do not agree with the valuation proposed by the taxpayers.

7. Eliminate estate and income "tax traps" inherent in the present rules of attribution

The restrictions on transferability of the small businessman's corporate stock should be eliminated or at least clarified. For example, generally an owner can sell his shares to the family corporation despite the fact that his immediate family also owns a portion of the business if he agrees not to acquire any additional stock in the business for ten years. However, when the owner dies and his estate or a trust under his will is involved in selling shares to the corporation the tax bill is often higher than if he had lived-all at a time when the family can least afford it (dividend income versus capital gain income).

Although there are numerous instances of bias towards small business from the attribution rules, one very common example occurs where the closely held business comprises such a significant portion of the estate that some stock is allocated to both the marital deduction trust and the family trust. Since the stock may not have the capacity to pay dividends after the death of the principal owner, the spouse might request that her stock be sold to the corporation and converted to income producing property. The IRS interpretation of the attribution rules do not allow for a waiver agreement here and the result is that the family trust's stock is attributed to the children and is reattributed from them to their mother. Consequently, the sale of stock by her marital deduction trust results in a dividend and not capital gain. It's obviously a difficult situation to explain to a widow why she should have dividend consequences as opposed to capital gain treatment merely because she has stock in a family business and not the Fortune 500. This type of bias and uncertainty is what causes many small business owners who are concerned about their family's security to sell or merge with a large conglomerate upon retirement. Therefore, we recommend that the Code should be amended to allow estates and trusts to waive the attribution rules as is now accorded family members.

BUSINESS VALUATION

Contrary to publicly held companies whose value is readily ascertainable on a daily basis, the valuation of a privately held small business is arrived at by a costly process of negotiation and compromise between owners, their advisors, the IRS and federal courts having jurisdiction over such matters. During most of this process, the burden of proof is upon the small business owner to show that the proposed IRS valuation is incorrect. The value of the business often determines the options the owners have for continuity of their business. Value determines the amount of estate taxes which may dictate to the owners the choice of the continuity route, the Internal Revenue Service and the business owner's experts admittedly have divergent motives for their respective valuations. There are understandable differences of opinions as to the proper value. SBU believes, although it did not attempt to substantiate this opinion, that the IRS often takes an arbitrary approach to this valuation process and completely disregards the negative impact that excessive estate taxes may have on the continuity of ownership of small businesses. The valuation problem arises in estate and gift tax returns, ESOPs, holding companies, and recapitalizations.

The current valuation process can be very costly and time consuming to the IRS and particularly to the small business person. There have been situations where it has taken years to resolve a valuation dispute. The recommendations relating to this area of Internal Revenue Service policy are:

(a) Amend the Internal Revenue Code to allow taxpayers to request binding arbitration to arrive at a valuation figure when it cannot be agreed upon at the agent or supervisory level. The arbitration process could be conducted under the auspices of any accredited arbitration organization.

(b) SBU recognizes that the IRS normally will not rule on valuation matters when issuing letter rulings of advance determination with respect to proposed transactions. However, the valuation problem is a constant issue, and is uniquely a problem for small businesses because valuation in this sector often is extremely difficult to resolve. Therefore, we urge that when a request for an advance determination letter ruling is submitted to the IRS containing a valuation issue that it be resolved as follows: The taxpayer submits a detailed statement, with supporting documents, as to the valuation he proposes to use and agrees to bear the expense of having the valuation certified by an accredited valuation firm selected by the IRS. If the IRS does not accept the offer within a reasonable period, the valuation, prima facie, of the taxpayer shall be deemed correct.

(c) At present, for estate tax purposes, under Revenue Ruling 59-60, when valuing the underlying assets of a closely held corporation, the current market value of the corporate assets is employed. Another factor in valuing the shares of a closely held corporation is the earnings-per-share. This is calculated by the IRS by using a depreciation deduction that is based on the historical (original) cost of the depreciable assets. This results in an over statement of the "true" earnings-per-share. SBU recommends that for estate valuation purposes before the factor of earnings-per-share is applied that the earnings be adjusted downward to reflect a larger depreciation based upon current replacement values of the depreciable assets. SBU recognizes that Congress is likely to alleviate this problem when it considers more rapid capital cost recovery systems for all depreciable assets. Thus, in the future, it is probable that earnings-per-share will more closely approximate current replacement costs.

Thank you for inviting Small Business United to express its views on the impact of estate and gift tax laws on capital formation.

Mr. Nowak. Thank you very much, Mr. Tonneson.
Mr. Kolbe?

TESTIMONY OF WILLIAM F. KOLBE, CHAIRMAN, INDEPENDENT BUSINESS ASSOCIATION OF WISCONSIN

Mr. KOLBE. Thank you, Mr. Chairman.

I am William F. Kolbe, a practicing lawyer in Racine, Wis. I have been there practicing law for 20 years and for 5 years before that I was a lawyer with the Internal Revenue Service trying cases for them, so I have been on both sides of that table. Our practice is largely a tax practice and a good deal of it is in the estate planning area.

The heart of my statement-and I have a prepared statement to be made part of the record.

Mr. NOWAK. Without objection, it will be included.

Mr. KOLBE. The heart of that statement is that the taxes which are imposed on small family held businesses are not really taxes on their owners that result in their owners having a different lifestyle than they had before those taxes were imposed.

