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Sunday, November 23, 2008

Small Businesses and the Inheritance Tax

I have referred to the death tax as pernicious, however it is most pernicious to those with assets with value beyond the liquid cash or equivalents attached to it. The two most common forms of such assets are real estate and small businesses. Small businesses like any business are valued by measuring current value of future cash flows. This measures all sorts of assets beyond cash on hand. As such, a business worth $10 million will likely have far less than that in cash on hand. The inheritance tax charges the heirs of an estate a tax on any value above whatever the threshhold of the estate tax is. Currently, there is no federal estate tax, however Barack Obama is floating the idea of re instituting it above $4 million. As such, a small business valued at $10 million would face a tax on $6 million of that. If that business only had a $1 million cash on hand, the heirs would likely be in a position to be forced to sell.

In fact, the inheritance tax figured prominently in the transfer of two different well known entities. The Cubs are no longer owned by the Wrigley family because the estate couldn't afford to keep them when their inheritance tax bill came due.



The problem here is making sure that your assets actually go to the people you would like to will them to, rather than those assets being sold to cover estate taxes. The Chicago Cubs are no longer owned by the Wrigley family, because upon the death of the family patriarch, several family assets had to be sold in order to pay the estate taxes.

Then there is the case of the Robbie family. They not only lost the Miami Dolphins but the stadium that had their name on it because of the bill that came due as a result of the inheritance tax.



In the 1800s, George Sand remarked, "to have no cash means, absolute powerlessness." In wealth transfer planning, no cash can be devastating. Particularly if your family wealth includes large real estate holdings or a business. Estate taxes can mean the loss of treasured family assets. Ask Joe Robbie’s family: they lost the Miami Dolphins and Joe Robbie Stadium due to the need for cash to pay estate taxes. In a recent survey among successors of successful family businesses whose businesses failed after they were passed on to the next generation, 97.9 percent had to sell the business to raise the cash to pay estate taxes.


Let's look at a scenario.


Family Home $1,000,000
Vacation Home $500,000
Checking & Savings Accounts $100,000
Stocks, Bonds & CDs $1,000,000
Business Property $1,700,000
Business $5,000,000
Total $9,700,000

In such a scenario, the total value of the estate is $9.7 million. If we go back to an inheritance tax level of $4 million, the family would be looking at paying an inheritance tax on $5.7 million. The tax is usually about 55%. This means a bill of about $3 million. Even after liquidating the stocks and using all their cash, the family wouldn't have enough. As such, this family would likely be forced to sell the business.

Of course, for every tax there are also lot's of loopholes. In fact, a large part of the field of estate planning involves using the tax laws to help clients avoid or minimize the onerous nature of the inheritance tax. There are many tried and true techniques of avoiding the inheritance tax.



One of the simplest ways to avoid the inheritance tax is to leave your estate to your family members in the right amounts. That means that, while you and your spouse are still alive, you should equally divide your assets between the two of you so that the value of each of your possessions does not surpass the nil-rate band.

It is true that you can avoid inheritance tax payments if you leave your assets to your spouse after you die, since spouses do not pay inheritance tax for the goods that they have inherited from the other spouse. However, once your spouse dies too, your children will not be able to avoid inheritance tax payments.

If you divide your assets between you and your spouse before you die, you can each leave your children an amount of money that is below the nil-rate band. This way, your children can completely avoid inheritance tax payments

...

If you do not want to pay inheritance tax, you can reduce the value of your estate until it is under the nil-rate band. You can do this by giving small gifts to a large number of people, giving large wedding gifts to your children or anyone else in your extended family and making donations to charitable organizations.

These three categories of gifts are excluded from the inheritance tax law. If you cannot reduce your estate enough to avoid inheritance tax payments, at least you can reduce the value of that tax.


In fact, the story of the Wrigley and Robbie family is the exception. The rule usually involves hiring lawyers and accountants and paying them hundreds of thousands of dollars in order to avoid paying millions of Dollars in inhertances taxes.

