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STATEMENT
OF

AMERICAN BANKERS ASSOCIATION

ON

THE "DISCUSSION DRAFT" RELATING TO
ESTATE VALUATION FREEZES
BEFORE THE

COMMITTEE ON WAYS AND MEANS

U.S. HOUSE OF REPRESENTATIVES

MAY 8, 1990

The American Bankers Association is pleased to have the opportunity to express the views of bank trust departments concerning the Discussion Draft of a replacement for Internal Revenue Code Section 2036(c).

The American Bankers Association ("ABA") is the national, trade and professional association for the United States' commercial banks. Assets of ABA members are about 95% of the industry total. Approximately 3,500 bank trust departments provide fiduciary services for their customers.

The ABA is appreciative of the thought and effort that has gone into the preparation of the Discussion Draft. We feel that the process of issuing a Discussion Draft and holding hearings is a very helpful step down the road toward the repeal of Section 2036(c).

On March 22, 1990, Chairman Rostenkowski of the House Ways and Means Committee introduced a Discussion Draft of a replacement for IRC Sec. 2036(c), which would be repealed from the date of its original enactment, December 17, 1987. The replacement is by a new Chapter 14 captioned "Special Valuation Rules," which constitute essentially a gift tax valuation approach to the perceived transfer tax "estate freeze" problem. These comments regarding the application of the Discussion Draft focus primarily on its application to trusts and buy-sell agreements and on transition rules, after brief comments on the classic estate freeze (with preferred and common stock) and partnership interests.

I. Classic Estate Freeze

Such a freeze results from a recapitalization, with the owner of a closely-held business who desires to transfer ownership to younger family members retaining preferred stock and gifting common stock to such members. The tax law should encourage (or at least not hinder) such transactions which seek to continue ownership in younger family members. IRC Sec. 2036(c) does not do this. Neither does the Discussion Draft, which requires the owner of the preferred stock to accept compounding of unpaid preferred dividends at an "appropriate" market discount rate to avoid a gift tax on such dividends. The Draft intentionally does not describe how this rate is to be determined. When a decision is made on the discount rate, we doubt that it will be much below an arm's length rate. If this occurs and the Discussion Draft (with appropriate revisions) is substituted for IRC Sec. 2036(c), some other encouragement should be offered to closely held business owners. A simple way would be to reduce the interest rate on estate tax deferred under IRC Sec. 6166 to 80 percent of the normal rate. A 4 percent rate is now applicable to a part of the deferred tax but this part is subject to so low a ceiling that little relief is provided.

II. Partnership Interests

We have serious reservations regarding the operation of the Discussion Draft to partnership interests, which is not explained by the Summary or in the pamphlet (JCS-13-90) of the federal transfer tax consequences of estate freezes prepared by the staff of the Joint Committee on Taxation for the April 24, 1990 hearing.

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The

Our concern may be illustrated by using the facts of Estate of Daniel J. Harrison, 52 TCM 1306 (1987), discussed in the Joint Committee pamphlet. decedent entered into a partnership with his two sons. Each of them was a general partner and prior to his death could withdraw his interest in the partnership. At death this right terminated and the deceased partner's interest was "locked in" the partnership for a fixed period of time. Would the execution of the partnership agreement be a transfer of a partnership interest by the decedent to his sons for purposes of section 2701(a)(1)? The answer is not clear. An inquiry to staff produced a yes answer. The value of the decedent's retained interest (and also the sons' interests) is zero, unless (1) section 2701(a)(2)(C) applies (because each partner's interest is the same) or (2) the election in section 2701(b)(4) is available. The election is troublesome because of the requirement that the election state the amounts and times of the payments from the partnership.1/

The important point is that a Harrison fact pattern should not be handled by a gift tax solution. Since each partner can withdraw his entire interest before death, what is involved is a revocable transfer, and it should be treated as such, which occurs with a trust pursuant to section 2701(a)(4)(A).

The easiest way to make Chapter 14 work with partnership interests, in general, would be to limit its scope to section 2702(b)(4)(B)(i).

III. TRUSTS

A. In General

Section 2701(a)(1) states:

IN GENERAL. - Solely for purposes of determining whether a transfer of an interest in a 10-percent owned entity to a member of the transferor's family is a gift (and the amount of such gift), the value of any interest in such entity retained by the transferor (or a member of the transferor's family other than the transferee) shall be determined as provided in paragraph (2).

Thus, Chapter 14 overrules Chapter 12 regarding transfers subject to this provision. Pursuant to section 2703(e)(1)(A)(iii), a trust is a 10 percent owned entity if 10 percent or more of the value of the beneficial interests in such trust is held by the transferor, and for this purpose the transferor is treated as holding any interest held by any member of his family. As a result, almost every inter vivos trust will be subject to section 2701(a)(1).

