-6

The recommendations set out in the Treasury Department Report to the President, Tax Reform for Fairness, Simplicity and Economic Growth (1984), reverse the order in which the taxes are imposed from that used in the discussion draft. In the words of the Report:

Retained beneficial enjoyment. The proposal would simplify present law by providing that a transfer tax would be imposed only once, when the beneficial enjoyment retained by the donor terminates. Thus, if a donor makes a gift of a remainder interest in property, but retains the intervening income interest, no gift would occur until the termination of the donor's income interest. At that time, the property would be subject to gift or estate tax at its full fair market value. Because the transferor would be treated as the owner of the property during the interim, any distributions made to beneficiaries other than the transferor would be treated as transfers when made. . . .

These recommendations have their own set of special problems. Nevertheless, the approach set out therein seems to me to provide a much more promising starting point for discussions as to means of meeting the trust abuses that gave rise to the enactment of §2036(c). It conforms to the traditional definition of a testamentary transfer, fully taxes the appreciated property from which the grantor has been deriving benefits for the period of his life or the term of the trust, and, because it does not represent such a revolutionary departure from existing concepts, will be more easily understood and thus more readily accepted.

Respectfully submitted,

Elias Clark

Elias Clark

Lafayette S. Foster Professor

of Law

EC/PP

WRITTEN STATEMENT

by

David E. Lajoie
Partner

Coopers & Lybrand

Hearing Before House Committee on Ways and Means
U.S. House of Representatives
April 24, 1990

on

Estate Valuation Freezes "Discussion Draft"

Mr. Chairman and Members of the Committee, I am pleased to provide our analysis to the Committee on the discussion draft of a bill to repeal §2036 (c) and to replace it with special valuation rules. I am submitting this statement on behalf of my firm, Coopers & Lybrand, an international accounting firm.

We commend you, Mr. Chairman and Members of the Committee, for recognizing the misguided approach of current §2036 (c) and proposing a framework that both repeals $2036 (c) and replaces it with an approach that appears more reasonable and responsive to perceived abuses in the estate freeze area.

The problems with $2036 (c) stemmed, in part, from a desire to stamp out all possible means of avoiding transfer taxes in the family context: This desire to enact an all-encompassing provision resulted in a provision that placed all family businesses in jeopardy of having even minor transfers of property to relatives produce unexpected and sometimes disastrous consequences upon the death of the business owner. With the history of §2036 (c) in mind, we offer the following analysis of key provisions of the discussion draft.

We endorse the conceptual framework upon which the discussion draft is based. The government is entitled to receive transfer taxes on the legitimate fair market value of transferred assets. The overvaluation of certain retained rights in the family context has in the past subverted this goal.

However, the discussion draft does not accomplish the goal of basing the transfer tax upon true fair market value. It is our opinion that the provisions of the discussion draft should be revised to reflect simpler valuation rules that will go a long way to reaching this goal without being unduly burdensome.

1.

The

The special valuation rules would apply to family transfers of interests in 10-percent owned entities. The potential for abuse is minimal where an element of control is not present. The threshold for application of these rules should be increased to a more objective ownership level of 50-percent. The ability to cause a change in the capital structure of an entity (i.e., recapitalization, redemption, etc.) is not present in real life without some element of control. The element of control is necessary to accomplish any type of discretionary payments or changes in capital structure. discussion draft establishes an arbitrary 10% threshold that has no correlation with control, particularly when considered in conjunction with the family attribution rules and the indirect ownership rules. In a situation where a 10% total interest in an entity is owned by an individual, his family members (including siblings, parents, children, and spouses), and indirectly through entities in which by these persons own an interest - the individual simply is not generally in a position to impose his will on the unrelated and sometimes adverse owners of the remaining 90% interest.

In addition, the inclusion of siblings and their spouses in the definition of family for attribution purposes is not reasonable. Typically, parents and children will have

2.

3.

4.

similar interests and concerns that are not present in a brother and sister context. Each brother and sister has their own interests and the interests of their family (spouse and children) as a primary concern. Therefore, it is not reasonable to presume that they will act in concert when, in fact, they may have adverse interests.

This sibling rule is also inconsistent with other definitions of family in the Code. Although $267 (c) (4) includes siblings (but not spouses), it is a related party rule that has nothing to do with constructive ownership. Section 318 of the Code deals with constructive ownership of corporate stock and does not include siblings in the definition of family.

Present $2036 (c) is too ambitious in scope. It is urged that the replacement be less pervasive and that the 10% requirement be dropped in favor of a more objective 50% threshold. Fifty percent is less arbitrary and control would be a valid consideration. In addition, the inclusion of siblings and their spouses in the attribution rules should be eliminated.

The minimum value of a transferred junior equity interest cannot be less than the proportionate share of 20% of all equity and any debt owed the transferor or his family.

The requirement that 20% of the equity be represented in the
appreciating portion of the business is an arbitrary rule.
The gift tax cost associated with transfers subject to this
rule could make legitimate transfers prohibitive. Selection
of 20% as the minimum value has no real world basis.
If an
arbitrary minimum value is to be imposed, it is recommended
that it be a more nominal arbitrary amount, say 5-10%.

The Chapter 14 valuation rules would create serious cash
burdens upon a typical family business.

a.

b.

