Will the Death Tax Buy the Farm?

FOR MORE AND MORE people today, dying seems to be a bad idea. This is particularly true for the growing number of Americans who are discovering that their demise could bury their estate under a heavy tax burden of 37 percent to 55 percent.

What once was considered a non-issue to the majority of taxpayers, due to its focus on a tiny subset of upper echelon society, is now a startling reality for many. This change is felt acutely in California, where merely owning a home for 20 years can put one squarely within the tax bracket of the elite--at least upon death. Politicians have taken note of these trends and are sounding the trumpet of reform.

"In the beginning, no one thought that the estate tax ever would be repealed because it is a tax that only can be applied to very few people and it is viewed as accomplishing good social goals," explains Michael Allmon, a Marina Del Rey-based CPA and chair of CalCPA's newly-formed Estate Planning Committee. "Estate tax prohibits dynasties and family monopolies, and spreads the wealth of the very wealthy. But now, because a good job wasn't done with indexing estate tax exemptions for inflation, more people are subject to the estate tax than ever."

A POLITICAL ISSUE

The debate over the estate tax, which some have dubbed the "death tax," heated up dramatically in the past year. Traditionally, Republicans have supported repeal of federal laws governing taxes on estates, gifts and trust funds, and Democrats have supported the status quo. This is changing as each groups' constituency becomes more wealthy due to factors such as real estate appreciation, increased savings for retirement, and the phenomena of IPO and stock market millionaires, not to mention the baby boomers, who soon will be staking claims to trillions of dollars in inheritances.

Recently, Democratic presidential hopeful Al Gore changed his position to support targeted relief for small-business owners and family farmers, the "poster children" of estate tax reform, while his Republican rival, George W. Bush, supports outright repeal of all estate taxes. No matter what happens, estate tax reform will surely be a hot issue in the November elections.

STEP-UP VS. CARRYOVER

Under the current laws, estates worth more than $675,000 (going up to $1 million in 2006) are subject to estate taxes, starting at 37 percent. Suggested reforms that seek to abolish estate tax, include recommendations to eliminate stepped-up basis when selling inherited assets and instead use a carryover basis. Exceptions would include: the first $1.3 million of any estate could receive the step-up at death, and a married person could leave an additional $3 million to a spouse with a stepped-up basis. Although, when the surviving spouse dies, only $1.3 million could be passed on with a step-up in basis. Capital gains taxes would have to be paid on any amounts over these exceptions.

"The biggest problem with this suggestion is the income tax implications," explains Allmon. The income tax would apply in more situations than the estate tax would. For example, today, if a husband and wife who own a $200,000 house die, and that was the extent of their estate, there is no estate tax and no income tax. If estate taxes are repealed however, that same family could end up paying an income tax via capital gains. "The repeal of the estate tax could actually end up being a big tax for less wealthy people," says Allmon, noting that in a case like this, heirs might feel that they have to hold onto property they might otherwise have sold. Although recent repeal efforts address this issue, often other proposals have not.

FAMILY BUSINESSES & FARMERS

Repeal supporters are eager to note that small-business owners and family farmers are forced to deal with complicated estate planning to ensure that surviving family members can afford to keep the business or farm. Often, if this planning is not done, the heirs are forced to sell the business or pay a hefty toll for keeping it.

Keith Schiller, an attorney with Schofield and Schiller, a Walnut Creek-based estate planning firm, and a supporter of estate tax simplification, but not repeal, doesn't buy this argument: "The argument of closely-held businesses being liquidated because of estate tax is an inaccurate, misleading overstatement. Overwhelmingly, those businesses liquidate because of dynamic, control and business reasons. If business owners do not focus on family communication, control and succession empowerment issues, their businesses are going to liquidate regardless of the tax system. In many, many cases there's just no one to run the business."

Schiller adds that of the 42,901 estate tax returns filed in 1997, only 1,400 had a closely held business or farm as the asset totalling at least one-half of the estate value. Additionally, more than 70 percent of closely held businesses liquidate upon the death of the principal owner, but estate tax was the reason for liquidation in fewer than 10 percent of those cases.

Schiller, a frequent Education Foundation instructor on federal estate taxes and succession planning, notes that under current law, there are allowances in which a married couple could pass on at least $6.7 million of a family farm estate-tax free.

"This is with the most minimal estate planning--a standard credit sheltered trust and a standard marital trust. That's what the present law provides for if a person has more than half of their net worth in a farm as community property, and after the parents die, the kids keep the farm and don't sell it to real estate developers," says Schiller.

"With effective estate planning, even the most wealthy individuals can reduce estate tax down to sales tax rates, effectively, below 10 percent. This is what can be done right now with valuation discounts, life insurance trusts, present-value discounts and other estate planning techniques," says Schiller. However, he adds, "the system is too complex to carry out social policy fairly."

"The biggest problem with estate tax is that it can be a trap for the unwary," says Michael Ettlinger, an attorney and tax policy director with Citizens for Tax Justice, a Washington D.C.-based public interest research and advocacy organization. "If you really want to reform the tax you should close the loop-holes to prevent people from planning their way around the tax. That would raise revenue and you could use that revenue to make the tax overall a lower and more fair tax." He adds that if there are sympathetic situations with farmers or small businesses, you could then take care of them by making sure that those who do the most aggressive estate tax planning give their fair share.

THE FUTURE FOR ESTATE PLANNERS

Would outright repeal be the beginning of the end for estate planners? "For CPAs who do estate planning exclusively, it would definitely be an adjustment because the tax work involved to reduce or avoid the estate tax is substantial," says Allmon. "But the non-tax area still is significant. If it is repealed there will be a significant amount of work and planning to be done in the income tax area, because of the change with respect to basis." Allmon adds that personal financial planning would be a natural area for CPAs and estate planners to venture into should the estate tax be repealed.

For an intriguing example of some of the gaping loopholes in today's estate tax laws, go to www.calcpa.org/califoiacpa to read Schiller's article "How to Pass $31 Million Without Gift Tax, While Saving $159 Million in Estate Tax."

Deanna McCrary is CalCPA editor/writer.

CALIFORNIA'S UNIQUE SPIN

As the estate tax reform debate gathers steam at the federal level, California legislators have approached estate planning issues with a slightly different focus. This year Assembly members introduced legislation to curb the activities of what legislators refer to as "trust mills."

Assembly Bill 1138 (Strom-Martin) provides consumers with some added protection by allowing them to pursue full restitution, if products are sold by trust mills engaging in the unauthorized practice of law.

A trust mill generally sells inappropriate financial products including annuities or flawed trust documents and frequently employs non-attorneys to prepare the documents and to provide what clients believe to be legal advice.

As originally drafted, AB 1138 would have prevented non-lawyers from engaging in any estate planning services. The impact on CPAs who perform estate planning services would have been enormous. To remedy this apparent oversight, CalCPA acted quickly to have the problem corrected.

AB 1138 has broad bipartisan support and should be enacted by Aug. 31, the end of this Legislative session.

By, Bruce Allen, government relations director