We commend the committee for the substance of the discussion draft. We also commend the process of offering draft statutory language as a focus for public comment. We at the Treasury have benefited substantially from discussing the draft with interested members of the public and we have received many constructive comments for improvement of the draft. We are prepared to support modifications that improve the draft in terms of taxpayer flexibility, simplicity of administration and compliance, or that enhance the overall workability of the statutory framework. My written statement cites a few examples of proposed modifications that we believe should be made. We will oppose, however, changes which would effectively undermine the premise of the discussion draft, which is the proper valuation of the various interests at the time of transfer. The Treasury Office of Tax Analysis estimates that repeal of section 2036(c) standing alone would reduce revenues in the period from 1991 through 1995 by $1.021 billion. OTA estimates that if the discussion draft in its current form were enacted to replace section 2036(c), the net effect on revenues during the same period would be a reduction of $50 million from current law. The Treasury Department looks forward to working with the Congress and interested members of the public to develop a fair and workable replacement for section 2036(c). To retain our support, any proposal must prevent abusive valuations in estate freeze transactions. We are encouraged by the progress thus far. That concludes my opening statement, Mr. Chairman. I will be happy to answer questions at this time. [The statement of Mr. Gideon follows:] For Release Upon Delivery STATEMENT OF KENNETH W. GIDEON COMMITTEE ON WAYS AND MEANS UNITED STATES HOUSE OF REPRESENTATIVES Mr. Chairman and Members of the Committee: In 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. particular, we commend the Committee for circulating the discussion draft of March 22 so that testimony today could focus on specific legislative language. BACKGROUND "Estate freezes" may be structured in many ways but all have as their common objective limiting or reducing the value of an interest in a business or other property includible in a transferor's estate. Typically, this is accomplished by having an older-generation transferor retain a non-appreciating interest in a business (e.g., preferred stock or a promissory note) while transferring the equity interest (which will benefit from future appreciation) to a younger-generation transferee. The Treasury Department does not object to estate freezes so long as the value of the business or other property for gift tax purposes is properly measured. This is because the value of the right to future appreciation will be taken into account in setting the current value of the business or other property. However, during the early 1980s, taxpayers made increasing use of techniques that were designed to value the various interests in a business in a way that effectively eliminated the transfer tax on a significant portion of the fair market value as of the transfer date. These techniques usually involved retention by the transferor of rights which the transferor had discretion to exercise. In fact, many of these rights were likely not to be exercised at all in the family context since their exercise would undermine the transfer tax benefits of the freeze transaction, if not undo the freeze completely. However, because fair market value must normally be determined for transfer tax purposes according to what a willing buyer would pay a willing seller, these rights were assigned value by appraisers on the assumption that they would be exercised as if held by an unrelated third party. This encouraged planners to include as many of these rights as possible in the retained interest in order to maximize the value of the retained interest and minimize the value of the transferred interest. This, in turn, minimized the gift tax consequences of the 1 Illustrations of a variety of freeze transactions appear in the Appendix. -2 transfer. Thus, virtually the entire value of the business would be "soaked up" by the discretionary rights retained by the transferor. For this reason, these features are often referred to as "soak-up features." One of the common ways in which this "soak up" was accomplished was by structuring the right to receive income or cash flow (e.g., dividends on preferred stock) so that value could easily be passed to the younger generation. For example, planners often structured corporate freezes so that the dividend right on preferred stock was "noncumulative." This means that if dividends were not paid in a particular year, there would be no continuing obligation on the part of the corporation to pay those dividends in a later year. Because the decision whether or not to pay dividends often remained in the control of the older generation after the freeze, the dividends frequently would not be paid at all. These passed dividends would not be included in the transferor's estate, but would stay in the corporation, thereby increasing the value of the common stock held by the younger generation, often without payment of gift tax. Appraisals of the preferred stock for gift tax purposes, however, generally assigned substantial value to the right to receive noncumulative dividends, notwithstanding the likelihood of non-payment in a family context. The cumulative effect of these valuation techniques was the assignment of virtually the entire value of the business to the retained interest for gift tax purposes, resulting in significant understatement of the value of the transferred interest. When the transferred interest was assigned to the younger generation, little or no transfer tax would be due, even though all future appreciation in the value of the business would inure to the transferred interest. Soak-up features retained by the transferor often escaped transfer tax because of lifetime events, expiration at death, or inconsistent valuation for estate and gift tax purposes. Internal Revenue Service and the Treasury Department consider such techniques to be abusive. SECTION 2036 (c) The In order to deal with these abuses, Congress enacted section 2036 (c) in 1987. Under section 2036 (c), the entire value of an enterprise is included in a transferor's estate (or treated as a deemed gift) if the transferor transfers a disproportionately large share of the potential appreciation in the enterprise while retaining an interest in the income of, or rights in, the enterprise. By treating a freeze transaction as a transfer with a retained interest, section 2036 (c) therefore reaches not only valuation abuses but also includes future appreciation in the transferor's estate. Serious concerns have been raised about the possible overbreadth of this result, as well as about the uncertain operation of the section. 