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continues notwithstanding good-faith efforts of both the Congress and the Internal Revenue Service at refining and clarifying the statute, by amendment of the statute in the Technical and Miscellaneous Revenue Act of 1988 and administratively in IRS Notice 89-99.

Section 2036(c) differs in its approach from the accepted reach of Section 2036(a) in the "reserved life estate" situation. Section 2036(a) taxes property passing to a remainderman on the death of a transferor life tenant because the transferor has retained a continuing interest in the same physical property that was transferred. In contrast, Section 2036(c) taxes an individual on the future value of property previously transferred by such individual solely on the ground that the transferor holds a separate interest in the underlying entity in which the transferred property also is an interest. Retention of control of the common enterprise by virtue of a different and separate interest in the entity is in itself an insufficient basis for taxation, as has been recognized, since neither Section 2036(c) nor the Discussion Draft would impose a tax on transferred property solely by virtue of retention by the transferor of voting rights. For example, neither the transfer of nonvoting stock while retaining all voting power nor the transfer of minority stock while retaining majority control is sufficient under either Section 2036(c) or the Discussion Draft to include the transferred property in the transferor's taxable estate. Our estate tax law, even under Section 2036(c) and clearly under the Discussion Draft, recognizes that parallel interests in business entities can exist side by side and be recognized as discrete interests in different property. Hence, the rationale for determining abuse can only be that the retained property has been overvalued, and, conversely, that the transferred property undervalued.

In point of fact, Section 2036(c) discourages proper and desirable intrafamily planning. It is entirely appropriate for an older-generation individual to pass an interest in the family business to descendants, with payment at the time of appropriate transfer tax, even though retaining control until it is clear that the transferees are adequate to assume the mantle of management. The post-transfer value, perhaps created by the transferees' efforts, should not be brought back into the parent's estate solely because the parent retains a preferred interest in the business to provide, for example, income for old age.

We recognize that Section 2036(c) properly addresses an area of tax avoidance. Accordingly, our Proposal in replacement of Section 2036(c) offers a solution that makes no change to substantive concepts of estate and gift transfer taxation under pre-OBRA 87 law but that, nevertheless, gives the Service the tools it needs to address substantially all the perceived pre-OBRA 87 abuses. Limiting the remedy to proper valuation avoids the needless complexity inherent in tampering with established property-law concepts. The Discussion Draft is a welcome step in the proper direction. However, it too adopts complex new property concepts and expands transfer-tax law beyond abuse cases. Even though the statutory scheme of the Discussion Draft is valuation based, by treating nonconforming retentions as having zero value, it, in effect, changes substantive property law and results in transfer taxation of future appreciation, in an intrafamily context, arising after completed transfers and fair market value sales. In a system that depends in large measure on self-assessment, the rules must be both reasonable and intelligible.

II. Summary of the Proposal

Our Proposal reflects our experience that underlying practically all the preOBRA 87 estate tax freeze devices that can fairly be characterized as abuses are one or both of two handicaps of the Service. The first is the inadequacy of rules for determining valuation of inter-vivos transfers. The second is the inadequacy for the Service of reporting and auditing tools. We propose changes in the rules respecting

*See $2701(a) of the Discussion Draft in which a so-called "qualified fixed payment," with limited exceptions, would be the only kind of retained interest a transferor could safely hold.

(i) valuation for transfer tax purposes, (ii) the reporting of transfers and (iii) the pertinent statutes of limitation, to place the Internal Revenue Service on an equal footing with the planners of sophisticated estate tax freeze devices. At the same time, in contrast to the "look back" approach of both current Section 2036(c) and the Discussion Draft, our Proposal will not extend the reach of transfer taxes to apply to changes in value of an asset in the hands of an irrevocable and unconditional transferee who is fully at risk as to the value of the transferred asset.

The Proposal would apply to Section 2036(c) situations where (i) the transfer involves an "enterprise," as currently defined under section 2036(c); (ii) the transferor retains an interest in the enterprise post completion of the transfer; and (iii) the transferor and the transferor's family own before completion of the transfer more than 10 percent of the enterprise.

