business without being subject to an appropriate transfer tax liability. Under prior law, some business owners made gifts of common stock, while retaining preferred stock in the same corporation, and claimed that the preferred stock represented substantially all the value of the business at the time of the transfer so that little or no gift tax was paid on the transfers of the common stock. Further assuming that the common stock would soak up any future appreciation in the corporation, these owners anticipated a "freeze" in the transfer tax value of their retained business interest at its value on the date of the transfer of the common stock. The principal concern leading to the enactment of section 2036 (c) was a fear that these disproportionate appreciation transfers were being seriously misvalued for transfer tax purposes. That concern could probably have been met by improved enforcement of existing rules. After all, the IRS has developed a substantial expertise in valuing closely-held business interests over the years, and increased transfer tax exemptions have led to the filing of fewer estate and gift tax returns which are likely to receive greater audit scrutiny. Significant undervaluation penalties exist to assist the IRS in this effort. Instead, section 2036 (c) was enacted. As originally written, and even after amendments in 1988, the statute remains dangerously overbroad and ambiguous, and aimed almost exclusively at family-owned businesses. IRS Notice 89-99 provided useful interpretation of some of the issues in section 2036 (c). It could not, however, cure all of the flaws in the statute. Further, many essential questions were left open for later regulations. There is virtually universal agreement that this statutory provision is unworkable. In our view, this state of affairs is a direct result of efforts to make section 2036 (c) apply to multiple and diverse transactions that do not necessarily relate to the original statutory purpose. For example, section 2036 (c) hurts family businesses by creating a potentially enormous penalty for gifts or sales within a family (in the form of a later transfer tax), thus making it more desirable to sell a business to an outsider than to keep it in the family. Section 2036 (c) is also being applied to many nonbusiness transactions, including transfers to garden-variety trusts. This amounts to a radical revision of the transfer tax system, and represents a far reaching change that was accomplished by indirection and without legislative hearings. The legislative history gives no indication that Congress recognized the fundamental changes being made by this new provision with its "Alice in Wonderland" approach to transfer taxation, in which transfers "in effect" occur and individuals are taxed on property long after they have irrevocably severed all connection to it. Section 2036 (c) represents the first time that the transfer tax has diverged to this extent from basic property law concepts, the first time that sales for full fair market value give rise to transfer taxation, and the first time that an action taken by one spouse is deemed taken by the other spouse for transfer tax purposes. Fortunately it now appears that these startling departures from traditional transfer tax principles are being recognized and corrective action is being taken. Section 2036 (c) originated as a response to a valuation concern but now threatens to undermine the entire transfer tax system. It operates improperly and, as a solution to a specific abuse, its effects are not commensurate with the targeted problem. Its flaws are fundamental, varied and irreconcilable, and it should be repealed. JOINT TASK FORCE RECOMMENDATION The Real Property, Probate and Trust Law Section is part of a joint task force formed with the Section of Taxation of the ABA and with the American College of Trust and Estate Counsel Under the joint task force recommendation nonpublicly traded stock and partnership interests are to be valued for gift tax purposes by assuming that any discretionary liquidation, conversion, dividend or put rights in the stock or partnership interest retained by the donor or the donor's spouse will not be exercised by them in a manner adverse to the donee's interest if the donee is a member of the donor's family. This rule effectively increases the value of the transferred interest. Because this assumption against economic self interest runs contrary to normal experience, the task force rule represents a departure from the usual hypothetical willing buyer/willing seller valuation standard. We recognize that any shift from this standard is problematic and should be limited to very specific transactions. In short, we believe that a modest deviation from the basic valuation standard is justified to meet Congress' concerns with respect to abusive estate freezes, but the application of the new rule should not extend beyond that particular target. We We have submitted our proposal to the Treasury Department and the staff of the Joint Committee on Taxation. appreciate the consideration it received and the role it played in the development of the proposed Chapter 14 contained in Chairman Rostenkowski's discussion draft. THE DISCUSSION DRAFT We commend the Treasury and Congressional staffs for the basic approach of the discussion draft, which adopts a valuation based solution to the estate freeze valuation problem. We have conscientiously studied the Chapter 14 approach and conclude that it is both an excellent effort and an unsuccessful one--at least in its present form. We believe it is an excellent effort because it creatively and directly seeks a valuation solution for a valuation abuse and attempts to apply that solution fairly by including numerous and complex adjustments for tax overpayments caused by the statute. We believe it is unsuccessful because it suffers from the major shortcomings of section 2036 (c), namely, it is overbroad in its application to perfectly legitimate transactions and represents an extraordinarily complex response containing significant ambiguities. We believe it too will prove unworkable (impossible to understand and evenly administer) and will operate mainly as an in terrorem device that inhibits desirable, nonabusive