I would like to point out that although they are given the same name, preferred stock in a private and a public business serve two different purposes. In a public business, it is used to attract money. In a private business it is used to account for money already committed.

If we adopt the thesis that Treasury needs to be made whole in order to prevent abuse, it doesn't seem to me to make much difference whether we have minimum coverage requirements or not as long as Treasury is going to get its transfer taxes and money isn't leaking out of the system and it is getting a time-the time adjusted value with money, then whether or not the preferred is deemed to be worth 90 or 80 percent of the enterprise becomes somewhat irrelevant and it frees up some complications that occur with an 80 percent minimum coverage rule.

For instance, what happens if I own 90 percent of the preferred stock and my children own 10-excuse me of the common stock and my children own 10 and I exchange all of my common for preferred, have I made a deemed gift to them? Do I have to take 10 percent of the common.

In multi-tiered structures, how do we measure it that well?

I would also think that that, by requiring that a preferred instrument carry a rate of yield on it, that is somewhat constant with inflation and geared to inflation, we can value an instrument coming and going the same way. One of the difficulties, I think in the current proposal, is the fact that it requires you not only to identify instruments that are going to be valued under the so-called QFB rules, but you have to identify the type of transaction in which they occur.

If the stock is moving, interest is moving in one direction, one set of valuation rules apply. If it is moving in another, another set of valuation rules apply. I think that gives rise to a lot of problems. I would prefer a structure, and I think one can be made, where you have parallels throughout.

My last comment is that I don't think that the issue of buy-sells is really appropriately included in this context. That is an issue where the business itself perhaps could be undervalued but not one interest being under or overvalued relatively to another. I think it can be addressed under 2033 or elsewhere.

It is just mucking up the waters in this particular context.
Thank you very much.

[The statement of Mr. Dubin follows:]

Statement of Steven H. Dubin

before the House Ways and Means Committee

regarding estate freeze provisions of the Internal Revenue Code on behalf of National Small Business United April 24, 1990

Mr. Chairman and Members of the Committee:

Good morning. My name is Steven H. Dubin, and I am an estate planning specialist out of Quincy, Massachusetts. I am very pleased to be here this morning to testify on behalf of National Small Business United regarding Subsection 2036 (c) of the Internal Revenue Code. This section of the code has been devastating to the estate plans of many small family-owned businesses. We are, however, very pleased that this Committee has expressed such great interest in putting forth a more workable alternative to the current situation; we believe that we have some helpful comments to that end.

As you may well know, National Small Business United (NSBU) is the oldest association exclusively representing this country's small business community--for over 50 years now. NSBU is a volunteer-driven association of small businesses from across the country, founded from a merger of the National Small Business Association and Small Business United. NSBU serves some 50,000 individual companies with members in each of the 50 states, as well as local, state, and regional associations.

Let me give some examples to illustrate the problems with 2036 (c). Let us say that I own 100% of Corporation X, which is currently valued at $1.0 million. X has one class of stock: common. I give or sell 10% of my shares to my heir. At more or less the same time, I might exchange my retained 90% of the common for a new class of preferred stock, which will have a liquidation/participation ceiling (of $900,000) that will "freeze" its value. Over time, the business appreciates to be worth $2.5 million.

.

If I do not recapitalize, and the business is sold during my life, I will receive $2.25 million ($2.5M * 90%). If I discover that I bet on the wrong heir, it will cost me $250,000 to buy him or her out. And if I die having neither sold the business nor bought out my heir, $2.25 million will be includible in my estate.

If I do recapitalize, and the business is sold during my life, I would only receive $900,000. If I had to buy out my heir, it would cost me $1.6 million! And if I die having neither sold the

business nor bought out my heir, includible in my estate would be: 1) $900,000 pre 2036 (c); 2) something slightly less than $2.25 million under 2036 (c).

Obviously, the recapitalization "freeze" has significant economic consequences during one's life, and it has been my experience that the potential estate tax savings (pre 2036 (c)) was more often than not outweighed by the very real lifetime give-up. And if 2036 (c) was limited in its application only to "estate tax freeze" recapitalizations, I would object to it on these grounds alone. But for 2036 (c) to be anything more than an avoidable pitfall in the path of estate planners, it has to encompass all the possible ways in which the results of an estate tax freeze can be obtained indirectly: through tiered structures, family partnerships, holding trusts, leasing agreements, etc. And like any net spread over so much ocean, it is likely to catch a good many dolphin with the tuna. For instance:

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I have a client who wishes to retire, and is in the process of selling--to a son in the business--his stock; all of it. supplement his retirement income (and ultimately to provide an "equivalent" inheritance to his inactive children) he is retaining the real estate in which the business operates. The son would like to keep the lease payments on the modest side; dad would like them a bit heftier. In the bigger world, this kind of issue is negotiated every day with a participating lease; base terms are modest, but the lesser participates in business sales or profits. In the targeted world of small family businesses, a participating lease falls afoul of the 2036 (c) dragnet (disguised frozen equity?), and my client would run the risk of the entire value of the business, less any consideration from son, being dragged vicariously into his ultimate estate! Actually, until the first round of regulations were issued, we were not even sure any kind of lease was not problematic. And while we are at it, better check to make sure that if son is buying out dad over time, the installment terms fit neatly within the prescribed safe harbor (installment notes having the potential to be disguised frozen equity). And even it we want to compensate dad for periodic consulting services to the corporation, we had better make sure his contract and payments are not for more than three years and are not tied to company performance: consulting/compensation agreements are also a proscribed end-run around the 2036 (c) statute.

