Speech by Marc J. Lane
I'm back to talk about your estate tax planning and before doing so I think a disclaimer is in order or perhaps a confession might be a better characterization. I am not a great fan of our estate tax system. I am a Congressionally-appointed delegate to the White House Conference on Small Business and, in that capacity and wearing other hats too, I have tried my best to encourage the powers that be in Washington to repeal the federal and estate gift tax system in its entirety. "Rip it out by the roots," as some might say -- because the reality is that the estate tax, in particular, is absolutely devastating, not only to the small family-owned business, but the family-owned farm, and represents relatively little by way of revenue to the federal coffers. Indeed, the costs of administering the program are astronomical. So, as a social policy tradeoff, I think it is just imprudent. Nevertheless, notwithstanding that there have been some improvements in the law, which we'll talk about today -- one of which I claim some credit for, by the way -- we find that the estate tax system is largely unchanged after the Taxpayer Relief Act. So, as a result, I feel some obligation to declare that bias so that the coloring of my thinking can be taken into account in your evaluating my remarks. But, further, I assume some responsibility at the end of my remarks to lay out some strategic approaches you might entertain in terms of your own estate planning, notwithstanding the existence of this confiscatory law.
One of the most highly publicized estate tax benefits under the new law is an increase in the so-called "unified credit". Those of you for whom we've done estate planning -- and I think that represents many, if not most of you know that we take great pains in terms of balancing estates and taking full advantage of credits and exclusions so as to minimize the estate tax burden even before we embark upon the fancier strategies. The unified credit allows estates to escape tax and this applies not only to lifetime gifts, but also transfers of death where the assets are up to $600,000. So the first $600,000 amount is exempted from taxation and we have, of course, a unified transfer tax system, which treats gifts and transfers at death, not identically, but for this purpose closely enough that I think it's reasonable for us to say we have one system where the $600,000 is available throughout life and, to the extent not utilized during one's life, at death. That $600,000 shield is going to be ratcheted up and is going to be phased in to exempt a total $1,000,000. That amount will be the exempt amount in the year 2006. Regrettably, the credit is not much higher, however, near term. Six years from now it will protect an estate of $700,000. If it had merely been adjusted for inflation, as many have argued, it would have already reached $828,000. One parenthetical recommendation here: if your will includes a so-called "credit shelter", it should be redrafted or you will inadvertently take money out of the hands of one beneficiary and give it to another. Obviously, if your estate plan is affected and it's in our hands, we'll let you know.
There's another planning point to be made here. The increase in the exemption, allowing as it does transfers of property not only at death but also during one's lifetime, lets you claim really deeper tax savings by making lifetime transfers. And the reason for that is appreciation after the transfer shifts to the recipient of the gift, rather than the donor's estate.
Let me spell that out for you through the use of an example because I think these tax principles can be very arcane and sometimes incomprehensible. When we talk actual cases, particularly cases that may be relevant to your situations, I think we have a more meaningful dialogue.
Let's suppose you have a stock portfolio which will be worth $1 million -- it's a number I'm choosing for a reason in the year 2006, when the exemption is fully phased in. Assume, too, that you're going to live several years thereafter, and at your year of death, when that may be, instead of 2006, let's say 3006, your stocks be worth not $1 million, but now $3 million. Were you to give the stock to your children in the year 2006 and I' m using that number that year only because that is when this exemption is fully phased in there would be no tax costs. There's no gift tax. There's obviously no estate tax; nobody's died. There's no income tax, this is a transfer -- nothing's been earned.
But if they sell that stock at your death years out for $3 million, which we have already established factually will be your date-of-death value of that stock portfolio, they would pay a capital-gain tax of up to $600,000, depending upon what you paid for your stock. That's the largest capital gain tax it could be on $3 million, given a 20% bracket. So, that's one choice.
If instead you continue to own the stock when you die, remember now that value in your taxable estate will be $3 million and the estate tax due on the $2 million of appreciation would be $1,100,000. So, by accelerating the transfer, making a gift to the children earlier rather than letting them inherit it, your family would save at least $500,000. That assumes the largest income tax burden that they might suffer in theory.
So, lifetime transfers and transfers at death are sometimes thrown in the same hopper and the perception that people sometimes have is, well, there's really no economic difference between making a gift today or letting the kids inherit it because the tax rates are essentially the same and the calculations are essentially the same. Well, more or less that's true, but here differences in timing, differences in growth and where that appreciation accrues, in whose hands, factoring in the income tax consequences, obviously shows us that there is significant difference in lots of cases. The principle works today, too, but a little better down the road as that exempt amount increases.
