discount rate, is used to value the retained interest. The special value computation is not specifically defined in §2701(a)(2)(B). Presumably the par or face value of the retained interest (QFP) is multiplied by a fraction whose numerator is the stated yield and denominator is the test market yield.

In many cases, preferred stock and debt in a closely held business entity are not investment grade. The test market yield or discount factor on such instruments may be very high, perhaps 15-20%, because of the non-predictability of future cash flows, high risk of a small business firm, concerns on management succession, etc. Thus, if the stated yield is 8% and the market yield is 16%, the retained preferred stock will be worth only one-half of its par value. This results in a larger value for the gift of the common stock reportable by the transferor, or a larger price to be paid by the transferee to the transferor, unless a 16% yield is stated. Alternatively if the high required yield is stated, it simply cannot be sustained by the entity, particularly if internally generated capital is required for business operations. We recommend that the lower of the internal rate of return of the entity, or the applicable Federal rate, be deemed to be the market rate used to compute the special value of the retained preferred interest in the entity. IRS published safe harbor market rates based on the principal industry in which the entity is engaged should also be considered.

Many small business firms operate with lower rates of return than publicly held firms because of family tradition and concerns for the community and employees. These firms should not be valued at high market rates, particularly when these rates increased for risk and quality, are higher than the cash flow rate of return for the firms.

Assuming the market rate of return concept is mandated,the transferor should be permitted to rebut the special value of the retained interest, perhaps with a heavy burden of proof, in order to avoid legal issues. In addition, there should be a tolerance rule or range when the market rate factor is redetermined on examination of the transferor's return, in order to avoid significant unexpected gift tax consequences as a result of judgmental disputes on the market rate. Consideration should also be given to making the entire special value system only a safe harbor that can be elected by the transferor.

Definition of OFP

The arbitrary zero value for a non-QFP interest produces a harsh result. A lease providing percentage rentals or license with percentage royalties based on a percentage of the lessee's or franchisee's revenue could be quite valuable and should be reflected in the value of the entity and the junior equity interest in the entity transferred if such payments are required by a binding contract. Similarly, to ignore a right of first refusal or a lease burdening the interest unreasonably exaggerates the value of the interest transferred.

Other interests that might be retained by the transferor include an employment agreement, a non-installment refund annuity and open account debt (even if interest bearing). None of these provides for fixed payments and may not provide a fixed termination date. Each is a valuable non-QFP interest that should reduce the value of the interest transferred in the entity. An exception to Chapter 14 should be provided for interests whose return is based on objective factors such as underlying cumulative cash flow, financial reporting profits or taxable income.

The proposal permits a QFP election for a noncumulative preferred stock dividend or a fixed payment right limited only by income or cash flow of a partnership. This election may not be available where the profits interest changes upon recovery by the holder of his investment in the partnership. This election therefore generally unavailable for partnerships engaged in the development and operation of real estate or conduct of natural resource extraction activities.

The ability to elect into QFP status should be significantly expanded by directing the IRS to issue regulations or rulings that would specify other QFP interests and transactions to include trusts. Section 2701(b)(4) should be expanded to permit a QFP election on the transferor's income tax return where the transfer is by a sale rather than a gift transaction. Provision should also be made for a gift, bequest or recasting during the holder's lifetime or at the holder's death of a non-QFP interest such as a percentage rental lease. QFP elections by parties related to the transferor should not be required.

Definition of Interest

Debt and leases are treated as interests in the entity by §2703(e)(3). Interest in an entity is not otherwise defined. The intent of the proposed statute appears to include any right to receive payments from the entity and not merely equity interests in the entity. If so, the broad reach of the proposal will result in many of the same problems for small business firms as those posed by $2036(c).

We recommend that Chapter 14 be confined to the retention of and transfer of equity interests in business entities and division of investment instruments into senior preferred and junior residual rights. Debt, employment agreement, lease, license and property sale interests in the entity can be monitored by IRS enforcement of the §7872 imputed interest, §1272 original issue discount and an expanded §482 arms-length standard for sale, debt, lease and license transactions.

Clarification is needed as to whether general or limited partnership interests can be treated as instruments of the same class for §2701(a)(2)(C) purposes, e.g., if the transferor retains a general partner interest and transfers a limited partner interest or vice versa, similar to retentions and transfers of voting and nonvoting stock. The IRS should be given authority in rulings and regulations to expand the definition of certain other rights which can be excepted from the operation of Chapter 14, such as limited partner payback and oil and gas carried interest arrangements.

Junior Equity Rule

The minimum valuation rule for junior equity under §2701(a)(3) requires that shareholder debt be included in determining the value of the transferor's interest. For example, with a 50-50 shareholder debt-equity ratio, 40% of the transferor's equity ownership must be left "unfrozen." We believe this rule is unfair for debt which satisfies $385 and constitutes an asset includible in the holder's estate. Will debt owed by the entity to third parties and guaranteed by shareholders or partners be considered debt of the transferor for this rule?

