active in the business is contributing to its growth, wants to have that growth, and the parent is ready to retire. The other child is not in the business and is very angry that such child is not receiving any income from the business, so the business is recapitalized with the parent and the inactive child taking preferred. Expecting the dividends to be paid, the parent retires and the other child lives off of the dividends. The child active in the business doesn't run it very well and quits paying dividends. The siblings do not have kindly relations at this time by reason of the failure to pay dividends. This proposal would impose a gift tax from one sibling to another in that situation, adding insult to the injury of not receiving the dividends. We believe that there are a number of areas like this that should be addressed. Although we prefer the task force approach, whereby, what is bad is defined if the revisions that we suggest in our testimony were adopted, we could support the discussion draft. We are very willing and anxious to work with the staffs of the tax-writing committees and Treasury in attempting to develop a suitable solution to this problem. We believe that the steps that have been taken so far are good first steps in that regard, but that much work needs still to be done. Thank you. [The statement of Mr. McGaffey follows:] TESTIMONY OF JERE D. McGAFFEY on "Discussion Draft" relating to House Ways and Means Committee I am Good morning. My name is Jere McGaffey. Chair-Elect of the Section of Taxation of the American Bar Association. I am one of two spokespersons on behalf of the American Bar Association. I am pleased to be able to testify today on a proposed alternative to the present Section 2036(c). We want to compliment all of those involved in the procedure concerning this alternative. The staffs of the tax writing committees and the Treasury have been interested in our views as to an alternative. We believe that having the statutory language of the Discussion Draft has forced us all to focus on many difficult problems and has been a very helpful step. We appreciate the opportunity of hearings to comment on the Discussion Draft. We believe such procedures will make for better tax legislation, whether we completely agree or not with the ultimate results. We are very pleased that repeal of Section 2036(c) is being considered. Repeal of Section 2036(c) has been the position of the American Bar Association. We recognize the need for a substitute. We believe prompt action in this area is necessary. Prior to the enactment of Section 2036(c) there were valuation abuses in certain freeze transactions. The most typical of these were situations in which a corporation was recapitalized, the parent taking preferred stock, which purported to have virtually all the value of the corporation, and then giving the common to children. The corporation normally was unable to pay a dividend at market rates on the amount of preferred that was issued (seldom would an active business have cash flow equal to a market interest rate on its entire value). If the preferred was made cumulative and the dividend not paid, the growth of the preferred's liquidation preference could grow to be more than the entire value of the company. Therefore, noncumulative preferred was issued. Noncumulative preferred would normally not have significant value unless there was some compulsion to pay dividends. To increase its value various features ("bells and whistles") were added to the preferred. These might be features entitling the preferred to cause the corporation to repurchase the preferred at any time at its par value (put rights), a right to require liquidation at any time or a right to convert the preferred at any time into common having a value equal to the preferred's liquidation preference. All of these rights gave an arguable value equivalent to the liquidation preference. However, the parent would not exercise these rights and thus the growth in value of the business would all increase the value of the common stock held by the child. In this manner the parent's estate was frozen and the appreciation was transferred with little or no gift tax. Something needed to be done to prevent such transactions. Section 2036(c) prevents such transactions by including in the parent's estate the value of the common since the transactions were a transfer of a disproportionate amount of appreciation while retaining an interest in the enterprise. Whereas Section 2036(c) prevents abusive recapitalization it goes much further. It prevents all divisions of ownership between family members. Some of these were neither abusive nor motivated by estate tax avoidance considerations. A parent may have reached the point in life where retirement was desired and a child may have been active in the business desirous of taking over the management. In such situation it was appropriate for the parent to receive preferred stock with an adequate income stream to provide support and the child to receive the growth which the child was creating. child may have a business which required additional capital which the parent advanced through a preferred stock issue in order to provide capital and to increase the business's borrowing base. There was even concern that Section 2036(c) might apply in situations in which an unrelated employee received common stock at less than fair market value as part of a compensation package, if there was preferred stock held by the major owners. A Many practitioners did not realize the breadth of Section 2036(c) until it was amended, to create purported safe harbors, and it was recognized that it applied to loans, leases, employment agreements and buy-sell agreements. What one had thought was primarily a regulator of capital structure became also a regulator of compensation agreements. If the corporation had only common stock and annual gifts were being made by parent to child, if the parent had a more than three-year employment agreement, if salary was based on income or parent participated in a bonus program based on profits these gifts would be included in the estate. There is great uncertainty as to the possible breadth of Section 2036(c) and a closely held corporation cannot take any action with their shareholders without considering the possible application of Section 2036(c). It has greatly increased the importance of estate planners with their corporate partners but both partners and clients are amazed at the implication of Section 2036(c). Details of problems with Section 2036(c) have been dealt with elsewhere and I assume all parties realize some different approach to the problem is necessary. After the American Bar Association went on record as favoring repeal of Section 2036 (c) the Section of Taxation formed a task force to consider alternatives to deal with the abuses in the area. This task force