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Example 5


Son owns a company which he has built and established with money not received from his family. The corporation has 50 shares of single class common stock outstanding, all of which are owned by Son. The stock has a value of $100,000. Son's company is having some

financial difficulties, Son's Father agrees to contribute to the company's capital $50,000 in exchange


par value preferred stock redeemable at par value. The capital contribution allows Son's company to expand and enhance productivity.



Results under Section 2036 (C):

Before Section 2036(c) this contribution would have been an acceptable way to assist family members without increasing estate tax liability. However, since Section 2036(c) the result of the above exchange would be to include the value of the enterprise in Father's estate because he has made a deemed disproportionate transfer. Father's actual share of appreciation is zero; therefore, he is deemed to have conveyed one third of the appreciation to Son' in exchange for a. preferred income stream and depreciation protection. Section 2036(c) makes it difficult for family members to assist or contribute to family business without risking inclusion of portions of the enterprise in one's estate.

Results under Sections 2701-2703:

Under Section 2703(c), contributions to capital that have "substantially

same effect"


transfers of interest by a member of the family are treated as transfers under this section. It is unclear how this section will affect examples like this one. The terms are undefined and leave much room for interpretation. The section also provides for exemptions as provided in later regulations. How these future regulations will interpret Section 2703(c) with relationship to changes in capital structure is yet unknown.

Assuming that the example would be treated as a transfer under-Ehese sections, the dividend right may

be a QFP that will lower the value of the initial gift. Section 2701(a)(2)(B)(ii) offers a favorable assumption that if no fixed termination date exists the payment

will be assumed to be made in perpetuity. Therefore, the only questions which remain are whether the payment

is fixed as to amount and whether it is

cumulative as required by Section 2701(b)(1)(A) (ii). If the payments are both fixed

and cumulative, the value of the $50,000 gift will be decreased by the value of the dividend right. If they are not,

the value of such rights will be zero, leaving the value of the gift at $50,000. However, as in Example Four, it must be noted that part of any reduction will be recovered in either the Father's estate should he die owning the stock or in gift tax should he later transfer the stock.

Example 6



Father and Son wish to jointly purchase real estate for investment purposes. They jointly purchase a piece of property for $200,000. The Father purchases life estate and Son purchases the remainder

in the property.

Father pays $150,000 which has been determined to be fair market value of a life estate using current valuation tables. Son furnishes $50,000 which


been determined to be the fair market value of the remainder interest.

Results under Section 2036 (C):

Because of
the nature of their purchase,

it is deemed an enterprise and Father is deemed to have transferred 75% of the potential appreciation in the value of the land to the Son in exchange for the Son's 25% interest in the income or rental value of the land. Thus, Father has made a disproportionate transfer and the value of the enterprise would be brought back into his estate upon his death.

Results under Sections 2701-2703:

The new proposed section deals with joint purchases in 2703(d). This section states that when two or more members of a family jointly acquire interest in property the individual which receives the term interest is treated as having acquired the entire property and subsequently transferring to

the other persons

their respective interests in such property. A term interest can be defined as either a term of

years or lifetime. The

Father will be treated as having made a gift of $50,000 to the Son.

As was the case under 2036(C), it is very difficult to analyze specific examples without the benefit


any explanation or definition of the terms within these proposed sections. As with Section 2036(C), we will probably have to wait for an explanation from the Service before all of the questions can be answered.

Example 7

Wallace V.

566 F.

Supp. 904, 49 82-1482,

is an
excellent example of the

real risk take in making gifts as

part of estate-freeze. shows that an appraisal can be quite accurate.

AFTR 2d parents It also


The Wallace brothers made gifts in 1972 of common stock to trusts immediately after recapitalization of their corporations (classic freeze) as

part of

an estate plan. The value of

the gifts
was determined by


independent appraisal firm.

In 1973, the brothers paid over $440,000 of gift taxes with timely filed gift tax returns. Unfortunately, the value of the corporations dropped.

In 1976, the brothers sought a refund of the gift taxes paid claiming the appraisals on which they relied in reporting the gifts excessively valued the donated shares. The brothers lost.

Chairman ROSTENKOWSKI. Thank you very much, ladies and gentlemen, for joining us here this morning.

Our next witness is Don Lubick.



Mr. LUBICK. My name is Don Lubick, chairman of the tax policy committee of the District of Columbia Bar, and with me is Jane Bergner, who is the chairman of our tax section; and George Levendis, who is chairman of the ad hoc committee that dealt with this particular problem. Also on the panel as an invited witness is Mr. Aucutt, who participated in our work.

I would like to simply point out that everybody seems to agree that the problem that requires legislative solution in the estate freeze situation is the problem of valuation. We seem to have unanimity on that, and the 2036(c) approach is not a workable approach.

The discussion draft attacked the problem, in our judgment, in a needlessly complex way. It has been pointed out by earlier testimony that this is to be the year of simplification, yet the discussion draft would value any business arrangement that doesn't meet its standard at zero, something that is contrary to fact.

