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Proposed Chapter 14
with new code Sections 2701, 2702 and 2703 is not good start toward simplification. What is being suggested is 25 pages of new, complex statutory provisions to replace the four burdensome pages of 2036(C).
We urge that family businesses and farms be totally excluded from a person's gross and taxable estate. Families should be encouraged to keep and
expand their businesses and farms.
ections 701, 2702 and 2703 must have been drafted by the
same team that did 2032 (A) in 1976. You may recall that Congress had a wonderful idea
let family farms be taxed as farms. This simple concept was unfortunately converted to 11
pages of statutory complexity. Many pages of regulations have only explained some of the questions. By latest count:
there have been 80 court decisions deciding 2032(a) issues: Sections
provide a wonderful bonanza for tax lawyers to litigate.
The number of abusive situations in the estate-freeze area were quite small, probably no more than
percent. Instead of 2036(C) or new Chapter 14, the IRS should be left to correct any abusive
situations through audit. Virtually every estate-freeze transaction can be identified from either the review of gift tax estate tax returns. Every estate tax return filed is currently reviewed.
If the IRS needed better reporting, it would simple to substitute for 2036 (c)
and proposed Chapter 14 the filing of a gift tax return together with а qualified appraisal of any interest transferred in
an estate freeze. This simple approach was used to reduce valuation concerns regarding gifts to charities.
Is it not more consistent with our system of free enterprise and entreprenurial spirit to encourage family owned business and farms to grow, be productive and stay within the family? The goal of 2036 (C) and Sections 2701, 2702 and 2703 is to force the most successful family businesses and farms to be sold or liquidated to the very burdensome 55 percent gift and estate taxes.
Following are a few examples of the adverse effect Section 2036(c) and proposed Sections 2701, 2702 and 2703 have and will have on family businesses and farms.
In 1950 Husband formed a successful partnership with Wife. Through the years they made gifts of their general partnership interest having a value equal
the gift tax annual exclusion to their son. In 1988 when Husband retired, he still retained a majority interest in the partnership. However, upon Husband's retirement Husband and wife exchanged for full value all
of their general partnership interest for a limited partnership interest. They maintained certain preferred rights including right to the profits of the partnership interest but only until Husband and Wife had received amount equal to 10% of the beginning capital account of their preferred limited partnership interest. This preferred income right was cumulative and gave Husband and wife the right to call upon future profits to compensate in the event of under payment. Upon liquidation Husband and Wife were entitled
amount equal to their beginning capital account. Other than the income and liquidation rights of Husband and Wife, Son's
general partnership interest is entitled to all profits and any assets from liquidation. By its terms, the partnership will terminate in 1995.
Results under Section 2036(C):
Upon termination of the partnership, a gift tax will be triggered under Section 2036(C). The full value of the enterprise will be considered a gift by Husband and Wife at that time. Husband and wife will receive consideration offsets for portions of the enterprise owned by Son before the gift or still owned by Husband and wife on the valuation date. Section 2036(C) will force a gift tax to be paid even though the original exchange was for full value and though the return paid to the Husand and Wife by means of the preferred limited partnerhsip interest exceeds the growth of the enterprise.
this situation Section 2036(C) may put unexpected burdens on the partnership exchange leaving Husband and Wife without liquid funds with which to pay the gift tax.
Results under Sections 2701-2703:
Without some additional guidelines it is difficult to answer exactly how the retained interest would be valued in this example. The result would depend on whether
the Husband and Wife's limited partnership
interest could be defined as a Qualified Fixed Payment (QFP). The income interest would only be qualified if fixed as to amount and time for payment. Under 2701(b)(1)(A) (i), the interest could not be tied to a percentage of corporation profits. Under 2701(b)(1)(A)(ii), the payment rate could be variable but only if tied to a fixed market interest rate. The liquidation rights would probably not meet the requirements of
a QFP therefore, this value would be zero.
In addition to the importance of a
fixed amount, the income interest needs to have set termination date or a provision to
pay in perpetuity. The existence of a life contingency disqualifies the payment as
QFP under Section 2701(b)(1)(c). In Example One the agreement provided for payment until the Husband and Wife received 10% of their beginning capital account. Arguably, this is a fixed termination provided for in the agreement. Regulations will probably be needed to more clearly define these termination requirements.
Father owned majority of the voting common stock of a closely held business which he and his family had owned and operated for a number of years.
Father's business was successful and he found himself needing more employees. Father hired twenty new employees and as an incentive program offered each new employee an equity ownership in the enterprise through a stock option program. None of the employees were family members except Father's daughter. Through the stock option plan, Daughter acquired 10% ownership interest in the corporation
the time of Father's later retirement. Under Father's retirement plan his stock was redeemed for a note that matures in 2004. In addition, he is entitled to recieve benefits under a salary continuation plan even though he is no longer performing services for the corporation. The debt is never reduced and father dies in 1990.
Results under Section 2036 (C):
Section 2036(c) will cause
the enterprise to be included in Father's gross
estate. Father indirectly conveyed part of his interest in the enterprise to Daughter when the corporation redeemed his stock under his retirement plan. Daughter had
а greater interest in the potential appreciation after the redemption of the stock and Father retained an interest in the corporation through his note and
salary continuation plan. The amount includable in Father's gross estate will be the full value of the enterprise, adjusted for the value of the non-family member ownership, the value of Daughter's interest in the enterprise in 1988 compared to Father and Daughter's interest in the enterprise in 1988, the value of the interest and Father's note and salary continuation. In addition to these offsets, the 10% share of consideration that Daughter received on Father's retirement divided by the value of Daughter's interest in the enterprise on Father's retirement can be taken as a family member consideration offset.
