Hearing on Estate Taxes


Comments Submitted to the United States Senate Committee on Finance

April 3, 2008

Prepared by Paula A. Calimafde Esq.
Chair of the Small Business Council of America

The Small Business Council of America (SBCA) appreciates the opportunity to submit our comments to the Senate Finance Committee’s April 3, 2008, hearing titled “Thinking Outside the Box.”

The SBCA is a national nonprofit organization which represents the interests of privately-held and family-owned businesses on federal tax, health care and employee benefit matters.  The SBCA, through its members, represents well over 20,000 enterprises in retail, manufacturing and service industries, virtually all of which provide health insurance and retirement plans for their employees.  The SBCA is fortunate to have many of the leading small business advisors in the country on its Advisory Boards, many of whom are the leading experts in the estate tax law and how that law impacts small and family-owned businesses.

Background 
The 2001 Tax Act created a legal landscape that makes it impossible for small business owners and other taxpayers to plan their estates with any predictability.  Over the next four years, the amount exempt from estate taxes will vary from $3.5 million to $1 million and in one year (2010), the entire estate tax system is repealed!  This unpredictability has undermined taxpayer confidence in the estate tax system.

The estate tax system was developed to avoid the problems that occur when a very small elite of the country is able to amass great wealth and pass this wealth down to the next generation; it was not intended to cut in half the estates of working Americans who had built up a family business or a small business based on their own hard work.

Estate Tax Certainty and Reform Needed Now for Small Business Owners

Small businesses need certainty in the estate tax area.  In order to assist small businesses, the estate tax exemption should be increased to the $3.5 million dollar level this year B not in 2009.  The SBCA is in favor of reforming the existing estate tax system and does not support repealing the estate tax law in 2010 and beyond. We believe the following reforms are needed:

Ž          Increase the estate tax exemption amount immediately to $3.5 million and then increase it gradually over a number of years until it reaches at least $5 million and thereafter have it increase by COLA

Ž          Preserve the step-up in basis at death for simplicity

Ž          Reunify the estate and gift tax exemptions, increasing the gift tax exemption to immediately equal the estate tax exemption, for simplicity and flexibility

Ž          Exempt retirement plan assets from the estate tax in an amount up to an additional $1 million if assets are going to a surviving spouse and up to an additional $500,000 if the assets are going to other heirs

By implementing these steps, small business owners who have worked a lifetime to build their companies will, in most cases, be exempt from the estate tax system.

The SBCA is opposed to the proposed repeal scheduled to take place in 2010. This is because total repeal would be accompanied with a loss of the step-up in basis and a continuing $1 million cap on the gift tax exemption.  Unfortunately, many small businesses would end up paying more taxes under the proposed repeal in 2010 than they would with the increased exemption proposed to be in effect in 2009 because of the loss of the step-up in basis.

To understand the repeal proposal and our pro-small business reform proposal, there are a few basic concepts to our estate tax system that should be discussed.

Step-Up in Basis

Under our current estate tax system, any assets coming from a decedent’s estate receive a Astep-up@ in basis – this means that the person receiving them gets the assets with a tax basis increased to fair market value as of date of death.  Thus, when a person decides to sell the property, he would be taxed on the difference between the sales price and the date of death fair market value (this gain would be subject to either income tax or capital gains tax depending upon the asset).

Upon the full repeal of the estate tax in 2010, the current rule providing for a fair market value basis in property acquired from a decedent (i.e., the step-up in basis) is repealed.  In lieu of this rule, the recipient of property acquired from a decedent will have basis in such property equal to the lesser of the decedent=s adjusted basis in the property or the property=s fair market value at the time of the decedent=s death.  However, recipients of property from a decedent will be entitled to an aggregate basis increase of $1.3 million (adjusted for inflation after 2010).  In addition, the decedent=s surviving spouse will be entitled to an additional aggregate basis increase of $3 million (adjusted for inflation after 2010).  Accordingly, if a decedent is survived by the decedent=s spouse and the value of the decedent=s estate is $4.3 million, the full amount of the estate will pass to the spouse free of any estate tax and the surviving spouse will have a stepped-up basis for the entire estate. If there is no surviving spouse, then only $1.3 million of assets will receive the step-up in basis.

AExemption Level@ (formerly the AUnified Credit@)

Any assets that a person owns up to the estate tax exemption level – $2 million this year, can be given away at death, free of estate taxes.  This is referred to as the estate tax exemption or exclusion amount and it is scheduled to increase in 2009 to $3.5 million.  This means
a couple could leave $7 million to their heirs without the imposition of estate tax and with a step-up in basis on the entire $7 million of assets, if they did some basic estate planning.  If they did not do any estate planning, then only $3.5 million would be exempt from estate taxes. Assets in excess of $3.5 (or with proper estate planning done for a married couple, $7 million) in 2009 would be subject to the maximum estate tax rate of 45%.

