Small Business Owners Face Estate Tax Dilemma

With the fate of the estate tax stuck in the Senate, concern is growing that the legislation could ensnare many small businesses as soon as next year. As many as eight times more estates could get smacked with the tax next year as this year -- and for some, that could mean enormous problems.Two key figures play into the estate-tax debate: the exemption, the amount of money or assets that can be passed to the next generation tax-free, and the rate of tax, which is the amount of an estate that goes to the government after the exclusion. Under a 2001 liberalization of the law, Congress raised the exemption from $675,000 to $3.5 million in 2009, and reduced the tax rate from 55% to 45%. But a loophole effectively repeals the tax for 2010, and then next year will revert the tax to pre-2001 levels of $1 million exemptions, and a top tax rate of 55%.

Indecision and Confusion

The Obama administration has proposed extending and making permanent the 2009 exemption and tax rate, a measure the House of Representatives adopted in December. But the Senate has balked, pushing back consideration during the debate of health-care reform. Sen. Max Baucus, chairman of the Senate Finance committee, says that estate tax reform is likely to be passed this year and made retroactive to Jan. 1.

Some tax opponents claim that making the law retroactive is unconstitutional, but the Supreme Court has ruled in a similar case that such acts of Congress are legal.

And the indecision is perplexing tax advisers. "It's a very difficult environment we're living in right now," says Neil Katz, managing partner of Katz, Bernstein & Katz, a law firm in Syosset, New York. "We're advising our clients that we're going forward assuming that at some point in time, an estate tax of some magnitude is going to come back into existence." Katz says he is telling clients to wait until Congress acts before changing wills and estate plans.

Small Businesses Worry

About 5,500 estates -- about one quarter of 1% of all estates -- paid death duties in 2009, says Roberton Williams, a senior fellow at the Tax Policy Center in Washington. But 44,000 estates could be hit by the tax next year if Congress doesn't change the law before then, Williams says. And some small businesses have such limited cashflow that they couldn't withstand the hit, he says.

One small business-owner watching the debate is Bruce Nevins, 63, who owns a New York wine store. Nevins says he has been forced to purchase expensive life insurance to ensure that his four children, three of whom he employs, can inherit the business without having to sell it to pay the estate taxes. "There are only four years left on the policy, and then it becomes absurdly unaffordable," says Nevins, who hopes the estate-tax law changes before then.

Uncertainty over the tax gives business owners a chance to take advantage of other estate-planning tools, says Steve Hartnett, associate director of education for the American Academy of Estate Planning.

One strategy is for owners to give some assets to their children. The gift tax has a $1 million exclusion this year, so a married couple could give their children $2 million tax-free this year. For amounts of more than $1 million per person, the gift-tax rate is 35%, making it a better deal than the estate tax. Another strategy Hartnett recommends: establishing trusts that let businessmen pass some assets to their heirs tax-free. In one such plan, a business owner would deposit assets in a trust, which pays the owner back over a fixed period. During that time, appreciation of those assets -- which can be substantial -- passes to children tax-free.

Still, such estate-planning tools are beyond the reach of most small business owners. "We don't have that kind of money, we don't have those kinds of assets," Nevins says. "Our net profits aren't millions of dollars. For most small businessmen, the only way to raise liquid assets is to liquidate the business."

John C. Anthony, who owns a timber company in Hot Springs, Arkansas, says that while his business is large enough to create trusts to shelter the estate, the tax is still so high that his business will probably have to be sold to pay the "death duties." "It's futile to build a business over 100 years," Anthony says.

Raise the Exemption?

Both Nevins and Anthony favor a permanent repeal of the estate tax, and both realize there's little realistic chance of that happening. Instead, they both support an amendment sponsored by Sen. Blanche Lincoln (D.-Ark.), and Sen. Jon Kyl (R.-Ariz.) that would raise the exemption to $5 million, or $10 million for married couples, and lower the tax rate to 35%.

Ten Democratic senators support the Kyl-Lincoln amendment, blocking passage of the Obama plan. Because all 41 Senate Republicans oppose the Obama proposal, it's unclear if the proposal can win passage. That causes some concern among small-business owners that no change will be made, and that the law will revert to its $1 million exclusion and 55% tax from 2000.

Williams says that, rather than letting concern for small-business owners lead to a lower estate-tax rate for everyone, Congress would be more productive if it "tailors the law is such a way that will exempt small businesses in some fashion." That way, big multimillion-dollar estates won't benefit from a lower tax rate.

For a reform proposal to succeed, Congress will have to balance small-business interests with the desire to raise a substantial amount of money for the federal budget, which is under huge strain this year. But so far, a compromise is proving elusive -- and it may be impossible to achieve.
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