The 20% minimum valuation rule for junior equity should also consider other rights such as the non-QFP interests and first refusal options discussed above. In addition, it is unclear whether dividend arrearages in QFP preferred stock would be treated as senior equity for the junior equity minimum value rule. Finally, it should be clear that a QFP does not lose its status as such because the junior equity minimum rule is no longer satisfied due to a decline in overall value of the entity.

Effective Date

Chapter 14 is an entirely new valuation concept and should be applied only prospectively. We believe the effective date of these new valuation rules should be transactions on or after the date of enactment. At a minimum, transactions before the date definitive legislation is introduced should not be affected by these rules.

Constructive Gifts

A constructive "Dickman" gift results when dividends on QFP preferred stock are not paid, even though there may be valid business reasons for not paying the dividend, and the transferor may have no control over dividend declarations. The insolvency test under state

corporation law (inability to pay maturing debts) may prevent payment of the preferred dividend. Under present law a court may find that no gift had occurred in these circumstances. Section 2701(g) unreasonably expands the "Dickman" gift rule.

The deemed gift exception in §2701(c)(2)(B) where the omitted preferred dividend is compounded often will result in a reverse freeze to the transferor, i.e., the QFP preferred stock or senior partner capital interest will increase in value more rapidly than the common stock or regular partner capital transferred. The compounding could even decrease the value of these junior equity interests. This same result could occur with a QFP election for debt of the entity held by the transferor when unpaid interest is compounded.

The $2701(c) and (d) deemed gift and estate tax increase seem to apply even though the total value of the entity has declined below the stated or special value of the QFP, as increased by omitted QFP arrearages. The deemed annual gifts should cease no later than the time of which the QFP plus arrearages equals the total value of the entity minus the 20% junior equity minimum value. The provision should be expanded to compute the value of the QFP at the date of later transfer or death by reference to the total value of the entity reduced at least by the 20% minimum value of the junior equity.

Provision should also be made in the deemed gift or gross estate inclusion provisions of $2701(d) to reduce the deemed gift or estate increase by the consideration paid by the transferee and/or the actual regular gift or estate tax value of the QFP transferred or held upon death of the QFP holder.

Section 2701(c)(3) provides a Federal gift tax refund if the omitted dividend, which resulted in a deemed gift after the lapse of three years, is thereafter paid by the entity to the QFP holder. Provision should also be made for refund of the direct skip gift tax and restoration of the unified credit and the GST (generation skipping transfer) exemption where applicable, both for the transferor and a spouse consenting under §2513 to split report the gift. Adjustments must also be made for actual payments on non-QFP interests which could not be considered in valuing the junior equity interests in the transferor's gift tax return reporting the initial transfer. Treatment upon death of the holder, for missed QFP payments, should be explained.

The exception contained in §2701(d)(3) for the additional estate tax upon death of the QFP holder prevents a basis step-up when the QFP passes to the holder's surviving spouse and qualifies for the §2056 estate tax marital deduction. Treatment of an QFP transfer as a gift in $2701(d)(1) presumably entails a Federal gift tax basis adjustment under §1015(4). However, the gross estate increase in §2701(d)(2) upon death of the QFP holder, does not appear to permit a rebasing of the QFP under § 1014. Provision should be made for a basis adjustment under the general marital deduction property basis rules.

Section 2701(d)(5) related to termination of an interest may be interpreted to treat the termination of a grantor retained income trust (GRIT) as a transfer. However, the gift valuation rule of §2701(d)(1) does not appear workable inasmuch as a GRIT interest has no value at the time of termination and deemed transfer.

Section 2701(f) excuses the omission of a dividend by a corporation or a guaranteed payment by a partnership to the QFP holder where the entity is insolvent or subject to a Title 11 case. However insolvency for §2701(f)(2)(A) defines insolvency for §108(d)(2) without regard to debt in fact owed by the entity to the transferor. Local corporate law prevents payment of dividends on preferred stock using a definition of insolvency related to ability by the corporation to pay maturing debts or obligations (as compared to the proposed balance sheet definition of insolvency), including debt to family members and omitted QFP arrearages. Additional circumstances should be provided by statute or regulatory authority to excuse the nonpayment of dividends, and the resulting "in effect" taxable gifts, based on business hardship, or legal constraints such as the local corporation laws.

The requirement to pay dividends may aggravate a business decline. If no dividend is paid, the deemed gift tax imposes a further burden on the family. The insolvency exception is too narrow and should be expanded. Finally, the computation of the gift for an "unexcused" missed QFP payment should reflect the proportionate junior equity interest retained by the transferor.

Certain Options

The rules related to certain options, in particular buy-sell agreements, are especially troublesome. The requirement in §2702(b)(2) that the price formula in a buy-sell agreement be reviewed (renegotiated?), in effect at three-year intervals, poses practical difficulties particularly where non-family members are parties to the agreement. Guidance is needed as to what constitutes a review of a buy-sell agreement price formula under § 2702(b)(2)(A).

