Thank you, Mr. Chairman, for giving me this opportunity to testify today. My name is Richard Larson and I am Chairman of the Board of Charles E. Larson & Sons, Incorporated, a forging business started in 1895. This is a third and fourth generation family-owned and operated business. We are located in Chicago, Illinois, with 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 formulation 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.

NAM believes that estate taxes, in and of themselves, have an adverse impact on capital and initiative necessary for industrial activity and expansion of employment opportunities. The association believes that the overall tax burden on estates--at rates of up to 55 percent--should be reduced. Furthermore, the rules should be amended to avoid hardships and inequities to estates consisting primarily of equity ownership in closely-held businesses, to prevent forced sale of these firms.

This issue is critically important--not only to NAM's 9,000 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

The discussion draft correctly 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 because it attempts to devise methods to fairly value what is being transferred to the younger generation. However, the narrow definition of Qualified Fixed Payments (QFP) excludes items of value. It is under inclusive because it excludes payments that do 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.

PROBLEMS INDIGENOUS TO FAMILY FIRMS

The discussion draft should be modified to consider problems peculiar to family-owned and operated firms. For example, the draft overlooks the difficulty of obtaining unanimous consent of other family members who own stock in the business--something required in order for a payment to be counted as a QFP. Yet, all too often familial problems having nothing to do with business operations can interfere in such decision-making. I believe this particular issue can be addressed adequately without complicating the proposal.

Mr. Chairman, I opened my remarks by noting that our members considered repeal of section 2036(c) to be critically important to their futures. To Charles E. Larson and Sons, Incorporated, the current law will be the demise of this 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 taxes. The borrowing costs to pay future estate tax liabilities would be excessively high.

My business' available cash for payment of QFPS and estate taxes will be further reduced because of the expected decline in the 35% of my business which is defense-related work.

Under the proposed requirements of the discussion draft, using a market rate of return of 10% 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 competitive 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.

In a survey of NAM's small manufacturers completed earlier this year, more than 85 percent indicated that they are family-owned and operated. Almost 80 percent of respondents indicated that their business had been in existence for more than 25 years. More than 28 percent of the company CEOS are 60 years of age or older.

It follows that a number of these well-established firms will eventually be changing hands, with controlling individuals ready to pass the reins of ownership and management to a new generation. 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 for 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.

I need to make clear the difference between a public corporation and a private one. A public company has to enhance short-term

earnings and make happy analysts on Wall Street and stockholders throughout the country. A family firm, on the other hand, does not measure its success quarter by quarter. It takes a longer view stretching years or decades into the future. It is willing to take a financial hit--sometimes for years--in the hopes of a strong return at some point later on.

The values of American enterprise add something back to the society in which we live. They provide good jobs. Create products that make life easier. Build companies that pass on through generations and give stability to the communities in which they're located. Contribute to local charities and help when help is needed.

The effect of section 2036 (c) has been to strike fear into these family-owned firms. Fear that they will be forced to liquidate. Fear that they will be forced to sell out to absentee owners for whom the company will be just another factory, there to be shut down when the first sign of bad times comes.

Mr. Chairman, we applaud your recognition of this problem, and the steps you have taken in this discussion draft to reverse the significantly adverse effects of Section 2036(c). We have offered a number of suggestions in this testimony, as have others.

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.

STATEMENT OF DAVID R. BURTON, MANAGER, TAX POLICY CENTER, U.S. CHAMBER OF COMMERCE

Mr. BURTON. I am David Burton, manager of the Tax Policy Center for the U.S. Chamber of Commerce. I appreciate this opportunity to present the chamber's views on the discussion draft of a proposal to replace section 2036(c) of the Internal Revenue Code released by the Committee on Ways and Means on March 22, 1990. The chamber has actively supported the repeal of section 2036(c). This provision eliminates estate freeze recapitalizations, calls into question the viability of many other legitimate methods of transferring family business assets from one generation to the next and creates uncertainty with respect to many business arrangements that are unrelated to estate and gift tax planning.

