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from adjusting, for gift tax purposes, the value of a gift in a Section 2036(c) situation, and it will have the burden of proof with respect to an estate tax adjustment.
In addition, if there has been an actual gift-tax audit of the value of the transferred property, the Service will be precluded from adjusting, for estate tax purposes, the value of such a gift in connection with the estate tax return filed at the transferor's death. The termination date with respect to the gift-tax valuation of Section 2036(c) transfers
will provide taxpayers with a degree of certainty, thereby promoting compliance. By the same token, the longer, six-year statute of limitations assures the Service that the comfort given taxpayers by such possibility will not be granted at the expense of its adequate audit opportunity.
Both Section 2036(c) and the Discussion Draft are considerably more complicated than our Proposal because of their respective "look-back" requirements. In particular, we note that the Discussion Draft would require such a "look back" on the first to occur of (i) a subsequent transfer of the transferor's retained rights in circumstances where such rights originally were valued, under the Discussion Draft, at zero, and (ii) the death of the transferor.
3. Statute of Limitations - Estate Tax Return. The statute of limitations will not preclude the Service from revaluing a Section 2036(c) situation transfer (ie, again, determining the transferred property's value at the time of transfer) in connection with the tentative tax computation performed for purposes of computation of a deceased taxpayer's estate tax, unless there has been a prior determination of value after audit by the Service, including under the new review procedure proposed in III.D., below. Moreover, where there has not been a gift tax audit (even if, for example, a taxpayer thought the transfer to be an annual-exclusion gift when made), the tentative estate tax computation will be made pursuant to Section 2001(b)(1), based on the sum of the decedent's inter-vivos taxable gifts and the gross estate otherwise reportable at the decedent's death, but without subsequent revision, in connection with the applicable estate tax computation, of valuations in determining the tax on the prior gifts under Section 2001(b)(2).12 This will increase the tax due at death.
Once the Service has audited a taxpayer's return and has determined a gift-tax value for a Section 2036(c) situation transfer, it is foreclosed from subsequently revaluing the transfer subject to the prior audit, either for gift-tax or for estate-tax purposes.
In addition, if the gift was not properly reported, the Service may adjust the value of the gift on a gift tax audit without regard to the six-year statute of limitations.
Under all circumstances, the offset under Section 2001(b)(2) to the estate tax will include only gift tax actually paid with respect to a Section 2036(c) situation transfer.
Undervaluation penalty. The Service may assess a substantial undervaluation penalty comparable to that of Section 6622(g) of the Code, either in a gift tax proceeding or in the estate tax proceeding, if not barred by the statute-oflimitation rules of III.C.2. and III.C.3., above, but not in both such proceedings.
Because the Service has been left with power to redetermine valuation in the estate tax proceeding, even though there may have been full return disclosure of the earlier Section 2036(c) transfer, but no audit, (a) the undervaluation penalty will not apply in the gift tax context after expiration of the gift tax statute of limitations, and (b) in the estate tax proceeding, the burden of proof on valuation will be on the Service if there was prior disclosure of the transfer by the taxpayer. The
In contrast to current Section 2001(b)(2), unless there has been a prior gift-tax audit, the estate will be entitled to an offset of only the gift tax paid, and not the hypothetical gift tax which would have been paid on a proper valuation.
rules as to retrospective use of post-transfer facts with respect to deviation from the valuation tables, described above in III.B.2.a., will apply in the estate tax proceeding. The expanded reporting and disclosure requirements and the lifting of the statute of limitations in the absence of disclosure to the Service will discourage taxpayers from playing audit roulette to avoid tax. Requiring disclosure will give the Service information to curb abuses, but without the changes in substantive rules effected under current Section 2036(c).
D. Taxpayer Request for Review. Because Section 2036(c) situations have historically resulted in transfer tax avoidance abuses, we recommend revision in the manner of applying the statute of limitations and reporting and disclosure rules. These additional tools, combined with the change in valuation standards, are critical to eliminating abuses. At the same time, we feel equally strongly that taxpayers have a right to certainty of the tax results of their transactions. Accordingly, our Proposal provides that a taxpayer with respect to a particular Section 2036(c) situation transfer may request that the Service review the taxpayer's valuation of the property transferred. Such a proceeding will be treated as an audit under III.C., above, to secure the benefits of the statute of limitations for both gift-tax and estate-tax purposes.
