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IV. THE CONTROVERSY OVER DEFINING ABUSIVE VALUATIONS
IN A CLOSELY-HELD BUSINESS 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. Valuation lies at the heart of the estate and gift tax system since taxes are calculated based on these valuations. These questions of valuation are rendered even more complex when posed in the context of a closely-held business, for although IRS regulations specify factors to be used in determining value, value can seldom be ascertained on a mechanical basis. 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-hold businesses, however, valuations cannot be ascertained on a purely mechanical basis. Questions of value and the variety of rights which might be associated with a closely-held business caused the IRS to assert that there was a need to prohibit estate freezes. This view did not prevail in the courts. So, the IRS proposed Section 2036(c) to prohibit passing between generations any asset which might appreciate over time, no matter which other attributes of ownership might have passed between family members. As a result, wholesaler-distributors and other business owners are now blocked from attempting to fashion a plan for ensuring the orderly perpetuation of their businesses. The obstacles presented by current law are prohibitive whether the need is to plan for an orderly transfer of the business between generations or for a plan which provides for continuity of the business in the face of an untimely or accidental death.
Last month, this Committee issued a discussion draft which would repeal Section 2036(c) and replace it with new statutory language. We commend the Committee for the spirit in which this draft was introduced and are committed to a cooperative effort to produce an acceptable replacement statute for Section 2036(c). A statutory replacement for Section 2036(c) is realistic and desirable provided that it is carefully targeted to the primary abuses which 2036(c) initially sought to address. Any proposal to replace 2036(c) should, however, be limited in scope. It should focus only on preventing abusive valuations and preventing the owner of a closely-held business from passing on substantially appreciated assets without taxation. It should also permit a business owner to craft a plan which is fair and representative of the facts in each individual situation. Such an approach must recognize the unique nature of a closely-held business which can be subject to variations in profits and income over a number of years. It must also provide for certainty in the process. While NAW believes the proposed draft is an extremely positive first step in the process of reforming current law, we would like to state our concerns and offer our suggestions for improvements. I am sure that this Committee would like to see the best law possible enacted so that we can all have the current situation well behind us. These suggestions are offered in that spirit.
VI. DISCRETIONARY RIGHTS
First of all, the proposed limitations on various discretionary rights seem far too severe. There are circumstances in which a discretionary right is critical, even if it is never exercised. Rights to purchase common stock or to share in the future appreciation of the company with a conversion right has a determinable value which should be recognized. We suggest that the Committee more broadly review those rights and specifically list those which are considered abusive. Clearly abusive rights should be distinguished from those rights which have a value which can be independently verified.
The rules should also be internally consistent and if a value of zero is ascribed for gift tax purposes, it should also follow that the same value should result for estate tax purposes at death. The rule should not place the IRS in such a position that it can arbitrarily disregard or include those rights when it is in their interest to do so. This potential inconsistency creates vast future uncertainties, making perpetuation planning impossible.
VII. INDEBTEDNESS CONSIDERATION
Secondly, we suggest that consideration of indebtedness be eliminated from the 80-20 calculation. Including indebtedness in this equation can cause problems because debt to deferred compensation plans, retirement plans or other qualified debt-- all of which may have a perfectly valid business purpose--would have to be factored into this equation. This particular rule opens the door for the IRS to consider issues of compensation and control, which are very complex issues. The 20% rule itself is curious for it seems to allow for the combination of preferred and common stock to have a value below that of the original equity. In our view, it places too great a reliance on increasing the value of the common stock while reducing the value of the preferred stock. If the other valuation principles are sound, we question the appropriateness of this safe harbor approach.
VIII. DETERMINATION OF RATE
Thirdly, the value of the preferred stock is also impacted by the dividend rate which the parents will receive. The chosen rate must be compared to the market rate at the time of the recapitalization, and if it is below market, the value of the preferred stock must be reduced by a percentage based upon a relationship of the actual rate to market rates. This can have the effect of increasing the value of the common stock and increasing the gift tax due at the time of the recapitalization. The definition of market rate for a security of a closely-held business should not result in a rate so high that the gift tax liability from a recapitalization would exceed the actual income tax liability from an outright sale. Clearly, dividend rates far below market are a transparent attempt to shift value. However, requiring a rate far above market rates is equally unfair. The fact is that requiring a rate which is too high discriminates between the business owner whose assets are tied up in his business over the business owner who is wealthier and can simply transfer cash to his children. The uncertainty is compounded by the potential zealousness of the IRS agent who may review the whole transaction ten or fifteen years after the fact. It is critical that there be some clear guidelines in the proposal on defining market rate, or, in the absence of such guidance, a consideration that the market rate be limited in some manner, similar to what has been done in the imputed interest rules.