It would then require a revaluation subsequently at death to compensate for the misvaluation earlier. It requires a minimum valuation of 20 percent for junior equity, again, something which in very many cases would be contrary to fact.

And it requires all kinds of special rules, elections and adjustments. We have learned already there will have to be a number of technical amendments. I suggest that we are going to have another statutory monster.

Now, we believe that if the problem is valuation, let's attack that problem head on. We asked why has valuation been so difficult for the Internal Revenue Service in those cases where there are abuses? We believe there are two reasons for this.

One, there have been some ill-advised substantive rules of valuation developed by the courts, and second and most often IRS has been operating under a procedural handicap of not learning about these estate freeze valuation problems in a timely fashion.

Therefore, one can go at this problem simply directly and in a straightforward way without the need for all of the complications.

First of all, let's eliminate the bad decisions in calculating value. We have suggested two particular specific areas where there can be change. One is the elimination of an unrealistic minority discount in a transfer, in a 2036(c) situation among family members. It is not really right to simply base your valuation on what is transferred without reference to the fact that the transferor and the transferee are operating together to control the particular corporation.

Second, in a number of situations, there has been a mandated use of table valuations, which are based upon interest assumptions that are totally unrealistic, or on mortality assumptions that are also unrealistic.

We suggest that in appropriate cases, both the IRS and the taxpayer ought to be able to deviate from these rigid assumptions which produce inappropriate results.

If there are other valuation abuses, let the case be made, and they can be dealt with specifically, but I believe we have dealt with the major ones.

Next, we should put sunshine on these transactions in order to give the IRS the chance to scrutinize them. We have suggested that we have an increased reporting procedure, and an extension of the statute of limitations. Even in cases of sales, and in cases where the value of the transferred interest is reported at zero and, hence, under the exclusion, there ought to be a report.

We would allow looking at post-transfer facts as evidence of value. We would limit the credit at death to the tax on the valuation reported. We believe that we have responded to those concerns that Mr. Gideon expressed this morning about soak-up rights.

We do not believe new major principles of law are required. If these matters can be brought to the attention of the IRS and dealt with directly, the abuses can be eliminated.

Mr. LEVIN (presiding]. Thank you.
The statement of Mr. Lubick follows:]


Business Related Taxes
Employee Benefits
Estate Planning/Death Related Taxes
Exempı Organizations
Tax Audits and Litigation
Tax Policy

The District of Columbia Bar

Steering Committee
Janc C. Bergner, Chair
Collette Goodman
Ellen A. Hennessy
Gerald A. Kalka
Stephen A. Nauheim
Celia L. Roady
Bradley Seltzer
Charles B Temkin




[blocks in formation]

The Section of Taxation of the District of Columbia Bar' appreciates the opportunity to comment on both the modification of Section 2036(c) and the Discussion Draft (the "Discussion Draft") released on March 22, 1990. We also offer a proposal (the "Proposal") that incorporates many of the principles of the Discussion Draft but that, in a number of areas, achieves the objectives of the Discussion Draft more simply and consistent with familiar and established legal concepts.

Section 2036(c) was enacted as a part of the Omnibus Budget Reconciliation Act of 1987 ("OBRA 87") to enable the Internal Revenue Service to deal with avoidance of transfer taxes through various devices generically referred to as "estate tax freezes." By using one of these devices a transferor could retain, substantially intact, his interest in the current benefits of ownership of a business, such as management and control and its current income stream, yet still be able to pass increases in its underlying value to his beneficiaries without transfer tax. In the abusive cases, the transferor overvalued the retained interest and valued the donated interest at zero or at a grossly inadequate value.” The classic preferred stock recapitalization and many complex variations on that theme have caused avoidance of transfer taxes, either because the valuation rules before enactment of Section 2036(c) were inadequate to deal with them or because the Service has had inadequate means to detect undervaluations of transferred interests.

Instead of dealing with valuation abuse, Section 2036(c) changed the substantive rules of transfer taxation by a sweeping inclusion, generally at death, of interests transferred during lifetime by an individual who retains an interest in an underlying "enterprise“ apart from property that has been unconditionally and irrevocably transferred. The new law extends well beyond the principal abuse that prompted its enactment, namely undervaluation of the transferred interest in future growth. The statute attempts to cover all intrafamily transfers within the statute's parameters regardless of the correctness of any reported values.

Section 2036(c) has been criticized on all sides, both for introducing expanded new concepts of taxation of property in cases where the transferor has retained no traditional "string" over the transferred property and for its unworkability because of ambiguous and difficult-to-define terms that trigger its application. Such criticism


The views expressed herein represent only those of the Section of Taxation of the District of Columbia Bar and not those of the District of Columbia Bar or its Board of Governors. The Section of Taxation is comprised of approximately 1,400 members.


"Section" references are to the Internal Revenue Code of 1986.

3 Even if the property were properly valued at the time of transfer, the Service found it difficult to discover the subsequent transfers when rights incident to property retained by the transferor were allowed to lapse or were not exercised in an arm'slength manner.

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