• In a Section 2036(c) situation, all transfers must be reported by the transferor on a gift tax returns for the year of transfer, even if the transfer (i) is within the annual exclusion amount or (ii) is a bona-fide transfer for value. The reporting rules would include specific disclosure requirements to be prescribed by Treasury Regulations.

• All prior transfers in Section 2036(c) situations must again be reported on an estate tax return of a transferor.

• For transfers in Section 2036(c) situations, (1) generally, a minority interest discount will be unavailable; and (2) either the Service or the taxpayer may value transferred property without regard to the Treasury's actuarial tables in cases where it can be established that the nontabular valuation more closely reflects the actual income produced by the enterprise and mortality factors.

• In a Section 2036(c) situation, if a transfer is reported on a gift tax return and is audited by the Service within the applicable statute-of-limitations period, the Service is permanently foreclosed from revaluing the property transferred either for gift-tax purposes or for subsequent estate-tax computation purposes upon the death of the transferor.

In a Section 2036(c) situation, if a transfer is properly reported on a gift tax return, but if such return is not audited, then the Service is foreclosed after expiration of the statute of limitations from revaluing the property transferred for the purpose of redetermining gift tax, but the Service may revalue (with the burden of proof) the property for estate tax purposes in connection with the tentative tax computation under Section 2001(b)(1) and limit the Section 2001(b)(2) offset to the actual gift tax paid with respect to the transfer."

• If, in a 2036(c) situation, a transfer is not properly reported on a gift tax return, then the statute of limitations will continue to remain open with respect to the transfer, and the Service may subsequently revalue the transferred property both for gift tax purposes and for the purpose of making the tentative estate tax computation at death under Section 2001(b)(1).

• With respect to a transfer in a Section 2036(c) situation, the Service may assess, within the statute of limitations, a substantial undervaluation penalty in either a gift tax proceeding or an estate tax proceeding, but not in both. If there has been full return disclosure of a transfer, however, the Service will have the burden of

The form required by the Service may be an informational return, other than a Form 709, in cases such as a claimed annual-exclusion gift or a bona-fide transfer for value.

"This is in contrast with current Section 2001(b)(2) which apparently permits an offset of the aggregate amount of tax which would have been payable if the provisions of Section 2036(c) in effect at the decedent's death had been applicable at the time of the gift.

proof with respect to assertion of the penalty in the estate tax proceeding, assuming no gift tax audit was conducted. If, on the other hand, a timely gift tax audit is conducted by the Service and the Service does not assert a penalty, it is foreclosed from asserting the penalty in the subsequent estate tax proceeding.

• An expanded six-year gift tax statute of limitations will apply to transfers in Section 2036(c) situations, thereby providing the Service with sufficient time to marshall its facts on a retrospective basis and conduct an adequate review of the valuation placed on the property transferred.

At any time after a disclosure of Section 2036(c) type transfer, whether or not within the six-year statutory period, a taxpayer may file with the Service a request to review the transfer. The Service then will have until the later of either (i) the expiration of the six-year limitations period or (ii) the period ending two years after the request to audit the taxpayer's gift tax return with respect to the transfer. If it fails to conduct an audit within the statutory period, the Service will be foreclosed from revaluing the property transferred either for gift tax purposes or for the purpose of the tentative estate tax computation under Section 2001(b)(1).

• The Proposal explicitly recognizes that periodic gift taxation may result where certain post-transfer discretionary action or inaction by the taxpayer inures to the benefit of the transferee.

III.

Discussion of Proposal in Substitution for Section 2036(c)

Limitation of Changes to "Section 2036(c) Situations." Our Proposal would only apply to transactions currently within the scope of Section 2036(c). Thus, as under current Section 2036(c), we would apply the new rules where (a) the transfer involves an enterprise, (b) the transferor retains an interest in the enterprise post completion of the transfer and (c) the transferor and the transferor's family own before completion of the transfer more than 10 percent of the enterprise.

