Feast or Famine

With the federal budget and Social Security already in the fiscal spotlight, it was only a matter of time before estate taxes were thrown back into the Congressional debate. As anticipated, a number of bills have been introduced in Congress that either repeal the estate tax immediately or extend the one-year phase out of 2010 indefinitely.

The lobbyists have been busy. While most Chambers of Commerce, general contractor associations, and manufacturers have been in favor of a repeal, the insurance industry is the primary opponent. It has unlikely allies in billionaires Bill Gates, Ted Turner, and George Soros, all of whom have indicated they oppose the elimination of the estate tax, despite the likelihood their own estates would be subjected to the tax.

If you own your own business, how does the estate tax affect you? Does it in fact have a negative impact as it currently stands? And what advantages might repeal bring?

One of the most oft-cited reasons for the need for repeal is to prevent an unreasonable hardship on closely-held and family-owned businesses. It has been argued that the 'paper value' of businesses results in large estate tax bills without liquid assets with which to pay the tariff. For example, a family farm that is worth $2 million on paper would not necessarily have cash assets in order to pay the estate tax. Congress has made a number of changes in the estate laws over the past few years to ameliorate these concerns:

Increased Unified Credit

Over the past few years, the estate tax exemption (the 'unified credit') has increased steadily, from $600,000 to $1.5 million in 2005 and 2006. As a result, fewer than 2% of the wealthiest estates in the U.S. have paid an estate tax. The unified credit under current law will reach $3.5 million in 2009, meaning that a couple may effectively pass $7 million to their heirs without being subject to the estate tax.

The non-partisan Congressional Joint Committee on Taxation estimates that only 7,500 estates would be subject to estate tax in 2009. Nonetheless, it has been estimated by the federal budget office that eliminating the estate tax and related federal gift tax would reduce government revenue by almost $290 billion from 2006 to 2015. With increasing federal deficits, one may argue that we have a fiscal responsibility to continue generating this revenue. Regardless, there is support for keeping the unified credit at $3.5 million permanently.

Deduction for Family Business Interests

In 1998, a deduction of $675,000 in addition to the unified credit of $600,000 was established for 'qualified family-owned business interests.' These are defined as any stake in a U.S. business in which one family owns 50% of the business, two families own 70% percent, or three families own at least 90%, as long as the decedent's family owns at least 30%. So long as this interest constitutes 50% of a decedent's estate, and the decedent and heirs are involved in the business, the benefits are allowed.

With the increase in the unified credit over time, the value of this benefit has been reduced. One possibility in new tax legislation will be an enlargement of the deduction, allowing more taxpayers to avoid a tax.

Special Use Valuation

The run-up in real estate values in the Northeast has many business owners fearing that their business interests may have greatly increased in "paper value." In the case of most assets, the fair market value of the asset on the date of death is used for determining estate tax. However, in the case of real estate for farming or other closelyheld business use, the interest may be valued as a farm or business, rather than its "highest and best use." This means that a manufacturing site would be valued at its current use, rather than for what it might be used (a condominium complex?). This could be the difference between being taxable or not under the current law.

Special Extension of Time to Pay

While most estates must pay all estate taxes within nine months of death, if 35% of the estate's value is a farm or closely-held business, the tax may be paid over an additional 14-year period, with interest only being due for the first five years. The interest rate varies based on the size of the estate. This means that immediate liquidity at a decedent's passing may not be necessary, lessening the fear that a business would have to have a "fire sale" to pay estate taxes.

A 2005 repeal would eliminate this concern, as there would be a complete absence of estate, gift, and generation-skipping taxes. However, there would also be a repeal of the "step-up in basis" on inherited assets. Under current law, the basis of any assets that a decedent owns at his or her death is "stepped up" to fair market value upon death. This effectively means that while there might be estate tax on an asset included in a decedent's estate, there will be no (or at least a reduced) capital gains tax when the beneficiaries sell the asset. The chief tax counsel for the Democratic staff of the House Ways and Means Committee stated that permanent repeal would subject up to 1 71,400 estates annually to capital gains taxes beginning in 2010.

This approach seems to show that the repeal may actually be a tax shift, from estate tax on one generation to income tax on a different generation. Of course, the income tax on inherited assets could he considered 'voluntary' in that it only happens when an asset is sold. If a business is passed on from parents to children, and then from children to grandchildren, there would be no tax of any kind in a postrepeal world. Historically, few family business make three generations, but repeal may supply additional incentive for continued familial efforts.

It is not clear if repeal of the estate tax will be an 'if' or a 'when.' What is clear is that business owners must carefully examine under which scenario they would prosper. Those who are building a family dynasty may find advantages in the post-repeal world, while those who view their business as their "financial legacy" through buy-sell agreements with partners or third parties may be better off without repeal, planning for avoiding or minimizing the estate tax and allowing future generations to enjoy the fruits of their labors income tax free.