That is not where the real impact of those taxes comes. Those people live in the same homes and send their children to the same colleges and belong to the same country clubs and manage to keep the same golf handicap and live about the same lifestyle after those taxes are paid.

The impact of those taxes falls on the business. The taxes are extracted from the businesses' working capital. That result is unavoidable because if you have got 1 million dollars' worth of A.T. & T. stock and you have to pay $300,000 in taxes, you sell $300,000 worth of stock by calling your broker, paying the tax, and that is the end of it.

If that is a closely held business, there is nobody going to buy 30 percent of that business. No one is going to deal with the minority

shareholders as a 70-percent owner-excuse me, as a 30-percent owner and have nothing to say.

So no one is going to be able to sell 30 percent of a closely held business. The only thing they are going to be able to do is, if they sell the business, they are going to sell the whole business.

Now, the Congress has not wanted to force business owners to sell these small businesses, so they have provided, in section 303 for the extraction of funds from the company, from the corporation tax free because that probably is the only available source.

Through section 6166 and 6166(a) deferral periods for the payment of the tax have been provided, but the impact of the tax is so severe and, as Mr. Reister said, it hits with such a vengeance, that the company cannot continue to be the same competitive, viable force that it was after those taxes as it was before they were imposed.

In my prepared statement that I filed with the subcommittee, I have a chart on page 3 which shows the impact of present estate taxes on businesses of different sizes.

I would just point out that a $5 million business might be one doing $6 or $7 million in sales, with a decent after tax return. It might have a total value of around $5 million. It might be a company that employs maybe 200 people. That would be about what we would see in Racine, Wis.

Through two estates, the tax extraction from that company under present law is in excess of $2.1 million. It is 40 percent of its total value.

If we had a company like IBM or General Motors and they had to embark on a program, whether it was over 10 or 15 years, or in a hurry, to distribute from their invested capital 41 percent of the total value of the company, they would be through.

They would no longer be a viable, productive company.

The same thing is true with small business and there lies the problem.

Now we have-especially, I think, that is serious with farms. Most of our practice though is with manufacturing companies. I think with farms that is an especially serious situation.

We have now proposals here to do something about the estate tax. We have heard it mentioned many times that it would be repealed. That would certainly be a fine solution.

I don't know if it is politically possible for some of you gentlemen to support that.

Also, there is the bipartisan bill and H.R. 3682, which I have read.

I filed a supplement to my statement. I would like to make a couple of comments on those bills.

This committee is concerned with small business. I feel as those bills apply to small business they really do not do very much for any business except a real small business.

If you have the supplement to my statement there, it shows under the bipartisan bill, with good estate planning, $1,200,000 can pass tax free through two estates, but then that Federal estate tax impacts at 37 percent, and under the bipartisan bill, when you reach a business having a value of $5 million and pass it through one generation, through husband and wife, pass it through one

generation, the taxes under the bipartisan bill would be $2,151,000, and under present law they are $2,117,000, so there is really no benefit at that level.

That is small business, really. You are talking about somebody employing a couple of hundred people, maybe doing $6, $7, $8 million in sales or somewhere in that area.

That is a very typical type business in Racine, Wis. There is no relief for that business in these bills.

I would like to make this comment: The solution to that-see only these solutions: The estate tax is reduced in amount through rate deductions to the point these busineses can afford to pay it without affecting their working capital.

Or, for the sake of the businesses-not their owners, but for the sake of the employees, the people that work there, the people that buy the products, for the sake of the business that those taxes be deferred until the stock of the corporation is ultimately sold.

At some point in time it is probably going to be sold. At that time, the tax could be collected. I would think an indefinite deferral like that would make a lot of sense.

If there were interest to be charged, if that was thought necessary to be fair, that that could be done by reducing the basis of the inherited stock so there would be additional income taxes when it was sold to catch up that interest.

Somehow there should be a measure of how much these businesses should be expected to extract from their working capital in order to pay Federal estate taxes.

I do not think that that is really addressed in the bills now. I would think that this committee might want to make some suggestion on that.

If I may, one other comment. The bipartisan bill accomplishes its reductions by using a tax credit of $192,800.

As Mr. Reister pointed out, when you use a credit like that, what you do is you offset the-up to $192,800 of tax. You forgive that much tax, but that means that the estate has waded into some awfully heavy brackets when it gets past that credit.

So the estate, by the time it gets past the credits, it has incurred $192,800 worth of tax which the credit forgives.

Once the estate gets past that, it is literally up to its ears at that point. It is up to a 37-percent rate.

I wonder if it makes sense to say that at $600,000 we shouldn't tax it at all but any dollar beyond that is taxed at 37 percent or higher.

Doesn't it make more sense to say if $600,000, whatever the number is, is our starting point, that we than start with a modest rate because if $600,000 ought to be exempt, it seems like $601,000 ought to be taxed-the next one ought to be taxed at a low rate. H.R. 3682 uses the exemption approach rather than the credit approach. That means that, of course, you deduct it from the estate and every estate starts at the tax rates at the bottom and goes on up through them.

With the credit, it starts in the middle of them. So, while both bills are probably, considering everything, better than present law, I think the best solution is repeal.

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