We recognize that, thereby, we have retained some of the imprecision that justifiably subjected Section 2036(c) to criticism as causing hardship for taxpayers engaged in legitimate planning. The critical difference is that we are retaining in our Proposal the scope of Section 2036(c) and its definitional terms as a procedural matter only. No taxpayer's substantive liability is changed. Our tolerance for giving the Service latitude in definition is, therefore, significantly greater than is the case under either current Section 2036(c) or the scheme of the Discussion Draft.

Further, we suggest new review and disclosure procedures that will enable taxpayers to determine with certainty the effects of their transactions and will give the Service adequate tools and time to effectively evaluate the transactions, thereby forcing both taxpayers and the Service to place their cards on the table. The situations to which our Proposal applies are called "Section 2036(c)

situations."7

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1. Minority Interest Discount. In a Section 2036(c) situation, valuation of property transferred to a family member (as is currently defined in Section 2036(c)(3)(B))8 will be made without any reference to a discount for lack of control inherent in the transferred property. Taxpayers have frequently avoided taxation of a transfer, in substantial part, by looking only at the property transferred and claiming a discount for its status as a subordinate minority interest. Since the

7 Examples of such situations include, but are not limited to, preferred-stock recapitalizations.

8 An individual's spouse, lineal descendant or lineal descendant of such spouse, an individual's parent or grandparent, or the spouse of any of the foregoing.

transferor in a Section 2036(c) situation has retained an interest in the enterprise associated with the transferred property, it is logical to value the transferred property as if it were associated with the retained property, instead of as a minority interest. Of course, if the retained and associated property combined would have been valued under pre-OBRA 87 law as subject to a legitimate minority-interest discount, the value of the transferred property in a Section 2036(c) situation would be determined with appropriate allowance for its share of the minority-interest discount applying to the combined property."

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2. Artificial Valuations by Application of Treasury Actuarial Tables. Taxpayers have frequently taken advantage of actuarial tables, set out in the Treasury Regulations and Notice 89-60, to justify artificially low valuations of property transfers involving split interests such as life estates and remainders. The actuarial tables assume both a standard interest rate and consistent mortality experience. If, for example, a transfer of a remainder in appreciating, nonincome-producing property is valued from the tables, there will be a serious undervaluation of the remainder.

a. Right to Ignore Tables. Either the Service or a taxpayer may value a transfer without regard to actuarial tables if the proponent of the nontabular valuation establishes that the income or mortality assumption of the tables is likely to be, or, in certain cases, was in fact, substantially different from the actual income produced or mortality factor experienced in connection with such transfer. Thus, solely on the question of use or deviation from the actuarial tables, the retrospective use of the pertinent actual facts may be applied in a Section 2036(c) situation as evidence of the reality of the original assumptions at the time of the transfer, unless the factual deviation from the tabular actuarial assumption is due to circumstances not foreseeable at the time of the transfer and is attributable to factors beyond the reasonable control of the transferor or transferee.10

The following examples are illustrative. One: A taxpayer transfers common stock in a corporation to a family member and retains all of the preferred stock and one share of the common. The preferred stock carries a dividend based on earnings. The taxpayer uses an eleven-percent interest-rate assumption in valuing the preferred stock, even though the applicable tables use a nine-percent rate. The taxpayer is permitted to depart from the tables because he or she is able to show that eleven percent was a reasonably anticipated dividend rate for the corporation. On audit, the Service will use actual experience as evidence of the realism of the assumption. Two: A taxpayer transfers a remainder interest in stock using a valuation table that assumes a nine-percent interest rate. No dividends are paid for three years after the transfer. The Service may use the fact that no dividends were actually paid to show undervaluation, three years earlier, of the remainder interest. If, however, the taxpayer shows that dividends of approximately the assumed income rate historically had been paid and that the cessation of dividends was due to extrinsic and unforeseen post-transfer circumstances, outside of the transferor's control, the taxpayer's valuation may be accepted as realistic.