Under paragraph 2701(a)(2), the value of any retained interest in the transferor which is not a right to receive qualified fixed payments is zero. Pursuant to section 2701(b)(2), a qualified fixed payment (QFP) for a trust is defined as:

(A) any fixed amount which is payable not less frequently than
annually;

(B) any amount which is payable not less frequently than annually and is a fixed percentage of the fair market value of the property in the trust (determined annually);

(C) any payment described in paragraph (1)(A)(i) under a debt
instrument or a lease; and

(D) any amount payable under a noncontingent remainder interest if all of the other interests in the trust consist of interests described in subparagraph (A), (B) or (C).

1/ Quite apart from the Harrison example, this requirement will raise problems with virtually all partnership interests that do not qualify for the exception of section 2701(a)(2)(c)(i) or (iii).

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(A) and (B) refer to an annuity amount or unitrust amount similar to those found in the charitable lead and charitable remainder trusts areas.

Section 2701(a)(4) states that subsection (a) shall not apply to any transfer of a trust interest if:

(A) such transfer would not constitute a gift if no consideration were received for such transfer, or

(B) all of the property in such trust consists of a personal residence to be used by persons holding term interests (as defined in Section 2703(d)(3)) in such trust.

Under (B), a common law GRIT would continue to be permitted for a personal (not principal) residence. A term interest is defined as a life interest in property or an interest in property for a term of years. This definition is taken from IRC Sec. 1001 (e)(2).

B. Important General Comments and Recommendations

The Discussion Draft would, in general, treat grantor retained interest trusts (GRITs) more severely than current law does with the Statutory GRIT exception in IRC Sec. 2036(c)(6). This is a questionable policy decision in the context of a replacement which is intended to lessen the impact of IRC Sec. 2036(c) and would be the third modification of the GRIT rules since June 1988. Even assuming the technical problems discussed below can be resolved, the further confusion and required learning process resulting from another change is, in our opinion, undesirable. On balance, we prefer a continuation of the two main restrictions on the grantor's retained interests in the Statutory GRIT concept in IRC Sec. 2036(c)(6), viz., an income interest not to exceed 10 years in duration and a limited contingent principal interest. If the approach of the Draft as to trusts is used, we have a significant problem with the "layout" of Chapter 14. Almost all trusts created by grantors are for the grantor or members of his or her family, with the result that section 2701(a)(1) is operative. Therefore, substantially all inter vivos trusts will have to be analyzed under Chapter 14. This is difficult under the Discussion Draft, in part because it merges trusts with partnerships and corporations and then proceeds to create many special rules for trusts. See sections 2701(a)(2)(B)(ii), 2701(a)(2)(C), 2701(a)(4), 2701(b)(2) and 2701(c)(4).

Considerable simplification would be achieved by separating the rules for trusts from those for partnerships and corporations. If this suggestion is accepted, the trust provisions should be made public for comment. We understand that with regard to trusts, only GRITS (and joint purchases) were intended to be covered by the Discussion Draft. If this is so, the trust provisions should be crafted to cover only such transfers and thereby avoid the problems presented by a broad statute with narrow exception. If separate trust treatment is rejected, ease of analysis as to trusts under the Discussion Draft would be greatly helped by the creation of another exception stating that if the entire trust is subject to gift tax, Chapter 14 will not apply. Other needed exceptions are discussed below.

The difficulty of the trust approach in the Discussion Draft may be illustrated by the language of section 2701(a)(1). Read literally, it seems to be referring to a transfer of a trust interest after the trust is created rather than to the creation of the trust itself. In this connection, see section 2703(e)(4), stating that in the case of a transfer of an income or remainder interest in a portion of a trust, Chapter 14 applies only to such portion. However, Staff has indicated section 2701(a)(1) is not intended to cover assignments of trust interests. Also, the word "retained" is inaccurate as to a trust and members of the transferor's family.

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C. GRATS and Charitable Lead and Remainder Trusts

The application of section 2701(a)(1) to a GRAT (grantor retained accumulation trust), which does not appear subject to IRC Sec. 2036(c), seems wrong. Under a GRAT, income is accumulated, with the trust property (and accumulated income) passing either to the grantor if he dies during a fixed term or to others if he survives the term. The application of the actuarial tables to this contingency - survivorship of the grantor for the fixed term does not involve the imprecision of valuing an income interest.

For

Clarification is needed regarding the extent to which the split-interest rules of charitable lead and charitable remainder trusts are applicable. example, is a commutation power permitted? See Rev. Rul. 88-27, 1988-1 C. B. 331, as to a commutation power in a charitable lead trust. Also, may the fixed amount be different in different years? Presumably, Revenue Rulings 76-273, 1976-2 C.B. 268, and 82-105, 1982-1 C.B. 133, would be applied in determining the includible portion of the trust when the grantor dies during the fixed term of his annuity interest or unitrust interest. Some issues arise in determining the includible amount which need to be resolved, as does the application of IRC Sec. 2642(f).

