use" test is met where the decedent cash leases the property to a family member; and third, whether the formula method for determining special use valuation may be used where the only comparable property is not cash rented. Where a family farm constitutes a large part of a decedent's estate, the estate may value the farm for estate tax purposes under a "special use" valuation method under section 2032A, of the code. Although special use valuation is also available for certain other real estate, it applies principally to family farms and we will be thus discussing these issues in the context of farms. Special use valuation is intended to permit a farm to be valued as a farm even if someone would pay more for the land, because of its value for nonfarm purposes. In order for the farm to be eligible for special use valuation, a number of requirements must be met. These requirements are intended to limit the availability of special use valuation to cases where the farm was, and will remain, a family farm. Before addressing the specific issues of interest to the subcommittee, some general observations are in order. While the purpose of section 2032A, may be easily summarized-to provide for valuation of farmland based on its use as a farm rather than on other potential uses of the land-the statute is quite complex and, if read literally, goes far beyond its purpose. The development of the regulations under section 2032A represents an effort to reconcile the literal language of the statute with its purpose. Given the differences between the purposes of the statute, as reflected in its legislative history, and the literal language of the statute, the regulations as a whole, in our view, represent a reasonable attempt to give guidance in this area. However, the Treasury and IRS have determined that certain modifications should be made in the regulations in two areas. The first area to be addressed is the circumstances under which property held in trust may qualify for special use valuation. Under the legislation it is required that property pass to "qualified heirs", a statutorily defined term that does not include trusts. However, in recognition of the widespread use of trusts in estate planning, the legislative history of section 2032(A) provides that the rules for special valuation are to apply to property which passes in trust. For this purpose, trust property is deemed to have passed from the decedent to a qualified heir to the extent that the qualified heir has a present interest in the trust property. The final regulations recognize that property passing in trust may qualify for special use valuation, and define "present interest' in the trust property by a cross reference to the gift tax provisions of the code, where an established body of law has developed for defining that term. The incorporation of the gift tax definition of present interest has caused problems for "discretionary" testamentary trust. In the typical discretionary trust, the trustee is given the power to accumulate or distribute income, and, in some circumstances, corpus among a group of beneficiaries. To the extent the trust grants absolute discretion to the trustee so that none of the beneficiaries may compel distribution, no one has a present interest in the trust as that term is defined for gift tax purposes. Thus, property passing under a discretionary trust would, under the current regulations, be ineligible for special use valuation. Senator GRASSLEY. John. Mr. CHAPOTON. Yes, sir. Senator GRASSLEY. Senator Melcher has come into the room. He was the first one who was going to testify. Senator Melcher, we have arranged with the administration's witnesses, that they would let us interrupt them so you could give your testimony. I would like to welcome Senator Melcher to the witness table, on the right or left, either one. I would rather have you on the right. Senator Melcher was a former colleague of mine on the House Agriculture Committee, before he came to this body. He knows that I understand his concern about agriculture, but for those of you who don't in the audience, or in the Nation at large, John was, as a member of the House Agriculture Committee, an outstanding spokesman for American agriculture. I have known him to be that as a Member of the U.S. Senate, as well. I would like to ask you to proceed, Senator Melcher. STATEMENT OF HON. JOHN MELCHER, U.S. SENATOR, STATE OF MONTANA Senator MELCHER. Thank you, Mr. Chairman. I am very pleased to have this opportunity to appear before you today and to testify on proposed IRS regulations governing section 482 and 483, of the Tax Code. On August 29 of last year, when IRS published proposed new regulations which would set imputed interest rates on loans between financially related entities at 12 percent, if the stated interest rates are not at least 11 percent, and would set imputed interest rates at 10 percent on deferred payments, in the case of certain other sales of property, if the stated interest rates are below 9 percent. The proposed modifications to these sections of the Code would increase imputed rates in such sales of property 50 percent or more or existing levels. I understand the Department is testifying today and saying that they would modify at least the rate on sales between related parties. But, when these regulations were published, there was an immediate outcry of opposition from farm groups and small business people and those in the real estate and the whole building industry. In a short period, the IRS had received some 2,500 written comments_opposing these regulatory changes, and many hundreds more flooded congressional offices. The opposition has continued to grow, because while these new regulations do not create any significant improvement in tax equity, it would have a distinct negative impact on business and the economy in promoting higher interest rates. Seldom