Is 2036 (c) fixable? I think not. Even in its simplest / narrowest case, it ignores the economic reality that the sword of bifurcation cuts both ways. When a business owner agrees to freeze his participation in the future appreciation of the business, he limits his benefit if the business is sold, and increases his exposure if he has to buy back a non-frozen interest. 2036 (c) also ignores the contributions that the next generation may make in growing the business, primarily because there is not way to quantify this. In fact, it actually discourages such initiative, |

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at least until "old dad" has passed on and the business can be safely grown without its growth being vicariously taxed in dad's estate at fifty to sixty cents on the dollar!

So it is with great relief that I see Treasury and this Committee re-examining this area and concluding that there is no abuse inherent in transactions which "freeze" value except to the extent of valuation abuse. In the estate freeze context, valuation abuse arises from over-valuing the fixed instrument, thus making it less expensive to sell or give away the growth. One of the simplest ways to do this is to assign to the preferred a noncumulative dividend preference great enough to substantiate its postulated value, then not paying dividends. Not only has the inflated value of the preferred made it less expensive to sell or transfer the common, but the lack of dividends inure to the benefit of the corporation, and specifically the holders of the common, or growth, interests.

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 intra-family transfer purposes is clearly an abuse. But let us consider its implications. By over-valuing the preferred, we are increasing the estate tax exposure of the holder and saving some up front transfer tax costs. Gift and estate tax rates being the same, the loss to Treasury is first one of timing: Treasury taxing value later rather than sooner. For instance, assume the recapitalization of a $1.0 million business. Some "bells and whistles" are hung on the preferred to substantiate a $900,000 value; without those bells and whistles, it would be worth $600,000. The transfer tax value of the common would be $100,000 if the preferred's higher value is recognized; $400,000 otherwise; assuming all transfers were in the 50% marginal bracket, the donor would pay $50,000 in gift taxes in the first case; and $200,000 in case two. However, at the donor's death, the preferred stock would cause $450,000 in estate taxes in the first case, and $300,000 in case two. Total transfer taxes in each case is $500,000. And earlier disposition of the preferred only accelerates the donor's tax consequences.

A reasonable way to counterbalance the timing loss to the fisc is to require the preferred to pay dividends: Treasury picking up in income tax what it might be losing in forgone time value of money, but at what rate? In light of the foregoing analysis, it seems that all Treasury needs to break even is a rate sufficient to provide it with a constant dollar--the inflation rate. In this context, it is worth noting that while given the same name, preferred interests in a private and public business serve two different purposes entirely: one is used to account for money invested, the other is to attract money for investment. If the purpose of a valuation statute to replace 2036 (c) is to assure that Treasury is not taken advantage of, then a yield rate tied to inflation should be satisfactory.

Under the proposal on the table, the non-payment of the stipulated yield will either compound (at ?) to be added into the donor's ultimate estate, or the donor can recognize a gift in the amount of the forgone yield in the year in which it occurs. Presumably, these "phantom" consequences would be adjusted in proportion to the benefit conveyed on the donor's family as opposed to unrelated parties where a business might not be held entirely by one family/family line. This does not seem unreasonable. However, it should be noted that under some circumstances, state law and/or creditor agreements may prohibit dividend distributions. While the current proposal provides a three-year period to make up a missed distribution, it makes no provision for economic hardship. It is suggested that a hardship petition provision be included, similar to the waiver of minimum funding provisions allowed qualified retirement plans. It is also suggested that payments in excess of the stipulated amount made in any year be given carry forward credit; this is just paying the Treasury its time value of money sooner rather than later.

In this spirit, it seems somewhat unnecessary to have minimum coverage rules. The current proposal mandates that the preferred interest cannot at creation consume any more than 80% of the business' valuation. If Treasury receives the same constant dollar value as discussed above, then where is the abuse in maximizing the current value of the business reflected in the preferred? If the argument is that the business will grow faster than inflation and thus by maximizing the amount/value of the preferred for which an inflation adjusted cost is paid, we are illegitimately shifting value. The counter argument is that this arbitrage only means that the business is functioning productively--creating value from opportunity, which as a general policy matter is obviously desirable. Furthermore, the minimum coverage rules present application problems in tiered and related businesses, and in situations where common interests may already be owned by family members. For instance, how should the 80% rule apply where son owns 10% of the common stock when dad exchanges his 90% for a new class of preferred? Must dad continue to retain 10% of the common? If he does not, has he made a vicarious gift of 10% of the business' worth to son? Is it really necessary to have a rule which creates this problem?

I would also submit that the adoption of this single requirement that a preferred instrument provide for an inflation related yield to substantiate value would obviate the difficulties and complexities associated with the dual valuation principles under the proposed law. The proposed law values preferred interests according to yield when such interests are sold or transferred in a tax freeze context, but according to general valuation principles otherwise. This, of course, is necessary so that taxpayers could not turn the law on its end and beat the Treasury by giving away for their mandated zero value, preferred instruments with no fixed yield. But it means that the type of transaction must now be scrutinized, along with the instruments. It also means that adjustments will have to be made when an