Does Christmas continue for business owners?
- January 7, 2010
Business owners who have followed the estate tax saga may have felt they received a huge Christmas present when Congress adjourned without extending the estate tax into 2010. Right now, there is no estate tax. Whether you own a business worth $3 million or $50 million, you can pass it to your children estate tax free. So did Santa arrive with the ultimate Christmas present? The answer in a nutshell is no. First, a little historical perspective.
Most estate planning advisers believed Congress would enact legislation prior to 2010 to avoid the disappearance of the federal estate tax. As mentioned above, those of us sharing this belief were proven wrong, as we enter 2010 with no estate tax, at least for this year. In 2011, the estate tax returns with only a $1 million exemption amount and a 55 percent tax rate. Thus, for business owners ready to celebrate the death of the death tax, it is premature. Besides the prospect of a meager $1 million exemption amount in 2011, the uncertainty and complication of current law balances some of the advantages of no estate tax.
What do I mean? Well, consider the rules applying under current law. As of this day, the following applies:
- there is no estate or generation skipping tax.
- Tax-free gifts are still limited to $1 million with a tax rate of 35 percent for amounts exceeding $1 million.
- although there is no estate tax, there is an income tax that applies to inherited assets. The income tax results from the elimination of the inherited assets’ “stepped-up” basis. In contrast to prior law, inherited assets now have a carryover basis. There is a $1.3 million tax exemption, and a $3 million marital exemption. But inherited assets sold at a gain above these exemption amounts will be taxed at ordinary or capital gain rates.
This last point, the elimination of the step up in basis, is one not widely discussed but very significant. In fact, some have speculated that a majority of small business owners will pay more tax under the new law as it currently exists.
Why? Since many businesses are worth less than $7 million (the amount a business owner and spouse could protect from estate tax under 2009 law), but over current exemption amounts for basis purposes, there would be more tax to pay. In any event, the planning options business owners should consider under the 2010 law are now being analyzed and considered. However, some basic questions, and speculated answers (with the emphasis on speculation) are the following:
1. Will Congress reinstate the estate tax in 2010? Probably. There is too much tax revenue at stake, not to mention the chaos the law is creating. Further, there is a need to address the $1 million exemption amount returning in 2011. This provides an incentive for all members of Congress to compromise on an exemption amount - those members who believe there should not be an estate tax and those members who believe virtually all “wealthy” people should pay some estate tax.
2. Assuming Congress addresses the estate tax in early 2010, which is what is expected, is the exemption amount $3.5 million or as much as $5 million? Again, nobody knows, but these are the range of exemption amounts widely discussed. Assuming there is congressional action, it is virtually certain the new exemption amount will exceed $1 million.
3. What if you die before the estate tax is reinstated - is it constitutional to apply the tax retroactively? Nobody knows because there is precedent to support that Congress can and cannot enact laws applying taxes retroactively. Assuming there are wealthy people dieing prior to any 2010 legislation, this constitutional issue will likely be answered by the Supreme Court.
4. Is it possible nothing is done all year and the exemption amount is only $1 million as scheduled in 2011? As suggested above, this is possible but not likely. But then again, not many of us saw this mess continuing into 2010 so who can say.
5. Most importantly, what is a business owner to do? There obviously is not one answer. Much depends on the value of the business, your existing plan and your objectives. It is likely you will want to consult with your estate planning counsel.
For example, consider this scenario:
Dad and mom have a common estate plan that provides, upon the first death, that the surviving spouse receives all assets, including the business, necessary to eliminate estate tax at the first death. The business and the balance of the assets pass to children. In the past, this clause may leave all but $1 million, or $2 million, or even $3.5 million, to the surviving spouse. Now, under this clause, the surviving spouse would be disinherited and the children would receive not only the business but the home, 401(k), etc. Conversely, without any estate tax, dad and mom may deliberately leave the business and all other assets to the children (and future generations because there is no generation skipping tax) because they are confident the children will take care of the surviving parent. Or, the business owner may leave the surviving spouse a small amount, such as a first or second residence, because the business owner assumes the value will be below the eventual exemption amount. The rest of the assets would be left to a generation skipping trust for children and future generation.
The only thing we know for sure is that Congress has provided business owners much to consider.
John P. Dedon is a principal in the firm with the Trust, Estate & Tax Planning practice group of Odin, Feldman & Pittleman. Dedon blogs about estate planning issues for Virginians and U.S. citizens at dedononestateplanning.typepad.com.