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STATEMENT OF FRANK MERLINO, ASSOCIATED GENERAL CONTRACTORS OF AMERICA
The Associated General Contractors of America is a construction trade association representing more than 32,500 firms, including 8,000 of America's leading general contracting companies, which are responsible for the employment of more than 3,500,000 employees. These member construction contractors perform more than 80% of America's contract construction of commercial buildings, highways, bridges, heavy-industrial and municipal-utilities facilities.
The construction industry is composed predominantly of small, family-owned firms competing in local geographic markets. Eighty-five percent of AGCs membership has average annual gross receipts of less than $10 million; ninety percent qualifies under the Small Business Administration's definition of a small business.
AGC appreciates this opportunity to present its views on the estate valuation rules of Section 2036(c). AGC would like to express its appreciation to the Chairman and to the Committee for circulating the discussion draft on reforming the valuation rules and requesting comments.
HISTORY Section 2036(c) was added to the Internal Revenue Code in 1987. If an individual holds a substantial interest in an enterprise and after December 17, 1987 in effect transfers property having a disproportionately large share of potential appreciation in the enterprise while retaining an interest in the income of or rights in the enterprise, the retention of that interest is considered a retention of the enjoyment of the transferred property. The value of the transferred property comes back into the parent's estate, at its value as of the time of the parent's death.
Section 2036(c) eliminated the traditional corporate and partnership estate freezing techniques. Section 2036(c) went beyond those transactions to cover a variety of other everyday business transactions. The 1988 Tax and Miscellaneous Revenue Act (TAMRA) added several safe harbors, but also added a "deenied gift“ rule. IRS Notice 89-99, published on September 1, 1989, gave the first guidance on how the IRS intends to enforce the statute.
PROBLEMS WITH SECTION 2036(c) The broad statutory language contained in Section 2036(c) makes estate planning and orderly business succession very difficult. Congress also granted the IRS unusually broad authority to write regulations in this area and to expand the types of distributions to which it applies. This broad ability to interpret the statute means that taxpayers may carry out a transaction that is not subject to Section 2036(c) when it is designed, but the IRS may decide several years later that the transaction is actually subject to Section 2036(c). It took two years to get the first guidance on the statute.
For example, Section 2036(c) as presently interpreted by the IRS applies not only to transfers of interest in a business but transfers of passive investments as well. If a parent trai fers a bond to a child but retains he right to the interest payments, that transaction is subject to Section 2036(c). That was an extremely broad and unexpected interpretation.
Transfer. Section 2036(c) applies if an individual "in effect transfers“ property. That phrase is extremely vague. IRS Notice 89-99 states that it includes the creation of trusts, intra-family sales (including installment sales, private annuities and sales of remainder interests), transfer and leaseback arrangements and joint purchases of income and remainder interests. Transfers may include gifts, sales or trades of property.
"Potential Appreciation." Neither the legislative language nor the notice defines "potential appreciation" or explains how to estimate it. IRS Notice 89-99 established an extremely broad test. The taxpayer is required to assume that any combination of circumstances that would maximize the potential appreciation of the interest would take place.
"Enterprise." Section 2036(c) applies to the transfer and retention of interests in an "enterprise." The legislative language does not define enterprise, but the conference report states that it includes a business "or other property which may produce income or gain." The definition is extremely broad and creates a great deal of uncertainty as to what transactions are covered.
The recent IRS notice states that Section 2036(c) covers passive investment activity as well as the operation of a business entity. Until the guidance was issued, life insurance policies and sales of personal residences were believed to be covered by Section 2036(c). The clarification on those two issues is helpful, but it also indicates the confusion surrounding the scope of Section 2036(c).
Sale to Family Member. Generally, Section 2036(c) does not apply to a transaction if the individual receiving the asset pays fair market value for it. However, Section 2036(c) states that its rules apply to sales to family members, even if the family member pays fair market value for it. If the parent retains an interest in the business or asset, the asset that was sold will be included in the parent's estate.
The only exception is if the family member purchaser can prove that he or she had enough money from other than family sources to purchase the assets. Income from gifts the parent has given the child would not be considered an "outside" source
AGC supports the repeal of Section 2036(c). The repeal removes a great deal of uncertainty as to which transfers are covered and will help family businesses plan an orderly succession.
DISCUSSION DRAFT AGC supports the abandonment of taxing future increases in value by including it in the transferor's estate. Valuing interests more accurately at the time of the transfer is a better approach. AGC also appreciates the flexibility of the approach contained in the Chairman's draft proposal. AGC would like to offer several points for consideration.
In considering any replacement for Section 2036(c), one goal should be preserving the family business. If the next generation is working to build the business, they ought not be penalized for doing so. Family members should not be taxed more harshly than strangers. Family members working in the business are contributing to its growth and increased equity and to the increase in value of the common stock. They should not face a gift tax as well as income taxes on those efforts.