2 Section 2036(c) was enacted as part of the Omnibus Budget Reconciliation Act of 1987 (P.L. 100-203), and was amended in the Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647). 3 The Internal Revenue Service issued Notice 89-99 to provide guidance as to how the Service would interpret section 2036 (c). This notice has allayed some of the concerns about how the section will be administered. However, the notice does not address all the underlying concerns about the potential scope of the section, which can be addressed only through legislation. -3 While sharing many of these concerns, 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 the return of those abuses. We therefore support repeal of section 2036 (c) today only if a replacement adequate to prevent valuation abuses is substituted for the repealed provision. DISCUSSION DRAFT We believe the standard by which a replacement should be judged is whether or not it eliminates the abuses described above while permitting flexibility in intra-family transfers consistent with this objective. Stated another way, does the discussion draft (or any other proposed replacement for section 2036 (c)) result in the various interests being valued appropriately on the date of the freeze transaction, and does it assure that the subsequent behavior of the various parties will not cause that value, once determined, to be undermined? Judged by that standard, we believe that the discussion draft circulated by the Committee prior to this hearing offers a constructive and workable approach for such a replacement." In The basic mechanism of the draft is straightforward. valuing a transfer of rights in a business among family members, generally only rights retained by the transferor which are "qualified fixed payment rights" ("QFP") will be valued. Discretionary rights such as put or call options or noncumulative preferred dividends generally will be disregarded, because such "soak-up features" have so frequently been used in cases of valuation abuse. QFPS are essentially rights to receive payments in specified amounts at specified times. Qualified fixed payment rights are assumed to be paid on schedule for valuation purposes. If they are not, the transferor is considered to have made a "deemed gift" in the amount of the missed payment. Finally, a minimum valuation rule ensures that the appreciating equity interest (such as the common stock or a non-preferred partnership interest) cannot be valued at less than 20 percent of the total equity in the business, which for this purpose includes debt owed to the transferor. Thus, the discussion draft attempts to deal with the abuses which existed prior to enactment of section 2036(c) in the following ways: O Discretionary rights (i.e., soak-up features) Congress could also require inclusion of gift tax paid in the transfer tax base (as is already the case for estate tax purposes), thereby eliminating a substantial advantage of inter vivos transfers over testamentary transfers. This would, in turn, eliminate a significant incentive for freeze transactions. 5, Generally, the valuation of the right to receive QFPs, such as guaranteed payments from a partnership, will be made using the standard technique of discounting the payment or payment stream to present value, using the market rate of interest or return appropriate for the particular business. Transferors would be free to set the interest or dividend rate at whatever rate they choose, including variable interest rates, recognizing that if the rate selected is below the market rate for that business, the value of the QFP right will necessarily be lower as a result. -4 Rights to receive QFPs, such as fixed principal and interest payments on a note, are given value based on the assumption that they will be paid. However, if they are not paid, a deemed gift will result. The minimum value rule prevents taxpayers from undervaluing the transferred interest, thus ensuring that the right to future appreciation is appropriately taken into account. In addition, the discussion draft contains certain other rules intended to prevent these basic rules from operating inappropriately: O O O O Explicit rules are included to prevent the same value from being taxed twice for estate and gift tax purposes. Transferors may elect to apply the QFP rule to transactions which would not otherwise qualify (such as noncumulative preferred stock or real estate partnerships in which payments are dependent on income or cash flow) to provide flexibility in structuring transactions. The deemed gift rule provides a three-year grace period for corporations and partnerships so that the failure to make QFPS due to temporary cash flow difficulties will not trigger a gift. No deemed gift will occur in any event if the QFP right provides for compound interest and the fully compounded amount is accounted for when the retained interest is transferred. Special rules are provided to mitigate the deemed gift rule if a corporation or partnership that fails to make QFPs is insolvent or bankrupt. The draft does not change the treatment of minority discounts; voting rights will continue to be valued as under current law. The discussion draft would not apply to transfers of the same class of stock which the transferor retains, nor would it apply to transfers of interests none of the rights of which are junior to the retained interest. Explicit exemptions are provided for personal The discussion draft also addresses three related problems: trusts in which the transferor has retained an interest, 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. The primary focus of the trust rule is the grantorretained income trust ("GRIT"). A GRIT is a trust in which the transferor has retained an income interest for a term of years, while transferring the remainder interest to another person (usually a family member). The various interests in a GRIT are valued according to tables published by the Internal Revenue Service which assume a rate of return specified by statute. Frequently, however, the property placed in a GRIT either does not generate any income or does not generate income equal to |