Not to put too fine a point on it, there is a hidden tax break here that I haven't mentioned yet and it has to do with gifts and it has to do with, when you make a gift, how comfortable you are that the IRS is going to be satisfied about the way in which you valued that gift. Let's suppose instead of dealing with publicly-traded stock, we're dealing with privately-traded stock, a company you own or some work of art or real estate or some other asset whose value with respect to which there could be some controversy, you want to play the strategy I've just described, but you're concerned about the risk the IRS can come in and audit and claim that the value is really much higher than your position on your return reflected. Under the new law, this is a benefit that hasn't been reported a whole lot in the public press. For gifts made after August 5, 1997, so we're there now, if gifts are adequately disclosed on a gift tax return, the IRS can no longer go back and re-value them for estate tax purposes after the three-year statute of limitations.
So, if you want to make a gift today, you'll know three years down the road you're off the hook as long as you filed a gift tax return and accurately reported the gift. The burden would shift to the IRS where they must step forward, audit, seek to challenge and then, of course, you have the opportunity to defend. But this is no longer a time bomb without an end where the wick is long as your life. We now know that there is a finite period of time during which the IRS can challenge your valuation and you can deal with it while you're still here to deal with it. And it is not a case, as is had been before the law was enacted, that upon one's death all gifts during one's life could be scrutinized by the IRS with unpredictable consequences.
So, the unified credit is increased, albeit modestly. And the $10,000 amount you can give each year free of any gift tax to any number of recipients will now be increased by an inflation adjustment and it's going to be adjusted to the Consumer Price Index. Again, there is a wrinkle. An adjustment is only going to take effect after 1998 and only when an adjustment can be made in a multiple of $1,000. Putting it another way, if you give more than a $10,000 gift, we must see a 10% increase in the CPI before the IRS will allow any adjustment at all. So, it may take several years before this inflation adjustment takes hold and when it does it's only that, an inflation adjustment. If one were cynical, one could characterize this liberalization of the law as having more political effect than substantive planning benefit. As you know, we often encourage clients to give excludable gifts to family members. We continue to think that's a good idea with or without an inflation adjustment. Not only does each gift escape gift tax or ultimately, alternatively estate tax, but so does the appreciation on the gift escape all tax. And we've seen how that can work.
There have been substantial changes in the use of trusts that will benefit most of us. The people for whom we've done estate plans by and large we've done trusts for one way or another. Revocable or "living" trusts, they go by lots of names, and estates are now going to be on an equal tax footing. It may surprise you to learn that they weren't. As you know, we recommend revocable trusts for many of our clients to wind up one's affairs and distribute assets to heirs efficiently. They avoid the costs, inefficiencies and publicity of the probate process and they allow for an orderly mechanism to manage one's financial affairs in the event of disability in fact, without the necessity of a judicial determination of incapacity or disability.
Under the new law, a trust can be treated as part of an estate. Now I'm going to lay out a few consequences of that legal conclusion, some or all of which will be important to many of the people in this room. The first thing is that now revocable trusts will be allowed a charitable deduction for amounts permanently set aside for charitable purposes. Before they weren't: you had to put the charitable bequest in some special kinds of trusts, typically irrevocable trusts or charitable remainder or charitable lead trusts or else deal with them within your wills. Now, it can all be consolidated and it's much easier to manage the planning aspect when it can all be done through one document.
Another technical change which is beneficial to those people it effects: the active participation requirement under the so-called "passive loss rules " these provide for limited recognition of losses attributable to businesses that aren't actively managed by the taxpayer who claims a loss well, these are now going to be waived in the case of revocable trusts. Again, we're achieving parity between estates and revocable trusts. Or, putting it another way, revocable trusts have become so popular and legitimately so -- that people who have them ought not be penalized vis-à-vis others like them who've opted not to go the trust route or haven't been educated about trusts and just have plain, old wills.
Revocable trusts can now choose a fiscal year rather than a calendar year. Real important. This can save income taxes by splitting up anticipated estate income into smaller units. And where we have progressive tax rates you may find that the smaller units have a lower income tax bite against each.
Finally, there had been some controversy over whether gifts from a revocable trust made within three years of death were to be included in the donor's gross estate. The new law has settled the issue, treating gifts from a revocable trust just the same as if they were made by the individual who created the trust. When we set up a revocable trust we, as others should, encourage our clients to re-title their assets into the name of the trust or else those assets will go through probate, defeating the whole purpose of the revocable trust in the first place. So now we can have the assets titled to the name of the revocable trust, make the annual exclusion gifts out of the trust to any number of donees and that will successfully remove those assets from one's estate for estate tax purposes. I think it's really important.