In the 2001 Act, Congress was concerned that once the estate tax was repealed, taxpayers would refocus their efforts on shifting assets to lower income tax bracket taxpayers (such as their children or grandchildren).  Accordingly, Congress capped the gift tax exemption (which had for a long time been Aunified@ [or in lockstep] with the estate tax exemption) at $1 million.  Thus, although a person can pass up to $2 million estate tax free today (scheduled to increase to $3.5 million in 2009), only $1 million can be passed during lifetime.

Many estate planners have found that this artificial cap on giving has caused the senior generation owners of small businesses to not be able to pass ownership of the family business to the next generation.  It serves no function if estate taxes are not repealed.

Why Making The Law in 2009 Permanent Rather Than Repealing the Estate Tax is Advantageous for Small Businesses – an Example

Assume there is a small business owner who has $3.5 million of assets and no surviving spouse.

 

Under total repeal:        $1.3 million of the assets receive a step-up in basis to the fair market value of those assets at date of death.  The remaining $2.2 million of assets will have the basis that the decedent had in those assets.

As an aside, imagine if the decedent were an 85 year old man who acquired many of these assets more than 40 years ago… how anyone is even going to be able to figure out the carry over basis of those assets is beyond us.

The burden is on the heirs to prove any basis, and many will fail to have enough records, resulting in a zero basis. The step-up in basis was repealed back in 1976 and was then reinstated in 1980, though the carry-over rules never became applicable during that period, because Congress learned from attorneys and accountants who handled the probate process that the carry-over basis rules were unworkable because it was almost impossible to determine the carry-over basis for many assets.

Now when the heirs of this decedent sell this $2.2 million of assets, they will be subject to income tax on the difference between the then fair market value of the assets and any basis they can prove the decedent had in those assets.  For example, let=s assume that the heirs are able to prove that the carry-over basis in the assets is $1 million – then the heirs will be taxed on $1.2 million (assuming the fair market value of the assets was still $2.2 million).

With a $3.5 million exemption:

All $3.5 million of assets receive a step-up in basis to the $3.5 million level (this is the fair market value of his assets as of his passing).  Now when the heirs sell any of these assets (assuming the fair market value of the assets was still $3.5 million), there would be no income tax and no estate tax.

A single person with assets greater than $1.3 million up to $3.5 million is better off under the estate law as it stands in 2009 and in most cases ends up in a worse tax position under repeal of the estate tax.  Similarly, a decedent who is married with assets greater than $4.3 million up to $7 million does better under the law as it would stand in 2009 than he/she would under total repeal.  This covers a significant amount of taxpayers based on the data that illustrates how many taxpayers drop off of the estate tax rolls as the exemption amount increases. Based on data set forth in a March 16, 2005, issue paper from the Center on Budget and Policy Priorities :

 

$          If the estate tax exemption were $1 million in 2011, then 53,800 estates would be subject to the estate tax. Of the 53,800 estates that would be taxable, nearly half (46%) would have assets of less than $2 million and nearly three-fourths would be valued at less than $3.5 million.                           

$         If the exemption level in 2011 were $2 million instead of $1 million, then the number of taxable estates would shrink to 21,000.  This is a reduction of 61% in the number of estates that would face the estate tax.

$         If the exemption amount in 2011 were $3.5 million instead of $2 million, then the number of taxable estates would drop to 8,500 (84% of the estates would be exempt compared to the number that would have been subject to estate tax  if the exemption amount were $1 million in 2011).  

These numbers demonstrate how many small business owners would be worse off under total repeal than if the law were frozen at 2009 (with the $3.5 million exemption and the step-up in basis).  Unfortunately, many small businesses owners do not understand the negative impact of repeal because they do not understand the carry over basis and the ultimate imposition of income tax on those assets which do not receive a step up in basis.

If the SBCA represented the interests of the wealthiest individuals in America, our suggestions would be entirely different.  We would not suggest increasing the exemption amount because when one’s estate is a billion dollars or more, it does not matter at all if the exemption amount is $1 million or $3.5 million – the impact is negligible.  What does matter is the tax rate.  Thus, a tax rate of 45% is incredibly significant when a billion dollars is involved.  Contrast this to the small business owner whose entire estate is $3.8 million.  If the exemption amount is a $1 million or $3.5 million will make a huge difference to the heirs and an estate tax rate of 45% on $300,000 does not appear to be overwhelming.