Charitable remainder trusts, as defined in IRC Sec. 664, should not be subject to Chapter 14, and a specific exclusion of them should be inserted in section 2701(a)(4). In this connection, a charitable remainder trust described in IRC Sec. 664(d)(3) would not involve qualified fixed payments as defined in section 2701(b)(2). Charitable lead trusts (where the entire charitable interest qualifies for the gift tax charitable deduction) should also be outside the scope of Chapter 14.

D. Technical Comments

1. In General

Section 2701(a)(1) and (2) create uncertainties and technical problems with certain trusts. The meaning of "transferee" in section 2701(a)(1), which is not defined, is unclear. To illustrate, if T creates a lifetime QTIP trust with income to his wife for life, remainder to his children, is the transferee the trust or the wife and children? The term "transferee" must be defined for trust transfers. Also, why is the value of any interest in the trust of a member of the transferor's family referred to when such an interest is subject to gift tax in any event?

Suppose T creates a discretionary trust for himself pursuant to which the trustee may pay him income or principal and upon his death the trust property is to be distributed to his surviving issue. Under current law, the creation of the trust would not be a gift if creditors of T can reach the trust property, as would be the case with the law of most states. Under the general rule of section 2701(a)(1) and (2), the entire value of the trust would be a gift because the grantor has not retained a right to receive qualified fixed payments. However, as noted, section 2701(a)(4)(A) creates an exception for a transfer which "would not constitute a gift if no consideration were received for such transfer." This provision is ambiguous because the word "gift" could refer to the meaning in section 2701(a)(1) or the meaning under Chapter 12 and a different result is produced with each meaning. In section 2703(a)(2), reference is made to a "gift for purposes of chapter 12." The intent seems to be to refer to the Chapter 12 meaning in section 2701(a)(4)(A), and the provision should be changed to so state. In addition, the double negative should be eliminated by referring to consideration in a separate sentence, such as:

For purposes of [the preceding sentence] any consideration
received by the transferor should be ignored.

Suppose T creates a trust with the income payable to himself for life, remainder to charity. Under section 2701(a)(1), the full value of the trust property will be a gift, although under present chapter 12 only the value of the remainder interest is subject to gift tax. The same result would follow if the remainder were at T's death given to the surviving issue of T.

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Neither of these cases, where the entire trust property will be included in T's gross estate, should be subject to section 2701(a)(1).

Suppose T creates a trust with income payable to his children for a fixed period of time and with the trust property then to be returned to him or, if he is not then alive, to his estate. Under section 2701(a)(1), T would make a gift of the full value of the trust property.2/ Section 2701(b)(2)(D), applicable to a noncontingent remainder interest, does not apply because all other trust interests are not described in paragraph (A), (B) or (C). If, however, T has retained a lesser interest - a right to receive an annuity amount or a unitrust amount its value appears to be deducted in computing the amount of the gift. This is the case even though it is a future interest and in back of a "tainted" interest, and even if it is conditioned upon survivorship. An additional exception should be added to section 2701(a)(4) to cover a transfer if the trust property must either be included in T's gross estate or distributed to him during life.

Section 2701(a)(2)(C) states:

Valuation of Certain Other Rights

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The value of the following retained interests shall be determined without regard to this section:

(i) Any instrument of the same class as the transferred
interest.

(ii) Voting rights.

(iii) Any instrument none of the

rights under which have a

preference over any rights under the transferred interest.

This subparagraph shall not apply in the case of a trust.

The effect of excluding a trust, which is not explained in the summary of the Discussion Draft, is uncertain and should be clarified. The exclusion could be read to prohibit minority discounts for stock placed in a trust. A trust should not be treated differently than an individual in this regard.

Suppose a trust directs that income be paid to A for life and at A's death the trust principal is to be distributed to A's surviving issue. A has one child B and no other children. B makes a gift of his contingent remainder interest to his two children. This appears to result in a gift equal to the full value of the trust property because the value of A's income interest is determined under section 2701(a)(2) and is zero. The result is wrong when the gift is the entire interest owned, or a fractional share thereof.

As previously noted, a term interest is defined as a life interest in property or an interest in property for a term of years, which are words used in IRC Sec. 1001 (e). Treas. Reg. #1.001-1(f) (2) states in part:

Term interest defined. For purposes of section 1001 (e) and this
paragraph, a "term interest in property" means

(i) A life interest in property,

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(ii) An interest in property for a term of years, or

(iii) An income interest in a trust

Generally, subdivisions (i), (ii) and (iii) refer to an interest, present or future, in the income from property or the right to use property which will terminate or fail on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event

2/ The same result would occur if the income beneficiary was not a
member of T's family because of Section 2703(a)(4).

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