Planning ahead: while controversy and uncertainty about the estate tax rage, financial advisers can help small-business owners pass their assets on intact.

They chase the American dream. They are owners of small businesses, the kind who employ half of the nation's private work force. They work long hours, take big risks, help create the fabric of communities. Only some succeed. When they do, their rewards can be considerable.

Until, that is, they try to pass their businesses and their assets to their heirs. Congress has worked in recent years to reduce their exposure to the estate tax, but the onerous levy remains a threat to small-business owners.

Or does it? Two years ago, the nation's legislators took steps to reduce the bite on such owners over the next few years. That reduction is temporary, however. In 2001, Congress voted to phase out the tax over 10 years, with no estate tax at all in 2010. But without further action, it would return to 2001 levels in 2011.

Few issues generate the passion that the estate tax does. That is partly because it is argued on so many levels, from simple fairness to social engineering to revenue generation for government and charities. It is both a political and an economic issue. And estate-tax planning is big business for financial professionals, including insurance underwriters and advisers.

The Internal Revenue Service in 2002 reported collecting $25.5 billion in estate tax from 120,576 tax returns--only 1.3% of total tax collections of $1.98 trillion. But those who would keep the tax alive point out that many trillions of dollars--probably at least $10 trillion, even after the bursting of the stock bubble--are expected to pass to baby boomers, and estate-tax collections can grow significantly. Permanent repeal would lose $64 billion of revenue in 2013 and $820 billion in 2014 through 2023, according to a June 17 report by the Center on Budget and Policy Priorities, a think tank that supports the tax. Critics say eliminating the tax would generate other kinds of taxes through more economic activity. On June 18, the U.S. House of Representatives voted to permanently repeal the tax, but the U.S. Senate is not likely to move the bill.

The consensus is that the estate tax as currently construed affects only about 2% of the population. Half of all estate taxes are paid by the wealthiest one tenth of 1% of Americans, according to Americans tot a Fair Estate Tax, another group opposed to repeal. In 2009, when the amount of an estate exempt from tax rises to $3.5 million per person ($7 million per married couple), less than one half of 1% of Americans will be subject to the tax, the group estimates. By comparison, the top 1% of taxpayers in 1999 paid more than 36% of the federal income tax, according to the IRS.

While the richest 2% of Americans are subject to the estate tax, IRS statistics show that less than 1% of the 130.9 million tax returns filed actually paid the tax. Estate planning might account for that, but other factors might be involved.

Debate about the future of the tax centers not on the wealthiest Americans, but on those a step below, and they tend to be small-business owners and farmers. Both groups are very concerned that their businesses will not survive them, mad that their heirs will have to sell all or part of the business to pay estate taxes, which have rates as high as 49%.

A Potential for Harm

Patricia Soldano, who has for 20 years run a consulting business that helps families manage their businesses and assets, said clients like hers are very much affected by the estate tax. She told of a family" that had to sell a third-generation ranch on which the would-be heirs became ranch hands rather than owners. She said five family businesses in Williamsport, Pa., had to be sold to larger companies due to the estate tax, and now those businesses no longer exist in the town. Many small-business owners sell before they die to avoid the "nine-month fire sale"--her reference to the requirement that estate taxes be paid within nine months of an owner's death. The idea is that owners can get a better price before they die, so their heirs will inherit more and will have the liquidity to pay the tax. When sales occur after death, prices are much lower, and competitors swoop in like vultures, she noted. Sales before death don't show up in the estate-tax statistics.

Soldano is owner and president of Policy and Taxation Group, a Costa Mesa, Calif.-based organization of family businesses dedicated to the elimination of the estate tax. She is also one of 25 founding partners of Women Impacting Public Policy national bipartisan organization claiming to represent more than 430,000 women in business and women business owners across the country.

Laws usually penalize people for wrongdoing, but the estate tax is different and perverse, Soldano noted. It hammers people for failing to be proactive. "That's another reason the tax shouldn't exist," she said." It's a very complicated tax, and a lot of people are not sophisticated enough to handle it."

One reason small-business owners may fail to plan their estates is that they are so busy. Most want to become big-business owners, she said, but the tax is a disincentive to both building the business and saving money. Instead, she said, it motivates people to spend.

