Despite a presidential veto, the "death tax" is still a hot political issue. What's a small-business person to do?
It's ironic. Today's financially savvy entrepreneurs have distinguished themselves from their predecessors by displaying a willingness to dive right into the complicated, time-consuming, and all too often costly process of estate planning. Many of them have grasped the importance of getting started early and have dutifully upgraded their plans with each new phase of corporate growth. They've come to terms with the undeniable benefits of making gifts through irrevocable trusts. So how can it be that now, of all times, the so-called death tax has seized center stage in the nation's political arena, with members of both parties vowing that it's only a matter of time before it disappears entirely?
"Clients are definitely asking me what I expect to happen to the estate tax," says Laurie J. Hall, a partner and estate planner at Palmer & Dodge, a law firm in Boston. "That's a difficult question for anyone to answer right now."
Still, estate planning is too important for entrepreneurs to put off until the political debate is resolved. Aaron Cohen, CEO and cofounder of Concrete Inc., a four-year-old consulting company that helps companies develop Internet businesses, says, "I'm in a fast-growth mode, a capital-markets mode. It would not be appropriately conservative for me, speaking from a personal financial perspective, to just take for granted the idea that sweeping changes are going to occur that would eliminate my need for estate planning. The longer I delay, the more valuable my company will be -- which will just make estate-planning activities more difficult and more expensive."
There may be no better time than the present to figure out which strategies make sense in today's uncertain environment and which might be worth postponing or redesigning. Some observers remain dubious about the prospect of a major overhaul. "Many people might not realize this, but some years ago Congress promised to lower the top estate-tax rate at some point in the future. But it never happened, even though the vote did go through," says Carlyn McCaffrey, a partner in the trusts-and-estates department of Weil, Gotshal & Manges LLP, in New York City. "The timing for that tax-rate reduction just kept getting pushed into the future."
Currently, the top federal estate-tax rate is 55%. Through the end of 2001 the lifetime exclusion amount (the value of the estate over which estate-tax returns must be filed) is $675,000. That gift-and-estate-tax exclusion is scheduled to gradually rise to $1 million by the year 2006. There's an annual exclusion for up to $10,000 for gifts to each of any number of people; that means that a husband and wife can each transfer up to $10,000 a year in cash or assets to a child without triggering a tax liability. There is usually no tax on bequests or gifts between spouses.
The most recent reform measure, which was approved by the House and Senate earlier this year but vetoed by President Clinton, would have phased out the federal estate and gift taxes by the year 2010. "Looking at this realistically," McCaffrey says, "even if that bill did get passed again, this time without a veto, it's only another promise. It's a long time between now and 2010, and nothing prevents another set of politicians from coming in and changing the law once again. People can't count on significant change -- and they shouldn't count on it."
Appealing as it may be to hope for political miracles (especially when tax savings would be attached to them), business owners tend to agree. "If the estate-tax law is repealed -- which I personally don't expect to see -- it would be foolish to forget that what one government takes out, another can put back," says Terri Alpert, the founder and CEO of Professional Cutlery Direct LLC, based in North Branford, Conn. Despite the current political debate, Alpert has no regrets about her own estate-planning activities. When she incorporated her business as a limited-liability company, four years ago, she turned over a majority share of her company's stock (minus voting rights) to trust funds for her children.
"My husband and my corporate attorney are the trustees, and I can replace them if I ever want to, which I can't imagine doing. My own financial interests and management control are assured by the management contract that I've set in place. What's to regret?" Alpert asks. "I view this as a hedge that will protect my family's interests no matter how big my company gets or what happens to the tax laws. There wasn't any downside for me, other than the cost of setting up the trusts, which was relatively low."
But even though few experts expect to see the dismantling of our gift-and-estate-tax system, more-modest adjustments are probably inevitable. "The truth is, there hasn't been any significant change in these laws since the 1980s," says Jonathan Forster, a lawyer and tax planning specialist at Greenberg, Traurig LLP, in Tysons Corner, Va. "There's so much momentum for change -- if only to keep up with all the wealth that's been created in the nation during this recent period of prosperity -- that I'd be surprised if we don't see a bumping up of the lifetime exclusion, maybe to the point where a couple could pass on something between, say, $3 million and $5 million in bequests without needing to pay any taxes."
McCaffrey agrees. "We easily could see a situation in which people who are now at the margins, when it comes to the exclusion amounts, will no longer need to carry out extensive estate-planning activities. The problem is," she adds, "this is very tough to predict, especially for entrepreneurs whose businesses may grow rapidly or unexpectedly beyond the exclusion point. My great fear is that people will get lulled into inactivity because they think they'll be all right -- and then when they realize that they need to act, they'll find that they've missed out on the best opportunities."
For owners who are still uncertain about whether to act, there's another point to consider: Even under rosy reform scenarios -- something along the lines of the tax phaseout Congress passed this past summer -- some form of estate tax will remain for nine years. That represents a large and dangerous window of vulnerability for any growing company. If you suspect that your future heirs won't be able to pay Uncle Sam without conducting a fire sale of your company or its key assets, you owe it to everyone (and to your business as well) to explore estate-planning options sooner rather than later.
Jill Andresky Fraser is Inc. 's finance editor.
