Nation's Business: The estate-tax toll on small firms

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The estate-tax toll on small firms

Joan Pryde

The federal estate tax may not have killed Gordon Perkins' business, but the administrative headaches and the costly drain on his resources it has caused are another matter.

His mother, Ella Perkins, who was a co-owner of Perkins Flowers Inc. in Lapeer Mich., died in March at age 83. Gordon is still trying to determine the value of her estate and to calculate the estate-tax liability--a process he says will take several months altogether, not to mention more than $20,000 in legal and accounting costs.

It's not as if the mother and son hadn't prepared. Three years ago they agreed to several estate-planning steps. Ella relinquished part of her ownership and became a minority stockholder in the firm to minimize the amount of estate taxes due after her death. Gordon sank $60,000 into monthly payments on a life-insurance policy for his mother that will pay out $200,000, which he hopes will be enough to cover the estate-tax bill. If it's not, he is prepared to sell a 43-acre tree farm that is part of the business.

But it galls Gordon that he has used up so much time and money preparing for and trying to minimize estate taxes. "We weren't blindsided by this; we did our estate planning," he says. "But I can tell you this for sure. At the very least, it's going to repress the growth of my business for some significant amount of time."

That, according to small-business advocates, is the crux of the problem: The estate tax carries too high a price tag for small, family-owned enterprises, whether they end up paying the tax or finding a way around it with careful estate planning.

For small-business owners like Perkins, however, and for owners of family farms, help may be on the way--though it's not clear how much help. Congressional leaders and President Clinton included estate-tax relief in their balanced-budget proposals, and House-Senate conferees are working out the details. (See the article "Reform Plans On Congress' Agenda.)

A Trio Of Levies

Federal estate taxes--or "death taxes," as they have been dubbed--were first levied by Congress in 1916. The current estate tax is actually one of a trio of so-called wealth-transfer taxes; the other two are the gift tax and the generation-skipping tax, which carries a flat rate of 55 percent on assets passed to grandchildren or great-grandchildren.

Since 1976, the estate and gift taxes have shared the same rates, ranging from 37 percent to 55 percent, depending on the value of the estate. (See the chart on Page 24.) Each citizen has a one-time exemption of $600,000--called the unified credit--from either tax. In addition, an individual may give up to $10,000 each year to anyone--with no limit on the number of gifts--without paying the gift tax.

The taxes on an estate are generally due nine months after the death of the individual, but Internal Revenue Service rules allow estates involving closely held businesses to make installment payments--with interest--over as long as 14 years. In addition, the first $1 million of the value of the business is eligible for a 4 percent interest rate. Yet despite the favorable terms, IRS records show that very few small firms opt for the extended payments.

On the surface, it may seem surprising that the estate tax is such a hot issue among owners of small businesses and farms. IRS figures published in April indicate that only a fraction of taxable estates are small companies or farms. The figures show that in 1995, the IRS collected a net $11.8 billion from 31,564 taxable estates. Of that total, only 5,397 estates, or about 17 percent, contained closely held businesses or farm assets.

But small-business advocates insist that the IRS figures fail to give the total picture. Not included in those numbers, they say, are an undetermined number of business owners who eliminated their tax liability with savvy estate planning.

A 1996 survey of 1,003 small-business owners nationwide underscores that point. Conducted by researchers at Kennesaw State University in Kennesaw, Gal, the survey found that more than half of the respondents believed that their estates would be hit with a tax bill that would limit their firms' growth potential. About one-third of the respondents said payment of the expected estate tax would require the sale of part or all of their businesses.

Moreover, the number of small firms that will be affected by the estate tax is likely to grow. Estimates released in April by Congress' Joint Committee on Taxation indicate that the chances of a small business being subject to the effects of the levy will increase substantially in the next few years. According to a report by the committee, the number of taxable estates is expected to nearly double in the next 10 years, from 37,200 this year to 73,200 in 2007.

For business owners who worry about estate taxes, there is some comfort, however: Financial planners maintain that there are many ways to minimize liability.

