STATEMENT OF HARRY L. GUTMAN, ESQ., PARTNER, DRINKER BIDDLE & REATH, PHILADELPHIA, PA

Mr. GUTMAN. Thank you, Mr. Chairman.

My name is Harry Gutman. I am a practicing attorney in Philadelphia. I am appearing here today as an invited witness to offer comments on the infirmities in the transfer tax structure that led Congress to enact section 2036(c), to comment upon the proposed replacement for section 2036(c) set forth in the discussion draft, and to offer a number of specific suggestions to further the purposes of the legislation.

I do not intend to dwell on the technical issues relating to the discussion draft. Technical issues exist, and others appearing before the committee today have brought many of them to the committee's attention.

Rather, I would like to emphasize a number of more general issues. First, the problem that led to the enactment of section 2036(c) is basically a valuation problem. Therefore, it is appropriate that the proposed replacement focus primarily on valuation issues. The discussion draft does this and it, therefore, provides a very useful starting point for further elaboration.

Second, it is important to recognize that the Internal Revenue Service must be given the tools, both appropriate statutory authority and administrative resources to deal with these difficult issues. And in this context, the proposals of the District of Columbia Bar deserve particular attention.

Third, whatever legislation is ultimately passed, it should recognize that when closely related parties who are otherwise subject to the statute deal with each other in an arm's-length manner, the special rules of the statute ought not apply. This means that the special rules of the statute should be presumptive, in my view, and taxpayers should be given the ability to refute it by demonstrating to the satisfaction of the Commissioner that their transaction is equivalent to one between unrelated parties.

This presumption should cure some of the concerns of small business representatives who feel that the statute unfairly discriminates against transactions that are engaged in by small business or closely held businesses.

I recognize that this suggestion builds some uncertainty into the statute. However, the alternative is to try to anticipate the terms of the transactions that would be deemed similar to arm's-length transactions so that the statute could be avoided. An extraordinarily complex statute would result. It would be impossible at the outset to determine all of the forms of qualifying transactions. Therefore, regulatory authority and administrative discretion with all of the concomitant lack of certainty, would be necessary in any event.

It is important to recognize that the valuation abuses and planning objectives that are easily recognized in the classic partnership or corporate freeze can be achieved through manipulations of capital structures, sales of stock for notes, buy-sell arrangements and options.

There seems to be little disagreement that the classic and easily recognized situation should be corrected by appropriate legislation.

There is less agreement that other methods of achieving the same substantive result should be subject to similar rules.

I would have thought it obvious that corrective legislation must apply, not only to the classic case, but also any transactional forms that reach the same result. I am uncomfortable with any statutory substitute to section 2036(c) that fails to deal with the abuse potential that can arise if a note, buy-sell agreement or an option is substituted for preferred stock.

I understand that the buy-sell agreement poses a particular problem. No one can plausibly deny that buy-sell agreements serve an important and legitimate business function in general and in closely held businesses in particular.

The desire to control the devolution of ownership of a closely held business, to avoid expensive appraisals to determine purchase price, and to determine and provide for liquidity needs in advance are all concerns.

But, on the other hand, one must recognize that under current law the buy-sell agreement may be used to pass wealth without the payment of transfer tax. One way out would be to provide that agreements or options to acquire property that are entered into between related parties, will be ignored for purposes of determining the value of that property. Any property subject to such an arrangement would be valued at its fair market value without regard to the arrangement. However, the taxpayer would have the opportunity to demonstrate to the satisfaction of the Commissioner that the terms of the agreement were similar to those that were obtained in an arm's-length bargain. Under those circumstances, the value determined under the agreement would be sustained.

The foregoing rule also ought to apply not only to contractual arrangements and options, but also to partnership arrangements and capital structures that have the same effect. Thus situations that have recently faced the courts such as Harrison v. Commissioner could be redressed.

I would like to make one additional suggestion. One of the principal reasons for a buy-sell arrangement and one of the items that representatives of the small business community have commented upon is that the buy-sell agreement fixes values so that liquidity needs can be anticipated.

The planning problem under current law for illiquid estates is exacerbated by the uneven statutory relief. There seems to me to be no compelling reason why an illiquid estate no matter what the source of the illiquidity, should not be able to defer the tax attributable to the illiquid assets, so long as the interest rate is sufficient to equate the present value of that deferred tax liability with the tax that would be paid now.

The knowledge that illiquidity relief is readily available ought to alleviate some of the pressure on buy-sell agreements.

In my prepared statement, I also made a number of suggestions with respect to so-called grantor retained interest trust and joint purchases which I think ought to be dealt with in a manner different than that set forth in the discussion draft.

The overriding difficulty it seems to me, Mr. Chairman, in this area is crafting a solution to abusive valuation techniques that distinguishes between those that serve legitimate purposes and those

that do not. This is important in the context of a closely held family business where the mechanisms also contain the seeds for abuse. You have to be scrupulous in devising rules that do not discriminate against closely held family businesses when the activity undertaken is similar to that which would be undertaken by unrelated third parties.

