ELIAS CLARK YALE LAW SCHOOL NEW HAVEN, CONN. 06520 May 3, 1990 The Honorable Dan Rostenkowski, Chairman Committee on Ways and Means U.S. House of Representatives Dear Mr. Chairman and Members of the Committee: I regret that I was unable to attend the public hearing on the Discussion Draft to Modify Section 2036(c) of the Internal Revenue Code held on Tuesday, April 24, 1990. I am writing now to present my views for the record on three points: 1. Because the problems it addresses are real and substantial, §2036(c) should not be repealed without the enactment of a new statute to take its place; 2. The approach set out in the Discussion Draft for the taxation of transfers within the family of interests in a family business or partnership strikes a fair balance between the legitimate concerns of taxpayers and of the proponents of an effective transfer tax system and provides an appropriate basis for discussion and refinement prior to enactment; 3. The approach is not in my opinion well suited to correct the abuses that have developed from the use of GRITs, private annuities, joint purchases and similar trust devices. I believe that the recommendations set out in the Treasury Department Report to the President, Tax Reform for Fairness, Simplicity and Economic Growth (1984), provide a better basis upon which to construct legislation in this area. The popularity of various estate freeze strategies and their capacity to transfer large amounts of wealth to younger generations of a family at little or no tax cost have been well documented and need not be repeated here. §2036(c), as amended in 1988, was enacted to counter these abuses. That legislation is not criticized for failure to achieve its objectives but rather for casting its net too widely and ensnaring business arrangements that do not involve freeze techniques. I am not convinced that §2036(c) is so lacking in merit or unworkable as to justify its abandonment without further effort to correct its deficiencies. Repair of §2036(c) is not, however, the issue here. Rather, interested parties are asked to comment on the form that substitute legislation should take. -2 My orientation is that of a trusts and estates professor, and I will focus most of my comments on the impact of the draft proposals in that area. It seems reasonably clear to me, however, that the draftsmen set as their primary target the corporate recapitalization. Trusts are secondary. I believe that the system they propose is well adapted to impose a fair and realistic tax on the interests that result from a recapitalization. The proposal lets the parties set their own terms, saying to them in effect, we will hold you to those terms and will establish the value of the interests and impose the gift and estate taxes accordingly. In this respect, it does not unduly intrude into business transactions that are made for non-tax reasons. The method of establishing values is simple and straightforward and thus can be administered with maximum efficiency. It identifies those retained interests that may be considered and directs that their value be subtracted from the value of the entire interest held by the transferor to set the value of the interests being conveyed to other members of the family. There will undoubtedly be debate on the details. For example, there may be additional claims held by non-family members against the transferor's retained interest that should be included in the valuation process. Further, it may be unreasonable to attribute control to a person who, with his hostile siblings, shares a 10 percent ownership of the entity. Presumably, the opinions of experts will be heard on these and other topics and a compromise struck. The basic structure remains sound and provides a solid foundation for taxing transactions among family members involving interests in a family business or partnership. The trust sections are, in my opinion, seriously flawed. First, they should be separated from the larger whole, which is primarily concerned with transactions involving business interests, and presented as a distinct, coherent unit. At stake is not just the need to bring order to the confusion. The trust has a unique feature that must be uniquely dealt with. The transferor's retained interest does not remain intact as in the corporate recapitalization but rather diminishes in value each year until it ultimately disappears at the end of the specified term. Second, the draft is incomplete. It does not make clear what if any tax is to be imposed at the termination of the trust, makes no mention of the effect when consideration for the transfer is supplied by a transferee, and leaves to the imagination the manner in which the draft provisions are to be coordinated with §§2036(a), 2038, 2037 and 2035 of the estate tax and the provisions of the generation-skipping transfer tax. Finally, for the reasons outlined below, the proposed statute, depending on how it is construed, is either under inclusive, in which case the interests of the Treasury and Congress in preserving the integrity of the transfer tax system are not served, or over inclusive, in which case trust beneficiaries are called upon to pay a maximum gift and estate tax and are allowed none of the offsets that now appear in §2036(c). -3 Ambiguities in the draft statute are best revealed by making reference to an example of a grantor-retained-interest trust. Mother, age 40, transfers $1 million to a trust that is to continue for a 30 year term. Pursuant to the mandate in §2701(b)(2)(B), she directs the trustee to pay her each year 6 percent of the fair market value (determined annually) of the property in the trust out of the income earned by the trust but, to the extent that the income is insufficient, to make up the shortfall out of principal. At the end of the thirty year term, the trust is to terminate and the assets paid to Mother's two children. Using the method by which the value of interests in a unitrust is computed, the value of Mother's gift of the remainder to the children is $163,460. If the Mother uses an annuity trust rather than the unitrust and sets the annual payments at $60,000, the value of the remainder is $434,390. Mother has made a gift of the remainder and will file an appropriate gift tax return. The important question that next arises, and the one on which the proposed statute is ambiguous, is what, if any, additional transfer taxes will this trust be required to pay. The deemed gift provisions, which serve as a device to insure that stipulated payments set out in transactions involving the family business are actually paid, are not necessary to police trusts and will seldom, if ever, come into use. Performance of the trust obligations is insured by the fact that the trustee who fails to implement the terms of the trust will be in breach of trust and thus personally liable for the consequences of that breach. The thirty year term passes, Mother's retained interest terminates and the appreciated trust corpus is turned over to the children. At this point under existing law, §2036(4)(c) treats the trust termination as a deemed gift from mother to children. The gift is equal to the amount that would have been includable in the Mother's