Probably the most touted form of estate tax relief under the new law relates to family-owned businesses and here is something that I had some hand in because the origin of this particular provision and a much more generous version was the White House Conference on Small Business and I had some hand in drafting this. Of course, through the political process, there has now been some erosion. Well, I'm glad we have some benefit and I'll tell you what it is, but it is far afield from what is started being or what I hoped it would be.
Some family-owned business are now eligible for an estate tax exclusion of $1.3 million. So, do we have a $1.3 million bonanza? Well I've already telegraphed that. Hardly. For one thing, $1.3 million is the total exemption. The relief for family businesses is the difference between the $1.3 million and the unified gift and estate tax exemption available to everyone, the one that's gradually increasing from $600,000 to $1,000,000. And when that happens in the next century, the family business break is really reduced to $300,000 the difference between the $1 million that everyone's going to get then and the $1.3 million that now the qualified small business owners will get. Even at the highest estate tax bracket of 55%, the family business bonus would be worth no more than $165,000 in tax savings. So this is no magic bullet.
And look what you need to do to qualify. First, the business interest must be worth more than half the adjusted gross estate. Now, for many people, the arithmetic doesn't work. For our clients, in particular, who are very sensitive to protecting wealth and growing wealth, this is a burden. In fact, we work hard to build up our clients' other assets so that our clients won't be so dependent on the success of their businesses. Many of you have heard me describe your respective businesses as assets in your portfolio and that's what I believe they are. By helping them accumulate substantial wealth in other pockets over time, we think they're financially healthier and they make better business decisions. Why? Because they don't have to worry about the bulk of their wealth being placed at risk. To the extent we're successful, we may be disqualifying our clients from the exclusion. Never fear, what we're doing far outweighs the benefit of the exclusion.
There's another 50% test business owners must pass to qualify for this. At least 50% of the business must be owned by the decedent and members of his or her family. Or at least 70% must be owned by members of two families. Or at least 90% must be owned by members of three families. It sounds like it was drafted by lawyers, doesn't it? And if two or three families are involved, at least 30% of the business must be owned by the descendent and his or her family.
So, let's translate this into English. A small business with four or more equal partners from different families simply won't qualify. They're ruled out. More important for most of our clients, businesses with outside backers are also ruled out. And so are businesses for whom we've established employee stock ownership plans. They're ruled out. And so are business for whom we've established equity incentives for key employees. They're ruled out.
Not tough enough yet? For at least five of the eight years before the date of death, the deceased family member must have materially participated in the business and the business interest must be left to qualified family members. And they, the heirs, must themselves materially participate in the business for 10 years after the decedent's death or all bets are off. For the first six years, there's a 100% recapture of the tax savings, plus interest. For the next four years, there's a 25% annual phase-out. And there are no exceptions to this 10-year "tail" requirement.
I think this provision is almost literally a killer. Sadly, too few successors carry on a family business for 10 years. So, the small business exclusion may help some family farms and it may help some types of specialized family businesses where the underlying assets are not easily marketable, but for most small business this is a non-issue.
For those who do qualify, I have a word of caution the family business, and I haven't heard this touted in the press the way I've seen the $1.3 million touted in the press without all the fine print, the family business exclusion is an estate tax break, not a gift tax break. So here is another example of a divergence gift tax and estate tax. No, they are not identical. Here's a perfect example. So strategies calling for the senior generation to give away shares to younger family members, often taking advantage of valuation discounts, cannot be piled on the small business exclusion. It is simply not a gift tax exclusion, only an estate tax exclusion.
There has been in the law for a long time an opportunity for estates to elect to value farm property or more relevantly for most people here other closely-held business real estate on the basis of its actual use as a farm or in the business, rather than its fair market value based on its highest and best use. Now, understand the Internal Revenue Service's function, recent publicity to the contrary notwithstanding, is to collect revenue. So, ordinarily without this provision real estate gets appraised at its highest and best use irrespective of how it's actually being used and that becomes the value for purposes of assessing federal estate tax (or gift tax, for that matter) or income tax, where applicable. Here, where it is "special use" property, used in conjunction with a farm or closely-held business, it doesn't have to be that way. You are permitted to take the value to the business, the value to the farm in operation and the total decrease in property value of that property has been $750,000. That is the amount of decrease that has been available. Pretty attractive. And we take advantage of that in places that we can. Now the law allows for an inflation adjustment based on the CPI, but again there is a kind of trigger. It is only in multiples of $10,000. Not as bad a trigger as the earlier one I've discussed, but there will, over time, be a way of enhancing that relief and, in the meantime, you should be aware that relief exists because we do take advantage of it.