Related resource at inc.com:
Estate Planning 101
Five Situations, and What You should Do
It's not simple to chart out a personal financial course when politicians keep roiling the waters and prolonging a murky future. But some estate planning is essential for all business owners regardless of what happens on Capitol Hill. Tax minimization is only one reason for such planning, although it's the reason that attracts the most attention. No matter what happens to estate-tax rates, if you care about how your assets and your company get distributed after your death, you need a will. If your children are minors, you should address their guardianship. Finally, if you're an entrepreneur who is concerned about your company's long-term survival, you need the equivalent of a corporate will that addresses management succession and related matters.
That said, the uncertainty about estate taxes does suggest certain courses of action, depending on your circumstances. The hypothetical questions and the answers outlined below may help you sort out the alternatives that make the most sense for you and your company.
Q: I'm in the start-up phase but expect my company to grow very big, very fast. Should I begin making gifts now or wait to see how the political debate is resolved?
A: Because of the likelihood of changes in the gift-and-estate-tax exclusion, some business owners should postpone making major gifts or putting large sums into irrevocable trusts, because their estates may fall below the new exclusion limit. But given the accelerated growth profile that you describe, you're not one of them. If you anticipate that your entrepreneurial venture will quickly reach a value greater than, say, $5 million, then think about starting to give away stock soon. If you start early, you may be able to avoid the gift and estate taxes entirely. As long as your company isn't profitable and hasn't yet attracted large-scale investors, its stock could be considered nearly worthless; also, any gift of a minority equity stake in a privately held company gets discounted in value by the IRS, making a gift-tax liability even less likely.
Q: What if I'm uncertain about my growth potential -- and think that the company could stay in the $3-million-to-$5-million range, or even lower?
A: Then it probably makes sense to delay all but the most minor gift-giving activities. The exclusion could easily grow to the point at which you could bequeath that much value at death without the estate's incurring a significant liability. So why deal with the hassles of equity transfers sooner than you want to?
Q: I'm thinking about starting a company, and I anticipate no problem raising private-equity funds, given my rÃ‰sumÃ‰, contacts, and turbocharged idea. There's no reason for me to begin estate planning now, is there?
A: Wrong. With or without the involvement of politicians, the world of estate planning has been permanently affected by the superheated capital-market trends of the past few years. Would-be entrepreneurs like you could pass from the private fund-raising stage through an initial public offering or company sale in less than two years. So the best time for estate planning is when you're conducting all the other planning for your company launch. No matter how high the gift-and-estate-tax exclusion gets, it's unlikely that in your circumstances your estate will be under it. So it will pay to do the right kind of planning now.
Q: My company is large and successful, and my estate is potentially liable for a high estate tax. Since I didn't plan ahead, is there anything I can do now, or does it make sense to wait and hope for the best?
A: You're in the worst of all worlds, although you're scarcely alone. In the past -- when the tax situation was clearer and more predictable -- many estate planners would have advised you to bite the bullet and make large gifts to your heirs (or their trusts) right away. That's because of a subtle but significant difference between the way that federal taxes get imposed on gifts versus bequests above the exclusion limits. For instance, if you're in a 50% gift-tax bracket and you gave $1 million worth of stock this year to your daughter, you would owe $500,000 in gift taxes, adding up to a total transfer of $1.5 million. If, instead, you died, leaving that same $1.5 million in assets to your daughter, estate taxes would gobble up roughly $750,000, leaving her with $750,000 -- $250,000 less than she'd get from a gift made during your lifetime.
But these days all bets are off, and few planners are willing to advise their clients to incur significant current tax bills that they might later find they could have avoided. "It makes one quite nervous to contemplate taxable transactions, given the possibility that relief may be in sight at some point in the future," says Laurie J. Hall, whose practice, at Boston's Palmer & Dodge, includes estate planning. "Right now I'd have to advise people to stick to tax-free activities, which would include making their $10,000 annual gifts."
Another strategy that Hall recommends for business owners is making a gift of stock to a GRAT (a grantor-retained annuity trust). "An entrepreneur retains the right to receive back a percentage of the value of the initial stock gift every year for a specified period of time, say three years," Hall explains. "At the end of three years, the stock goes to the entrepreneur's children. For tax purposes the IRS discounts the value of the gift -- the higher the percentage the entrepreneur gets back every year, the deeper the discount. If the stock price goes up substantially, a lot of value could go to the children gift-tax-free." Hall adds, "With careful planning, you can get a lot of leverage on the tax front from the use of a technique like this one. You shouldn't face a current tax bill."
Q: I own stock in other privately held companies besides my own, either through angel investments or strategic partnership deals. Should I think about them any differently, for estate-planning purposes, when I decide whether to wait for changes in the tax law?
A: The answer is yes and no. Follow the same estate-planning strategy that makes sense for the rest of your assets. But with private-equity holdings like these, your heirs could find themselves saddled with all kinds of headaches and even an estate-tax liability -- regardless of what happens to exclusion amounts. Make sure your estate planner evaluates all relevant documents in advance, including each private company's rules regarding stock transfers in the event of a shareholder's death. Based on your planner's assessment, you may want to set up an irrevocable life-insurance trust to help your heirs handle the likely financial costs.
Related resource at inc.com:
Estate Planning 101
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