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Chairman ROSTENKOWSKI. Thank you, gentlemen and ladies for joining us this morning. We look forward to receiving your testimony.

Mr. Carlson, you be the leadoff witness.

You all understand what the rules are. We would like, if your statement is longer than 5 minutes, to have it summarized.

STATEMENT OF DONALD W. CARLSON, CHAIRMAN OF THE

BOARD, NATIONAL ASSOCIATION OF WHOLESALER-DISTRIBUTORS, AND PRESIDENT AND CHIEF EXECUTIVE OFFICER, CARLSON SYSTEMS, INC., OMAHA, NE

Mr. CARLSON. My name is Donald W. Carlson. I am president of Carlson Systems, a family-owned business. We are headquartered in Omaha, NE, and operate 33 warehouse and service centers in major cities west of the Mississippi.

I am also chairman of the board of the National Association of Wholesaler-Distributors (NAW) and it is in that capacity that I appear today.

NAW commends you, Mr. Chairman, and the entire committee for holding this hearing and for the time and interest you have given to the very critical issue of estate freezes. I would also like to commend Mr. Archer for his very early efforts to resolve the enormous problems which have been created by section 2036(c).

Mr. Chairman, last fall you visited with NAW's board of directors and acknowledged at that time that a problem existed with this section of the code and indicated that you intended to work with us and others to resolve this difficult issue.

As always, you were true to your word and I would like to express my personal appreciation for your efforts. We look forward to working with you and Mr. Archer, and the other members of the committee, along with the committee staff, to reach a resolution that will be mutually acceptable.

NAW is a federation of 116 national wholesale distribution trade associations, 57 State and regional trade associations and 2,000 individual wholesale distribution firms. All told, NAW represents approximately 40,000 companies with 150,000 places of business.

The wholesale-distribution industry is typified by small, closely held companies. Well over 90 percent of wholesale-distribution firms are privately held. The average size firm represented by NAW has approximately $5 million in sales and employs 30 individuals.

The distribution industry experienced a rapid growth in business starts just after World War II. The entrepreneurs who started these companies or took over the reins of family-run businesses are now at retirement age. For most of them, passing on the family business to future generations has been a lifelong goal. Unfortunately, however, section 2036(c) is a profoundly significant barrier to keeping a business in the family.

Last month, this committee issued a discussion draft which would indeed repeal current law-which delights all of us—and replace it with new statutory language. We commend the committee for its action and we are committed to a cooperative effort to produce an acceptable replacement statute.

NAW believes the proposed draft is an extremely positive first step in this process. We believe modifications are necessary, however, and my written statement which I will submit for the hearing record elaborates on our concerns with the discussion draft

What I would like to do is to give you some personal thoughts from the perspective of a businessman from Omaha.

At the heart of the controversy over estate freezes are the rules by which individual assets of a business, individual rights of a stockholder to receive future income from the business, and the rights to future appreciation of the business are valued.

Valuations for publicly held companies are relatively easy to calculate because the future income of a publicly held company is generally not dependent on any one business, fashion, trend, geographic area, or person. And the value of their stock is set in a public market and can be easily found in the newspaper.

For closely held businesses, however, valuations cannot be made on a purely mechanical basis. Closely held businesses are like fingerprints, they are all different.

Let me make a few points about just one of them-our company. Our company is a third generation enterprise which started in 1947 and the third generation is actively at work in it. My brother, my nephews, my son-in-law, my son and I all work in the business. The basic imperative in operating a privately held business like ours is that in order to survive, our company must grow.

Companies in my industry, like most others, which do not grow do not stay in business over the long term.

Growth requires continuous reinvestment of profits and reliable sources of capital. Unlike publicly traded corporations, most privately held companies do not have ready access to long-term financing. We have ongoing commitments to lenders in order to keep our company viable.

Despite what may be perceived by some, the typical closely-held business person is not a "fat cat."

Substantial profits do not necessarily translate into excess cash. A company may be highly profitable, but lack sufficient cash for daily operations. On the other hand, a company with excess cash could be in that position because it is selling off assets and inventory and may be in a negative profit mode.

That being said, one concern I have regarding the discussion draft is its requirement to pay a regular dividend over an indeterminate amount of time. Cash required for business operations would have to be diverted to pay dividends.

Therefore, loan agreements, supplier agreements and asset needs of the business could potentially be jeopardized.

Another concern with the discussion draft is the dividend rate used to value the preferred stock. In our case, it would be impossible to look into a crystal ball and predict our future earnings and ability to pay a specific dividend indefinitely.

A third concern with the draft is its failure to distinguish between abusive valuations and the needs of a business like ours to have a mechanism for the legitimate transfer of ownership between generations.

Mr. Chairman, above all, we need certainty about our obligations, and we need a statute responsive to the needs of our market

place. It is essential that the replacement statute be crafted carefully, so that the proverbial baby will not be thrown out with the bath water.

In conclusion, I would like to again commend you for the way you and your staff have worked with those of us most affected by 2036(c), and hope that our concerns will be addressed as final product emerges from our cooperative effort.

We look forward to working with you as this process progresses, and thank you again for giving us the opportunity to testify before you today.

