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substitute set of rules that would necessarily ignore the facts; the change is startling and disconcerting, to say the least.
Another troubling similarity to section 2036(C) is the extreme hardship that Chapter 14 could cause closely-held business owners not engaged in tax motivated transactions. The deemed gift provision is a good example of the potential hardship. Consider a corporation in which a parent owns $3,000,000 of 10% cumulative preferred stock and his child owns the common stock. If the corporation has some bad times and is unable to pay the preferred stock dividends for several years, the parent may be subject to gift tax on a $300,000 deemed gift at a time when he may already be feeling a financial squeeze because he is not receiving the dividends on which he depended. There is a safeguard in the discussion draft for insolvent corporations, but this is grossly inadequate to deal with the many potential hardships falling short of insolvency that might be encountered. Furthermore, in determining insolvency, debt owed to the preferred shareholder and his or her family members would be ignored, increasing the likelihood that hardships will occur in struggling family businesses.
The 20% minimum value requirement in Chapter 14 will create similar hardships. This rule, while perhaps appropriate in some cases, is inappropriate with respect to a troubled company--perhaps a company going through transition in management from parent to child where common stock ownership is the inducement the child needs to persevere with the company. The joint task force recommendation contained a similar rule--but only in the context of meeting a safe harbor, not in the context of an exclusive valuation rule.
We are opposed to the discussion draft's provision ignoring buy-sell agreements, options and restrictions held by family members because it too creates conclusive presumptions in a fact specific area and inhibits the use of legitimate business or estate planning techniques. Pre-section 2036(C) law, embodied in section 20.2031-21h) of the estate tax regulations, contains appropriate safeguards against abusive buy-sell agreements. It provides that options or contract prices are disregarded in determining the value of the securities unless it is determined under the circumstances of the particular case "that the arrangement represents a bona fide business arrangement and not a device to pass the decedent's shares to the natural objects of his bounty for less than an adequate and full consideration in money or money's worth." This standard has been successfully applied by the courts to prevent abuses of the normal valuation rules. Furthermore, if there is a concern that this test is uncertain or not being interpreted properly, then the test could be clarified.
There are many legitimate nontax reasons for having buy-sell agreements. These reasons lead parties to set prices geared to what they believe to be the fair market value for the company, usually by employing a valuation formula that adjusts appropriately for changing economic conditions. Often the parties also take into account their desire that the company survive the death of a partner or shareholder and establish a price that would not cripple it. In all cases, buy-sell agreements create a system of rights and obligations that are to apply at a future point in time and allow the parties to plan in a stable environment for future contingencies. Often situations change after the agreement is entered into making it practically impossible to reopen the agreement.
For example, buy-sell agreements can be used to create a mechanism for an amicable separation if shareholders cease to get along or to provide a market for an essentially unmarketable minority interest in order to obtain the liquidity to pay taxes.
Buy-sell agreements and stock transfer restrictions can help many families keep the businesses together by solving potential problems regarding the disposition of the stock or the partnership interest at the death of a shareholder or when the shareholder leaves the company. It can provide a mechanism for determining the otherwise unknown price of a particular ownership interest in a company or a partnership. It can prevent the sale or other disposition of business interests to someone outside the family or to someone who is not acceptable to the other owners. It can provide a mechanism for liquidating on an equitable basis the ownership interest of a decedent or someone leaving the partnership or the company. Another important purpose of the buy-sell agreement is to provide adequate liquidity upon death so that the estate taxes can be paid. Their validity and use, already policed by an adequate set of safeguards, should not be inhibited by the heavy handed approach proposed in the discussion draft.
Finally, the discussion draft rule forces a valuation differential between the fair market value of business interests subject to buy-sell agreements and other stock restrictions for estate tax purposes and for state law purposes, thereby imposing serious and undesirable hardships on taxpayers who use these heretofore standard arrangements to facilitate their business and tax planning. A rule of sort can have extraordinarily harsh and unintended results. Consider the case of a decedent who leaves to his spouse stock in his closely held corporation that is subject to a mandatory buyout under a buy-sell agreement. If the buy-sell agreement is not recognized for estate tax purposes under proposed section 2702 the gross estate would include a value higher than the value in the buy-sell agreement whereas the marital deduction would be limited to the value in the buy-sell agreement. The differential in value would be subject to estate tax and that estate tax could in turn further reduce the marital deduction in a continuing spiral until it subsumes the entire marital gift. Under pre-section 2036(C) law, this result could occur only where the buyout obligation itself is a disguised testamentary transfer to the other shareholders. The whipsaw effect produced by this one element of the discussion draft illustrates why an objective, all encompassing rule is an inappropriate approach for Congress to take in the estate tax valuation area.
Grantor Retained Income Trusts and Joint Purchases:
We question the discussion draft's treatment of grantor retained interest trusts (GRITS) and joint purchases because it increases instability and uncertainty in the estate and gift tax area. The discussion draft effectively eliminates GRITS currently permitted under section 2036(C) (6) and joint purchases by valuing the retained interest at zero and taxing the entire value of the property involved in the transaction as a transfer from the holder of the current interest to the holder of the remainder interest. With respect to GRITS, this treatment represents a complete reversal of the decision reached when Congress last visited this issue in TAMRA less than two years ago, and leads one to ask what has happened in the interim to cause an about face of this sort within such a brief time frame.
Put more broadly, this questioning of certain split interest transactions apparently reflects a concern that the Treasury Tables do not work well in the context of these two specific cases because the taxpayer may secure an advantage if the current yield of the subject property falls below the assumed rate of return in the tables. On the other hand, use of the tables to determine the transfer tax consequences of gifts of life estates and terms of years, or the transfer tax implications of charitable lead and charitable remainder trusts, will work to the advantage of the Treasury under similar circumstances. We question whether a change that rejects the use of the tables where they work against the Treasury, but insists upon their application where the opposite result occurs, represents good tax policy and fosters likely taxpayer agreement that our transfer tax system is fair, equitable and worthy of their highest standard of voluntary compliance.