Section 2036(C) will force the closely held business to avoid hiring family members and providing any equity ownership incentives to these members. The traditional goal of many closely held corporations before Section 2036(c) was to maintain family characteristics. That goal has been made much more difficult in view of estate taxes after the passage of Section 2036(C).
Results under Sections 2701-2703:
The result would remain the same
new sections. The Summary
Discussion Draft states that the treatment of a QFP valuation is designed to "ensure that discretionary rights which are likely not to be exercised in an arms length manner cannot be used to understate the value of
property transferred.' The above statement gives the approach of Sections
2702 and 2703. The retained rights would probably not meet the requirements of a QFP. The debt although fixed in time remains unpaid in the example. This debt would not be defined as true debt under Section 2701(c)(2)(B) because the debt instrument provides for no mechanism
payment of accrued interest or unpaid principal in
The value of the debt for gift tax purposes would be zero.
The Discussion Draft states that employment agreements will not be affected by these new rules. They are not specifically addressed by the new proposed sections. We may have to depend on regulations to more clearly outline how
determine the valuation of such contracts. Under this example, whether the agreement can truly be classified as an employment agreement is also left open to doubt. Whether one could assign some value outside the proposed rules
to reduce the transferred interest for gift tax purposes is uncertain.
two Sons form limited partnership that is not subject to taxation under Section 2036(C) but for an unqualified buy-sell agreement. At
formation of the partnership, the partners had entered into a buy-sell agreement providing for the right of first refusal if any partner attempted to sell his limited partnership interest.
Results under Section 2036(C):
Section 2036(c) provides safe harbors for buy-sell agreements which utilize formulas that approximate fair market value of the interest in the enterprise. The effect of а right of first refusal on the value of a partnership interest may decrease that value by as much
30% according to the Estate of Hall v. Commissioner, 92 T.C. 318 (1989). Therefore, Section 2036(c) will bring into the Father's estate
part of the enterprise because
buy-sell agreement did not approximate fair market value of the enterprise at Father's death. Because the Father's life expectancy was considerably shorter than that of the
other partners, his partnership interest had a low potential of appreciation, thus entering into the partnership he made a deemed conveyance to his Sons of a disproportionately larger share of potential appreciation while retaining interest the enterprise. His estate would have to pay estate tax on the value of the partnership minus the value of his ownership interest in the enterprise at the time of his death. In addition, his estate would get an adjustment for that portion of the enterprise owned by Father's family prior to that partnership agreement.
The effect of Section 2036(c) language has basically caused simple right of first refusal buy-sell agreements which have been a practical part of any
business planning to be costly and unusable in the family situation.
Results under Sections 2701-2703:
Proposed Section 2702 addresses various contract options and their valuations. The option will be alued under Section 2702 without considering rights such as first refusal, price options which value property at less than fair market value, or leasing rights. It appears that proposed Section 2702 and Section 2036(c) both have a similar purpose designed to force buy-sell agreements among family members to reflect fair market value more accurately. The exemptions provided for under Section 2702 reflect in substance the safe harbor for buy-sell agreements under Section 2036(C). For purposes of this section "family" is defined as in Section 2036(C).
Husband and Wife have assets which consist of 3 million dollars basically composed of a house and personal items totaling 1 million, and the family farm operated by a corporation and worth 2 million. А trust owns a second-to-die insurance policy that is designed to provide liquid funds for the payment of estate taxes. Anticipating growth and desiring to keep the farm within the family, Husband and Wife decide to recapitalize the farm stock and
freeze the value of the farm at 2 million dollars for estate tax purposes. Husband and Wife retain preferred stock with preferred dividends and liquidation rights. Ten years later the farm has appreciated to 4 million dollars.
Results under Section 2036 (c):
Before the passage of 2036(C) at the
death of the second to die of Husband and Wife, the use of their unified credits and life insurance policy proceeds would have enabled their estate to pay the approximately 1.3 million dollars owed in estate tax,
leaving their family assets intact. However, since the
passage of Section 2036(c), Husband and Wife will not able
to maintain this estate plan without incurring additional tax. The
prohibited Section 2036(c) exchange will cause the value
the enterprise (farm) at death (4 million) to be brought back into the estate leaving an estate tax liability of approximately 3.3 million. Insurance proceeds will
not be sufficient to cover the additional 2 million dollars in tax captured by Section 2036 (C). Their options are limited because their children have always worked on
wages from the enterprise; therefore, no money that had been obtained outside the enterprise (clean money) would exist within the family to purchase the farm out
the Husband and Wife's estate avoiding Section 2036(C) problems. The result for the family will probably be that the family farm will have to be sold to pay the estate taxes.
Results under Sections 2701-2703:
The transfer would be immediately valued as a $2 million gift for gift tax purposes. The value of the gift would be reduced by the market value of the preferred dividends if those dividends meet the definition of a QFP. The dividends would have to be cumulative, payable on a periodic basis, and determined at а fixed rate. In addition, the dividends could not be tied to
life contingency. Assuming that the dividends in this example meet the definition of a QFP, the value of
gift is reduced by the value of these dividends. However, it must be noted that part of this reduction will be later recovered in the husband's or wife's estate should they die owning stock (2071(d) (2)) or in the form of additional gift tax should the stock be subsequently transferred (2071(d)(1)). The amount the gift or the amount included in the gross estate will be increased by the amount that the dividends decreased the value
the initial transfer. Therefore, the proposed sections under this section will cause
gift liability and, in addition, may cause future estate tax liability. Whether the overall tax burden under the new sections would be greater than under 2036(c) would depend in large part to the amount of appreciation attributable to
property transferred. In addition to these problems, the
new proposed sections may
cause the family financial problems upon the initial fer du to the gift tax. In
example, no funds are available for taxes before second to die of the Husband and Wife.