There is a subtlety that attaches to this. The benefit of the special use value that I've just described for you will not be recaptured as it was under prior law if the real estate is leased for cash by a linear descendent of the decedent to a member of the lineal descendantís family who continues to work the farm or in the business. The idea is, simply put, leasing farmland among family members is a societal good because it helps prevent family farms from being forced to liquidate to pay estate taxes. Well, other business owners now benefit from the same opportunity. Leasing within a family is going to allow this to occur. So, the one-two step here is to take advantage of the valuation discount and thereupon re-engineer or recast relationships within that family so that we have lessors and lessees none of whom is going to have us give back the valuation discount that otherwise became available and in time that valuation will adjust for inflation and that will be still another incremental value.
Having said all of that, most of what I've described indeed, most of what is in the new law as it relates to estate tax is, regrettably, tinkering.
So where does that leave small business owners? Sadly, many of them fail to plan. Many of them, you'll note are not necessarily here and their families are ultimately hit with enormous estate taxes. About one third of small businesses never survive beyond their founders' generation. Two-thirds of those that do never get to the generation after that. And all of the wealth that is created, forget tax rates now, all of the wealth that has been created by you is effectively forfeited to the government.
Our job then is to be proactive. Our job is to help the business owner realize the full value of his or her business and to help the business owner get it into the hands of successor ownership. And, along the way, we must be as tax-efficient as we can.
Let's look at some examples because I promised you I would do that.
The new law continues to allow any estate tax related to a closely held business to be paid in installments, and in fact reduces the rate of interest on the money owed. You see much of this is very political. It has immaterial economic effect but it sounds better and it sounds as though it's an improvement. For most people, a better strategy to meet that future obligation is to use leverage. Ideally positive rather than negative leverage. Now, a lot of different ways you can do that. We have done it with and for many of you in many different ways.
One classic way it gets done is through the use of insurance. Well, insurance by definition is a way of leveraging relatively few dollars to pay off relatively larger dollars upon the happening of a given event. Well, estate tax is payable at death. When we do it, it isn't always payable at death, but it is payable at some time and the insurance can create a source of funding to meet that obligation. The problem that people encounter with insurance, of course, is that too often insurance is inadvertently included within the taxable estate either by design, because somebody thinks he's smarter than he is, or by default or neglect. When one goes out to budget an amount to cover an estate tax burden, one should place the insurance purchase in a separate entity, an irrevocable trust, so that the decedent will have no incidents of ownership in the insurance policy and there will not be the case of the insurance proceeds being brought back themselves into the taxable estate, thereby increasing the size of the taxable estate so that, guess what, you then need more insurance. You get into an algebraic conundrum. By having a certain kind of irrevocable trust and certain kind of insurance policy designed in a given fashion, you avoid all of that and you're able to target exactly how much insurance you need to meet that obligation. And the proceeds are excludable from the estate and that's very effective leverage. In the case of a closely-held business, it's often a good idea to have the proceeds buy assets from the estate, thereby substituting liquid assets to pay estate tax for illiquid business assets. This strategy alone may not eliminate the problem, but it does make it more likely for the business to survive intact, allowing us now to supplement it with other strategies, rather than having to be sold to pay estate tax. Yet, as I've suggested, this is not necessarily enough.
So what else can be done? There is, even under the new law and, indeed in some cases enhanced by the new law, a wide array of tax-incentive vehicles that business owners and their heirs can use. Pinpointing the best strategy or more likely combination of strategies depends on the owners' goals. Do they want to give the ownership interest to their successors or do they want to be paid for it? We look at all the facts and circumstances and, as I'm also a great believer in saying form follows function, the appropriate recommendation is a product of exactly what you clients are seeking to achieve.
But let me give you a laundry list of the sorts of things we're doing these days -- and this is not intended to be exhaustive, but rather suggestive. I'm not going to have time to get into all of them but I want to give you one treat before we run.
Leveraged gifting, family-limited partnerships, self-canceling installment notes, private annuities, charitable remainder trusts, charitable lead trusts, grantor retained annuity trusts "GRATS" each can have a strategic effect in a well-crafted estate plan of a business owner.