Thank you.

Mr. LEVIN. Thank you very much.

[The statement of Mr. Gutman follows:]

STATEMENT OF
HARRY L. GUTHAN

BEFORE THE HOUSE COMMITTEE ON WAYS AND MEANS

APRIL 24, 1990

Mr. Chairman and Members of the Committee:

I am pleased to appear today as an invited witness to offer comments on the infirmities in transfer tax structure and administration that led Congress to enact section 2036 (c), the proposed replacement for section 2036 (c) set forth in the Discussion Draft released for comment by the Chairman on March 22, 1990 and a number of specific suggestions to further the purposes of the legislation.

I will not dwell on technical issues relating to the Discussion Draft. Technical issues do exist and others appearing before the Committee today have brought many of them to the Committee's attention. I and others stand prepared to assist in their resolution.

The existence of technical difficulties should not be, and is not being, used as a tactic to divert attention from the underlying issues. Representatives of the organized bar have engaged in an ongoing dialogue with Committee and Treasury staffs with a view toward devising a statutory alternative to current section 2036(c) that both addresses and is limited to legitimate administrative and structural transfer tax problems. It is natural that there will be disagreement as to the scope and nature of the problems. However, disagreement at the margin does not imply that agreement on basic principles cannot be reached. It is in this spirit that I offer below my comments on the scope of the problem and a number of specific solutions to it.

The Scope of the Problem

Over the years, a number of techniques have developed to exploit the transfer tax structure by taking advantage of valuation uncertainties, manipulating valuation tables and creating devices to transfer wealth in ways that are difficult for the Internal Revenue Service (the "Service") to detect. In part these techniques have been successful because lack of adequate notice, manpower and other administrative problems have prevented the Service from detecting and questioning doubtful transactions. Thus, one part of the solution is to provide the Service with adequate notice and manpower to deal with these issues. Another part of the problem has been the court response to cases brought by the government. Here in a significant number of instances, strict adherence to the "willing buyer/willing seller" test has led to results that permit transfer tax avoidance. The solution to this part of the problem is substantive legislation directing a different result in appropriate cases.

The classic illustration of the problem is the "estate freeze" by which corporate or partnership interests are re-arranged with the objective of fixing the value of a retained portion of a business in the transfer tax base of the transferor while transferring the future growth potential to another (in many cases the natural object of the transferor's

bounty) at little or no gift tax cost. There should be no objection to this technique if the retained and transferred interests are properly valued. However, the technique is suspect when the objective is accomplished by creating discretionary features for the retained interests which are alleged to have substantial value but which, in fact, would not be exercised for the benefit of the transferred transferor. Moreover, it is important to understand that the identical objective could be achieved through other manipulations of the business entity's capital structure, sales of stock for notes, buy-sell arrangements, options, or the provision of property or services to the entity through lease or employment arrangements.

There seems to be little dispute that the classic and easily recognized -- situation should be corrected by appropriate legislation. There is less agreement that other methods of achieving the same substantive result should be subject to similar rules. I would have thought it obvious that corrective legislation must apply not only to the classic case but also any transactional forms that reach the same result. Accordingly, I am uncomfortable with a statutory substitute to section 2036(c) that fails to deal with the abuse potential that can arise if a note, buy-sell agreement, or option is substituted for preferred stock.

Owners of closely-held family businesses have suggested that section 2036 (c) is unfairly targeted at them. The focus of that legislation (and the Discussion Draft) is on closely-held family businesses. This does not necessarily indicate an intention to discriminate against closely-held family businesses. Rather, it is a candid acknowledgment of the fact that more opportunity for manipulation exists in the context of closely held family businesses and therefore greater scrutiny is required." At the same time, it is axiomatic that arm's length transactions between family members should not be subject to special rules. There is no inherent evil in recapitalizing a corporation and transferring a growth interest to a third party. The problem arises when the transferred interests are misvalued. As a notional matter, any time the parties to a suspect transaction can demonstrate that the terms of their transaction are substantially identical to those which would exist in the case of a transaction between unrelated third parties, there is no need for a special statutory rule. Thus, I would urge that any legislation be presumptive and afford taxpayers who are subject to it an opportunity to demonstrate, to the satisfaction of the Commissioner, that the actions they have taken correspond to actions that would be undertaken between unrelated third parties.

I recognize that this suggestion builds some uncertainty and administrative complexity into the statute. However, the alternative is to attempt to anticipate, as a statutory matter, the terms of transactions that would be deemed sufficiently similar to arm's length transactions to avoid the application of the statute. An extraordinarily complex statute would result. Moreover, since it would be impossible at the outset to determine all forms of qualifying transactions, regulatory authority and administrative discretion, with its concomitant lack of certainty, would still be necessary to fill in the interstices.