The draft proposal substitutes a gift tax approach for the estate tax approach. If the company is unable to pay the preferred stock dividends, 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 lead to higher gift taxes.
The proposal would subject the transfers to additional levels of taxation. The dividends that must be paid is taxed. It limits the ability of the company to grow. If the parent can't transfer the business, it's taxed within the parent's estate. The child is taxed on the value of the business he or she is helping to build.
In the construction industry, insurance and bonding capabilities are directly impacted by the business's capital structure. Construction contractors must maintain equity in the business to ensure adequate bonding capacity to be able to bid on jobs. The equity that must be left in the business to ensure its viability will cause the gift taxes to be higher than they would otherwise be.
The draft proposal could worsen the effect of business cycles. If the company is cash-poor or encounters problems with operating capital, paying gift taxes would worsen the financial problems. If the financial problems are large enough to force forgone dividends, then paying a gift tax will worsen the problem.
The draft proposal would also reduce the ability of the business to accumulate capital for expansion. would force certain payments regardless of whether the timing would help or hurt the business. There is some flexibility in the proposal which is helpful, but further consideration ought to be given to this issue.
The "current market rate" set in the proposal takes insufficient account of business problems. A national current market rate wouldn't reflect regional economic downturns and the problems faced by businesses. This provision should be eliminated.
The regulatory authority granted to the IRS in this area should be restricted. If the statute of limitations is to be unlimited for transfers subject to the rules that are not reported, then taxpayers should be told what transfers are subject to the rules. Given the current backlog of regulations at the IRS, it would be unfair to subject taxpayers to any uncertainty. The statute should be very specific
to the transactions covered or the statute of limitations should be put back into place.
The statute of limitations should not be unlimited. There can be bonafide disputes as to the application of the statute. Good faith actions should not be penalized years later.
Section 2036(c) was added to the Internal Revenue Code in response to concerns that family businesses were being incorectly valued. Options that were unlikely to be exercised were thought overvalued. To correct that problem, the draft proposal sets certain valuation rules, as follows:
The total value of the common stock could not be less than 20% of the sum of the total equity in the corporation and any debt owed to the transferor's family. Only certain rights in the corporation would be given value. Other discretionary rights not likely to be exercised in an arm's-length manner would not be permitted to reduce the value of the business.
AGC believes this is a sensible approach to the problem Congress identified and resolves it in a simple manner.
CONCLUSIONS AND RECOMMENDATIONS AGC believes incentives for entrepreneurship and capital growth are vital for a healthy, growing and competitive economy. To foster competitive and innovative businesses, which in turn provide economic growth and jobs, tax policy must provide incentives for hard work and entrepreneurship. Section 2036(c) penalizes family businesses by making it more difficult for them to finacially survive the transfer of ownership. It penalizes efforts to encourage younger generations to join the business, and discourages efforts to sell the business to company employees.
For small businesses to thrive, the founders need to leave capital in the business. In the construction industry, insurance and bonding capacity are directly impacted by the business's capital structure. Construction contractors must leave equity in the business to ensure adequate bonding capacity so that they and their successors may bid on jobs.
Not only does Section 2036(c) affect orderly succession planning, it affects the basic viability of the business. If equity is taken out of the construction company, its bonding capacity is reduced. If equity is left in the company, the founder may die and leave so much valuable equity in the business, the next generation cannot raise enough money to buy the business or pay the estate taxes on it. The business would have to be sold to pay the estate taxes.
This is particularly inequitable when the next generation has been working to build the business. At least part of the buildup of the business has been due to their efforts. As the construction company grows, the increased equity left in the business will make it that much harder for the next generation to take it over. However, under Section 2036(c), the next generation is so hampered by constraints that it often makes economic sense for them to work elsewhere than to stay with the business.
Individuals need incentives to take risks. One of the incentives in forming a family business is the opportunity to pass something on to the next generation. Without incentives, the financial risks that must be faced early in the business's formation are not worthwhile.
The interaction of the estate valuation rules with the other recent tax code changes are hurting small businesses. For example, the 1986 Tax Reform Act repealed the General Utilities doctrine. Previously, a single tax was paid at the shareholder level on liquidating sales and distribution of a business. The proceeds were not taxed at the corporate level. Under current law, if the owner retires and liquidates the business, the double taxation reduces the amount the owner will realize on the sale of the business.
The proceeds from the sale of the company are further reduced by the repeal of preferential tax treatment for long term capital assets. The 1986 Act's repeal of preferential treatment for capital gains means that an owner that had invested for the long term instead of spending for the short term is penalized.
The 1988 tax act further reduced the ability of the owner to sell the company to employees or third parties. Sales of property are restricted in their use of the installment sales method of reporting income.
In effect, the tax code penalizes the owner of a business at the end of his or her career no matter how the transfer is accomplished or to whom the business is sold.
