Statement of Arthur S. Hoffman, Chairman of the Federal Taxation Executive INTRODUCTION Mr. Chairman, I am Arthur S. Hoffman, Chairman of the Executive Committee of the Tax Division of the American Institute of CPAs (AICPA). Joining me is William T. Diss, who chairs our Estate and Gift Tax Committee. The Tax Division has a membership of 25,000; and the AICPA is the national organization representing 296,000 CPAs. Mr. Chairman, you have commented that since the provisions of section 2036 (c) were enacted, "concern has been expressed about their complexity and breadth." The AICPA shares that concern, and we congratulate you for the release of the "Discussion Draft," and for holding these hearings to begin an "informed discussion," as you phrased it, "about possible modifications to section 2036 (c)." We believe that the modifications proposed are an excellent basis for beginning a dialogue 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 or closely-held businesses, which employ millions of Americans and provide 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. And 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. You have heard from others that there are many technical concerns both with section 2036 (c), and its proposed replacement. The AICPA shares many of those concerns. But, today I want to speak in a very non-technical vein about the two, and make several suggestions. SECTION 2036(C) the Section 2036(c) was passed in 1987 in response to a problem: Internal Revenue Service 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 counter-action, in the form of section 2036 (c), was a virtual poisoning of the waters on which closely-held businesses depend for their intergenerational existence. The passage of section 2036 (c) produced a delayed reaction. after its passage did tax practitioners come to realize how broadly it could be interpreted, and how vague it is. Only To illustrate, tax advisers usually discuss with their clients the economics and tax results of standard business matters: compensation, leases, stock ownership, formation of new businesses, retirement, insurance coverage, and indeed "freezes." However, after tax advisers examined section 2036(c), and discovered a shocking absence of functional limits, conversations with clients went like this: "I have told you what I do know about the Then the client says: "When will you know? The tax adviser responds: In a month? In a "We may not know until about 3 years after After the client expresses a few obscenities, he may ask: "What will be the tax cost, if the IRS The tax adviser then responds: "Oh, about 60 percent of the value of the with that, the client's reaction too often is: "My kids can't handle a tax payment of 60 Some say that taking 60 percent of the wealth of a successful business owner is a desirable thing to do in our society and that a "freeze" thwarts this objective. The AICPA takes no position on such questions. However, as tax and business advisers to all types and sizes of businesses, we can tell this Committee that we foresee that the consequence of section 2036 (c) is a relentless pattern of sales and liquidations of family-owned businesses. If Congress does conclude that it is desirable for the American economy to permit business to continue generation-to-generation, even though they have achieved financial success, then the AICPA believes that section 2036 (c) must be repealed. REPLACEMENT OF SECTION 2036(C) I have said that we share some of the concerns expressed by other speakers about proposed Chapter 14 as it appears in the "Discussion Draft." The AICPA will submit our technical observations in the near future. The AICPA recommends that Congress consider whether any proposal to replace section 2036 (c) serves the two goals I mentioned earlier: preserving the integrity of the Federal estate and gift tax system, while simultaneously permitting successful closelyheld businesses, as a practical economic matter, to maintain their existence. The "Discussion Draft" is a major step forward. Unlike section 2036(c), it does not ignore the "freeze" transaction. It does not penalize the founder and his family by forcing the appreciation on his long-past surrendered interest into his taxable estate. We believe that is a very positive shift in tax policy. But, 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 businesses. The valuation of the founder's retained interest presumably would be based virtually exclusively on the market rate of the fixed cash distributions. This is similar to the standard method of valuing pure debt. So, in the case of the typical corporate "freeze," the dividend rate for his common must be set high. high? Presumably, as high as the rate on the company's debt. any lower, the exchange will not be equalized, and the transferor will be subject to a gift tax liability. How However, dividends, of course, are non-deductible, 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 obligation. For example, 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. We are concerned that the results will be similar; that companies will fail to generate sufficient income to cover their obligations and to grow. In that connection, the company involved in a transaction covered by the "Discussion Draft" must pay dividends until it falls into insolvency or bankruptcy. If it does not pay to that point, the founder will be deemed to have made an annual constructive gift. What commercial lender would finance the working capital needs of a business that had such fixed pay-out obligations? Nonetheless, we consider the "Discussion Draft" an approach leading to a solution. The AICPA believes that it can be modified so that the company can undertake an economically feasible pay-out commitment without causing the founder to be subject to a prohibitively high gift tax. 