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gift or estate tax return which items in the aggregate exceed in value 25% of the total amount of gifts stated in the gift tax return or 25% of the gross estate as stated in the

estate tax return.

The Committee recognizes both the government's legitimate concern in being timely and clearly apprised of estate freeze gifts and the historical difficulties in proving fraud or willful intent in omission cases in this area. Nevertheless, once the per se valuation rules of Chapter 14 are effective, the government's burden in demonstrating culpable intent in the case of an omission or substantial understatement, other than a failure to report an annual exclusion gift, should be greatly reduced.

The Committee is equally concerned with the extension of the statute from three to six years in all cases involving reported Section 2701 gifts. The proposed Chapter 14 provides a concrete, detailed scheme for valuing estate freeze gifts and, should the open transaction approach be retained, for identifying and valuing subsequent taxable events involving the retained property. Once this scheme is in place and a gift is valued and reported pursuant to such scheme, there should be no need to treat Chapter 14 gifts differently from any other taxable gifts, and the provisions of Section 6501(c) and (e) should be adequate to deal with Section 2701 gifts.

The Committee understands that the government's enforcement problems in this area have resulted primarily from situations in which the gift is not reported at all or is otherwise "buried" within other items in a manner that does not provide adequate disclosure. Again, because of the bright-line approach of Section 2701, the risk of good faith nondisclosure or undervaluation of gifts would be substantially eliminated. To our knowledge, there has been no showing (nor, indeed, even any allegation) that the IRS cannot ordinarily carry out its assessment and audit functions within the usual three-year period once it has proper notification of a taxable gift on a properly filed return. Given the concrete nature of the provisions of Section 2701, once adequate disclosure is made, no justification seems to exist for an extended period of limitations beyond the three-year period, which has met the IRS's requirements in virtually all areas of the tax law for many years.

To address any concern that Section 2701 gifts may be "buried" within the return or not reported because they fall within the annual exclusion and, thus, are not identifiable to the IRS as meriting attention, the Committee suggests imposing the requirement that all gifts, including annual exclusion gifts, and assets included in the gross estate, under Section 2701(a), (c) and (d), as well as any adjustment under Section 2701 (e), be specifically identified as such on the return, and that a failure so to identify the gift would result in an extension of the statute to six years. The IRS would thus have adequate notice of the application of Section 2701, and all reported Section 2701 gifts disclosed as such would have the same three-year statute of limitations as all other gifts. Given the unambiguous nature of a Section 2701 gift, failure to report a Section 2701 gift as such could also be cited by the government as some evidence of the fraudulent or willful nature of an unreported or undervalued gift for purposes of the existing provisions under Section 6501(c) of the Code which have the effect of suspending the statute of limitations. As a technical point, it may be necessary to amend Section 6501 (e) (2) to include within its scope transfers made under the new Chapter 14.

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The Committee recommends that the effective date of Chapter 14 be prospective, applying only to those transfers occurring after the date of enactment, but in no event earlier than the introduction of definitive legislation. Any pre-Chapter 14 "safe-harbor" transactions under Section 2036 (c) should be grandfathered. In addition, we recommend a transition rule which would extend protection for a three year period with respect to existing buy-sell agreements.

Finally, in connection with the repeal of Section 2036(c), the Committee recommends that a provision be added, similar to Section 1433(c)(1) of the Tax Reform Act of 1986 with respect to the repeal of the former Chapter 13, to deal with refunds of gift and estate tax imposed pursuant to Section 2036(c).

STATEMENT OF JOHN J. O'NEIL AND EILEEN CAULFIELD SCHWAB
NEW YORK STATE BAR ASSOCIATION
TRUSTS AND ESTATES LAW SECTION
COMMITTEE ON TAXATION

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April 20, 1990

Discussion Draft, dated March 22, 1990, of proposed legislation to repeal Internal Revenue Code 2036 (c) and to add a new Chapter 14 relating to special valuation rules in cases of transfers of interests in ten percent owned entities to family members.

REPORT PREPARED BY THE COMMITTEE ON TAXATION OF THE TRUSTS
AND ESTATES LAW SECTION.

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The discussion draft, if enacted, would repeal Internal Revenue Code Section 2036 (c) retroactively to December 17, 1987, its effective date, and would replace it with a new Chapter 14 entitled "Special Valuation Rules." Proposed Chapter 14 is intended to address in a narrower and more coherent fashion the perceived abuses sought to be alleviated by the enactment of the present Section 2036 (c) stated to be the undervaluation for gift tax purposes of property transferred to family members (usually those in a younger generation), through the retention of overvalued retained rights, which, in a family context, are unlikely to be exercised. The approach of Section 2036 (c) is to treat retained rights in an enterprise as a retention, for purposes of Section 2036 (a), of the use or enjoyment of the property transferred to the younger generation, causing inclusion of the date of death value of such property in the transferor's gross estate. The Section is triggered if a person who holds a substantial interest in an enterprise, (i) "in effect" transfers property having a disproportionately large share of the potential appreciation in such enterprise, while (ii) retaining an interest in the income of or rights in the enterprise. If the transfer falls within the scope of Section 2036 (c) and the transferor holds the retained interest at death, the date of death value of the transferred property will be included in the transferor's gross estate. If before the transferor dies, he or she transfers the retained interest, or the retained interest terminates or lapses (e.g., the term of a note expires), or the transferee transfers the originally transferred property, the event will be treated as a "gift" by the original transferor, and a gift tax will be imposed on the fair market value of the originally transferred property at the time of the "gift".