in my experience have I seen such universal opposition to a new set of regulations. This overwhelming expression of opposition to the IRS proposals and the total lack of cooperation from the IRS, which included not even responding to my inquiries for more than 2 months, resulted in my introducing an amendment to the last continuing appropriation bill prohibiting the use of funds to implement the proposed regulations. I only withdrew my amendment after then Assistant Secretary of Tax Policy, Donald Lubick agreed to postpone issuing the final regulations until at least July 1, 1981, in order to give Congress time to review the issue. Early in this session of Congress, legislation was introduced from both Houses of Congress. My bill, with Senator Baucus, or Senators Baucus, Heflin, Jepsen, Luger, Pryor, Symms, Pressler, Andrews, Abnor, Zorinsky, Eagleton, Boschwitz, Kasten, and Cochran, as cosponsors, in the Senate, and the companion bill, by Representative Tom Daschle with two dozen cosponsors in the House. These bills are identical, I believe, and would permanenty kill these proposed regulations. Mr. Chairman, I believe that is what we ought to do, and I think there is sufficient support to pass this legislation. However, the supporters of this legislation have continued to try to work with the new administration to reach a satisfactory solution short of a total ban. Twenty-seven of the legislation's cosponsors wrote to Secretary of the Treasury Regan on March 13, 1981, requesting that Treasury withdraw the proposed regulations and work with Congress to devise new language which would protect against tax avoidance, and yet, not needlessly penalize the great bulk of taxpayers affected by these regulations. Prior to today's testimony, we have had no response. I want to focus my testimony today on two areas. The first deals with specific questions on the regulations, and the underlying code. The second raises a question on what our current tax philosophy ought to be in this area. One of the most often-asked questions about these regulations concerns interfamily transactions. Now, while the Department has modified their initial proposal, it still bothers me that IRS wants to be in the business of telling members of a family just what they ought to do with each other in transfer of property of one type or another, particularly as first proposed. I don't think these cases are necessarily decided on a view that was taken by the joint committee which said that if a parent sold a family farm to child upon retirement, the transaction would not be subject to section 482, because the parent would not be engaged in a trade or business. What about those cases where the parent sells part of a family farm to a child prior to their retirement? Does this mean that section 482 applies, with the result that a family member must pay even a higher interest rate on such a purchase than a total stranger? Well, that problem is being corrected by the Department's new proposal announced today. We see too much interference by IRS regulations. I find it unconscionable. Another area concerns the relationship between the tax treatment of the seller and buyer. The argument is made that higher imputed interest rates really benefit the buyer because he or she will get a larger deduction against taxes for interest payment. It has been pointed out that this isn't exactly accurate. Section 163(d), of the Tax Code, generally limits the deduction for interest on investment indebtedness to $10,000. This limitation has been in the Internal Revenue Code since 1976. If imputed interest rates are increased, thus increasing the interest costs to purchaser, but the limits on deductions of interest are not likewise increased, the seller's taxes because of the higher interest rate are increased, but the purchaser doesn't get the tax advantage of additional deductions. Thus, the Treasury single action of raising imputed interest rates has a double cost effect on taxpayers, representing the creation of its own unnecessary, inflationary effect. This brings us to the question of whether or not taxes are being avoided through the practice of lower than bank rate terms for interest. The assumption in the Finance Committee report, accompanying the addition of section 483 to the code, in 1964, was that "even where property involved is a nondepreciable capital asset, the difference in tax bracket between the seller and buyer may distort the treatment of the payments, and be advantageous from a tax standpoint.' I have already discussed the question of tax equity between seller and buyer. Now, I want to raise the question of how much revenue loss there may be to the Treasury unless imputed interest rates are increased. The seller now pays taxes on the capital gains from the sale, plus taxes on the interest, at least 6 percent under current law, while the purchaser is allowed a deduction on the cost of interest. I do not have the figures on this, but I believe that if the tax committee were to look at the revenue figure, then we would find that in the overwhelming number of transactions that fall under these regulations, the difference in tax bracket between seller and purchaser is not enough to result in significant gains for the Treasury. Mr. Bert Ely, a corporate financial consultant has worked up some figures on a hypothetical case. I would like to enter these into the hearing record at this time. Senator GRASSLEY. Without objection, so ordered. [Appendix to testimony by Bert Ely follows:] APPENDIX TO TESTIMONY BY BERT ELY IMPACT OF CHANGE IN INTEREST "TEST RATE" UPON TOTAL FEDERAL TAX REVENUES, GIVEN CERTAIN ASSUMPTIONS ASSUMPTIONS BASIC PREMISE: SELLER: BUYER: This appendix reflects the price discounting theory set forth in Married taxpayer sells an incorporated business in which he has a cost Pays interest out of the earnings of the acquired company. Since |