C.

The 20% minimum value that must be attributed to the
appreciation element will in many cases result in a
large upfront gift tax payment. It is suggested that a
deferral gift tax payment provision, similar to §6166,
be included. In many circumstances the transferor will
have only one major asset, that is the family business,
with resulting cash-flow problems.

A QFP (Qualified Fixed Payment) will be valued so long
as it has a required payment related to an appropriate
market rate of return which may be artificially high.
This could also create serious cash-flow problems for
the typical family business. First of all, market rates
do not necessarily take into consideration the cash
requirements of day-to-day operations. Secondly, these
types of entities typically are successful because
earnings and profits are put back into the entity for
capital expansion and capital improvement and cash for
dividends may not be available. In addition, less
successful businesses will also not have the cash
available. Requiring a pay-out in such an environment
is counterproductive and unfair.

Assigning a zero value for an interest that is not a QFP
is unrealistic and does not necessarily reflect true
fair market value. For example, a noncumulative
dividend right is a right with some real value and
should be allowed to have that appropriate value
assigned to it based on the financial and other cir-
cumstances existing in the particular case.

The overall complexity of the Chapter 14 valuation rules raises the concern that the change is being made from one complicated set of rules to another complicated set of rules. The concept of concentrating attention on the valuation of the original transfer is good the rules proposed to accomplish this are not.

5.

6.

The

The similarities to $2036 (c) contained in the discussion
draft are troubling. For instance, "entity" has been
substituted for "enterprise" and the broad scope of $2036 (c)
is a problem all over again. The replacement statute should
concentrate on the significant sources of valuation abuses
that exist in a preponderance of cases. Simple rules should
be devised that apply to these main valuation areas.
rules should promote ease of administration. For example,
the extension of the statute of limitation will be difficult
to administer, as will deemed gifts in future years, and
overpayment and refund adjustments. The situation could
arise in which the statute of limitations continues for an
older year subject to the special valuation rules while the
statute of limitation has already run on a later gift tax
year not subject to these special rules. Administratively,
such a situation may require a 6-year statute of limitation
for all gifts. The good of creating certainty by a completed
gift will also not be accomplished as these rules will
ultimately have an effect on decedents and their estates.

These rules reflect Congress' continued search to find the appropriate amount of transfer tax to be imposed on the transfer of ownership and management of the family business from one generation to the next.

The family business has proven important in our nation's
history. The family business has produced new ideas, new
products and services, and new jobs. The innovation and
risk-taking that has been largely responsible for the
successes of family businesses has not been as evident in the
publicly-held companies in our country.

Section 2036 (c) is a harsh rule for the family business and
the time has come for it to be replaced. It is suggested
that the Committee think in terms of relief provisions like
$303 redemption provisions and the §6166 deferred estate tax
payment provisions. The excellent concept of focusing on
fair valuation is in danger of being consumed by a set of
arbitrary valuation rules that apply to transfers of owner-
ship of the family business as distinguished from the
valuation rules applicable to other assets.

Additional areas of concerns and comment:

a.

b.

c.

d.

Establish a deminimis rule for transfers that will be subject to the Chapter 14 rules such as something similar to annual exclusion gifts.

Clarify the terminology in §2703 (d) (4) that concerns a term interest that would not have a substantial effect on the valuation of a remainder interest in property.

The effective date of the new provision should not be prior to the date of enactment and should include a transition rule for transactions not completed but subject to binding contracts.

The treatment of joint purchases by family members as a purchase and transfer by the term interest holder should not apply where consideration is paid by the purchaser of the remainder interest.

There is confusion as to how basis rules will work for $1014 purposes for valuations subject to Chapter 14 where the value of the retained rights exceed fair market value.

Because a number of unresolved issues remain, we recommend that a practitioner group be organized to work with the Committee, and other interested parties, to develop a workable solution. We appreciate the Committee's concern and are available to assist you in any regard.

My God, my family, my country and my company. I'd like to hold onto all four, but the odds are against the Sullivan's keeping the company we started and sacrificed to keep alive these past twenty years.

.

My wife and I started Dunmore Corporation in 1970 when I was 41 years of age with $10,000. of our own money and $42,000. from outside investors.

We had 9 children then; have added two since. une having Downs Syndrome. Of the 11 children, 8 are part of the 190 people

currently employed in the company which now provides jobs for

people in two States with sales in the $25,000,000. range.

In our case, the company would never have survived if it had not been for the cooperation of our children, and for this they will be heavily penalized at our deaths. You see, they did not ask for equity in the business; they only asked what they could do to help.

Over the years we had to re-mortgage our home more than once, had to borrow from my in-laws to meet accounts payable, borrow from our oldest son to avoid missing a payroll, and have had all the usual problems of keeping a young under-capitalized company from going under. So far the company has survived. can it continue?

But

It is doubtful the company can survive as a family owned business because we constantly reinvested profits in the business to grow the company. The Federal Taxes, as they now stand, mean there is no option except to sell the business to pay the Federal Estate Tax when we, the parents die. 2036 C as it stands or as it may be amended, really says that the family together is indeed very foolish. My children will be into debt for over fourteen years to hold onto the helped create.

that works forced to go company they