Not long before the 2001 law, the federal exemption was $600,000. This year it is $1 million, which Soldano said is used up fast since an estate can include a home, investable assets and personal belongings. Next year, it is due to rise to $1.5 million. Most small businesses--probably 60% or 70%, she estimated--buy life insurance to pay the tax, but she's not sure how many know to put the insurance into an irrevocable life insurance trust, which is outside the estate.

Like other opponents of the estate tax, Soldano maintains society and the economy would be better off if the law stopped hurting small enterprises and stopped driving them out of business altogether. Instead, Congress should end the tax and let them grow, she said, adding that growing companies generate greater payroll taxes, sales taxes and more income tax, and they reduce unemployment.

Ted Kurlowicz, the Charles E. Drimal professor of estate planning at American College, Bryn Mawr, Pa., said there is "no plausible argument" from a national public-policy perspective that the estate tax keeps businesses from growing and adding employees. "Yes, there are people who sell their businesses, but somebody buys them," he said. "What the estate tax does is cut down on amounts inherited by undeserving heirs."

But Kurlowicz added it is rare for small businesses to be sold due to the estate tax. "I don't even think they're on the radar screen," he said.

What Kurlowicz believes is happening is that small-business owners are well organized and effective lobbyists." They complain the loudest and in the most organized fashion," he said. "They want to get the government out of their fives. They complain about the regulatory costs of employee benefit plans and about OSHA [the federal Occupational Safety and Health Adminstration]. But have you ever talked to a business owner who said, 'It's too ranch trouble to grow my own business'? They continue to grow because they are entrepreneurial and aggressive and will try to grow."

Kurlowicz pointed out that as a compromise alternative to permanent repeal, Democrats have suggested permanent exemptions of $2.5 million-to-$3 million per spouse, which would effectively protect small businesses. "I don't think you can make an argument against the estate tax, but you can against the thresholds," he said. "We were stuck at a $600,000 exemption for a long time."

Repeal of the estate tax would put a 1.5% hole into the revenue side of the federal budget now, and it would be a bigger hole in the future, Kurlowicz noted. "You have to collect the tax from people who have the money," he said. "What you're doing with an estate tax is making sure you don't have a system where money stays in the same family generation after generation. The effect on economic growth would be much worse if you take more tax out of weekly paychecks."

Bryan Howard, a member of the estate practice group at Nashville-based Waller Lansden Dortch & Davis, said that in 20 years of practice in middle Tennessee, he has never seen a family farm or small business that had to be sold due to the estate tax. "There are a lot of other reasons a family will end up selling after their parents die, but the estate tax is generally not the impetus," he said. "I checked with others in our practice, and they concur.

"The people paying estate taxes have a whole lot of other assets besides their small businesses and farms. We think this is a political point rather than a real-life issue. It sounds good if you say you're protecting the small-business owner, but the reality is they're not really having problems with estate taxes."

Howard, a lecturer and author in addition to adviser/practitioner, said his main point is that heirs pay estate taxes from the liquid assets of their benefactors. "The notion that the tax is running people out of business and causing a loss of jobs is not the case," he said. "We represent about 50 estates at any given time, and about a quarter will end up paying some estate taxes. The two biggest types of assets are real estate and marketable securities, and they are by far the two biggest sources of inherited wealth." One other fairly significant asset is retirement assets, but that seldom makes up the whole estate, he added.

The Effects of Planning

One of the arguments against the estate tax is that planning for it detracts from capital that owners would otherwise use to build their businesses. Kurlowicz said this position puzzles him, since small employers spend lots of money each year on employee-benefit consultants advising them how to maximize benefits for the owners. "That's the sales call these people make," he said. "In that industry, the most sophisticated design work is to maximize the benefits of owners."

Howard said estate planning "has been tremendously effective" in cushioning the impact of estate taxes. Every individual, for example, can reduce the size of an estate by giving away up to $1 million during a lifetime and up to $11,000 a year to any individual. "By taking advantage of those exemptions and leveraging them, you can pass many dollars to heirs without paying taxes," he said. "The problem is that people have to be proactive. If they're not, those people really get hammered by taxes."

Critics of the tax seize on that issue, but Kurlowicz said he feels little sympathy for a business owner who has not planned. "For someone to say no one ever told me is just incredible," he said. "The popular press publishes tons and tons of articles, and I know these people get contacted by advisers."