Transactions among family members are particularly suspect because, although Section 2036 (a) specifically exempts bona fide sales for full and adequate consideration from the scope of the section, this exception does not apply to sales to members of the transferor's family, defined to include the transferor's spouse, lineal descendants of the transferor or the transferor's spouse, the transferor's parents or grandparents and any spouse of the foregoing.

Because of the potential application of Section 2036 (c) to family transactions not intended to avoid the estate tax, the Technical and Miscellaneous Revenue Act of 1988 excepted from the scope of the statute certain loan, employment, sale and trust arrangements that meet specified statutory requirements. On August 31, 1989, the Internal Revenue Service issued Advance Notice 89-99 (the "Notice"), intended to provide guidance under Section 2036 (c), including an explication of the statutory safe harbors.

Proposed Chapter 14 departs from the estate tax inclusion approach of Section 2036 (c), and provides rules for the valuation of retained interests at the time of transfer for gift tax purposes with respect to family transactions. The Committee is in favor of this approach.

Like Section 2036 (c), Chapter 14 would apply only where the transferor transferred an interest in a "10 percent owned entity," specifically defined to include corporations, partnerships and trusts. This is an improvement over the ambiguous use of the term "enterprise" in section 2036 (c), defined in the Notice to mean any undertaking or venture, ordinarily for profit. The definition of family would remain the same, and family attribution rules likewise would apply in determining whether the transferor owned a 10 percent interest in the entity.

If Chapter 14 is triggered, for purposes of determining the value of the gift of the transferred interest, the value of any retained interest which is not a right to receive a "qualified fixed payment" ("QFP") or is not a specifically exempt retained interest would be treated as being zero. Qualified fixed payments and exempt retained interests would be valued in accordance with present law, with one important caveat. In the case of transfers of interests in corporations and partnerships, the valuation of a qualified fixed payment may not reduce the value of the transferred interest (i.e., the common stock) below its proportionate share of 20 percent of the total equity interests in the entity.

With respect to corporations and partnerships, QFP's are defined as dividends payable on a periodic basis from any cumulative preferred stock, if determined at a fixed rate or tied to a specified market interest rate, or any other payment or distribution fixed as to both amount (which may be tied to a specified market interest rate) and time of payment. In the case of trusts, QFP's are generally defined as (i) any fixed amount payable not less frequently than annually (ie, an annuity trust), (ii) any amount payable not less frequently than annually which is a fixed percentage of the fair market value of the principal (determined annually) (ie, a unitrust) and (iii) a noncontingent remainder interest if all of the other interests in the trust consist of qualified fixed payments. Under certain circumstances, the transferor may elect to treat certain retained interests as qualified fixed payments, providing flexibility in structuring transactions.

Exempt retained interests would include interests of the same class as the transferred interest, voting rights and junior equity interests. (This provision would not apply to trusts, although, clearly if the trust contained shares of a corporation or partnership interests, the draft should be so amended.)

If a qualified fixed payment is not paid within applicable grace periods, the transferor would be treated as having made a gift of the unpaid amount.

The proposed draft includes rules applicable to the subsequent transfer of the retained interest designed to avoid double taxation. Special relief provisions apply in cases of transfers or discharges of retained interests during insolvency or bankruptcy.

Especially with respect to common business transactions between family members, proposed Chapter 14 is more closely tailored to the valuation abuses Section 2036 (c) was designed to combat. For instance, employment agreements, initially within the scope of a literal reading of Section 2036 (c) thus necessitating the enactment of a safe harbor, would not fall within the scope of the proposed

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draft. Moreover, unlike Section 2036(c), proposed Chapter 14 defines the transferor's rights and obligations at the time of the transfer, allowing him or her to quantify the gift tax liability. Under Section 2036 (c) the transferor may never know with certainty the extent to which the transferred property may appreciate, and accordingly, what his or her estate tax (or subsequent gift tax) liability may be. In addition, Section 2036 (c) would in many cases require a determination at death of whether a transferor transferred a disproportionate share of appreciation in a transaction possibly occurring many years before, raising problems of the availability of necessary proof. Accordingly, proposed Chapter 14 appears to take the better approach.