A recent CRS Report (“Estate and Gift Tax Revenues: Past and Projected in 2008, March 19, 2008”), set forth the following query:  “What explains the persistence of revenues despite a dramatic drop in the number of taxable estates?”  The answer is:

While large in number, the smallest estates as a group contributed relatively little in estate taxes.  Although the two lowest gross estate size classes accounted for 33,179 or 64% of the 51,736 taxable returns filed in 2001, they contributed only $2.7 billion or 11% of the $23.5 billion in estate taxes paid.  The large decrease in the total number of taxable returns between 2001 and 2005 can be explained by the elimination from taxability of the large number of estates in the two lowest gross estate size categories (under $1 million and $1 million up to $1.5 million) after the prevailing exemption rose to $1 million in filing year 2003.  There was a further large decrease in the number of taxable returns in the $1 million to $1.5 million category and a smaller decrease in the $1.5 million to $2 million category in filing year 2005, when the prevailing exemption rose to $1.5 million.

Between 2004 and 2005, the $1.4 billion loss in estate taxes paid by these two smallest size classes plus a $0.7 billion loss in the $2 million to $3.5 million gross estate size class, was more than offset by the $2.1 billion increase in taxes collected from the largest size class, with gross estates of $20 million or more.  (at p.10)

For years the SBCA has tried to come up with an effective reduction in tax rates for small business and we have not been successful.  When one takes into account that we have many of the leading estate planning advisors in the country for small business on our advisory boards and board of directors, and we have been unable to come up with an effective exclusion, our guess is that none exists that will a) work correctly and b) not be subject to abuse.

We know that such an exemption should not bear any resemblance to the Qualified Family Owned Business Interest (QFOBI) exemption that came into law a few years back (and would spring back into existence in 2011, if the law is not changed).  This rule was not only absurdly complicated, but suffered from the most severe planning defect – a small or family business owner would not be able to know if he/she qualified for the exemption until death occurred.

Promote Retirement Savings

The SBCA believes that giving an exemption for up to $1 million in retirement plan assets that are left to a surviving spouse and up to $500,000 for retirement plan assets that are left to others would go a long way towards promoting retirement plan savings by small business owners and others. This estate tax exemption on retirement plan assets is also important because these assets can be subject to estate tax and income tax when distributed to the deceased plan participant’s beneficiary.  Currently, the incentive for contributing money to a retirement plan (and thereby locking it up until retirement) is being diminished by the lower tax rates on capital gains and dividends that do not apply to funds coming out of a retirement plan.

Example of the Small Business Nightmare under the Current Federal Estate Tax Landscape

Imagine Mr. Entrepreneur is the sole owner of a small business, Innovative Inc., which, together with his home, totals $3.5 million in assets.  Mr. Entrepreneur’s wife has passed away and his single heir is his daughter, who may or may not want to take over the business, once her father passes away.  Mr. Entrepreneur wants to provide the best that he can for his daughter, Ms. Smart, upon his passing and he is currently seeking out the best plan.  Unfortunately, in the current federal estate tax landscape, the next 4 years are almost too volatile to do any planning unless he was able to decide what year to die!

Let’s say that Mr. Entrepreneur’s assets will be valued the following way upon his death:

Asset

Decedent’s Basis

Fair Market Value at Death

Innovative Inc.

$100,000

$2,600,000

Residence

$500,000

   $900,000

 

Without Congress Acting:

If Mr. Entrepreneur were to pass away in the next five years, the following will occur:

  • In 2008, Ms. Smart would owe $675,000 in federal estate tax.
  • In 2009, (when the exemption level is $3.5 million), Ms. Smart will owe no federal estate tax.
  • In 2010, the federal estate tax will have been repealed and the step-up in basis is significantly changed. Ms. Smart will have the burden to find the documentation of her father’s basis in his property (which could have been purchased decades ago).  In 2010, the law provides that Ms. Smart will receive $1.3 million in assets with a stepped-up basis to fair market value.  The remaining $2.2 million in assets will have the same basis that her father had in those assets.  Assuming Ms. Smart were to allocate all of the step-up basis to Innovative, Inc. and a capital gains tax of 15%, Ms. Smart would pay $255,000 in capital gains tax, if she chose to sell the business and the house.  That is $195,000 for Innovative Corp (15% of $2.6 million minus the $1.3 million in step-up basis and $60,000 for the residence (15% of $900,000 minus $500,000).  Depending on what documentation can be provided, Ms. Smart can pay as much as $330,000 (15% of $2.2 million) or as low as $255,000.  Note that these taxes will not be due until Ms. Smart chooses to sell the house and/or the business.
  • In 2011, the federal estate tax will be $1,220,000, because the exemption reappears at $1 million, which, in effect, would be devastating for Ms. Smart since she could not even cover the cost by selling the residence so she would be forced to sell all or a portion of the business, even if  she wanted to keep running it. It is possible that some portion of the $1,220,000 will be paid to a state government depending upon the state’s estate tax law.

