About 10 years ago, a politician asked us to find an example of a family farm in the area that had been financially wiped out because of the federal estate tax (or “death tax” as he called it). He was not pleased when we were unable to offer up such an example. Reality conflicted with the theme of his message. I’m not saying estate taxes are irrelevant, insignificant or otherwise unworthy of consideration. At a 40% tax rate, the estate tax is real and has the potential to damage or even destroy a privately-held business. I’m simply stating that what is more important is estate planning. With a properly structured estate plan, estate taxes can be mitigated, funded or eliminated.
Consider how few Americans will actually pay a federal estate tax. In 2014, an estate will not be subject to the tax until it has exceeded $5,340,000. This exclusion is indexed each year with inflation, and there is additionally a 100% marital exemption. In other words, with proper planning, a married couple doesn’t have to worry about federal estate taxes until their combined estate exceeds $10.6 million.
Many other assessments can harm an owner’s equity in a business long before the estate tax kicks in. For example, federal income taxes. If you include the impact of the Pease limitation on itemized deductions (1.2%) and net investment income tax (“NII tax”) on investment income (3.8%), the top marginal tax rate on wages is 40.8%. On other passive income it tops out at 44.6%. State income taxes can compound this affect. California, for example, doesn’t have an estate tax, but its top income tax bracket combined with the federal tax bracket sends the rate to over 50%. Before a business owner worries too much about a tax that occurs after death, he or she should first address income taxes.
Beyond Estate Taxes
So far, I’ve only mentioned taxes. In reality there are many other factors that can harm an estate besides taxes.
Living issues: It’s hard to plan an estate if the key asset, the business, is going to be wrecked before death. Take the example of a business centered on its founder. If the founder suddenly becomes disabled, the value of the business may plummet quickly, and the estate’s primary asset may unexpectedly be worth no more than its liquidation value. Even if the founder does not become disabled, and instead retires from the business, his business equity may be swallowed up by costs associated with health care and long-term care treatment. The point is that not attending to insurance and risk management issues during your lifetime can render the most clever estate tax plan moot. There may be little wealth left to pass on to heirs.
Asset transfers: I’ve seen owners of multi-million dollar businesses have their bequests dissolve into distributions of just a few hundred thousand dollars after death. The problem is the loss in share value that occurred between date of death and the distribution to designated beneficiaries. Disputes in probate, chaos in the boardroom and the passing of time without a business strategy can lead to a steep decline in the value of the stock after death. If a business is paralyzed by quarrels over ownership, valuation and control, it might as well die with its owner. However, an exit and estate plan created before the death of the owner could avoid this outcome, and net far more for the heirs. The more the distribution of wealth is anticipated and planned for, the less will be lost in its actual distribution.
Liquidity: The old country song declares, “If you’ve got the money, honey, I’ve got the time.” The same can be said for business: money buys time. The challenge in estate planning for business owners is that there is not always sufficient liquidity to carry the estate through to distribution to the beneficiaries. Once the owner dies, additional liquidity may be needed to pay off creditors, supplement lost revenue, fulfill benefit plan promises, fund a buyout and a myriad of other calls on cash. Assets, whether company stock or tangible property within the business, may need to be liquidated at bargain basement prices to pay the bills. In contrast, an estate plan properly funded with life insurance or other liquidity sources, and put into force before death, provides the cash and buys the time.
Family: In business we often talk of creditors and predators. Rather than the IRS, however, I find the biggest predator in the family-owned business is sometimes within the family itself. Without a properly drawn estate plan, it is not uncommon for the least deserving family members to make the biggest claims on the business booty. Chaos will reign in the family business until a judge sorts it out. The owner can avoid this calamity by establishing, during lifetime, the post-death business transfer process in a bullet proof, funded estate plan.
Few are fans of the federal estate tax: it’s a tax on previously taxed wealth, it is due nine months after death and it is complex. Still, this tax should not be the sole focus of a business owner’s financial issues at death. Rather, an owner should create an estate plan. A well-designed plan looks at all of the issues that can challenge the successful transfer of wealth, including the estate tax. Instead of focusing on what’s aggravating, it focuses on what’s important.