IX. OTHER ISSUES
Additionally, the dividend payment rule requires that upon failure to pay the dividend by the third year, such debt be considered a gift and that a gift tax be due. There is no exception for hardships except for bankruptcy or liquidation. A closely-held business can find that due to changing markets or simply increased interest rates on debt that payment of a dividend is not simply a hardship, but could place the entire business at risk. Violations of loan agreements could occur and the good will of suppliers could potentially be put in danger under these circumstances. A hardship rule is necessary and important to allow a deferral of time for the dividend to be paid without triggering the gift tax and to allow the business to work out its difficulties. The Tax Code already makes such provisions available under the Earnings and Profits Test which a company must make prior to paying a regular dividend. Of equal concern to the wholesale-distribution industry are: the additional complexities and compliance costs relating to the proposed rules on Buy-Sell Agreements outside of a recapitalization; complex elections which might be missed and need to be simplified; the requirement for mutual consent of all family members to the deemed gift rule; extension of the statute of limitations from three to six years; and, the absence of a specific list of requirements for which the statute of limitations is lifted.
In conclusion, Mr. Chairman, 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 a 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.
National Wholesaler Distributor Organizations Affiliated with the National Association of Wholesaler-Distributors
Air-conditioning & Refrigeration Wholesalers Association
Bearing Specialists Association
Ceramic Tile Distributor Association
National Kitchen & Bath Association
Electrical Electronics Material Distributors Association
Farm Equipenent Wholesalers Association
General Merchandise Distributors Council Graphic Arts Suppliers Association
Health Industry Distributors Association Hobby Industry Association of America
Independent Laboratory Distributors Association
Machinery Dealers National Association
National Appliance Parts Suppliers Association
National Association of Wholesaler Distributors
National Association of Tobacco Distributors
Optical Laboratories Association
Pet Industry Distributors Association
Safety Equipment Distributors Association, Inc.
Textile Care Allied Trades Association
United Products Formulators & Distributors Association
Video Software Dealers Association
Wallcovering Distributors Association
Leisure and Mobile Products, Inc.
4/23/90 116 Member National Associations
Chairman ROSTENKOWSKI. Mr. Dubin.
STATEMENT OF STEVEN H. DUBIN, PRINCIPAL, WILLIAM &
DUBIN, INC., QUINCY, MA, REPRESENTING NATIONAL SMALL
I am a principal in a small business firm in Quincy, MA, which specializes in business continuity and estate planning or what I would call bread and butter family businesses.
As I tried to illustrate in my written testimony, for my clients, 2036(c) is a nightmare. Normal intrafamily business transactions have to be put under the tax microscope for detection of inadvertently created prescribed business interests.
It is with a great deal of relief that I see the focus in this area shifting from the inappropriate extension of the principles of section 2036 (a) and (b) in business dealings to correcting credible evaluation abuses. I support and we support the spirit of this draft legislation.
I wonder whether or not that spirit could be embodied in a some what similar form. I would like to commend the draft proposal I had chance to review from David Barnett of the U.S. Chamber which I think is a continuation of distillation of the spirit.
We agree with, I think, all the previous speakers that the use of meretricious rights features to artificially inflate the value of a preferred interest so that the common growth interest can be undervalued for interfamily transfer purposes is an abuse.
I would like to take a look at the implications and suggest the abuse is principally one of timing.
The estate and gift tax are a unified structure. If I divide a business into two interests, common and preferred, if I overvalue the preferred, that will be caught in my estate at its overvalued price.
What I am doing is not paying a gift tax perhaps on the undervalued common up front. The example I give in my papers to take a business worth $1 million to create a preferred stock I claim to be worth $900,000 and give away the common for $100,000, assuming a 50 percent transfer tax cost, I am paying $50,000 up front to give away the common and I am leaving $900,000 in my estate for a $450,000 bill, and there is a half million of total taxes.
If, for instance, I had overvalued the preferred and was only worth $600,000, I would have paid $200,000 in gift taxes on transferring the common and $300,000 in retained estate taxes for the same 500. The difference is when Treasury gets the money.
If that is the case, to make Treasury even as it were, what I suggest is that dividends that approximate the rate of inflation be appropriate. That is going to get its money as it goes along by getting a common start dollar whether it got it up front or whether it gets it later, it gets a constant dollar.
The general principle of the draft legislation which would either be to subject missing dividends to a current gift tax or to include them later on in a compound basis makes sense.
I am just suggesting that the measure of compounding and also the measure what the dividend should be geared to the inflation rate and Treasury as a whole.