family and business transactions and will be ignored by many potential tax abusers. Further, we believe that Chapter 14's failings are directly attributable to its attempt to be an objective, airtight solution to a subjective, fact specific problem. Explanation: The discussion draft has four major parts: (1) retroactive repeal of section 2036 (c); (2) special valuation 33-144 0 - 90 - 3 rules applicable to "10% owned" corporations, partnerships and trusts, (3) a rule setting forth specific requirements that would have to be met in order for options held by family members to be taken into account in valuing property, and (4) a revision to the gift tax statute of limitations. Special rules are also included treating transfers made by one spouse as if made by the other in limited situations and treating all persons who are donees (without regard to Chapter 14) as if they were family members of the donor. The discussion draft contains a number of technical errors, many of which possibly may be identified and cured prior to enactment. Our testimony, therefore, does not focus on these technical errors except to mention them as an example of the provision's extraordinary complexity. We intend to submit a separate list of our technical comments for the benefit of the Committee and its staff. The purpose of the balance of this testimony is to raise substantive concerns about the operation of the proposed replacement rules. The discussion draft provides that, with respect to gifts of an interest in a "10% owned" partnership and corporation, any interest retained by the transferor (or a family member other than the transferee) has no value unless that interest is (i) a "qualified fixed payment" (QFP), (ii) an interest in the same class as what is being given away, (iii) a voting right, or (iv) an interest with no preference over the transferred interest. An interest in a corporation or partnership is a QFP if it is (i) a right to dividends payable at a fixed rate on a periodic basis on a cumulative preferred stock, or (ii) the right to any other payment or distribution if fixed as to both amount and time (and not subject to a life contingency). In addition, a floor is set on the value of all junior equity interests, such as common stock, by providing that such interests be valued at not less than 20% of the sum of the equity in the corporation or partnership and all debt owed to the transferor and members of his or her family. Rights to QFPs are valued with two special assumptions: (i) that all payments will be made when due and (ii) if there is no termination date, that payments will be made forever. However, if a QFP payment is not made by the end of the third calendar year following the year in which it was due, then a deemed gift will occur unless the corporation or partnership is bankrupt or insolvent. Adjustments must be made in the values of retained interests to reflect such deemed gifts. A taxpayer can elect (i) to treat rights to dividends under a noncumulative preferred stock interest as a QFP and (ii) to treat rights to partnership payments as a QFP where the right was not treated as a QFP solely because any such payment was contingent on and limited by the income or cash flow of the partnership. Thus, a sole shareholder of a $2,000,000 corporation who holds common stock worth $1,000,000 and non QFP preferred stock worth $1,000,000 (perhaps because it must be redeemed 2 years in the future for $1,200,000) will be subject to tax on $2,000,000 upon the transfer of the $1,000,000 of common stock. Furthermore, as presently drafted, there would not be an adjustment to compensate for the gift tax overpayment when the retained preferred stock is redeemed for $1,200,000, thereby augmenting the estate of the original shareholder. With respect to trusts, the discussion draft provides that a retained interest by a grantor would not reduce the gift tax value of a transfer in trust unless the retention constitutes a QFP of a different but comparable sort. A retained interest qualifies as a QFP if it is the right to (i) an annuity, (ii) a unitrust amount, (iii) payments under a debt instrument or a lease that are fixed as to both amount and time or (iv) an amount payable under a noncontingent remainder interest if the preceding rights under the trust are described above. Thus, under this proposal, where an individual transfers property in trust retaining the right to trust income, a gift tax must be paid on the full amount placed in trust because a retained income interest, which is not a QFP, will be valued at zero. With respect to options and agreements, the discussion draft essentially provides that options held by family members would not be taken into account in valuing property unless (i) the option is actually exercised, (ii) the property does not have a readily ascertainable fair market value, (iii) the property is not resold to a nonfamily member by the person exercising the option within six months of the decedent's death and (iv) the option price is determined under a formula which had been reviewed within three years of the event triggering the option and which at the time of the review was reasonably expected to produce a price approximating fair market value at the time of sale. The statute also provides that the value of property subject to rights of first refusal, leasehold interests or other transfer restrictions held by family members will be determined without regard to such rights. Thus, if a parent and child each owned 20% of a corporation and are subject to a shareholder's agreement entered into for a business purpose providing that upon a shareholder's death the company must buy and the shareholder's estate must sell all of the shareholder's stock at a price determined pursuant to a formula that was not reviewed within three years, then the parent's estate may be subject to tax at a value significantly higher than the amount actually received under this legally enforceable agreement, even if the reason for the failure to review was outside the control of the parent and the child. In the case of transfers subject to Chapter 14, the discussion draft extends the basic gift tax statute of limitations from three to six years and provides an unlimited statute of