Besides the recent higher exemptions, some special provisions have been available to protect small businesses for many years. One part of the tax code increased the exemption from $600,000 to $1.3 million if more than half of an estate is made up of business assets. This exemption, a qualified family-owned business interest, went into effect in 1997. It will disappear next year, when the individual exemption rises to $1.5 million from $1 million, said Howard.

Another exemption in effect for at least 50 years is the special-use valuation. It lowers the value of land used for farming when its value would otherwise be inflated by market pressures, such as its proximity to residential subdivisions. "If you sell some farmland, you could make a lot of money," said Howard. "This allows you to reduce the value to the way you're using it." With an inflation adjustment, the special-use valuation can currently reduce farmland value by as much as $800,000.

Another provision around for a long time allows estates to defer payment of estate taxes over a 15-year period if the property is in closely held business assets or farm property, said Howard. Soldano said people still have to pay, and with interest.

Constructing the Plan

Norbert (Norm) Mindel said that while the tax has long served as a way to "break up large dynasties," it is today "penalizing people who are successful." Mindel is executive vice president of sales and marketing for GE Financial's independent accountants network.

"The majority of people I work with are the American dream," he said. "When you tell them what the potential tax is, they're shocked. They've been good citizens and paying taxes along the way, and their businesses are very important to them. They have loyal employees, and they want their businesses to be there for them. They want to keep the businesses going into the next generation."

If business owners work with estate planners, they can mitigate the effects, he said, but he couldn't estimate what percentage actually do. "These people work 50 to 70 hours a week. Unfortunately, they wait until their 60s or 70s to start estate planning, and that's when planning is more challenging. When you're building a business, estate planning is not at the top of your list. It's human nature."

GE Financial reaches business owners, mostly those with closely held businesses, through financial advisers and accountants. GE has been in the business since the early 1980s, he said, and it often works now as a clearing-house for professionals that want to work through a case.

Planning opportunities tend to fall into one of two pots: family members taking over a business or not. When a family member is available to run a business, GE recommends that person inherit the business and that the owner buy last-to-die insurance or individual insurance to provide a share of the inheritance to nonworking children. If real estate is in the estate, GE commonly recommends that it go to non-working children in the form of a partnership that provides a long-term lease to the business entity.

In a hypothetical example typical of real cases, Mindel said a "very successful" light-manufacturing company started estate planning about 15 years ago. Many children were active in the business. GE helped set up an employee stock ownership plan, which gradually allowed the children to buy into the business. GE also recommended annual gifting, and it changed the stock form of ownership in the company. The effect was that the family was able to transfer wealth in the estate without subjecting it to high estate taxes, even though the company greatly increased in value. "We didn't use insurance, but now the children need last-to-die insurance, and we're doing a lot of estate planning for the next generation," he said.

Why Estate Tax Should Be Reformed, Not Repealed

* If the $3.5 million exemption and lower 45% rate scheduled for 2009 were extended, only 0.5% of decedents would be taxed.

* Reforming the estate tax preserves options to address the looming Social Security shortfall.

* Enacting a $3.5 million exemption and lower 45% rate would create a more stable and sustainable environment for estate planning.

* Repealing the estate tax would reduce charitable giving.

* Public rhetoric to the contrary, only a very small fraction of family farms or small businesses is subject to the estate tax even under today's terms. Such assets accounted for less than 3% of the total value of taxable estates in 2001.

Source: Center on Budget and Policy Priorities

Poll Finds Americans
Oppose Estate Tax

The poll was based on telephone
interviews with 2,506 voters and
conducted by the Luntz Research
Cos., which has Republican
clients, and Global Strategy Group
Inc., which has Democratic clients.

Inheritance taxes are an extreme form of
taxation, The tax rate, as high as 50%, is
higher than even the highest federal income
tax rate--and that's unfair.

Agree 79%      Disagree 17%

Inheritance taxes are unfair because they
single out these who save and invest for no
reason other than the fact that they became
successful.

Agree 69%      Disagree 27%

People do not work for inherited income, so
inheritances should be taxed at a higher rate
since it is not earned income.

Agree 19%      Disagree 79%

Source: Women Impacting Public Policy. Margin
of error: plus or minus 2%.