A taxpayer may petition the Service at any time following the year of a Section 2036(c) situation transfer to audit the valuation on the transfer. The Service will have until the expiration of the later of either (i) six years after the date of filing of the return reporting the transfer (treating a return filed before its due date as if filed on such due date) or (ii) two years after the date of such request within which to audit the taxpayer's valuation of the transferred property. During such period the gift tax statute of limitations will remain open or may be reopened. The Service will have the opportunity during such period to review post-transfer facts, to determine if assumptions made by the taxpayer (such as, for example, the regular payment of dividends) in determining the reported value of the transferred interest were reasonable. The Service may adjust the valuation where post-transfer actions, within the reasonable control of the taxpayer, are not consistent with the initial assumptions, but unforeseen post-transfer events not within such control of the taxpayer may not be used to alter a taxpayer's initial valuation. If the Service fails to audit after the taxpayer's request, the taxpayer's valuation will be accepted as if audited. The audit will be judicially reviewable as under existing rules for gift taxes. This new procedure will give a taxpayer the opportunity to achieve finality with respect to a Section 2036(c) situation transfer, but only if the Service first has been provided adequate disclosure and an opportunity to audit. Thus, the six-year statute of limitations is an integral corollary to the review procedure.
Comparison of the Provisions of the Proposal with Those of the Discussion
As we have said, the Discussion Draft is an improvement over current Section 2036(c). Our Proposal has much in common with the Discussion Draft, and, to that extent, it may be regarded as simply an alternative way to achieve the common objective of curbing valuation abuses.
In particular, both our Proposal and the Discussion Draft (i) abandon the troublesome substantive concept of a "disproportionately large” transfer of potential appreciation and the consequent potential for triggering substantive liability by the retention of some esoteric "interest" in an underlying "enterprise"; (ü) abandon the retained life estate model which departs from property law rules to effectively tax a decedent's estate on something the decedent had not owned for many years; (iii) give cash, conventional debt or other consideration the treatment normally accorded it, even among family members, without the complex requirement to test the "cleanliness" of the consideration; and (iv) limit their new approaches to ten-percent owned entities, thereby avoiding an unnecessary broadening of the Section 2036(c) rules. As a result, both our Proposal and the Discussion Draft attempt to avoid the discouragement of current Section 2036(c) to intrafamily transfers and efforts of members of the
younger generation to build up the value of a family business while their parents still are alive.
Our approach is both conceptually correct and simpler than that of Discussion Draft. The chief difference between our Proposal and the Discussion Draft is that the latter imposes fictional values on interests involved in a transaction. Because it imposes fictional values on the interests involved in the initial transaction, the Discussion Draft is obliged to provide elaborate rules to trace those interests and make certain they are valued consistently throughout the life of the transferor, as well as at the transferor's death. Those rules, contained in $ 2701(d) and (c) of the Discussion Draft, are very complicated, and their application to any but the simplest of paradigm cases is uncertain.
Even though the values imposed on an interest in property by the complicated rules of the Discussion Draft may sometimes be approximately the same as the interest's true value (as critics of valuation abuses might assert), the Discussion Draft's inherent imprecision in this regard is weighted against the taxpayer. Our Proposal, because it focuses on true value, automatically reaches a correct, as well as the desired, result, without such elaborate "consistency" rules. Nor do we place an arbitrary minimum value of twenty percent on the transferred interest, as does the Discussion Draft a punitive and harsh result where the transferred interest truly has only nominal value.
As a corollary, the Discussion Draft imposes certain structures -"qualified fixed payments" - on taxpayers who desire a satisfactory result, while our Proposal permits parties to choose the structure that best meets their nontax needs and requires only that they value interests accurately at the time of transfer. Our Proposal is also preferable in that, by eliminating the traditional minority-interest discount for valuation purposes, it prevents an individual with a majority interest from artificially bifurcating that interest into several "minority" interests with understated values, while, at the same time, recognizing that, if the aggregate family interest in an asset is itself a minority interest, fair market value historically and correctly must reflect a discount.
