Options

Options held by family members to purchase property at less than fair market value would be taken into account in valuing the property subject to the option under certain circumstances. The option must be exercised, the property must not have a readily-ascertainable fair market value (such as publicly traded stock), and the property must not be resold by the person exercising the option within six months after the decedent's death.

In addition, the option price would have to be determined under a formula which had been reviewed within three years, and which, at the time of review, was reasonably expected to produce a price approximating fair market value at the time of exercise. The value of property subject to other options, rights of first refusal, and leasehold rights held by family members would be determined without regard to such options or rights.

Special Rules

A person would be treated as owning any right or interest owned indirectly through a corporation, partnership, or trust. In addition, any recapitalization, redemption, or contribution to capital which has the same effect as a transfer will be treated as a transfer except as provided by

regulations.

Statute of Limitations

The gift tax statute of limitations is extended from three years to six years for transfers subject to these provisions. The statute of limitations would be unlimited for transfers subject to these rules which are not reported, regardless whether a gift tax return was filed for the year in which the transfer occurred.

Mr. PICKLE. The Chair will ask that all members and our guests please take a seat. The chairman of the full committee, Mr. Rostenkowski, and Mr. Archer are at a meeting at the White House and are expected back within the next 15 to 30 minutes.

In the meanwhile, they have asked us to start the committee hearing. I am going to make an opening statement for Mr. Rostenkowski and recognize other Members for any opening statements they might have.

This is Mr. Rostenkowski's statement. [Reading:]

The Committee on Ways and Means meets this morning to hear testimony regarding a discussion draft of a bill relating to estate freezes. Congress enacted the estate freeze rule, or section 2036(c), as part of the Budget Reconciliation Act of 1987.

The rules were intended to curb abuses of the estate and gift tax system. Since the estate tax freeze rules were enacted, there have been a number of complaints, some of the complaints have concerned technical questions in the Technical and Miscellaneous Revenue Act of 1988.

This committee and the Congress attempted to address many of these questions. Other complaints about the estate freeze rules go to more fundamental, substantive issues as to possible adverse effects on family businesses. On the other hand, tax experts warned that unless there are rules to police the estate freeze area, the Federal estate and gift tax may become a voluntary tax for sophisticated tax planners.

An objective of this hearing is to explore whether there is some middle ground to address legitimate concerns of small family businesses while protecting the integrity of the Federal estate and gift tax system.

In an effort to begin an informed discussion about some possible middle ground, Chairman Rostenkowski has released a discussion draft, which proposes to repeal the present estate freeze rules and substitute a new set of rules designed to address potential abuses. For the hearing today, we have solicited comments from the administration and the public concerning the discussion draft. We thank them for participating in the hearing today. [Ends reading.] Also, without objection, Mr. Archer's opening statement will be inserted in the record at this point.

[The statement follows:]

OPENING STATEMENT OF HON. BILL ARCHER

Thank you, Mr. Chairman.

I want to commend you for agreeing to hold this hearing. In placing the "discussion draft" before the Committee, you have taken a very constructive step towards dealing with the perceived problems of Section 2036(c). When I introduced H.R. 60 at the beginning of this Congress, it was with the hope that the bill would promote such a reconsideration.

As we proceed to testimony on the "discussion draft," I would like to set forth some of the considerations I believe should be weighed.

First, I want it to be clearly understood that I am all in favor of preventing real abuses which I understand may have existed in the past. However, I do not believe we should adopt broader anti-abuse rules than are absolutely necessary. It is important to craft anti-abuse rules which do not interfere with normal business transactions, especially in the context of family business. A major criticism of Section 2036(c) is that it went too far in preventing perceived abuses.

Second, the Congress has come under increasing criticism of late for the complexity of tax legislation. We are fortunate to actually have bill language available for our review. I would hope that in considering a substitute for Section 2036(c), we would make every effort to further the goal of simplification.

I appreciate all of the effort our witnesses have put into preparing for today's hearing. I am also grateful for the efforts of others who are not able to testify today but who have participated significantly in the effort to solve the Section 2036(c) problem.

Hopefully, this hearing can set the stage for a responsible, bipartisan solution. Mr. PICKLE. Now before we proceed, the Chair will recognize Mr. Schulze for an opening statement.

Mr. SCHULZE. Thank you, Mr. Chairman.

I commend our chairman for holding today's hearing. Practically everyone agrees that the backbone of our economy is America's small business. Particularly vital are the millions of family-owned and operated businesses and farms across our Nation.

In 1987 and 1988 Congress enacted restrictions on the transfer of small businesses between family generations. These legislative provisions, which I strongly opposed, now threaten to break the spine of family-owned businesses in America. Too often we are crafting our laws to address the exception rather than the general rule. In other words, to target abuse, we are throwing out the baby with the bath water.

In the case of a family-owned business, I feel we should broaden the general rule to provide that transferring of business to an heir would be tax-free.

I would go as far as to allow the sale of that business and allow a tax-free rolling over if the proceeds are used to purchase another business.

I look forward to today's testimony on what I have heard is a constructive draft proposal. I am interested in its impact on family farms.

In southern Pennsylvania, almost any farm left to an heir must be sold for development because of the estate tax burden. Open space across America is being devoured and developed with each generation. Whether it is a small business or family farm, estate taxes are destroying traditional family businesses in America. I welcome today's witnesses on this vital economic issue. Mr. PICKLE. Thank you, Mr. Schulze.