One of the principal steps that companies take in preparing for an expected estate-tax bill is to buy life insurance on the owner or owners, making certain that the policy is owned by the company or a life-insurance trust and that the proceeds are kept out of the owner's taxable estate.

Another popular estate-planning technique involves the annual gift giving that is tax-free as long as it doesn't exceed $10,000 per recipient. The gifts can be in the form of stock or other assets.

Another popular tax-minimizing technique involves tax-exempt charitable bequests of business interests.

Business owners can also shelter assets from estate taxes by creating one or more trusts. While there are numerous ways to structure trusts, all offer the benefit of removing taxable assets from an estate.

A Demanding Task

To hear some estate planners talk, all a small-business owner needs to do is pick the best tax strategy, put it into place, and forget about the estate tax. But advocates for small business and many owners themselves say it's not that simple.

The level of estate planning needed to minimize estate-tax liability significantly "generally requires a business to have a lot of discretionary cash to hire attorneys and accountants who can mastermind a plan to thwart the punitive nature of the estate tax," says Karen Kerrigan, president of the Small Business Survival Committee, a lobbying group based in Washington, D.C. And that amount of discretionary cash is not always available.

Grafton "Cap" Willey knows. Not only is he a small-business owner, but his business handles other people's finances. He is a co-owner of Rooney, Plotkin & Willey, an accounting firm in Providence, R.I. "You can create trusts, and you can create other vehicles, but they're very costly to administer, and they're very prone to being overturned by the IRS if you don't dot every `i' and cross every 't,'" Willey says. Trying to get around the estate tax "creates wonderful work for accountants and lawyers, but that's not really to the benefit of the small business."

For many small-business owners, the demands of developing their companies are so great that estate-tax planning catches them unawares.

When Ron Deabler and his father, John, a manufacturers' sales representative in Brookfield, Wis., visited an attorney three years ago to set up a succession plan for John's business, they didn't realize that they were going to have to plan for the estate tax.

Until then, "I never really knew what the implications of the estate tax were," says Ron, who owns American Technical Services, a small employment-placement firm in Brookfield.

John's sales business, which he started in 1959 with $100, has grown to a net worth of $1.5 million to $2 million, his son estimates. John's other wealth should push the value of his estate to several million dollars. Ron guesses that if the Deablers had not developed an estate plan, it would have become necessary eventually to sell the business to pay the estate taxes. But their lawyer created several trusts to shield the estate's assets from tax. The set-up cost was about $10,000.

That's not the end of it. Ron says the family will have to spend considerable time and money every year completing tax returns on the trusts to make sure they are legal. "Why should we have to jump through these hoops?" he asks.

More Is Not Merrier

Planning for estate taxes gets even more complicated and burdensome when a small business is owned by a sizable group of family members. John Dudley, a cattle rancher in Comanche, Texas, has been living with that problem for more than 20 years.

Dudley Brothers Ltd. Ranches was started in 1938 by John's parents, two of his uncles, and the uncles' wives. The ranch grew to 30,000 acres and employs 30 people, including several family members.

Dudley says that after his father died in 1976, it took 10 years of payments to the IRS amounting to several hundred thousand dollars to settle his estate-tax bill. In 1982, one of his uncles died, which meant another round of estate-tax payments.

"The result, of course, has been to sap the available cash out of the family business," Dudley says. "Any money that could have been spent on conservation efforts, brush control, water development, fence repair, and wildlife management has been spent to pay death taxes."

Dudley says paying estate taxes did not ruin the ranch financially, but he worries that more payments are looming: His mother, his uncle, and the uncle's wife are still active owners in the business, and they are all over 80. That means some of the property probably will have to be sold when tax bills for those relatives' estates come due.

The elder owners could take steps now to minimize their holdings in the ranch, but they are reluctant to give up control.

Difficult Transitions

Transferring ownership of a business through buy-sell agreements, partnerships, trusts, or outright gifts is a key component in many of the planning strategies available to minimize or eliminate estate-tax liability. But many small-business owners say the government shouldn't be forcing them to get out of their companies before they are ready.

Perkins Flowers is a case in point. The business was started in Westlake, Ohio, in 1903 by Gordon Perkins' grandfather. It moved to Lapeer in 1954 and has grown to include a wholesale greenhouse, a retail garden center, a landscape tree farm, and two retail flower shops. The company employs 35 people full time and 20 part time.