Let me talk about one real-life case. It's dramatic, it's extraordinary but it's real. Say the owner wants to give his business to his children during his lifetime, but wants to retain cash flow from that business for a number of years. Now what we used in this particular case is a GRAT. A grantor retained annuity trust. A GRAT involves the transfer of property in this case, the business interest to a trust in exchange for the irrevocable right to receive a payout of a fixed amount, every year, for the term of the trust.
At the end of the term, the property passes from the trust to the children and is altogether excluded from the owner's estate. The owner does make a taxable gift to his children -- they're the beneficiaries so it's deemed to be a gift to them on the initial transfer of the business interest to the trust. However, the gift is not the full value of the business interest. Instead, the government allows us to reduce -- and again I've talked about discounts before and I told you I'm a fan of them, where they fit and I only use them very cautiously. This is one case where you can. You discount the gift to account for the time the children must wait to get the property from the trust and there are tables that tell us exactly how to calculate that. We're also going to discount the gift to reflect the fact that dad is going be receiving payouts from the trust over its term. And we're going to have one other little discount I'll tell you about in a minute.
So this is the old present value concept a dollar today being worth more than a dollar tomorrow. As a result, the gift can be, and in this case is, a few cents on the dollar. What's even better is there is no further gift made to the kids when they later receive the business interest from the GRAT. All the increase in value escapes gift and estate tax. But, there are two contingencies. Two requirements or the whole strategy has no benefit. The first is the owner must outlive the term he or she selects for the trust. We have some control over that. Not how long necessarily the person lives, but how long the trust is. Second, the business must grow at a rate greater than the cash payouts made to the owner. Well, again we're able to forecast in many cases with pretty decent predictability what the growth trend on a business is and we can really peg the payout rate below that with a sufficient buffer that we feel comfortable. Now failure on either one of these counts we no longer have a GRAT that works.
But here's that extraordinary real-life example that I promised you and one I think that proves the point well. The client is a 54-year-old entrepreneur who owns a high-tech computer company on the verge of a technological discovery. Now, remember, I said don't worry about what's happening in the Far East so much. The reason we are investing in stocks in the U.S. is because the U.S. is dependent upon innovation and entrepreneurship and those of you who know me know that I am very supportive of those principles. Well, this was a client who benefitted from his own intelligence and work ethic and was able to create something extraordinary. He has four kids, two of whom are involved in the business. He'd like to keep the business in the family, but he believes he will probably increase the success of the business by going public, which is something we have not talked about. That will be for another day. Let's assume he has no assets of substantial value outside the business, and as you will see he needn't.
Since his goal is to transfer wealth to his heirs rather than to the folks in Washington, he is interested in moving value out of his estate before he takes the business public, before he sells it and before he dies. He's willing to transfer a minority interest in his business to his children. The full fair market value of the interest that he is willing to transfer today is $3 million. He expects that value to increase to $10 million after an IPO. As soon as he goes public, that's where shortly thereafter we have reason to believe there will be a run up in value of the magnitude. The current rate of return on the business is 12% per year.
Now our entrepreneur implements a 10-year GRAT. We're betting on him living at least until age 64. Based on his numbers, his children will receive $22,810,000 at the end of the 10-year term. Now that's an after-tax number. This assumes that
1) he gets a payout from the trust of about $338,000 a year, and
2) the trust can handle it based upon the earnings of the business and the trajectory of the business's earnings.
And one other discount I hadn't mentioned and that is that he is entitled to take a discount on the value of the stock when he gifts it to the GRAT because it is a minority ownership interest. Kids aren't going to be able to control that stock. It's also not going to be freely transferable. It's going to have a lot different deficiencies as a security which for tax planning purposes translate into value because we're able to discount the value in a way that you couldn't discount General Motors stock, freely trading. The amount of the gift, and this is the part that is amazing, it's truly amazing, the amount of the gift deemed made to his children at the time of the transfer of the business interest to the GRAT, remember now it's a $3 million interest, $5,625! I did not misspeak. I mean I occasionally do, but this is a correct number. As a result, in addition to all the other benefits I have already disclosed to you, our savvy friend also significantly reduces any liquidity problems upon his death. Understand, of course, he's holding back the rest of the stock. There will obviously be a broader strategy in terms of liquidation of his holdings in an orderly fashion creating additional cash. But this certainly helps.
Well I hope that this example and, indeed, all of our presentations have whetted your appetites and, we will now look forward to satisfying them, in fact, literally as well as metaphorically, so thank you again for joining us. We very much were happy to have you with us.