limitations for undisclosed transfers. Basic Distinction Between Proposals Causing Concern: The most fundamental distinction between the task force recommendation and the discussion draft, and the one that gives us the biggest concern, derives from the discussion draft's sweeping departure from the willing buyer/willing seller valuation rule in a manner that is light years beyond the limited departure from the rule contained in the joint task force recommendation. The discussion draft provides that only certain very narrowly defined retained rights or interests have value, and assigns no value at all to everything else except voting rights. It makes its new valuation standard, rather than the time honored willing buyer/ willing seller standard, the norm by assigning a zero value to all assets and interests within its scope unless they fall inside its narrow view of assets deemed to have value. The joint task force recommendation takes the opposite tack of preserving the current willing buyer/willing seller standard with a narrowly crafted exception for certain valuation techniques that have, in practice, been used to justify abusive valuation planning. The ultimate consequence is that Chapter 14 frequently will require taxpayers to pay gift tax on grossly inflated values, or to refrain from making gifts of closely held property interests or participate in intrafamily sales of such interests. Flaws in the Discussion Draft: As previously stated, the discussion draft ignores, i.e., values at zero, valuable retained interests having little transfer tax avoidance potential. We have been asked repeatedly to provide the staffs with a list of interests or rights that would be unfairly ignored by Chapter 14. We are in the process of compiling such a list. It includes, among other items, mandatory conversion rights, the right to use property held by the entity, as opposed to the right to income from it, automatic calls, or such rights exercisable by nonfamily members, consumer price index adjustments, and all rights tied to production or unit values, such as royalties, lease override payments, and participating preferred stock. We are confident that many additional examples of similar rights created in the ordinary course of business exist. Experience shows that innovative financiers are constantly creating new types of equity interests for public corporations that are being emulated by family businesses. As stated earlier, Chapter 14 suffers from many of the flaws of section 2036 (c). It contains fundamental uncertainties and ambiguities. After weeks of study, neither we nor the staff members to whom we have spoken can state with certainty whether and to what extent it applies in a variety of common situations. For example, it is not clear whether and to what extent the discussion draft would apply to a lifetime transfer of preferred stock to a child not active in the family business and common stock to a child who is active in the family business. The answer may depend upon a number of incidental factors such as the order of the two gifts, whether the gifts are considered part of the same transaction and whether the transferor/parent directly retains any interest in the stock. To the extent the provision would apply, it is not clear whether, if the preferred stock gift was made first, there would be any adjustment to prevent a double tax from being paid on the value of the preferred stock. By treating pure debt and leases as equity interests in the entity, the discussion draft creates the potential for inadvertent triggering of the provision. As discussed below, it unnecessarily attacks buy-sell agreements. Its rules for trusts add an avoidable complexity to provisions aimed principally at partnerships and corporations, and, like section 2036 (c), makes indirect and fundamental changes in the taxation of trusts that are inconsistent with our basic system of taxing such entities and are not required to reach the targeted abuses. Chapter 14 even applies in certain situations where section 2036 (c) itself did not apply. For example, if a parent transfers 10% of his common stock and 10% of his preferred stock to a child, section 2036 (c) would not apply, but proposed section 2701 would overvalue the initial transfer for gift tax purposes, requiring the payment of an excess gift tax followed by a later adjustment. The discussion draft is overbroad in several different ways. First, where it applies it ignores too many rights that can be reasonably valued. In doing so, it blurs property law distinctions and, in some situations, even independent individual taxpayers and family members are treated as a unit. Second, its 10% ownership test applies to too many taxpayers; if the goal is to prevent manipulation and if attribution rules are to be applied as presently written, a test consistent with the ability to manipulate, usually more than 50% ownership, would be appropriate. Furthermore, the use of the attribution rules should be presumptive only, rebuttable by the taxpayer's showing of family hostility. The Chapter 14 approach of granting only qualified fixed payments or voting rights value, represents, as noted earlier, a substantial departure from the willing buyer/willing seller determination of fair market value. As a result, it divorces the tax base from even theoretical reality and raises to a very high degree the likelihood that there will be instances of a confiscatory tax (i.e., where the tax equals or exceeds the "true" fair market value of the property transferred). Taxpayers' ability to pay the tax is clearly jeopardized by this approach. The willing buyer/willing seller valuation rule is embodied in section 20.2031-1(b) of the estate tax regulations, which states that "the fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." This standard has stood the test of time and generally works to value property for tax purposes at a realistic price. Revenue Ruling 59-60, 1959-1 C.B. 237, has amplified the rules for determining the fair market value of stock of closely held corporations under this standard, with only slight modifications, for more than 30 years. The approach taken in Chapter 14 would totally ignore and distort these long standing authorities for an untried and complex |