then worked with a joint task force of the Section of Real Property Probate and Trust and American College of Trust and Estate Counsel. We believed that the basic problem was the valuation of the gift at the time of a recapitalization. The problem arose by the use of special discretionary rights (puts, conversion features, etc.) which would give value to preferred stock even though the dividends were noncumulative. The problem arose because such rights would have substantial value if held by a third party. A related party could fail to execute such rights and thus give value to the instrument which really was not retained. Our solution was to recommend that such discretionary rights should be disregarded in the valuation process. (The task force recommendation is attached as Exhibit A). We provided a safe harbor which contained elements of compounding the cumulative feature and a 20% minimum capitalization as well as a safe harbor interest rate. These were not intended as requirements but a safe harbor and to imply factors that should be considered in valuation. We also were mindful of the fiscal effects and recognized that a gift tax approach would in the short run always raise more money that an estate tax approach as used in Section 2036(c). Although admittedly on a 20 to 30 year perspective an estate tax approach probably raises more funds. The Discussion Draft has a great many similarities in result to our recommendation. It, like ours, is a gift tax solution with an emphasis on value. We believe a gift tax valuation approach is a desirable one. The Discussion Draft covers three areas which we did not. It covers GRITS which we did not cover because of the statutory exception in Section 2036(c). Limiting such devices to structures similar to those used in the charitable area seems desirable. Joint purchases, other than of residences are included in the Discussion Draft. We did not view this as a problem area, but it may be that they would be used more if they were not limited. The limitation of joint purchases seems reasonably closely related to GRITS. We have technical comments on both of these areas and believe that it would be clearer if they were dealt with separately from corporations and partnerships. The third area included in the Discussion Draft is buy-sell agreements and rights of first refusal, if held by family members. We are opposed to legislation in this area. We believe that the existing regulation issued prior to enactment of Section 2036(c) which prevents the use of buy-sell agreements as substitutes for testamentary devices is adequate to deal with any abuses in this area. Buy-sell agreements in our experience are usually used for matters unrelating to reducing value and thus the legislation is intrusive into an area where there are few problems and it upsets expectation of private parties in ordering the ownership of closely held businesses. Valuing stock for estate tax purposes at more than the price it is sold can also defeat the marital deduction as it will be limited to the proceeds. The intended results of the Discussion Draft andour recommendation in the corporate and preferred recapitalization area I believe are quite similar. There are two differences in approach. First our recommendation attempts to define what is bad and not consider it in the valuation. The Discussion Draft defines what is good and values everything else at zero. If we were sure our definitions exactly met, the results would be the same. The legislation applies to a very broad area involving any dealing between owners and their closely held businesses. We have already discovered some eighteen areas in which the Discussion Draft, we believe, unintentionally applies. We are more concerned that we will not think of all of the possible transactions that it might apply to and that innocent transactions may be caught. This is particularly a problem when we are deviating from the normal willing-buyer willing-seller valuation rules. We thus prefer to define when we are deviating from such a rule. We understand the argument that the government can also be concerned that it may not be able to list all the rights that are bad and the burden should be placed on the taxpayer to avoid the unintended areas, since the taxpayer can devise the transaction. We believe that when we are dealing with such a large universe our approach would create less problems. Nevertheless we have attempted to evaluate and comment on the approach of the Discussion Draft. The second major difference in approach is the taxation of unpaid dividends as a gift. This result is derived from the concept of valuation of a QFP as if all dividends are paid. Whereas dividends may not be paid because of estate tax avoidance objectives they also may not be paid because of changes in the economic fortunes of the company. The imposition of gifts in the latter case is not justified and may not be based on any value being derived by the recipient. In the case where the corporation can pay the dividend and fails to do so, a gift tax may be imposed under pre-Section 2036 (c) law. Again the issue is one of whether the law unjustifiably taxes some taxpayers or whether some may slip through the transfer tax system. The Discussion Draft also considers leases and indebtedness. These we did not consider as they have not given rise to abuse and other sections address them if they differ from fair market value. We oppose including them. We are also concerned with the complexity of the Discussion Draft. We have been told that our proposal would have been more complicated. We would have thought it could have been easily done by providing for valuation without considering the discretionary rights of liquidation, conversion or put rights without the elaborate system of valuation upon subsequent transfers, and deemed dividends. We believe the approach of defining what is permitted is bound to lead to omissions. There are a number of situations which the statute seems to cover which it is believed were not intended to be covered. We think it likely that your staffs, upon consideration of these issues, are likely to be willing to recommend appropriate modification. They are described in detail in Exhibit B and merely listed here: 1. 2. Income to child for life then to grandchild treated as General and limited partnership interests that are 3. Transfer to trust with income 10 years to child and then to grantor, treated as a gift of the entire interest. 4. 5. Partnership with first $1,000,000 of cash flow to parent may not be able to elect to be a QFP. Only part of preferred and common owned by parent, the extent of gift is unclear. 6. Only part of preferred and common owned by parent and dividend not paid; the amount of the gift appears to not consider common held by others. 7. If give preferred first and then common, pay gift tax on value of preferred twice. |