mittee. That is because this statute, like current section 2036(c), continues to try to define the abuses in the same way that I would try to tell someone how to get to my house by telling them everywhere in America I don't live. We should identify the abuses, hit those and leave the broad range of statutory applications out. I want to suggest that there are many-18 or 20 ways-that we can improve the existing statute. First is to make the proposal narrower by not making it apply to buy-sell agreements, leases and debts, employment agreements and similar business arrangements. Unlike the Bar Association panel, I am not convinced that the statute was intended to apply to leases and debts in the way they suggest. The proposal seems to indirectly apply to that, and it may be just like the human appendix, an undeveloped evolutionary track that is saved for the future. I think that the proposal should only apply to the valuation of frozen equity interests, that is, stock or a partnership interest with a fixed value on conversion. That will do a great deal to limit the application of the statute. It should not apply to publicly traded securities and should not apply unless the corporation is actually controlled by the transferor, a 50-percent test and the proposal currently values too many discretionary rights, zero. This will have to change. The proposal is unfair primarily in a couple of ways. First of all, it discards the valuation rules when it benefits the taxpayers, but not the IRS. Second, it imposes a gift and estate tax on the same transaction—a continuation of current 2036(c). Finally, it applies to stock-going beyond the existing statute-held by family members that is frozen. And it continues, unlike the gift rule under 2036(c), even when the gifted stock has been given away. We also view as unfair the in-effect transfer rules and recommend you study the Chamber of Commerce proposal which revises that rule and incorporates it into section 2701. We also see a need for changes to increase the flexibility of family businesses to endure economic downturns by expanding the exceptions and allowing some flexibility in that regard.. I also want to mention the liquidation rules, which allow the IRS to value the preferred and common differently, thereby inflating the value of the common. Thank you. [The statement of Mr. Dees follows:] Prepared Statement of Chicago, Illinois Testimony Presented April 24, 1990 The Committee on Ways and Means Hearing On Discussion Draft to Modify Section 2036(c) STATEMENT ON TECHNICAL ASPECTS OF THE SECTION 2036(C) PROPOSAL 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. The Section 2036(c) Abuse. Of the 27 transactions to which the Committee Reports stated Section 2036(c) was to apply, 24 involved the following prototypical "freeze." A wholly owned corporation or partnership is recapitalized into two classes of stock or partnership interests: a preferred class which had a preference for dividend or income payments and on liquidation and a common class which was junior, but had a right to appreciation over the stated value ("frozen value") of the preferred. The owner then gave away the common while retaining the preferred. The dividends or other payments on the preferred may never have been paid, but the value of the preferred was artificially supported by a redemption right, a conversion right or a power to liquidate. These rights were never actually exercised so that over time the value of the preferred was frozen at its initial stated value. Moreover, the unpaid dividends or income payments accumulated in the entity to the benefit of the common owners. Using time value of money concepts, if the payments were deferred into perpetuity, their present value approached zero. The actual present value was never that low as the life expectancy of the parent was often short and the frozen value of the preferred would be taxed in the parent's estate. Thus the Section 2036(c) "abuse" involved four elements all of which were necessary: (1) preferred stock held by a parent with a fixed or "frozen" value, (2) the use of unexercised conversion, redemption or liquidation rights to artificially support the preferred's fixed value, (3) the failure to make the expected dividend or other payments on the preferred, (4) which accrued to the benefit of the children who held the gifted common. Drafting a replacement to current Section 2036(c) means targeting the elimination of the abuse without discriminating against family businesses. That is a delicate balance, but one which it should be possible to achieve. The Proposal is an acceptable starting point for such a replacement. We therefore appreciate the efforts of the drafters of the statutory language and this Committee for holding hearings on that language. Working together we can develop an acceptable replacement. The Proposal. The Proposal targets the abuse by - 1. 2. 3. Specifying that preferred stock (or partnership and trust interests) will be valued by assuming that all stated quantifiable payments ("QFP's" in the statutory vernacular) will be made That all other retained rights will be valued at zero, subject to a few limited exceptions (hereafter "non-discretionary rights") Providing (subject to certain exceptions) that a deemed gift will result if the stated payments, in fact, are not made General Concepts. While these elements of the Proposal are acceptable, in other respects the Proposal is an unacceptable replacement for Section 2036(c). First, the Proposal is overly-broad. Probably less than 5% of all family business owners and farmers engaged in preferred stock freezes, yet Section 2036(c) impacted 100% of those owners and farmers. The replacement must not apply to the 95%. In my testimony to the Senate Finance Committee I compared Section 2036(c) with trying to give directions to my house by describing everywhere in America I don't live. The Proposal has a similar flaw. It is drafted so broadly out of a concern that some tax savings device may not be caught. The result is an unnecessarily complicated statute which needlessly impacts business transactions. It is important to return to the notion of targeting the abuse and relying on regulations and the courts to end schemes which are designed to avoid the statute. Specifically: Specifically: The Proposal should not apply unless the transferor and family control the entity. With spousal attribution that should be 50% control. 9. The Proposal values at zero too many rights which are not discretionary. Second, the Proposal is unfair. Unfairness is present in several respects. 1. The Proposal disadvantages owners of family businesses and farms as compared with investors and public and foreign corporations. 2. The Proposal imposes no discipline on the IRS because it disregards the neutral valuation principles it purports to apply when those principles would benefit taxpayers. Finally, the Proposal is too complex. The purpose of Chapter 14 is to impose a gift when ordinary valuation principles would say that no gift occurred. Accordingly, the rules should be designed to mitigate any harm caused by this element of surprise. Another element of simplification is to cast the statute in terms of concepts which business owners and their tax advisers understand. Specifically: Specific Comments. The section by section comments which follow expand on these general comments above as they relate to partnerships and corporations. My comments on the trust aspects are that they do not belong in Section 2701 and that the problems of GRITS and their progeny require separate treatment. The final section of this testimony describes that treatment. Section 2701(a). This statement of the general rule contains a number of initial missteps: 1. 2. It adopts an entity approach that increases complexity and requires the valuation of the entire business. It speaks of valuing rights rather than valuing stock and partnership interests. This conveys the false notion that rights in 3. 4. a partnership or corporation can be conveyed without the conveyance of the underlying stock or partnership interests. The retained rights ("interests" are used interchangeably in some cases) which are specially valued needs to be limited to those right associated with stock or partnership interests which have a frozen value. Unless the appreciation rights have been severed from the capital rights no "freeze" has occurred. Likewise the failure to make the required payments accrues to the benefit of the preferred holder. Unless this change is made, impossible mathematical problems arise on allocating the benefit from the failure to make the required payments. The purpose of this expansion would be to ensure that the neutral valuation rules applied in all instances equally to the Treasury and taxpayers. It would eliminate the necessity of those portions of the Proposal which allows both a gift and estate tax to be imposed on the same transaction. It would also eliminate the unfairness inherent in taxing the appreciation in the value of retained rights without any offset for depreciation. Finally, it would remove any need for the "in effect" transfer rule. Section 2701(a)(2)(A). This section should provide that discretionary rights associated with the frozen equity interests should be valued at zero. The term "discretionary rights" should be limited to discretionary rights with respect to conversion, liquidation, put or call and dividend and other discretionary payments. QFP's can continue to be defined as in the Proposal. Section 2701(a)(2)(C). The lead-in should be revised to clarify: For purposes of determining the value of Section 2701(a)(2)(C). This laundry list of rights which are not impacted by the valuation rules under Chapter 14 needs to be expanded. 1. It is practically impossible to assign a value to voting rights. Moreover, in the context of preferred stock voting rights were traditionally used to artificially support the value of the |