Mr. McGrath, do you have an opening statement?

Mr. McGRATH. I congratulate you for leading this effort to change the provisions of section 2036(c) of the Internal Revenue Code.

At times we are faced with difficult situations in exercising our constitutional obligations to institute revenue bills. The issue before us began as an honest effort to stop tax avoidance.

We now see that our attempt to protect the Federal Treasury has interfered with other legitimate societal goals such as the preservation of family-owned businesses.

Many enterprises adversely affected by current law are essential to the communities throughout our Nation. I hope that this hearing will help the committee to achieve a better balance in the Federal estate tax scheme and I look forward to hearing from the diverse group of witnesses assembled before us this morning. Thank you, Mr. Chairman.

Mr. PICKLE. Does any other member have a statement to make? Our first witness, then, this morning will be the Honorable Ken Gideon, the Assistant Secretary for Tax Policy of the U.S. Department of the Treasury.

Mr. Gideon, obviously, this committee has created a lot of attention and we have a lot of interested visitors this morning, which indicates the importance that this subject has for a lot of people. We are glad to have you here and we will recognize you now as the first witness.

STATEMENT OF HON. KENNETH W. GIDEON, ASSISTANT SECRETARY FOR TAX POLICY, U.S. DEPARTMENT OF THE TREASURY

Mr. GIDEON. Mr. Chairman, and members of the committee, I am pleased to have this opportunity to present the views of the administration on proposals to repeal and to replace section 2036(c), relating to estate freeze transactions.

I have a longer written statement, which I would request be incorporated in full in the record and from which I will summarize my oral statement.

Mr. PICKLE. Without objection.

Mr. GIDEON. Estate freezes may be structured in many ways, but they have as their common objective limitation or reduction of the value of a business interest or other property includible in a transferor's estate. I have listed several of the more common transactions in the appendix to my written statement.

The Treasury Department does not object to estate freezes so long as the value of the business or other property for gift tax purposes on the date of transfer is properly measured.

The problem, however, is that during the early 1980's, there was growing use of techniques which allowed taxpayers to pass a significant portion of current value to family members free of transfer tax.

Let me outline some of the techniques that we view as abusive. They typically involve retention by the older generation of discretionary rights, many of which were likely not to be exercised at all in a family context because to do so would have significantly undermined the tax benefits of the freeze.

Nevertheless, planners included many such rights in the retained interest and appraisers assigned value to them on the assumption that the rights would be exercised. This had the effect of minimizing the value of the transferred interest, thereby minimizing the gift tax on transfer.

These discretionary rights would soak up virtually the entire value of the business and for this reason are often referred to as soak-up features.

A common way this was accomplished was by structuring dividend and other income rights in such a way as to pass value to a younger generation. For example, planners often used noncumulative dividends, which if not paid in a particular year, would never have to be paid at all.

Because a decision as to whether or not to pay dividends frequently remained in the control of the older generation, the dividends frequently would not be paid. Despite this, appraisers would

assign substantial value to these dividend rights on the assumption that the dividends would be paid.

The cumulative effect of these valuation techniques was significant undervaluation of the transferred interests. Little or no gift tax would be paid on the transfer even though all future appreciation in the value of the business would inure to these interests.

Section 2036(c) was enacted in 1987 to deal with these abuses. However, section 2036(c) not only reaches valuation abuses, but also pulls future appreciation back into the transferor's estate.

Many have raised serious concerns about this result as well as the uncertain operation of the provision.

While sharing many of these concerns, Mr. Chairman, the Treasury Department is strongly of the view that the abuses which Congress sought to remedy by enactment of section 2036(c) are real, and that simple repeal would invite a return of those same abuses. We, therefore, support repeal of section 2036(c) only if a replacement adequate to prevent valuation abuses is substituted for the repealed provision.

We believe that the discussion draft circulated by the committee prior to these hearings offers a constructive and workable approach for such a replacement.

It eliminates the abuses described above by appropriately valuing the various interests on the date of the freeze transaction and by assuring that the subsequent behavior of the various parties will not undermine that valuation.

At the same time, the draft permits flexibility in intrafamily transfers to the extent consistent with this objective.

The basic mechanism of the draft is straightforward. In valuing a transfer of rights in a business among family members, generally only qualified fixed payment rights, or QFP's, which the transferor retains will be valued. Discretionary rights generally will be disregarded because such soak-up features have so frequently been used in cases of valuation abuse.

QFP's are basically rights to receive specified amounts at specified times such as cumulative dividends on preferred stock. In valuing QFP's, the draft assumes that they will be paid. However, if they are not paid after a 3-year grace period, generally a deemed gift will result.

Finally, a minimum value rule ensures that taxpayers cannot significantly undervalue the transferred interest by providing that appreciating equity such as common stock cannot be valued at less than 20 percent of the total equity of the business. The discussion draft incorporates several rules which are intended to provide relief in specific circumstances, such as insolvency and bankruptcy, to prevent double taxation or to enhance planning flexibility.

The discussion draft also addresses three related concerns. Grantor retained income trusts, known as GRITS, joint purchase transactions in which the transferor purchases a life or term interest while a family member purchases a remainder interest, and buy-sell agreements.

These three transactions present many of the same opportunities for abuse that are present in the corporate and partnership context.