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The Cutting Edge^™ June 2005

Public Policy

Anybody who has spent some time with me knows that I think the estate tax is a dumb idea. The American dream is to work hard and be successful--then we take it all way with a tax! As we have been reporting, it does appear as though the Senate may be inclined to do something less than full repeal. I have been asked many times about the various options: increase the basic exemption, lower the estate tax rates, or create a small business asset exemption. Without going into the partisan politics of it, let me offer my personal observations about each option.

When it comes to the basic exemption, my belief is that it has to be higher than what some would consider reasonable in order to give you some estate tax planning peace of mind. Some folks on Capitol Hill are talking about a $5 million exemption. Based on statistics, they argue that takes care of nearly 98 percent of small businesses. However, experience suggests that is cutting it too close for anybody to attain estate tax planning piece of mind. There are advocates who argue that $10 million per individual ($20 million per couple) would allow you to attain estate tax planning peace of mind.

Some are advocating the adoption of a family or small business "carve out" based on an expired "QFOBI" provision. Enacted in 1997, the qualified family-owned business interest (QFOBI) deduction expired at the end of 2003. It protected $1.3 million in assets from the estate tax for farms and closely held businesses. The requirements for businesses to qualify for this exemption included: the family business must comprise at least half of the estate; the business must be passed to qualified heirs defined as family members or people employed by the business for at least 10 years prior to death; the business must be 50 percent owned by one family, 70 percent owned by two families, or 90 percent owned by three families, as long as the decedent's family owns 30 percent of the business; (Family is defined as the spouse, ancestors, lineal descendants of the individual, the individual's spouse, parents, and the spouses of the lineal descendants.) the decedent or a member of his family must have owned and materially participated in the business for a least five of the last eight years preceding death; and each qualified heir, or a member of their family, must materially participate in the business for at least five of eight years after the decedent's death. Publicly traded companies did not qualify.

Although QFOBI may look reasonable on paper, in practice it was a failure. Because it is so complex and vague less than three percent of family-owned businesses were able to take advantage of QFOBI. In 1998, only 173 of 97,856 estate tax returns used QFOBI. In 1999, only 889 of 103,979 estate tax returns used QFOBI. In 2000, only 1,470 of 108,322 estate tax returns used QFOBI.

My observation on this option is that it has been tried before, and it is too difficult from a technical standpoint to craft language that accommodates the diverse business structures found in the small business community. Hardly anybody used the family business exemption because of its complexity and it was allowed to expire. Having spent many years working with various definitions of small and family business in many different contexts, we don't think it is possible to develop a provision that is easy to use for this purpose.

There is also another school of thought that advocates a dramatic reduction in the estate tax rates. A rate reduction does not eliminate the need for estate tax planning and, if one does the arithmetic, it is quickly clear that such a provision benefits the super wealthy. Given the choice between a very high exemption versus a rate reduction, it would appear the high exemption would yield estate tax planning peace of mind for more business owners.

There is one last anomaly in the equation. If the goal is to maintain more independent businesses, that are not necessarily retained by the founding family, full repeal may not be the best option. This is because of the impact of the carry-over basis.

Basis is the amount of investment in property for tax purposes. It is used to estimate gains or losses when property is sold. The basis also determines capital gains taxes, depreciation, amortization, and many other tax computations. Stepped-up basis has been in the tax code for the past 80 years. Traditionally, when property was inherited its basis is stepped-up to current market value for the new owner, which has the effect of adjusting the value of the property for inflation. If the property were later sold, the person inheriting the property would pay capital gains taxes on the amount the property increased in value during their ownership.

The alternative to stepped-up basis is carry-over basis. Under carry-over basis, when property is inherited, the new owner also inherits the decedent's basis. In this situation, he or she would pay capital gains taxes on the amount the property increased in value during the combined time that he or she and the previous owner possessed the property.

If the estate tax is repealed, the carry-over basis regime would be in place. If just the exemption is increased permanently, stepped-up basis would remain the rule. If the business is not retained by the family, stepped-up basis might reduce the tax liability upon sale enough so it could remain an independent business.

Whatever the outcome, it has to meet two litmus tests for me. It has to give you estate tax planning peace of mind--permanently.

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