estate had she died on the day the trust terminated, reduced by the amount of the original transfer that constituted a taxable gift. The amount of the gift may be further adjusted to reflect the fact that the donees are liable for the payment of the gift tax and that some consideration may have been paid for the transfer when made. In contrast to these elaborate provisions, the proposed statute is vague on the tax consequences of the trust's termination. The relevant section, §2701(d)(5) states that a "termination of an interest shall be treated as a transfer and any amount received on such termination shall be taken into account under paragraph (2)(B) whether or not such amount is a qualified fixed payment." The enigmatic language "taken into account" is inappropriate here there should be a clear direction as to whether the remainder is taxable or not. Nor does the reference to (1)(B) provide clarification. That paragraph talks about the fair market value of the fixed payment rights which, in the case of a GRIT, are the rights to income that have now terminated. -4 Statements made in support of the discussion draft indicate that the objective of the proposed statute is to insure that a true valuation of the initial transfer is made. It is said that freeze transactions are not abusive per se and that if accurate initial valuations are made the system is working correctly, even though future appreciation is not subject to estate or gift tax. Consistent with this statement of the overall policy, it can be argued that the ambiguous message of §2701(d)(5) should be construed to mean that there is no tax at the time of the GRIT's termination. The fixed payment requirement does achieve a true valuation of the interests at the time the trust is created. Thus, in the example, the $163,460 value given to the remainder of a unitrust or the $434,390 value of the annuity trust are realistic values, reflecting not only the remainder's present worth but also its potential for appreciation. By way of contrast, if a fixed payment were not set out in the trust instrument, the value of the remainder would be $57,309. Also consistent with general policy objectives is the fact that the fixed payment requirement creates disincentives on the use of the GRIT to transfer property which is likely to appreciate but create little current income. In order to reduce the value of the remainder, the fixed payment percentage or amount has to be set high; but, in order to meet the annual payments out of income, the trust principal will have to be invested in high yield, low growth investments. While there is a degree of plausibility to this reading of the draft statute, it marks a dramatic departure from the present operation of the estate and gift taxes and creates several major problems. If, for example, Mother died at age 65, five years before the term has expired, §2036(a) requires that the then value of the trust corpus be included in her gross estate. It is manifestly unfair to make taxability depend on the fortuity of whether or not Mother predeceases the term of the trust. One solution would be to extend the valuation option to grantors who create §2036(a) trusts. If the retained income interest is defined in terms of fixed payments, the grantor pays a gift tax on the correct value of the remainder but no estate tax at the time her death causes the trust assets to be turned over to the children. Coordination of §2036(a) and the draft provisions would require some adjustments. §2036(a) is broader in its sweep, imposing the estate tax on transfers where the grantor has not retained a personal right to income but rather has only the right to designate others who are to receive it. It also has been used in a number of cases where a parent has conveyed the family home to the children but has continued to live in it as before until his or her death. The proposed statute covers only personally retained interests and, in §2701(a)(4)(A), explicitly excludes from its provisions incomplete transfers such as a trust in which the grantor has retained the power to designate beneficiaries. Subparagraph (B) of that same section also excludes, for reasons that remain obscure, a trust that consists of a personal residence. -5 Dissimilarities in definitions, however, represent only the tip of the iceberg. A system that makes no claim for a tax on the assets at the termination of the trust poses a serious threat to the integrity of the estate tax. It should not be adopted for any number of reasons, four of the most obvious of which are: 1. Wealth owners view these trusts as the functional equivalent to a will. It follows from that assumption that trusts with income interests retained until or near to death have always been treated as quintessential testamentary transfers and the legitimate targets of any system of death taxation. 2. It is arbitrary and unfair to exempt such trusts from the estate tax while continuing to tax in the traditional manner trusts over which the grantor has retained only a power to alter, amend or terminate. 3. Congress and the Treasury have waged over the past decade a valiant struggle to subject appreciated assets to some form of transfer tax. The approach under discussion here represents a substantial retreat from that position. The initial valuation of a unitrust does to a limited degree value the potential for appreciation, but there is still room for the kind of abusive manipulation that §2036(c) was designed to discourage. 4. One's intuition suggests that a gift-taxonly approach will cause a significant reduction in the total revenues produced by the estate and gift taxes. For those reasons and more it seems unlikely that the draft is intended to give away the store in this wholesale manner. Returning then to §2701(d)(5), it can be argued that "take into account" means "subject to tax as a deemed gift" and "amount received" means the full market value of the trust without any offset for the fixed payment income interest which has now expired. But this construction is equally unsatisfactory. Indeed, it is a continuation of the present §2036(c) with the ante upped in two ways. First, it double dips in that it subjects the potential for appreciation to gift tax and the actual appreciation to estate tax. Second, it omits the offsets which were included in the deemed gift provisions of §2036(c) in fairness to the parties. Section 2036(c) grants an offset for bona fide consideration supplied by the transferee. The draft appears to proceed on the assumption that the transferor is the source of any and all consideration. Although this may well be the typical situation, the exceptions present a problem. For instance, §2703(d)(2) concerning joint purchases states that if mother buys the income interest and the daughter the remainder the mother is to be treated as the transferee of the remainder to the daughter. This result is fair enough if the mother supplied the consideration by which the daughter brought her interest. If, on the other hand, daughter used her lottery winnings, mother is being taxed for property she never owned nor transferred. This is an extension of the taxing authority beyond constitutional limits. 33-144 0 - 90 - 12 |