While our Proposal provides the Service with a final opportunity to detect and correct gift tax valuation abuses, through increases to adjusted taxable gifts under Section 2001(b)(1)(B), without a corresponding gift tax credit offset under Section 2001(b)(2) beyond the gift tax actually paid, this feature operates only to implement the correct valuations when made. In our view, one of the most frustrating elements of current Section 2036(c), which is retained in the Discussion Draft, is unavoidable uncertainty. The uncertainty may be caused by a mandated undervaluation of a retained interest that requires compensation at the time of death or by the lack of a procedure to achieve finality of a gift-tax valuation. Our Proposal avoids that frustration by providing a structure of clear rules and consistently accurate valuations. Our Proposal also affords taxpayers an opportunity to obtain certainty with respect to Section 2036(c) Situation transfers by permitting them to file with the Service a request for review, albeit at the possible cost to a taxpayer of extending or reopening the gift tax statute of limitations.
Our concern is in providing an appropriate alternative to Section 2036(c) that addresses the legitimate valuation concerns of the Congress and the Treasury while, at the same time, providing taxpayers with a measure of finality. It is precisely the measure of finality provided by our Proposal that commends its consideration as an alternative to the Discussion Draft, which we believe suffers from a lack of certainty similar to that inherent in Section 2036(c). In addition, in contrast with both the Discussion Draft and current Section 2036(c), our Proposal does not have the potential for penalizing nonabusive transactions between or among family members. Moreover, we believe that our Proposal sets out a more realistic approach to valuation than does the Discussion Draft, which, in general, except for the narrowly
defined concept of "qualified fixed payments," provides that intrafamily retained interests are to be valued at zero.
We believe that the changes to pre-OBRA 87 law contained in our Proposal will be sufficient to impose taxation based on appropriate and traditional legal concepts of property and tax law, while, at the same time, eliminating the procedural and audit advantages that taxpayers have had over the Service. Accordingly, our Proposal replaces Section 2036(c) with a statutory scheme that remedies the perceived abuses at which Section 2036(c) was aimed and yet avoids complex and novel legal concepts at odds with normal business practices.
Mr. LEVIN. Mr. Dees.
STATEMENT OF RICHARD L. DEES, ESQ., PARTNER, McDERMOTT,
WILL & EMERY, CHICAGO, IL Mr. DEES. Thank you, Mr. Chairman.
My name is Richard L. Dees, and I am a partner in the Chicago office of the national law firm of McDermott, Will & Emery. In May 1989, I was an invited witness to the Senate Finance Committee on why current section 2036(c) should be repealed.
Since that time, I have given technical advice to members of the Business Coalition to Repeal Section 2036(c) and was named as a technical expert by the National Grocers Association and the Small Business Legislative Council to work with Treasury on a replacement to section 2036(c). My comments today, however, are my own and not necessarily those of the NGA, the SBLC, of any other business group or those of any firm client.
I am grateful for the opportunity to submit nine pages of technical comments about the proposal and to summarize those comments here today.
The structure of the proposal, in my view, is an acceptable path out of the 2036(c) quagmire. All of my comments suggest a continuation along this same path, not a departure from that path. We should continue to narrow the proposal. The proposal should be made even more fair to family business owners. To the extent consistent with the first two objectives, the proposal should be made simpler.
We already see the current statute narrowed in two more respects. Gone are the concepts of disproportionate appreciation and enterprise, which proved unworkable, and which are really an attack on family cooperation.
Finally, we see a severance of the “strings” approach in 2036(c). It is that strings approach that resulted in the attack on the continuation of parents in the family business if they wish only to reduce their involvement that was described by Mr. Zaucha.
The changes in the proposal which are needed to make it acceptable are not intended to open the door to abuse. There is a discipline to this process that everyone must recognize. If the replacement ultimately adopted allowed abuses to continue, then undoubtedly we will be back here next year facing a reenactment of 2036(c).
If the statute continues to impact 100 percent of all family businesses and not just 5 percent who actually do freezes, then there will be others here next year urging a repeal of chapter 14.
This ought to be a simple litmus test to apply to whatever proposal is ultimately adopted by this committee and the Congress. We have succeeded in narrowing the proposal only if the 5 percent who actually do preferred stock
freezes—the abuses that were designated in the enactment of 2036(c)-are the only ones who have to read chapter 14.
This is not the case presently in the proposal. Every family business owner will have to read and understand chapter 14 to see if there is some unexpected application. The reason is the same as that which I outlined in my testimony to the Senate Finance Com