This suggests to us that any review of the taxation of split interest transactions for transfer tax purposes should examine more than particularized aspects of the topic without regard to whether the outcome from a given rule produces a benefit for the Treasury or for taxpayers. Hopefully, this overall analysis will shed light on the vexing issue of the appropriate use of administratively convenient and understandable tables in a transfer tax system that offers taxpayers and their advisors complete freedom to transfer assets of their sole choosing.
In 1989, in connection with the Senate's vote to repeal section 2036 (C), the cost of repeal without a replacement was estimated at $245 million over three years and $878 million over five years.
We find such a large revenue loss both surprising and out of sync with the estimates that were published when section 2036(C) was enacted in 1987 and modified in 1988. In 1987 it was estimated that section 2036(C) would raise $109 million over three years and the 1988 modifications were estimated to lose $1 million over four years.
In order for any revenue to be lost within the next five years by the repeal of section 2036(C), one of the following three scenarios would have to occur:
(1) an actual transfer after December 17, 1987, and prior to repeal, triggering section 2036(C), followed by appreciation in the property transferred and the death of the transferor within five years of the repeal;
(2) an actual transfer after June 21, 1988, and prior to repeal, triggering section 20361C), followed by appreciation in the property transferred and an event triggering gift tax consequences occurring within five years of the repeal; or
(3) a transfer after repeal that would have triggered section 2036 (c) had it not been repealed, followed, within five years of the repeal, by appreciation in the property transferred and by either the death of the transferor or an event that would have triggered gift tax.
On the other hand, it should be noted that all appreciation that occurred prior to repeal on property not transferred by reason of section 2036(C) would remain subject to transfer tax.
Recognizing that there can be widely divergent views on any behavioral assumption, it is hard for us as attorneys practicing in this area, to imagine that the total of such scenarios would result in tax consequences anywhere near $1 billion (even at a 55% tax rate). Even if
revenue estimates are accurate, we believe that the joint task force recommendation would more than make up for any revenue loss over the next five years because (i) it would generate revenue by inhibiting most, if not all, of the same tax avoidance transfers and (ii) it would generate increased gift tax revenues even where the transferor does not die within five years.
Chairman Rostenkowski in his announcement which accompanied the discussion draft stated that the draft which would replace section 2036(C) was "intended to accomplish similar objectives in a less burdensome and more focused manner." Further, he said that it was his hope that the modifications would address legitimate complaints about the current law provisions "while seeking to preserve the integrity of the Federal estate and gift tax system.
We continue to applaud these goals and the process being followed to achieve them. We do not believe the discussion draft meets these goals, however. Moreover, we believe the joint task force recommendation meets these goals. Further, as it applies to those taxpayers who attempt abusive estate freezes, it will have much the same tax effect as the discussion draft. We respectfully suggest it be given further consideration. Even if the joint task force recommendation is not followed, we continue to be willing to assist in the efforts to produce a more narrowly focused workable provision and to secure a repeal of section 2036(C).
Towards this end, we intend to submit additional comments on the discussion draft, which will include both substantive and technical concerns. In addition we join in the comments submitted by the others on this panel and share the concerns raised in their testimony.
We appreciate the opportunity to be heard today.
STATEMENT OF JERE D. McGAFFEY, CHAIR-ELECT, AMERICAN
BAR ASSOCIATION, SECTION OF TAXATION Mr. McGAFFEY. I am Jere McGaffey, chair-elect of the section of taxation and testifying with my colleague John Wallace on behalf of the American Bar Association.
I want to second John's compliments to the procedure here used. Staffs have been very willing to talk to us about this section. Having detailed language forced us all to focus on some of the difficult problems.
I think in our testimony we have come up with a lot of detailed comments which I hope will be helpful. Whatever the end result, I think the statute will be better for having detailed language available early for comment.
We agree with the testimony of Treasury this morning that there were abuses that need to be solved by the statute. We concur with the discussion draft that the problem is one of valuation and is best solved by a gift tax solution.
Our approach was one of defining what was bad of the so-called soak-up rights, in the terminology of Treasury, and not giving them value. The discussion draft attempts to define what is good. We believe that approach is a much more difficult one because it must be much more all encompassing.
We have included in our testimony an appendix of matters which we believe should be included as being good that have not been included in the discussion draft. One appendix deals with those which we believe were unintentionally omitted in the draft.
The second list involves those transactions which we believe probably were focused on but were not included as being good and should be.
For example, the discussion draft covers leases.
If a child owns a business in a corporation that is a retail business, which is leasing the real estate used in the business from a third party, it would be quite common for the rental to be based as a percentage of sales. If the parent then buys that real estate from the third party and continues exactly the same lease, under the discussion draft that will be deemed a gift from the parent to the child. In our experience, leases have not been used in abusive freezes. We see no reason for them being included in the discussion draft.
Similarly, we believe debt should not be included. Prior to 2036(c), there was an adequate section which dealt with debt. Any debt on which interest was not paid or the interest was inadequate gave rise to a gift in the amount of the below market rate interest.
If a child had a business and needs some funds and the parent loans money on a demand no-interest basis, under the old law it would be deemed a gift of the amount of interest that is not paid. Under the discussion draft, it will be deemed a gift of the entire principal. When the principal is repaid, there is no provision for refund in the discussion draft.
We believe the discussion draft provides for a gift on the failure to pay dividends which are not motivated by tax considerations. Assuming a business which is owned by a parent and two children, one of which is active in the business and one not. The one that is