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(1) All definitions should be grouped together rather than being scattered throughout the Draft (as are the definitions in 2701(a)(3)(B)); if
cross-reference is desirable, place it where needed, e.g., the Draft does at the end of 2701(a)(4)(B) at the top of page 5. (2) Compare
language used to describe preferential rights in 2701(a)(3)(B)(i) on page 4 of the Draft to the description of "other rights" in 2701(a)(2)(C)(iii) on page 3
The former provision refers to any partnership interest which is not "preferential," and the latter provision refers to "any instrument none of the rights under which have a preference over any rights under the transferred interest." The language in the second provision should be used either in place of "preferential" or as a definition for "preferential." If short reference terms are desired (and they probably would be useful),
the terms "preferred interest" and "nonpreferred interest."
It seems unlikely that the "right" to a specially valued fixed payment
will be transferred separate from the specially valued retained "interest" of which the payment is a part. Section 2701(d) (5) of the Draft reflects the same idea because it provides that the termination of an "interest" (not a right) shall be treated a transfer. Section 2701(d)(1) should read:
If the transferor transfers any specially
Similar changes should be made to 2701(a)(2).
(2) We read 2701(d)(1) and (d)(2) to say that upon the transfer of an interest that includes a QFP as one of its rights, or upon death of
the transferor, the portion of the interest's value attributable to the QFP shall be the greater of (1) the value at the time of transfer or death under a normal valuation approach, or (2) the value at the time of transfer or death based on the special QFP assumptions (payments will be made as provided in the instrument; payments will be made in perpetuity if fixed termination date). Section 2701(a)(1) should be rewritten to say this:
Section 2701(a)(2) should be revised in a similar manner.
(3) We believe it is possible for more than one QFP to exist under a single interest, some of which may have lower value under normal rules than under the special QFP assumptions, and some of which may have a higher value than under the QFP assumptions. The statute should say that the interest shall be valued by combining the value of all of these rights for the purpose of this section
STATEMENT OF ARTHUR S. HOFFMAN, CHAIRMAN, EXECUTIVE
COMMITTEE, TAX DIVISION, AMERICAN INSTITUTE OF CERTI. FIED PUBLIC ACCOUNTANTS, ACCOMPANIED BY WILLIAM T. DISS, CHAIRMAN, ESTATE AND GIFT TAX COMMITTEE
Mr. HOFFMAN. Mr. Chairman, I am Arthur S. Hoffman, chairman of the executive committee of the tax division of the American Institute of Certified Public Accountants.
Joining me is William T. Diss, who chairs our estate and gift tax committee. The tax division has a membership of 25,000 C.P.A.'s. The AICPA is a national organization representing 296,000 C.P.A.'s.
While we enjoy the company of the members of the bar here today, this is not particularly coordinated testimony.
We believe the discussion draft is an excellent basis for beginning a dialog to accomplish two interrelated goals. One is to preserve the integrity of the Federal estate and gift tax system.
The other is to preserve the viability of family owned and closely held businesses which employs millions of Americans and provides goods and services in communities throughout the United States. I said that the two goals are interrelated. We believe that the two goals should not be in conflict.
But, we believe that section 2036(c) does put preservation of family owned businesses in dire jeopardy. We urge you to adopt a substitute which reconciles the two goals.
We believe that the substitute appearing in the discussion draft can be refined to serve the dual purpose.
Section 2036(c) was passed in 1987 and in response to the problem you heard about today. The IRS was not being informed when freeze type transactions took place. And if they were informed, they had difficulty setting values for gift tax purposes of the interest retained versus the interest surrendered.
The counteraction in the form of 2036(c) was the virtual poisoning of the waters on which closely held businesses depend for their intergenerational businesses. If Congress concludes it is desirable for the American economy to permit businesses to continue generation to generation, even though they happen to have earnings and even though they happen to have achieved financial success, the AICPA believes section 2036(c) must be repealed.
As to the replacement of section 2036(c), we share many of the technical concerns expressed by other speakers about proposed chapter 14. The AICPA will submit our technical observations in the near future. The discussion draft is a major step forward. Unlike section 2036(c), it does not ignore the freeze transactions. It does not penalize the founder and his family by forcing the appreciation on his long past surrendered interest into his taxable estate.
The discussion draft still operates out of the fear that the IRS is incapable of valuing interests which are common to business relationships, so long as family members are on both sides of the transaction.
Accordingly, the discussion draft compensates by adopting a rigid valuation structure which may make well-motivated, common business-oriented transactions too expensive for most closely held corporations.
Valuation of the founders retained interest presumably will be based virtually exclusively on the market rate of the fixed cash distributions. This is similar to the standard method of valuing pure debt.
In a case of the typical corporate freeze, the dividend rate on the preferred stock taken by the founder in exchange for his common must be set high.
How high? Presumably as high or higher than the rate on the company's debt. If any lower, the exchange will not be equalized and the transfer will be subject to a gift tax liability. However, dividends, of course, are nondeductible, unlike interest payments.
Consequently, a closely held corporation must earn approximately 50 percent more before Federal income taxes at 34 percent to meet its dividend obligations. If the market rate appropriate to the closely held business is 14 percent, then to cover the dividend it must earn 21 percent, not on the net assets on its books, but rather on its theoretical fair market value. Can a closely held business accept such a future commitment? It happens to be a commitment which bears an uncomfortable resemblance to the burdens in leveraged buyouts financed by junk bonds.
Nevertheless, we consider the discussion draft an approach leading to a solution. The AICPA believes it can be modified so the company can undertake an economically feasible payout commitment without causing the founder to be subject to a prohibitively high gift tax.
Our recommendations: The AICPA is preparing a set of technical observations and what we believe will be constructive recommendations to modify the discussion draft. In addition, we suggest that the following should be considered:
Safe harbor rates for qualified payments so that the market rate applicable to the individual company is not necessarily at issue. Reasonable standards for not making a qualified payment, short of insolvency or bankruptcy. Permitting companies making qualified payments since the sole resemblance debt to adopt S corporation status.
The AICPA believes section 2036(c) should be repealed as soon as possible and the effective date should be December 17, 1987, as described in the discussion draft.
The AICPA also believes the integrity of the transfer tax system should be preserved. Last year this committee adopted civil tax penalty reforms.
It was an excellent bill. It was devised in roundtable discussions with various organizations, the IRS, Treasury, and members and staff of the Oversight Subcommittee.
The discussion draft can be the frame of reference for similar intensive discussions starting immediately after this hearing if you authorize their commencement.
We appreciate the fear of some that immediate repeal of section 2036(c) and a delay would open a window to abusive transactions. We believe the IRS can keep the window closed by prescribing disclosure of the transactions which might have gift tax implications. However, if you consider disclosure inadequate, then we recommend that with repeal of section 2036(c), Congress prescribe that when a replacement is adopted, it will begin to apply on the date you announce your decision.
In conclusion, Mr. Chairman, we appreciate the opportunity to testify and the AICPA would be pleased to participate in further discussions with whomever you designate concerning a practical replacement for section 2036(c).
[The prepared statement of Mr. Hoffman and a supplemental statement received subsequent to the hearing follow:]