time and amount. The value of the income stream of these QFPS is then to be judged by comparing the income stream to some market rate, which is yet to be determined.

For example, if a condition of the transfer of future appreciation by the transferor was that the transferor would receive a 5 percent cumulative dividend, and the yet-to-beestablished market rate was 10 percent (close to the Applicable Federal rate currently) of the value of the retained interest of the transferor would be one-half of the fair market value of the business. This would mean that the firm would incur an immediate gift tax equal to 50 percent of the fair market value of the firm. If the cumulative dividend is not paid out in keeping with the original agreement of the transfer, a gift will deemed to Occur. This deemed gift will be susceptible to gift tax after three years if it is not paid, or if the firm elects, it can be pulled back into the estate if a compound interest rate is applied.

To reiterate, the proposal would treat all retained rights, with the exception of cumulative preferred dividends, as having a zero value. This means that they will be assumed to be worthless, and will not enhance the value of the retained interest. The purpose of this is to ensure that the value of these rights is included in the estate or treated as a deemed gift, i.e., that they do not escape tax consequence.

One of the presumed advantages of the proposal is that it will permit the business to fix the rate of return on the preferred stock at the market rate or at any other rate. Allowing the firm to fix the rate of return is not considered to be abusive because the assignment of a low rate of return on the retained interest will reduce the value of the retained interest and increase the value of the transferred interest, with greater gift tax consequences. Alternatively, the assignment of a high rate of return on preferred stock will cause the value of the preferred stock to be greater than the gift, with greater estate tax consequences. They are only concerned that the agreement to pay a fixed amount actually holds true.

Should the retained interest be transferred by the transferor outside the family (to a third party), the value paid for that interest will be considered the fair market value. There may be immediate gift tax consequences if the payment for the interest is less than the value assigned at the time of the original transactions.

There will be no trade or business requirement. In other words, the proposal will not target family owned businesses over the transfer of other forms of wealth in the family context. Similar rules as provided for recapitalizations will be provided for trusts. However, payments from a trust will be considered QFPS if they are based upon the profit to the trust.

Buy-sell agreements are also covered by the proposal. The proposal will not allow values to be fixed by buy-sell agreements unless those agreements are calculated within three years of the exercise of the option at death.

III. The Current Proposal is Little Better than Current Law as Applied to the Hardware Industry

The Hardware industry will be adversely affected by the current proposal for many of the same reasons it is affected under

current Section 2036 (c).

In sum, the new proposal still fails to provide an adequate mechanism for the transfer of family businesses in our industry.

The most significant problem with the proposal is its failure to understand problems of liquidity which exist in the hardware industry. The imposition of a tax on the transfer of a hardware store will, under the proposal, as under current law, require the sale and liquidation of assets integral to the business.

The income stream approach advanced in the proposal would not provide relief for the hardware industry. The approach, as noted, contemplates a comparison of the income stream, or earnings of a business with a yet-to-be-determined market rate. Under the approach, a business will benefit if it is able to pay out a qualified fixed payment which equals or exceeds the market rate return. NRHA's Management Report, the cost of business survey for hardware stores, shows that the annual rate of return (or net operating profit) before taxes is 3.76 percent. If the market rate chosen is the applicable Federal rate of 10 percent, or any rate approximating that rate, a business will incur an immediately assessable gift tax determined on the ratio of 3.76 percent to 10 percent. The difference of 6.24 percent will mean that 62 percent of the fair market value of the business will be deemed to be a gift at the time of the recapitalization. In other words, 62 percent of the business value will be subject to an immediate gift tax, unless the firm can afford a qualified fixed payment rate greater than the prevailing rate of 3.76 percent.

This approach, therefore, wrongfully assumes that the firm can pay out at a constant rate applicable to yields of other investments or businesses. However, a hardware business has a much lower asset to earnings ratio. The result is that a firm is faced with two alternatives:

(1) Sell the business to satisfy the estate tax obligations; or

(2) Cannibalize the business to meet the presumptive and artificially high rate of return.

Moreover, the hardware industry, because it is tied to the highly volatile housing market, is more susceptible to fluctuations in the economy. The retail market is too fluid, too flexible and too uncertain to commit to the kind of long-term, inflexible agreement contemplated by this proposal. Conditions can change quickly and make it impossible for the business to pay the QFP; it is also quite possible that conditions will not bring the business back in three years and thus, when it does comes back, could face heavy gift taxes. Poor economic performance will then provide a trap which, in conjunction with estate taxes, will make it doubly difficult for a firm to be passed along to second generations. The ability of a hardware owner to pass the business along to his or her offspring should not depend upon these artificial constraints.

