ness even though he never paid a dividend to himself over the course of time. Never converted it back to common. That is the perceived abuse here, that he was able to freeze it without ever paying a thing. Through inflation the value of the business would grow and through the reinvestment of the earnings 2036(c) reversed the situation. It said even though he was willing to pay $5 million of gift tax to get that appreciation out of his estate, if he retained an employment contract or some other string to the business, we would still tax the business on the full appreciation even though it may have been entirely due to the child's efforts. That is one of the problems with 2036(c). What the draft does, assuming you get rid of the 80/20 rule, which is unjustified and discriminates against family businesses, we can go to a situation where the parent can retain income, can have an interest in the business, you don't have to kick pop out, and if he is willing to pay the $5 million of gift tax up front, or alternatively pay whatever the dividend rate is that is justified under the circumstances so that his estate is not shrinking through the effect of inflation. It is a fair result from that standpoint. Now, we have talked about a sale of business for a note. That is one possibility. There, you have to pay the interest so that interest every year accumulates in your estate. We have talked about the possibility of a freeze existing if you pay the market testing rate. There are lots of ways that we built into the draft an option to either pay the gift tax up front or to pay some continually compounding amount in their estate to offset the effect of the gift. Mr. LUBICK. The D.C. Bar draft would permit the freezing of $10 million, would put in assurances that the retained interest is properly valued at the $10 million, and would permit the transfer of the appreciating junior equity stock. But, we would have gotten the correct tax on that interest which is retained. Mr. LEVIN. Maybe we better go on. I have appreciated your comments. I would urge you, if you have any further ones, to let us know. I think the more I have boiled this down, this complexity to at least questions that are easily understood, we may be able to act effectively. Thank you. We are now into the last panel, are we not? We are not. Well, then-all right. The next panel is Mr. Greenhaw, Mr. Merlino, from the AGC; Mr. Greenhaw is from the Retail Hardware Association. From the NAM, Mr. Larson. From the Chamber of Commerce, Mr. Burton, and from the Telephone Association, Mr. Woody. Mr. Greenhaw is accompanied by Mr. Schnakenberg who is owner of Ace Hardware. We are going to start with you, Mr. Greenhaw. One second, while we get our names in place. STATEMENT OF FRANK W. GREENHAW, OWNER, McWHORTERGREENHAW HARDWARE, INC., MESQUITE, TX, AND PRESIDENT, NATIONAL RETAIL HARDWARE ASSOCIATION, ACCOMPANIED BY C.J. SCHNAKENBERG, OWNER, SCHNAKENBERG'S ACE HARDWARE, CHICAGO, IL Mr. GREENHAW. I am Frank Greenhaw, the president of the National Retail Hardware Association, NRHA, a national association of 18,000 hardware store owners. I own a hardware store in Mesquite, Texas. My son is a third generation hardware man. He is home today operating the business. I am accompanied by C.J. Schnakenberg, also a third generation hardware store owner. He is from Chicago, Illinois. We are pleased to appear before you to discuss your proposal to replace section 2036(c) of the Internal Revenue Code, a provision that has become a household term in the hardware business. I compliment the committee for holding these hearings today, and for working to develop this proposal with the cooperation of the Department of Treasury and the business community. The retail hardware industry has been deeply affected by section 2036(c) and stands to be equally affected by your replacement proposal-perhaps more than most small businesses. Before I get into the details, I would like to state for the record the policy of the NRHA regarding the transfer of family businesses. We believe that small, family-owned businesses play an important role in this nation's economy, and all impediments to the transfer of these businesses should be repealed. Our problems with section 2036(c) can be summarized as follows: First, it focuses unfairly on family-owned small businesses. Second, the current law requires that retailers pay transfer taxes on the entirety of a business assessed value. Because most of this assessed value is tied up in real estate and inventory, we are forced to sell all of the business to pay the taxes. Third, hardware stores are valued by their market value rather than earning capabilities. This method creates unfair burdensome transfer tax assessments, often encouraging the sale of the busi ness. The discussion proposal before us today is very important to NRHA members because it signifies to our members that the committee and the U.S. Treasury have chosen to move away from the policeman mentality of 2036(c). However, as written, it fails to help NRHA members transfer hardware stores intact to their children. The system described in the discussion draft would prevent legitimate transfer of hardware stores to family members for the following reasons. The proposal attempts to value our business during recapitalizing using the cash-flow method. This system will not help hardware stores. The cash-flow method is most injurious to stores which generate the least earnings. The proposal places enforcement concerns over concerns for the continuing survival of family busi nesses. According to this proposal, family business owners are still forced to operate at a competitive disadvantage to those individuals with wealth represented by other business investments. More specifically, the income stream approach compares the stores earnings with some yet to be determined market rate. Businesses that can pay qualified fixed payments at or above the applicable federal rates escape large transfer taxes. However, the National Retail Hardware Association estimates hardware stores provide an average rate of return before taxes of less than 4 percent. If the market rate chosen to implement the plan is the applicable federal rate of 10 percent, hardware store owners in particular would be in trouble. According to our figures, this would mean that 64 percent of the average hardware store's fair market value could be deemed to be a gift at the time of recapitalizing, and thus subject to the transfer tax. This approach wrongfully assumes that the firm can pay out at a constant rate applicable to yields of other investments or businesses. When you do the math, you realize most retailers are faced with two alternatives. Sell the business to satisfy the estate obligations or cannibalize the business to meet the presumptive and artificially high rate of return. Neither of these options encourage survival of a business that pays federal, state and local taxes and the salaries of many employ ees. The main problem