We oppose the buy-sell agreement governance provisions and recommend they be deleted from the proposal. At a minimum, buy-sell agreements involving non-family members should be excepted from these rules.

Treatment of Trusts

The trust rules should be organized in a separate valuation rule provision. A trust beneficiary should be allowed to elect QFP treatment. In addition, it seems unfair that only a 65-day grace period is allowed for the payment of the annual amount due under a grantor-retained annuity trust (GRAT) or grantor retained unitrust (GRUT), compared to the 3 years grace period to pay the stated preferred stock dividend. Furthermore, coordination with §2036(a) is needed to prevent double counting of the trust property, i.e., inclusion of both the remaining QFP amount under $2033 and corpus under §2036(a), if the transferor dies during the trust term.

Clarification is needed as to whether the §2701(b)(1)(C) life contingency rule applies to a GRIT, both as to whether the QFP may terminate at the grantor's death and whether a reversion in the event of the grantor's death reduces the value of the transferred interest.

Definitions

An ownership attribution rule should be added to $2703(b) to compute the transfer by reference to the interest owned by the transferor in the related corporation, partnership, trust or other entity. The provision treating a donee unrelated to the transferor as a member of the donor's family should be eliminated.

Section 2703(c) mandates treatment of a redemption, capitalization, contribution to capital or other change in the capital structure of the corporation or partnership as a transfer of an interest in the entity except as provided in regulations. "In effect" transfers should be defined by regulations in order to avoid uncertainty as to transfers not described. For example, will a grant by the entity of a stock option be considered the transfer of an interest, i.e., be a change in capital structure for $2703(c)?

Section 2703(d)(2) treats a joint purchase of property (with term and remainder interests) as a transfer by the term interest holder of the remainder interest. The transaction should be treated as the purchase of undivided interests. Will §2703(d)(2) apply to a purchase of property or interest in an entity by parent and child as joint tenants? Will §2703(d)(2) apply to a gift of property or interest in an entity in trust to child for life and remainder to grandchild?

The deemed transfer rule for a joint purchase under §2703(d)(2) should be confined to the purchase of term and remainder interests in specific property and not include a start-up entity or enterprise.

Statute of Limitations

Section 6501(c)(9) tolls the Federal gift tax statute of limitations indefinitely where the transferor considered the transaction to be a sale and therefore did not show the transaction on a gift tax return, i.e., reports the transaction on his income tax return. An indefinite statute of limitations is not good tax policy. Mandated information return reporting of these transactions will promote better tax administration than the penalty of an unlimited period for IRS examination.

The unlimited tolling under §6501(c) of a transaction that was not shown as a gift, applies only to the transfer of the interest in the entity and not to other gifts made for that year. Clarification is needed as to the effect on cumulative taxable gifts on gift tax returns filed for subsequent years and adjusted taxable gifts on the transferor's estate tax return. The Federal gift tax statute of limitations should close when the estate tax statute of limitations close.

Other Matters

Control of the entity is presumed for a 10% owner transferor. The application of Chapter 14 should be confined to a transferor who actually controls the entity, e.g., owns more than 50% of the entity directly and indirectly.

Because Chapter 14 is such a novel statutory valuation concept, other areas of the Internal Revenue Code are affected by the concepts presented therein. We recommend that the legislative history explain that Congress does not intend that QFP senior equity interests be considered debt for $385 purposes. In general, S Corporations are only allowed to issue one class of stock. With the creation of QFPs as a specific interest with preferred valuation status for gift tax purposes, we believe that §1361 should be amended to permit an S Corporation to issue a QFP without violation of its S Corporation status.

STUDY PROPOSAL

A collegial effort involving the Treasury, IRS, Congressional staff, professional organizations and business groups should study the transfer tax system (1) to facilitate the intergenerational transfer of interests in operating business and farm entities, and (2) to prevent abusive freeze transactions. The project would resemble the group efforts that resulted in the 1980 Installment Sale Revision Act, the 1982 Subchapter S Revision Act and the 1989 Improved Penalty Administration Compliance Tax Act (subtitle G of the 1989 Revenue Reconciliation Act). We believe the product of this study will command general respect by the taxpaying public and their professional advisers, thereby strengthening the transfer tax system and aiding IRS enforcement efforts.

Measures to encourage lifetime transfers of business interests that should be considered include, but are not limited to the following:

1.

2.

A safe harbor freeze when the retained interest is preferred stock with a stated cumulative dividend yield at least equal to the after Federal income tax (income tax effected) long-term AFR (applicable federal rate). The income tax effect should reflect both Federal and state levies. For example, if the long-term AFR is 10% and the combined marginal Federal, state and local income tax rates are 40%, the safe harbor preferred yield would be 6%.

A safe harbor preferred freeze, using the internal rate of return or the $483 intra-family real estate sale interest rate, as the required return on the retained equity interest in the entity or enterprise.