For 3 years, a cloud of complexity and confusion has hung over the entire family business community. As a result, there now seems to be a consensus that section 2036(c) should be repealed. The issue has, therefore, become what will replace section 2036(c). Before I discuss the chamber's views on the substance of the discussion draft, I would like to take a moment to commend the Committee on Ways and Means and the Department of the Treasury for the process that led to the release of the discussion draft. The process is a model of how the legislative process should work. The process included extensive consultations with business and practitioner groups and was followed by a release of actual statutory language well before markup.

This kind of process will enable the public to review deliberately and make well-considered comments about draft legislation and will result in a superior legislative product.

If this kind of approach to the legislative process were to become the model, there is no doubt that the content of the tax law would improve, the need to revisit and change the law would decline and public respect for the tax system would grow.

A bipartisan effort has moved the process to this point. The chamber thanks Representative Archer for his sponsorship of H.R. 60 and for his determined effort to repeal section 2036(c). This legislation now has 218 cosponsors. Several bills have also been introduced in the Senate to repeal section 2036(c). Senator Symms has introduced S. 659, Senator Daschle has introduced S. 849, and Senator Helfin has introduced S. 838.

There are presently 36 Senators sponsoring or co-sponsoring at least one of these bills. Indeed, the Senate Committee on Finance approved the repeal of section 2036(c) as part of its budget reconciliation legislation last year.

The chamber has carefully reviewed the discussion draft released by this committee as a replacement for section 2036(c). We support the core concept underlying the discussion draft of establishing reasonable rules for valuing retained interests in recapitalizations while abandoning the 2036(c) approach of considering retained interests as retention of transferred property.

However, we have identified significant problems with the discussion draft, and unless a number of significant improvements are made in the draft, the chamber cannot support it. The balance of

my testimony will identify these issues and the manner in which the chamber thinks they should be addressed.

In addition, we have attached draft statutory language as an appendix. This language incorporates the changes to the discussion draft that would need to be made in order for the chamber to support it. We view our draft as only a starting point. There are no doubt ways in which it could be improved and we welcome comments about how it could be improved.

But we are convinced that our draft is a framework for a permanent solution to the problems caused by section 2036(c).

Buy-sell agreements should not be covered by the draft. The draft affects all buy-sell agreements, whether or not they are abusive in any way. The draft would disregard rights of first refusal and require buy-sell agreements to be renegotiated every three years.

The draft establishes an arbitrary and unfounded requirement that the junior equity interest be valued at no less than 20 percent than the equity of the business plus any debt owed to family members. Including the debt in the calculation is improper. Furthermore, 20 percent is too high if recapitalizations are to remain a viable option for family business.

The only exception to the compounding election under the draft is bankruptcy or insolvency. Analytically there should be an additional exception where a dividend would not be paid in an arm'slength transaction. It is difficult to draft such a rule.

We recommend that a bright line, administerable exception to the deemed gift rule be drafted where the sum of the entity's annual earnings and profit plus compensation to family members is less than the required earnings payout, provided there was adequate coverage at the outset of the recapitalization.

If this or a similar rule is not adopted, the business owners who have done recapitalizations may find themselves liable for a gift tax at a time they can least afford it.

The draft permits only two rights to hold value in determining the value of a retained interest in recapitalization voting rights and qualified fixed payments. This approach unfairly excludes many rights that are not abusive and are routinely used in the business world. The chamber's draft replacement statute, which is attached to our testimony as an appendix, would value at zero discretionary rights, would value qualified non-discretionary rights in a way similar to the discussion draft and value a number of other rights, for example, buy-sell agreements, under normal valuation principles.

Because of the importance of the discount rate to the valuation process, there is considerable concern in the business community over how that rate will be determined in practice.

There is concern that the rate may later in the political process or in the regulations be set at an artificially high rate. There is fear that the IRS will on audit regularly attempt to characterize small business securities as low grade high risk securities that should be discounted at a high rate.

At some point in the process there must be an assurance that this will not occur. There are a number of other issues addressed in