The application of proposed Chapter 14 to trusts appears, in some respects, to be more restrictive than under present Section 2036 (c). For example, the draft restricts the use of grantor retained income trusts ("GRITS") because the retention of an income interest for a fixed term would not qualify as a QFP and accordingly would be valued at zero. In addition, the grantor would not be permitted to retain a contingent reversion should he or she die before the trust term to further deflate the value of the remainder. The statutory GRIT exception added to Section 2036 (c) in 1988 represented a then legislative determination to exempt such trusts from the scope of the statute and should be incorporated into the proposed draft.

The personal property use exemption to Section 2036 (c) set forth in the IRS Notice should also be incorporated into the draft, which at present only provides a narrow exception for trusts containing a personal residence. If a trust contains tangible personal property, the grantor's retained interest would be valued based on the amount such interest could be sold to an unrelated third party.

Clarification should be made on the applicability of Chapter 14 to charitable lead trusts and charitable remainder trusts where an interest is retained by the grantor.

Because proposed Chapter 14 had apparently abandoned the spousal unity rule of Section 2036 (c), insurance trusts appear to be exempt from its scope.

Finally, proposed Chapter 14 would unnecessarily tighten the rules governing the valuation of property subject to options and buy-sell agreements by providing that any right of first refusal or option shall be disregarded in valuing such property unless (i) the right or option is actually exercised, (ii) the price at which the property is sold is determined pursuant to a formula which was reviewed no more than three years before such sale, and (iii) at the time of such review, the formula was reasonably expected to produce a price approximating fair market value at the time of the exercise. Only requirement (iii) appears to apply to such rights under present Section 2036 (c). In addition, with respect to buy-sell agreements, a provision should be added to grandfather such agreements or options already in existence on the effective date.

For the reasons stated above, it is believed that proposed Chapter 14 is an improved and reasonable approach particularly with respect to transfers of interests in corporations and partnerships, but should be modified to remain consistent with the legislative concerns that prompted enactment of the safe harbors now found in Section 2036 (c).

Person who prepared the report: John J. O'Neil, Esq.
Chair of the Committee: Eileen Caulfield Schwab, Esq.

NORTH AMERICAN EQUIPMEnt Dealers ASSOCIATION

Serving Farm, Industrial and Outdoor Power Dealers

STATEMENT OF THE NORTH AMERICAN EQUIPMENT DEALERS ASSOCIATION
BEFORE THE

HOUSE COMMITTEE ON WAYS AND MEANS

ON

INTERNAL REVENUE CODE SECTION 2036 (C)

Mr. Chairman, I am William E. Galbraith, Executive Vice President of the North American Equipment Dealers Association (NAEDA). NAEDA represents over 7,000 farm and outdoor power equipment dealers throughout the United States. They are located in every state and provide the equipment and service necessary to maintain the productivity of our nation's farmers. NAEDA'S dealerships are small businesses but are often among the largest employers in their communities. On behalf of those dealers, I am pleased to comment on Section 2036 (c).

NAEDA's members are extremely concerned about the impact of Section 2036 (c) on themselves, on their families and on their communities. As we understand it, Section 2036 (c) was intended to protect against abuses in estate planning. In fact, in its current form, it goes well beyond stemming abuses and prohibits what we believe to be are legitimate practices aimed at keeping businesses healthy and intact.

Many of our members are operating family businesses which have been passed down through several generations. The farm equipment business has not been an easy one, particularly in recent years, and a number of dealers have been forced out of the marketplace. Those who remain are committed to the industry, to the community and to passing on a way of life to their children. These are true family businesses with the husband, wife, and children working long hours alongside their employees to make the business succeed. That success is based upon good will and years of dedicated service to their customers.

It is only logical that parents want to pass on the business to their children who have helped build it. Unfortunately, Section 2036 (c) severely restricts their ability to do so. The imposition of estate taxes as high as 55% can effectively sound the death knell for the business.

The majority of our dealers have virtually all of their assets tied up in the business--both in the buildings and the inventory. Passing on the business is not the same as passing on cash. There is not the liquidity available to pay large estate taxes. Even if the heirs want to, it may be difficult to obtain loans to pay off an estate tax debt. As a result, in its application, Section 2036(c) can easily result in the heirs having to liquidate the business in order to pay the tax. The business is lost, jobs are lost, and the local source of farm equipment and service is lost.

It seems to us that Congress, while protecting against abuses, should actively promote the development and continuity of family businesses. During difficult times, it is often a combination of the experience of growing up in the business and the pride of carrying on the family tradition that keeps the business going. Forcing families to sell off the business to strangers (if buyers can even be found) who do not have the same experience or commitment does not serve any worthwhile public purpose. On the other hand, if the business is sold to another dealer who combines it with his own, another business is lost. In rural America every business lost is another nail in the coffin of many of our rural communities.

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