Hearing on Estate Taxes

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 The step-up in basis was repealed back in 1976 and was then reinstated in 1980, though the carry-over rules never became applicable during that period, because Congress learned from attorneys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:

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.

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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.