[The statement of Mr. Carlson follows:]

STATEMENT OF

DONALD W. CARLSON
CHAIRMAN OF THE BOARD
NATIONAL ASSOCIATION OF
WHOLESALER-DISTRIBUTORS

BEFORE THE

COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES

ON

2036(c) ESTATE FREEZE

pril 24, 1990

I. INTRODUCTION

My name is Donald W. Carlson. I am President of Carlson Systems, a family-owned business. We are a distributor of fastening products, packaging products and equipment for manufacturing and shipping use and materials handling equipment. Our company is also a major designer and manufacturer of machines for the manufactured housing, window and door industries. Carlson Systems is headquartered in Omaha, Nebraska, and operates 33 warehouse and service centers in major cities west of the Mississippi. I am also Chairman of the Board of the National Association of Wholesaler-Distributors (NAW) and it is in that capacity that I appear today. NAW commends you, Mr. Chairman, and the entire Committee for holding this hearing and for the time and interest you have given to the very critical issue of estate freezes. I would also like to commend Mr. Archer for his very early efforts to resolve the enormous problems which have been created by Section 2036(c). Mr. Chairman, last Fall you visited with NAW's Board of Directors and acknowledged at that time that a problem existed with this section of the Code and indicated that you intended to work with us and others to resolve this difficult issue. As always, you were true to your word and I would like to express my personal appreciation for your efforts. We look forward to working with you and Mr. Archer, and the other members of the committee, along with Committee staff, to reach a resolution that will be mutually acceptable.

II.

THE NATIONAL ASSOCIATION OF WHOLESALER-
DISTRIBUTORS AND THE WHOLESALE DISTRIBUTION
INDUSTRY

NAW is a federation of 116 national wholesale distribution trade associations (a list is attached as Appendix A), 57 state and regional trade associations and 2,000 individual wholesale distribution firms. All told, NAW represents approximately 40,000 companies with 150,000 places of business. These firms range in size from those with less than $1 million in annual sales to those with over $13 billion.

The wholesale-distribution industry is typified by small, closely-held companies. NAW'S Distribution Research and Education Foundation estimates that well over ninety percent of wholesale-distribution firms are privately held, most of which are managed by the principal owner. The average size firm represented by NAW has approximately $5 million in sales and employs 30 individuals.

The distribution industry experienced a rapid growth in business starts just after World War II. The entrepreneurs who started these new companies or took over the reins of familyrun businesses are now at retirement age. They are now in the process of developing plans to turn their companies over to their sons and daughters. For most of them, passing on the family businesses to future generations has been a lifelong goal. Unfortunately, however, Section 2036(c) is a profoundly significant barrier to keeping a business in the family. Studies of our industry point to a steady trend away from closely-held private corporations to more publicly and foreign-owned entities due to changing market forces and economies of scale. Quite frankly, section 2036(c) encourages a business owner to sell his or her company to an outside buyer rather than to pass it on to a family member. Additionally, Section 2036(c) causes discrimination between business owners who can simply lend cash to their children to finance the purchase of a business over a business owner whose cash is tied up in the business. As one wholesaler-distributor succinctly stated in a letter to her Congressman:

"Successful businesses such as ours are regularly solicited for purchase by
Fortune 500 companies. It seems inevitable to me with the lucrative offers
being made and the estate taxes that will have to be paid under the current
laws, that the small family-held businesses will eventually be eliminated. I
am sure that this is not the intent of Congress, but (estate) tax laws
combined with aggressive larger corporations will surely lead to this end."

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The Revenue Act of 1987, P.L.100-203, signed into law on December 22, 1987, added, virtually unnoticed and without public comment, Section 2036(c) to the Internal Revenue Code.

The term "valuation freeze" or "estate freeze" refers to a technique commonly used by owners of closely-held business to, for instance, give non-voting stock to children who are active in the business or to minor grandchildren who have not yet demonstrated the maturity to be involved in business decisions. Through this technique, the entire family benefits from the success of the business, but control of the business rests in the hands of those active in it.

Congress took the view in the Revenue Act of 1987 that "estate freezes" were being
abused. The only official description of the "abuse" that Congress was seeking to curb
with Section 2036(c) was contained in the House Ways and Means Committee report
accompanying House version of the 1987 Act. The description focuses almost exclusively
on recapitalizations or restructurings of business entities into "preferred" and "common"
interests followed by gifts of the common interest. According to the House report, this
technique:

"permits appreciation in the value of the corporate asset to pass between
generations without being subject to gift or estate taxes, even though the
voting and dividend rights of the preferred stock...give the owners

beneficial enjoyment of the entire corporation..." It was therefore concluded that a change in the law was necessary because "keeping a preferred stock interest in any enterprise while giving away the common stock resembles a retained life estate, and should be treated as such."

Despite the apparent clarity of the legislative purpose, the imprecision of the language in Section 2036(c) makes it susceptible to an extremely broad interpretation under which few family transactions or transactions involving family business entities are clearly outside its reach.

The most onerous result of 2036(c) is that any increase in value attributable to the assets transferred to the heirs through the typical estate freeze will revert to the parent's estate upon death, resulting in punitive taxation, even if it was through the efforts of the heirs that the value increased.

While the Technical Corrections Act of 1988 made certain clarifications to Section 2036(c) and the IRS has issued regulations, they are as ambiguous and imprecise as the original provision itself and, in fact, may have expanded both the reach of the provision and the severity of its penalties.

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