 

How can Mr. Entrepreneur plan properly for an estate tax which in the next 4 years can fluctuate between zero and over a million dollars on a relatively modest estate!

With Congress Acting:

If Congress enacts a $3.5 million exemption immediately, all of Mr. Entrepreneur’s assets would receive a step-up in basis of $3.5 million, assuring that there would be no federal estate tax and no income tax.  If Congress reunited the estate and gift tax systems, Mr. Entrepreneur could gift his business to his daughter during his lifetime, if that made business sense for the family.  Furthermore, if a gradual increase to $5 million exemption were enacted, Mr. Entrepreneur would not be disincentivized to grow his business which in turn would keep our economy growing.  In effect, Congress would have repealed the federal estate tax for Mr. Entrepreneur and most other small business owners who were never intended to be punished for their hard work.

Should Congress Think Outside the Box?

Even though the SBCA is often willing to “think outside the box”, in the area of estate taxes we think the better course of action is to reform the system rather than throwing it out.  The estate tax system is well understood; the dislocation that would take place by going to another system would be significant.  Further, the original purpose for enactment of estate taxes still makes good policy today.  We do think that our recommendation with respect to exempting a portion of retirement plan assets from the reach of estate taxes could prove to be a significant incentive for  small business owners to establish retirement plans. Because of current law, retirement plans must provide  meaningful benefits for non-owner employees and thus, Congress would have achieved  an important policy goal – assisting all small business employees in saving for retirement.

Recommendation

 

To protect small business owners, Congress should increase the exemption amount immediately up to $3.5 million and then increase the exemption amount over the next several years, retain the step-up in basis and reunify the gift and estate tax exemptions.   Retirement plan assets should be exempt from the estate tax in an amount up to an additional $1 million if assets are going to a surviving spouse and up to an additional $500,000 if the assets are going to other heirs

 

By enactment of these reforms, most small businesses will be removed from the reach of the estate tax.

______________

 

Ms. Calimafde is the current Chair, past President and a member of the Board of Directors of the Small Business Council of America, Inc., the only national non-profit organization which has represented the interests of privately owned businesses exclusively in the Federal tax, retirement, health care and employee benefits areas for the past twenty-five years. She received her B.A. from Swarthmore College and her J.D. from Catholic University.

She is a partner in the Bethesda, Maryland law firm, Paley Rothman, where she chairs the firm’s Retirement Plans Practice Area and the Employee Benefits Practice Area and is a senior member of the Estate Planning Department.  Ms. Calimafde has nearly 30 years of experience advising small businesses and closely held businesses in tax areas and estate planning. For nearly 30 years, she has been a legislative advocate for small and closely held businesses in the Federal tax, health care and employee benefits arena.

In 1986, Ms. Calimafde was elected at the Maryland State Conference to serve as a delegate to the White House Conference on Small Business. She was subsequently appointed by the White House Conference to serve as one of eleven National Commissioners of the 1986 White House Conference on Small Business. As such, she chaired the Payroll Costs Session at the National Conference, which covered qualified retirement plans, employee benefits and social security, among other issues.  In 1995, Ms. Calimafde was appointed by the White House to serve as a Presidential Delegate at the 1995 White House Conference on Small Business.

 

She is also a member of the Board of Directors of the Small Business Legislative Council (1992‑), Past Chair (1988‑1990) and Vice Chair (1986‑1988) of the Closely Held Committee of the ABA Tax Section, Advisory Board of the Journal of S Corporation Taxation, 1989‑1994, Employee Benefits Council, Chamber of Commerce of the United States, 1986‑1994, 1996‑, and Small Business Council of the U. S. Chamber, 1995‑1998 and the Washington, D.C. Estate Planning Council, 1994‑.  She is a fellow of the American College of Tax Counsel, the American College of Trust and Estate Counsel and a charter fellow of the American College of Employee Benefits Counsel.

 

  This paper is entitled, AEstate Tax Reform Could Raise Much-Needed Revenue: Some Reform Options with Low Tax Rates Raise Very Little Revenue@ by Joel Friedman and Ruth Carlitz.