When these provisions are taken together with the estate freeze rules, the consequences to small family businesses are very severe. Owners of construction companies who have taken financial risks and who have devoted a lifetime to building equity in a business and who transfer it to the next generation, transfer it to employees or even sell it to strangers cannot dispose of that business at the close of their careers without being subjected to confiscatory tax rates. This is a great disincentive to entrepreneurship and penalizes investment. AGC believes the most innovative and productive sector of the economy deserves better. AGC recommends that Section 2036(c) be repealed. Any replacement ought to focus on the question of valuation of the business. The next generation, which has been working to build the business, ought not to be treated more harshly than strangers.
Mr. LEVIN. Thank you very much.
STATEMENT OF RICHARD LARSON, CHAIRMAN OF THE BOARD,
CHARLES E. LARSON & SONS, INC., CHICAGO, IL, REPRESENTING THE NATIONAL ASSOCIATION OF MANUFACTURERS, ACCOMPANIED BY MONICA M. MaGUIRE, DIRECTOR OF TAXATION
Mr. LARSON. Thank you very much, Mr. Chairman, for giving me this opportunity to testify today.
I submit my written testimony for the record.
My name is Richard Larson. I am chairman of the board of Charles E. Larson & Sons, Inc., a forging business started in 1895. This is a third and fourth generation family-owned and operated business.
We are located in Chicago, Illinois. We have 100 employees and annual sales of $15 million. I am here today representing the National Association of Manufacturers. With me is Monica McGuire, the director of taxation for NAM. We applaud the chairman's formation of this discussion draft.
It is a solid first step in correcting the problems imposed by section 2036(c). We hope, in our comments today, to assist the committee in its effort to ensure the continued survival of the American family business.
This issue is critically important-not only to NAM's 9000 small manufacturers like myself, but to larger companies which rely on small family-owned distributorships for the sale of their products. Uncertainty in that distribution chain is economically unhealthy for both large and small companies, as well as the ultimate consumer of the product.
Definitions of the estate freeze and the impact of section 2036(c) have been well covered today. I plan, therefore, to highlight some refinements that will serve to improve the discussion draft, using my own company as a case study of the potential adverse effects that could result.
The discussion draft currently repeals section 2036(c) and recommends a replacement proposal that would more accurately value the various interests at the time of transfer. This replacement proposal is commendable. However, the narrow definition of qualified fixed payments (QFP), excludes items of value.
It is underinclusive because it excludes payments that do not have a value, such as royalties or percentages of gross sales, but are not fixed. We suggest that it may be better to itemize specifically those items or retained rights that will not be considered to have value.
The discussion draft also would negatively result in the next generation being required to pay dividends to the parent generation even when there are strong economic reasons not to do so. Citing my own company as an example, my company's rate of return is not sufficient to provide the income stream required under the definition of the qualified fixed payment.
Mr. Chairman, I opened my remarks by noting that our members considered repeal of section 2036(c) to be critically important to their future. To Charles E. Larson & Sons, Inc., the current law will be the demise of the 95-year-old business.
Six years ago my company recapitalized, giving common stock to the fourth generation and freezing the value of the preferred stock held by the third generation. Absent repeal or modification, the fourth generation of my company will not be able to afford to transfer business interests to the fifth generation because there is not a sufficient amount of accumulated wealth to pay the current punitive estate tax. The borrowing costs to pay future estate tax liabilities would be excessively high.
My business' available cash for payment of QFPs and estate tax will be further reduced because of the expected decline in the 35 percent of my business which is defense-related work.
Under the proposed requirements of the discussion draft, using a market rate of return of 10 percent or more to value the retained interests of the older generation would overstate the value of the interest transferred to the younger generation.
In the case of my own company, that current value would be relatively small because of my company's recent large capital investment in equipment that has provided technological advances which have contributed to my company's remaining competitiveness in an industry where competitors are increasingly liquidating. One result of this heavy capital investment is that the current income stream is relatively small. NAM, therefore, believes more flexibility in valuation must be allowed.
If the estate freeze rules are not amended, current law could cause a large number of these firms to liquidate.
Such an occurrence would be disastrous not only to the families involved, but for the individuals they employ, the customers they serve, and the Treasury Department—which would lose a steady stream of revenue in exchange for a one-time estate tax collection.
Mr. Chairman, family-owned firms symbolize the values of American enterprise. Not get-rich-quick schemes. Not junk bonds. Not Wall Street game plans to assemble a company and sell out quick to the highest bidder.
Although we recognize serious fiscal restraints face our nation today, NAM believes that an even more desirable step would be eventual elimination of Federal estate taxes on transfers of interest in, or assets of, a closely held business from one family member to the next. Such a move would help ensure the continued prosperity of small family-run business operations that are responsible for critical Federal revenues as well as employment, economic growth and expansion.
[The statement of Mr. Larson follows:]