Perhaps most importantly, we believe that the main problem with Section 2036(c) remains the main problem with this replacement proposal it targets family owned businesses, placing them at a disadvantage compared to families who have liquid assets represented by marketable securities, cash or collectibles. individual with less than 10 percent ownership in a publicly traded corporation, a wealthy individual with substantial assets in artwork or collectibles, even an individual whose wealth is

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represented by real estate in the form of a principle residence can take advantage of recapitalizations as under the old rules. Only those who have worked hard to acquire a business, performing an important function in their communities, generating tax revenues and jobs, will be adversely affected. Enactment of this proposal would perpetuate this basic inequity. At the root of the problem is not the family-owned business, it is the emphasis of our tax policy.

Again, Mr. Chairman, we would like to thank you for your leadership on this issue. We feel that this discussion draft has admirably fulfilled its purpose in that it has brought all of us in the small business community to examine the issue and determine exactly what our problems are with current law. Because this draft does not create a satisfactory mechanism for the transfer of hardware stores, we must respectfully continue to support complete repeal of Section 2036 (c). Thank you.

STATEMENT OF FRANK MERLINO, PARTNER, DARMODY, MERLINO & CO., BOSTON, MA, AND MEMBER, TAX AND FISCAL AFFAIRS COMMITTEE, ASSOCIATED GENERAL CONTRACTORS OF AMERICA

Mr. MERLINO. I am here on behalf of the Associated General Contractors, a construction trade association representing more than 32,500 firms, including 8000 general contracting companies who perform more than 80 percent of America's contract construction. I am the managing partner of a medium-sized certified public accounting firm in Boston, servicing the New England area.

All our clients are closely held firms with the majority of them in the construction related industry.

Ninety percent of these firms are family-owned businesses, many of which have been in existence anywhere from 25 to 75 years and have been passed from one generation to another. Since section 2036(c) has been enforced, these family-owned entities have been faced with a major decision as to whether they want to continue operating as a family entity or sell their company. It would be unfortunate to have the tax implications of section 2036(c) the major factor in making this decision.

AGC appreciates the opportunity to offer its views on section 2036(c) and the problems of value and transfer of family business. In particular, AGC thanks the Chairman and the committee for preparing the draft proposal and requesting comments.

The construction industry is dominated by small family-owned businesses competing in local geographic markets. The broad statutory language contained in section 2036(c) makes estate planning and an orderly business succession very difficult.

The IRS's ability to expand the scope of the statute through regulations creates great uncertainty. Taxpayers may carry out a business succession plan that they believe is not subject to 2036(c) when it is designed. The IRS may decide otherwise years later. AGC, therefore, supports the proposal to repeal section 2036(c) retroactively. It would remove a great deal of uncertainty as to which transfers are covered.

AGC also supports the abandonment of taxing future increases in value by including it in the transfer of real estate. Valuing interest more accurately at the time of transfer is a better approach. In considering any replacement for 2036(c), one goal should be preserving the family business.

The next generation ought not to be penalized for working to build up the family business. They are contributing to the business' growth and increased equity by increasing the common stocks value. They should not be taxed more harshly than strangers.

The proposal would subject transfers to additional levels of taxation. The dividends that must be made are taxed. It limits the ability of the company to grow. If a parent can't transfer the business, it is taxed within the parent's estate.

The child is taxed on the value of the business he or she is helping to build. The draft proposal substitutes a gift tax approach for the estate tax approach. If the company is unable to pay the preferred stock dividend, the company pays a gift tax on the unpaid dividends. If the preferred dividends are not set at a current

market rate, that decreases the value of the preferred stock and increases the value of the common stock. That would ultimately lead to higher gift taxes.

The draft proposal contains several excellent provisions for flexibility. However, there is some concern that the proposal could worsen the effect of business cycles. If the company is cash poor or is encountering problems with operating capital, paying obligatory gift taxes would worsen the financial problems.

The proposal would reduce the ability of business to accumulate capital for expansion. It would force certain payments, regardless of whether the timing would help or hurt the business.

It poses a particular problem for the construction industry. Insurance and bonding capabilities are directly impacted by the business capital structure. Construction contractors must leave equity in the business to ensure adequate bonding capacity so that they may bid on jobs.

The equity that must be left in the business will cause the gift taxes to be higher than they would otherwise be. The draft proposal sets certain valuation rules. The total value of the common stock could not be less than 20 percent of the sum of the total equity of the corporation and any debt owed to the transferor or his family. Options unlikely to be exercised would not affect the business valuation. This is a sensible solution to the problems Congress identified.

It should eliminate the valuation problem. It is not clear, however, that the transfer should then be subject to higher gift tax rates. AGC appreciates this opportunity to testify and looks forward to working with the committee on this issue.

[The statement of Mr. Merlino follows:]