9 While we address only the Section 2036(c) situation, in theory, the reasoning might apply as well to disallow a minority-interest discount in a situation where the transferor and transferee have a similar relationship.

10 The Proposal confirms that, under existing law, if the transfer of common stock is reported, dividends are paid during the applicable statute of limitations period, the transfer is audited by the Service and the taxpayer's valuation is sustained, then, any failure to pay dividends to the holder of the retained interest in a year subsequent to the expiration of the statute of limitations -- because of factors within the reasonable control of the transferor may be a gift to the holder of the transferred interest in the year of such failure and may be included in the transferor's estate for the purpose of determining the estate tax at the transferor's death based on the value of all lifetime and testamentary transfers. Of course, if the statute of limitations has not run, the Service can use the fact that no dividends were paid during the statutory period as evidence of undervaluation of the originally transferred interest on the gift

tax return.

b. Procedural Rules in Cases of Disregard of Tables. The

actuarial tables will continue to carry the presumption of correctness in a Section 2036(c) situation, and the party valuing a transfer on the basis of a different assumption will carry the burden of proof on that issue. Furthermore, a taxpayer who values a transfer of a split interest in property without regard to the actuarial tables will be required to disclose such disregard of the tables in order for the statute of limitations to run with respect to such transfer.

C. Disclosure, Reporting and Statutes of Limitation. The general principle supporting the aspects of our Proposal in respect of disclosure and extended statutes of limitation is that the Service must be given notice and opportunity to audit a transfer in a Section 2036(c) situation. Too many taxpayers have relied upon their own valuation, without the Service having a reasonable chance of review, to take a position that a transfer is either within the federal gift tax annual-exclusion amount (ie., under $10,000 per donee) or supported by an adequate, yet nominal, consideration. Statute-of-limitations questions arise with respect to each inter-vivos transfer, as well as with respect to inclusion of lifetime gifts, to ascertain the decedent's transfers (during lifetime and at death) reportable on the estate tax return of a deceased taxpayer as the basis for determining the estate tax.

1. Disclosure Requirements. In a Section 2036(c) situation, a transfer must be reported contemporaneously by the transferor, regardless of whether the taxpayer claims the transfer to be either within the annual gift-tax exclusion amount or a sale supported by adequate consideration. The Proposal contemplates that Treasury may prescribe by Regulations the information required to be reported in any such situation. In addition to such annual reporting, all Section 2036(c) situation transfers made by a decedent during his or her lifetime must be reported on the transferor's estate tax return after death.

2. Statute of Limitations - Gift Tax. A critical facet of our proposal is a new statute of limitations with respect to gift tax in Section 2036(c) situations. In such situations, the Service will have until the later of either (i) six (6) years after the date the gift tax return for the year of the transfer is filed (treating a return filed before its due date as if filed on such due date) or (ii) two (2) years after the date of a taxpayer request for review of a gift tax return, a proposed new procedure described in III.D., below. A gift tax statute of limitations longer than the historic three years is necessary because the Service currently does not have adequate time to properly evaluate gift transfers in Section 2036(c) situations.

The gift tax statute of limitations will not run and, therefore, will not preclude the Service from revaluing a Section 2036(c) situation transfer (ie., determining its fair market value at the date of transfer), for gift-tax purposes, unless: a. There has been adequate disclosure of the transfer in

accordance with Regulations;11 or

b. There has been a determination of value after an audit by the Service, including an audit under the new review procedure described in III.D., below.

Thus, the Service will not be precluded from asserting liability by a taxpayer's failure to inform it of an audit opportunity. On the other hand, if there has been adequate reporting of a Section 2036(c) transfer by a taxpayer within the statutory period, once the statute of limitations has run, the Service will be precluded

11 As indicated earlier, such disclosure might be on a Form 709 filed with respect to the transfer or, in the case of gifts that come within the annual-exclusion amount or transfers not characterized as gifts (e.g., transfers for consideration), on another form prescribed by the Service.

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