with section 2036(c) remains the main problem of this replacement proposal. It places family owned businesses at a disadvantage compared to families who have liquid assets represented by cash or collectables. To sum it up, Mr. Chairman, I am here before you today representing small businessmen who have spent their lives working 50 and 60 hours a week to nurse businesses that sometimes generate a 3 percent rate of return. Without federal funding, we have generated tax revenues and jobs for our communities. What we want is to transfer these businesses intact to the next generation. Neither section 2036(c) nor the new discussion draft allows this transfer to occur. Therefore, we must respectfully continue to ask for complete repeal of section 2036(c). [The statement of Mr. Greenhaw follows:] TESTIMONY OF FRANK W. GREENHAW REPRESENTING THE NATIONAL RETAIL HARDWARE ASSOCIATION Mr. Chairman and Members of the Committee on Ways and Means: My name is Frank Greenhaw, and I am the president of the National Retail Hardware Association (NRHA), a national association of 18,000 hardware store owners. I an accompanied here today by C. J. Schnakenberg, a fellow hardware store owner from Chicago, Illinois. We are pleased to appear before you to discuss your proposal to replace Section 2036 (c) of the Internal Revenue Code a provision that has become a household term in the hardware business. I compliment the committee for holding these hearings today, and for working to develop this proposal with the cooperation of the Department of Treasury and the business community. The retail hardware industry has been deeply affected by Section 2036(c) and stands to be equally affected by your replacement proposal perhaps more than most small businesses. Before I get into the details, Mr. Chairman, I would like to state for the record the policy of the NRHA regarding the transfer of family-owned businesses. We believe that small, family-owned businesses play an important role in this nation's economy. Regulations such as Section 2036 (c) that impede interfamilial transfer of hardware stores are bad tax policy and should be repealed. There are three factors that have caused our industry to be adversely affected by section 2036 (c): First, most hardware stores are small businesses, closelyheld and family-owned. These businesses have been singled out under Section 2036 (c) because they are presumably more susceptible to "non arms length transactions". Second, the assets of hardware stores are largely illiquid, and the application of heavy estate taxes, therefore, often causes the break-up of these businesses. A hardware store's assets consist mainly of inventory, real estate, customer lists and good will. Indeed, the most valuable asset of a hardware store can only be developed over many years of service in one neighborhood or to one community, and is enhanced as hardware stores are passed along from one generation to another. - its good will - Third, hardware stores, while they may have market value, often have low to moderate earning ratios, and very little cash on hand. The proposal before us today moves towards the elimination of these problems. Its emphasis on a valuation approach and away from a punitive approach is a step in the right direction, because it reduces some of the inequitable effects of Section 2036(c). However, it still does not constitute an adequate mechanism for the transfer of hardware stores from one generation to another. We believe that the proposal falls short in two significant respects: First, the proposal's reliance on a cash flow method for business valuation during recapitalizations is inflexible, and is an attempt to be scientific in an unscientific area. Basing the amount of the gift on the amount the firm can pay out, as judged 33-144 0 - 90 - 9 2 by a market rate of return, will ensure that hardware stores are disproportionately effected, and Second, it continues to emphasize enforcement concerns over sound business planning, placing small family-owned business at a competitive disadvantage to other enterprises. We believe the estate freeze mechanism is a valid way to transfer a business; and that a properly valued estate does not abuse the use of an estate freeze. We appreciate the concerns of this committee and the Department of Treasury in ensuring that "abuses" in the tax code are addressed, but these abuses cannot be rectified through the application of complex rules which fail to consider business realities. I. Problems with Current Law for the Hardware Industry In a nutshell, Section 2036 (c) effectively prevents hardware store owners from accomplishing what for many of them is their highest ambition: transferring the business to their offspring. While there are many other lines of business that provide a higher rate of return with less risk and shorter hours, Do-ItYourself retailers derive a special pleasure from building a living business legacy for their children. By exposing such transfers to estate or gift taxes beyond the scope of any cash reserves that the business might have, 2036 (c) effectively encourages the retailer to sell to strangers. For those who attempt to maintain family ownership, the alternatives can be bleak. The cash needed to pay the transfer taxes can only be generated by selling off inventory or cutting sales staff. Thus, 2036 (c) acts to kill the goose that lays the golden eggs, crippling or killing a valuable source of ongoing tax revenues and jobs in order to pay a one-time tax. Another significant difficulty caused by 2036 (c) involves the retailer's inability to plan, with certainty, the complete transfer. By essentially imposing an estate tax system on a gift tax issue, the freeze ban hangs an estate penalty "sword of Damocles" over the head of retailers for the remainder of their lives. II. The Current Proposal The discussion draft is meant to permit transfers of future appreciation in classic estate freeze "transactions," regardless of the nature of the asset transferred (i.e. trade or business property, collectible or marketable securities). The proposal, however, ensures that the entire value of the interests transferred are run through the transfer tax system, by means of an elaborate system which is designed to anticipate and preclude any form of abuse. More specifically, the proposal would permit transfers of future appreciation in a recapitalization, but would safeguard against abuses by: valuing the income stream from the transferred property (discounting the value of the income stream); and ensuring that either: (a) payments are actually made that equal or exceed the income stream, or (b) a gift is deemed to occur. Under the proposal, the income stream constituting payments from the transferee to the transferor after the recapitalization would not be considered to have value unless those payments are qualified fixed payments (QFPs) within the meaning of the proposal. In order for the payments to be QFPs, they would have to be fixed in |