The existing difficulties associated with preserving small business entities too often results in the loss of these businesses. Many end up becoming part of a national or regional chain or conglomerate. The resulting absentee ownerships usually run the business for short-term profits with little regard for the long-term interests of the community or workers. While this is an extremely important issue in our corporation, it is also a very important public policy issue. The national economy and our local communities would benefit immensely from a public policy that nurtured and encouraged the survival of private, small business with local ownership. Discussion There is no question the public would be better served if section 2036 (c) were repealed retroactively to its date of enactment. It is, and continues to be, poor public policy and an anti-family business statute. In addition to unduly restricting planning by family business owners, it is so complex and so overreaching that even with some clarification issued late last year, neither taxpayers nor the Internal Revenue Service really understand how it should be applied. The basic approach the "discussion draft" takes is not to include property in a person's estate, as did section 2036(c), but rather try to fairly value an interest in a closely held business, or other entity, at the time of its transfer. This (transfer) is the right time to deal with the problem. rather than waiting until someone dies. In that respect the draft is an improvement over section 2036(c). However, it appears to have many of the unfortunate characteristics of section 2036(c); it too is complex and overly broad in its application. We understand the basic problem at which section 2036 (c) was directed involved "abusive" situations where a taxpayer (often the owner of a family business) would transfer common stock from a company, and retain preferred stock which supposedly would pay a high dividend, but then no dividends were ever declared. However, in valuing the common stock the full value of the retained preferred stock that was kept was taken into account. The same thing apparently happened in a partnership setting. Section 2036(c) went far beyond that abuse, however. We had hoped the "discussion draft" was limited to dealing with the particular undervaluation problem. Unfortunately, it goes so far beyond and it is subject to a lot of the same criticisms leveled at section 2036(c) its complexity, its overly broad application and its unrealistic assumptions regarding family businesses. The Honorable Dan Rostenkowski Re: "Discussion Draft" Section 2036 (c) The basic thrust of the "discussion draft" is to permit the value of retained preferred stock to be deducted from the value of the company, in a situation where common stock of the company is given away, only where there are dividends fixed both in time and amount. If the payments don't qualify as such, then they are given a zero value. Even if the stock qualifies in terms of having that kind of a payment, if no payment is actually made for three years, then there is a deemed gift of the amount that should have been paid. In addition, we understand that taxpayers can elect in or out of that treat ment. If this is as far as the statute went, it would be an improvement over section 2036 (c), although we are troubled by an inflexible rule that gives zero value to something that clearly has value just because it doesn't contain a number of provisions that the government thinks it should. However, we are told the new proposal goes much further than that in terms of dealing not only with such things as preferred and common stock, but also prevents the deduction of the value of a lease or a debt from a company's value whose stock is transferred if the lease or debt is not properly structured in terms of providing for fixed payments. We also understand the statute covers all sorts of trusts although that is of less real interest to us than the business aspect. An example of why it is inappropriate for the statute to cover leases. Often a family will own real estate and a family business. The real estate is quite often leased to the business to provide an income flow to the family. Often the rent is dependent (realistically) on the amount of profits the company makes. That kind of a lease is not at all unusual with outside parties, either. Yet that kind of a lease, as I understand it, would be assigned no value at all (in terms of the value retained by the transferor of stock in a company) in valuing the stock. Likewise, if a corporation owes me money and the debt does not meet the standards of the statute, then I can't deduct it from the value of the company, either. The "discussion draft" also deals extensively with buy-sell agreements. These agreements are common in family-owned businesses. One of the chief criticisms of section 2036(c) was that it unduly restricted the utility of such agreements which usually are not used to try and reduce one's estate taxes. They are also dealt with, even more extensively, in the "discussion draft." The provision basically says that the value set by a buy-sell agreement for shares in a family company, for example, won't be respected by the Internal Revenue Service unless there is an actual sale of the stock, and unless it meets other requirements which are unrealistic. The "discussion draft" makes it clear that rights of first refusal will be given no value at all with respect to affecting the value of the stock, even though everyone knows they do affect value. Just as these provisions dealing with buy-sell agreements did not belong in section 2036 (c), they certainly don't belong in a statute which was supposedly only aimed at dealing with abuses involved in recapitalizations where unrealistically optimistic assumptions were made with regard to valuing the preferred stock. The statute is also intrusive and overly complex because it affects any company in which a person owns 10% or more and because all sorts of people other than the owner of the stock are involved in the statute's application. First of all, if one only owned 10% of a business, there certainly isn't enough ownership to make it "my" corporation as opposed to a public company. Furthermore, for purposes of computing the 10%, all sorts of family members are taken into consideration. As a businessman knows, you don't have real control of a corporation unless you have at least 50% of the stock and, in many cases, two-thirds of