Ella Perkins was always a strong influence in the business, especially after the death of her husband 16 years ago. She put in 12hour days until just before she died. Gordon knew that his mother didn't want to stop working, but that made their estate planning difficult.

"Handing down control was a slow, cautious process for my mother," he says. "One of the hardest things I ever had to do was to tell my mother, you have to start giving this away'" to shield the business as much as possible from estate taxes.

Perkins is beginning to think he may have to turn the business over to his son Chad, 26, to ensure its survival, but he's not ready to do that. And he resents the fact that the estate tax "forces you to make that decision prematurely. Now I have to start giving it away at 51? It kind of makes me mad."

There's always the ultimate solution: An owner can sell the business during his or her lifetime, although doing so creates another set of tax problems. Nonliquid business assets are indeed replaced with cash that can be used to cover the estate tax. But often the whole point of maintaining a business is to be able to pass it on to the next generation. So selling a business is usually the last resort.

For many small-business owners, the flap over estate taxes boils down to being able to save their business and put the money they earn back into their company instead of sending it to Uncle Sam or paying it out to estate-planning professionals.

The key question for lawmakers, says Drew Mendoza, program director for the Family Business Center at Loyola University Chicago, is this: Who should keep the money--the federal government or the business owner? Mendoza's answer: "I firmly believe that $100,000 in the hands of an entrepreneur will have a better return than that same $100,000 has in the hands of the government."

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RELATED ARTICLE: Reform Plans On Congress' Agenda

Congress is on the verge of providing at least some incremental estate-tax relief.

Estate-tax provisions contained in separate balanced-budget bills approved in late June by the House and Senate contain a number of similarities and one key difference. Among the similarities, the House and Senate packages provide for a phased-in increase in the $600,000 personal estate-tax exemption to:$1 million. The House bill would phase in the increase over 10 years; the Senate bill calls for nine years.

Under both tax packages, the exemption would be indexed for inflation annually after reaching $1 million, The $600,000 limit hasn't changed since 1982. If the exemption had been indexed all along in step with the Consumer Price Index, it would now be $838,000.

In addition, both measures::would extend to 24 years from 14 years the Internal Revenue Service's special installment-payment period for estate taxes owed by closely held businesses.

In a key difference between the two tax packages that will have to be resolved by a House-Senate conference committee, the Senate bill would target family businesses and farms by adding on top of the exemption an exclusion for the first $1 million of value in qualified family-owned businesses.

When combined, the proposed $1 million exclusion and the current $600,000 exemption would immediately put $1.6 million in small-business estate value out of reach of the IRS. Within a decade, that amount would rise to $2 million.

The conference committee is expected to complete its work before Congress adjourns for August.

Before the conferees got to work in early July, President Clinton proposed modifications in the tax-cut package, including an alternative approach to cutting estate taxes. Clinton proposed excluding an additional $900,000 from estate taxes for certain family-owned businesses and farms. Thus, Clinton would allow a qualifying individual to pass tax-free to heirs a total of $1.5 million--up from the current $600,000.

Clinton's narrowly focused estate-tax cut would cost the Treasury an estimated $7.2 billion over 10 years, compared with $28.6 billion for the House version and $35.2 billion for the Senate version.

Assuming that Congress does grant such relief, what are the chances that estate taxes will be repealed eventually? That's the option strongly favored by the U.S. Chamber of Commerce, though the Chamber and other organizations have said they support the incremental measures now in Congress as an interim approach.

Congressional leaders, while moving forward with interim relief now, say they want to revisit the issue of repeal later. "I believe the death tax is the wrong tax, it comes at the wrong time, it hurts the wrong people, and it helps the wrong people," House Ways and Means Committee Chairman Bill Archer, R-Texas, said in June. "It should be abolished."

Moreover, House Speaker Newt Gingrich, R-Ga., and Senate Majority Leader Trent Lott, R-Miss., say they want to get rid of the levy eventually. So don't count out the possibility of more estate-tax relief after 1997.