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 Permitting companies making qualified payments to adopt s corporation status. This Committee has two propositions before you, now in the form of the "Discussion Draft." The first, repeal of the section 2036 (c); and the second, a replacement prescribing a regimen for valuing what owners receive and surrender. The AICPA believes strongly that section 2036 (c) should be repealed as soon as possible, and the effective date should be December 17, 1987, as prescribed in the "Discussion Draft. " The AICPA also believes, as you have stated, Mr. Chairman, that the integrity of the transfer tax system should be preserved. Last year, this Committee adopted Civil Tax Penalty Reform. 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 believe they can result in a bill which satisfies your concern that there should not be abusive avoidance of transfer taxes, but also does not imperil the survival of closely-held businesses which are a major contributor to the health and diversity of the American economy. We appreciate the fear of some that immediate repeal of section 2036 (c), and a delay while the form of replacement is being debated would open a window to abusive transactions. We believe that 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 the replacement is adopted it will begin to apply on the date you announce your decision. CONCLUSION Mr. Chairman, we appreciate the opportunity to testify. The AICPA would be pleased to participate in further discussions with whomever you designate concerning a practical replacement for section 2036 (c). SUPPLEMENTAL STATEMENT OF THE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS EXECUTIVE SUMMARY The American Institute of CPA's (AICPA) Tax Division supports repeal of §2036(c) of the Internal Revenue Code (IRC) and submits comments on and suggested modifications to the proposed Chapter 14 substitute. These comments and modifications deal with both policy and technical aspects of the proposed rules. In addition, while we are not economists and do not address how revenue estimates should be made, as tax practitioners working with income, gift and estate taxes for many clients, we have included some factors which should be considered when revenue estimates are developed for this proposal. Finally, we conclude with a recommendation for a study leading to a more complete legislative solution which both facilitates the intergenerational transfer of operating businesses and farm enterprises and prevents abusive freeze transactions. $2036(c) REPEAL In general, $2036(c) captures the value at death in the transferor's estate of an equity interest in an enterprise which was transferred after December 17, 1987 by a post-December 31, 1987 decedent. This capture rule subjects to estate tax the appreciation in the transferred equity interest which accrues between the original date of transfer, to the date of death, or deemed gift. The deemed gift provision subjects the appreciation in the transferred equity interest to a "gift tax" computed as if the transferor died on the date of the deemed gift transaction. These deemed gift transactions include (1) a gift or sale by the transferor of an interest or interests retained in the original transfer, (2) retransfer by the transferee of the equity interest outside the transferor's family and (3) liquidation of the equity interest by the transferee. The capture rule of §2036(c)(1) reaches transfers which are irrevocable and complete, apparently based on the proposition that an interest in an enterprise cannot be divided among family members. We believe this capture rule, and especially the deemed gift rule of $2036(c)(4), may pose a legal issue as to the limit of Congressional power. Assuming no legal issue arises, we believe that IRC §2036(c) operates unfairly where the talent and efforts of the transferee, as well as inflation, have caused the increase in value of the transferred equity interest between the date of original gift or sale to the transferee and the date of the transferor's death or deemed gift transaction. This is especially burdensome where the transferor's estate, or the transferor during his lifetime, has insufficient resources to pay the tax on this appreciation. In these circumstances the transferee must pay estate tax or gift tax on the product of his own talents and efforts. For these reasons, as well as complexity of the provisions, uncertainties of application, and difficulties in enforcement by the IRS and compliance by taxpayers, we believe that § 2036(c) should be repealed retroactively. Transfer taxes on appreciation of property no longer owned are far too onerous a burden for this country's small businesses to bear. SUGGESTED MODIFICATIONS TO PROPOSED CHAPTER 14 Computation of Special Valuation Section 2701(a)(2) prescribes "special value" rules for the senior or preferred interest described as a qualified fixed payment (QFP) in a business entity retained when the junior or residual interest is transferred by gift (or sale). A discount factor, presumably a market |