the stock. One also can't rely on other members of a family to always vote together. There is also a provision that "equity" interest in such an entity must be at least 20% of the total value. In many instances involving closely held businesses the ratio is, for legitimate economic reasons, much lower than that, yet there is an arbitrary provision that if debt represents 81% and equity represents 19%, that the value of any preferred stock interest will be zero for purposes of determining the value of common stock which has been given away. Surely this is arbitrary and unfair and particularly so because it only applies to family businesses. We understand that if a dividend is provided for but is not paid after three years, then unless the company goes insolvent or bankrupt, one will be deemed to have made a gift of that dividend to the holders of the common stock, even though one may well not have control of the company. One can think of a number of instances where short of insolvency or bankruptcy it simply would not be prudent for a company to pay dividends, yet such dividends are in effect forced out in order to avoid a gift tax. Surely this is not the kind of abusive situation which Congress must have had in mind when first enacting section 2036(c). Summary There is serious question whether a statute is needed at all. However, if there is one, we would like to see a statute that deals directly with the really abusive situations which doesn't burn honest taxpayers and owners of closely held businesses in trying to carry out legitimate family succession planning. Section 2036(c), and also the "discussion draft," is the kind of legislation that really erodes the self-assessment tax system which has been a hallmark of our country for many years. Gift and estate tax rates are so high that a closely held business owner, if his business somehow becomes subject to this new statute (e.g., in terms of having to pay a dividend to prevent mount ing delinquent gifts) might be forced to sell his business to an outsider. These days, such an outsider means not just someone outside the family but often someone outside the country. Surely Congress cannot have meant to encourage foreign ownership of such U. S. business enterprises. I can guarantee you that there will be a lot less tax collected. It is also counterproductive to job formation and quality local involvement for local, private companies to be forced to sell to out of state conglomerations who operate for short-term financial gain rather than long-term community interest. Conclusion We hope section 2036 (c) is repealed promptly and that before any substitute is made that that substitute is well thought out, limited in scope, and responsive only to whatever perceived abuse there is. Enacting the provisions of the "discussion draft" will put us all in the same boat that we have been in for the last two years under section 2036(c). Surely, that is going backwards. The Seattle Times Company and Blethen Corporation appreciate this opportunity to submit our views with respect to a "discussion draft" to modify section 2036(c). Please contact Malcolm Moore, Davis Wright Tremaine, (206-622-3150), or myself (206-464-2957), if you have any questions or need further information. Sincerely, Frank A. Glithen Frank A. Blethen STATEMENT OF WILLIAM J. BROWN Professor of Law University of Pittsburgh Introduction Section 2036 was originally enacted nearly 60 years ago in reaction to the Supreme Court's opinion in May v. Heiner. Immediately after that decision Congress perceived the necessity for a provision to estate tax property conveyed inter vivos whenever the circumstances or terms of transfer enabled the transferor either to enjoy income from the property or to affect its enjoyment by others. The value of previously conveyed property, at its date of death value, was rendered includible in the transferor-decedent's gross estate by § 2036, and rightly so. Whenever a lifetime transferor continues to control or benefit from property that he has conveyed, its prior transfer ought be disregarded for Federal estate tax purposes. Eighteen years ago, another Supreme Court decision2 provoked a remedial amendment to § 2036 so that retained voting rights in corporate stock transferred inter vivos would be regarded as an estate-taxable string. Section 2036 (b) treats the retention of voting rights in transferred shares as a means of continuing one's enjoyment of the transferred property which results in estate taxability of the property's value whenever the transferor dies. Unfortunately, § 2036(b) did not reach those transferors who maintained control over their business by retaining preferred stock voting rights while giving away common stock. Valuation of the preferred shares includible in the transferor's estate would be based on its dividend rate and fixed dollar preference in liquidation, whereas the common shares that had negligible value at the time of gift would appreciate as the business thrived but completely escape estate taxability." As this evolution of § 2036 indicates, property owners have repeatedly sought to fashion transfers that become completely effective only at their death. Whenever inter vivos transferors receive benefits for themselves without incurring estate taxability of the value ultimately inuring to their transferees, an obvious abuse results requires corrective legislation. which Inventive estate planners most recently have contrived inter vivos conveyances that entail relatively little or no gift taxability but which leave the transferor with cash flow benefits from the conveyance. Because these economic vestiges of ownership were not estate taxed at the transferor's death, § 2036 was again threatened with erosion. Section 2036 (c) is aimed at interdicting these latest maneuvers, which are sometimes referred to as "valuation freezes" because their objective is to avoid transfer 1281 U.S. 238 (1930). 2United States v. Byrum, 408 U.S. 125 (1972). The Byrum case sounded the death knell for Revenue Ruling 67-54, 1967-1 C.B. 269, in which a transferor's ownership of 10 shares of voting stock in a corporation that also had 990 shares of nonvoting common stock outstanding (which were transferred inter vivos into a trust for the owner's children), constituted a § 2036 (a)(2) retention of control over the transferred shares. 3 See Revenue Ruling 81-15, 1981-1 C.B. 457. *Estate of Salisbury, 34 TCM 1449, CCH Dec. 33,503 (M), TC Memo. 1975-333 (1975). |