So, in the end for most successful business owners, they face one of two options. Either they hire professionals for hundreds of thousands in order to navigate the complicated tax codes in order to avoid having to pay the estate tax, or their families are left with such a massive bill that the business needs to be liquidated. This pernicious tax at best complicates the tax code exponentially and needlessly setting up a cottage industry and billions of Dollars in fees and expenses to navigate it. At worst, this pernicious tax causes families to lose their businesses and other illiquid assets. Either way, such is the pernicious nature of successful small businesses and the inheritance tax.

7 comments:

Jason Gillman said...

Ultimately, the death tax hurts the middle class the worst.

Folk who are doing well enough normally can count on a white elephant when a small enterprise or expensive single item is on the inheritance list. Item of value cannot be passed on without reallocating NON-Inherited assets to make cash flow at a time of grief.

Brilliant use of Government.

Families cannot accumulate wealth short of the manipulations you mention.

mike volpe said...

I would say that both the Wrigley and Robbie family would differ about who the death tax hurts the worst.

Frankly, what shocks me was that there wasn't more shock when these two events happened. There should have been a revolt against this tax when word spread that either of these families had to lose the stadium that had their names on it because of the tax.

If anything illustrates how vile a tax is, it is that the Robbie family has to sell Robbie Stadium in order to pay a tax imposed because a Robbie died. Talk about pernicious.

Anonymous said...

I don't see how you can think that the death tax hurts middle class families. The exemption level is $2 million. I don't think I could consider someone who has that much money left when they are dead to be middle class.

The laws are complicated, yes, but thats why you hire those expensive lawyers and accountants. If you plan well, you should be able to avoid those cash flow issues when the estate is being probated.

I love this tax. It helps to reduce the amount of money those spoiled rich kids get. Not to say they are undeserving, but how many trust fund brats do you know that actually deserve the money?

mike volpe said...

To the last anonymous poster, I appreciate your honesty and so you are welcome here to debate anytime.

That said, you are definitely in favor of using taxes for the purposes of social engineering. You don't like the lifestyle of trust fund babies and so you want the government to create a tax to stop it or at least to limit it as much as possible. That's social engineering. I would rather that individuals limit their kids from being trust fund babies on their own through limiting how much they leave their kids. That's what Bill Gates has done already.

Second, your point that people just need to hire an army of lawyers and accountants to avoid said tax is rather cynical. We want a tax system that is fair and simple so that someone doesn't need to avoid anything.

Third, your point says nothing of the substance of my piece. Small business owners aren't trying to create trust fund babies. They would just want their businesses to survive to the next generation.

Fourth, we are taxed everywhere throughout life: income, sales, capital gains, property, etc. You think that is not enough and you want some to be taxed in death. I disagree.

Finally, to your point about the middle class...if you put away $50 monthly for 40 years and you get an average of 12% per annum that grows to just over 1 million Dollars. Most people are putting away much more than that into their 401k's. This tax really punishes the savers and the middle class has plenty of those.

Jason Gillman said...

two things..

I say it "hurts" the middle class worse as they cannot as easily recover from the expense of having to lose the family business in the same manner. However, I cannot fathom the loss of a familial institution as you reference.

As to the exemption.. I am not sure the writer understands how many "millionaires" there are who are fundamentally broke. Having to "dump" family assets to pay the sheriff often happens with lousy timing. Hard to imagine some poor schmuck with a "million dollar" house inheritance in these times. Good luck making the sale to pay the taxes.

T-Bone said...

http://www.cbpp.org/cms/index.cfm?fa=view&id=2655

Only 80 businesses expected to be taxed at all by the estate tax, and at an average of 14%... Vast majority is plain old inheritances. Read the full link for more.

Anonymous said...

Please. We act like lemmings for everything else the goverment does, why do you think people would jump up and down about the Cubs and thier heirs.
73% of American do not want health care bill yet here it looks like we will have it.