So you want to plan for retirement, including what do to with your estate in the event of your death or a business transition. Good luck.
The 2010 mid-term elections are in mid swing, so nothing is likely to happen until the lame duck session of Congress that ensues. Even then, if Congress does not act to establish new personal exemption and tax rates by the end of the year, the law will revert back to the 2001 exemption of $1 million and the top tax rate of 55%.
At the moment, that looks like where the smart money is. “Congress has really done estate and succession planners a disservice by not addressing this,” said Daniel B. Purtell, an attorney with the Wilson Law Group.
While the current 0% estate tax rate was too good to last forever, some tax planners thought at this time last year that Congress would at least act to extend the 2009 law, which established an exemption on the $3.5 million of an estate’s value, and a top rate of 45%. When nothing was done and the rate was allowed to go to zero, nobody was more surprised than the accountants, attorneys, and business consultants who help business owners with succession planning.
“If you would have asked most prognosticators going back toward the end of 2009, I think everyone was convinced that we would end up with a hybrid, or $3.5 million would be made permanent or at least permanent until it was changed again,” Purtell recalled. “There was discussion of $5 million or even down to $2 million.”
Those discussions continue, although that’s no guarantee they will amount to anything. One rumor has the Obama administration and members of the House of Representatives crafting a bill that would restore the 2009 exemption and rates, while another rumor has them making it retroactive to the start of 2010. That latter approach would invite a host of legal challenges, no doubt including the family of the late New York Yankees owner George Steinbrenner.
With the rate set at 0%, Steinbrenner’s “timely” death earlier this year means upwards of $400 million or more in savings that could be applied to baseball free agents. [With our luck, it’s enough to pay Prince Fielder the $200+ million he wants — just to be a designated hitter!]
On the subject of retroactivity, Purtell has his doubts. “I don’t know that Congress or the President wants to open that can of worms,” he said. “I think families would be willing to spend a lot on attorneys fees fighting that in court just because of the potential exposure.”
More exposure is just what small business owners and family farms are facing if the exemption goes back to $1 million. “When we’re talking with clients, that’s what we have to talk to them about,” Purtell noted. “I feel somewhat awkward about it because it is a scary concept.”
Very scary for younger families under one tragic scenario: the husband and wife both in their 30s, with young children, each having planned well enough to have a half million dollars or more each in life insurance. In the event of a tragic turn, anything above that $1 million would be taxed at 55%.
It’s also scary for a farm family that doesn’t consider themselves particularly wealthy. If you take their inventory, receivables, and the real estate, and factor in the way it’s being taxed in terms of the assessed value, “they are going to get hammered even with real estate values leveling off,” Purtell stated.
“The problem the business owner and the farmer would have is they likely don’t have a lot of liquidity, and all of the sudden if you have $3 million in real estate and you haven’t done some planning, you’re going to have to come up with about $1 million of tax [in nine months] to pay that estate tax under a 55% tax rate.”
That’s precisely why farm bureaus, the Small Business Administration, and others have been lobbying hard to avoid going back to the $1 million exemption.
Obviously, business owners would rather have the larger exemption before taxes kick in, but they would also like some level of certainty. But if a higher exemption is considered, it’s not likely to happen until well into next year, especially given the level of Congressional turnover expected this fall.
Democrats could act immediately with the majorities they now have, but Purtell said a more likely scenario is as follows: nothing gets done before Jan. 1, a bunch of new House members and Senators take their oaths of office in January, but since they need time to put their staffs together, we might not see action on the estate tax until the middle of 2011.
“I don’t think the estate tax will be dealt with alone,” he added. “It will be in an overall tax bill that they are talking about as the Bush tax cuts lapse.”
In some ways, Purtell noted, estate taxes are optional. If you don’t plan, you likely pay the bulk of what is owned. If you plan and review your plan every year or two to adjust for tax law changes — estate tax, capital gains, and income taxes — you can minimize the impacts.
In Purtell’s view, the best estate planning strategy involves the use of a revocable trust. There are many benefits to a revocable trust, particularly because they are a much more flexible, fluid type of document that can be amended more easily than a will-based estate plan.
Given that millions of Baby Boomers will be retiring over the next 10 years, and a big chunk of those Boomers own businesses, they must start thinking about how they are going to transition their business. “If it’s going to the kids, you want to make the transfer pretty minuscule for purposes of the Internal Revenue Service,” he advised. “You want to make that mountain look like a molehill. So how do we make that transfer happen?
“For purpose of selling a third party, you still want to get that mountain valued, but you want to minimize the taxes as much as possible.”
One way to do that is to maximize personal exemptions for both a husband and wife in a bypass trust, also called a family trust, which effectively doubles the amount exempted from taxes. According to Purtell, families cannot make use of both exemptions by simply saying if the husband dies, everything goes to the wife because with that approach, the husband’s exemption is lost. Under a bypass trust, the surviving spouse is still a beneficiary of estate, but the use of each exemption is allowed.
“So even if we go back to $1 million, you’re protected up to $2 million of assets,” he explained. “In perfect world, if we go back to a $3.5 million per person exemption, that means we’re protecting $7 million.”
Another way to protect your assets is the use of charitable planning tied in with succession planning. That’s not a matter of simply giving assets to charity, but using a charitable remainder trust, an irrevocable trust into which a donor transfers highly appreciated assets such as closely held corporate stock. With a charitable remainder trust, the donor receives an income tax deduction for the gift, the stock is sold by the trust without incurring a capital gain (which will be taxed at a higher rate beginning in 2011), and the owner is paid interest income either for life or some other predetermined period. At the end of this period, the underlying assets pass to the designated charity.
According to Purtell, a charitable giving succession plan is often a good option for the following: business owners who have most of their net worth concentrated in the stock of their company and want to diversify; a family business owner who has widely scattered heirs who would be likely to sell the stock upon inheritance; the family business owner who wants to sell his or her stock with more favorable tax treatment; and stockholders want to use partial redemptions to obtain preferred tax positions.
Not only can business owners use this kind of trust to transfer their business to heirs with minimum income and transfer tax exposure, it can ensure retirement income and create a permanent legacy.
The trick is to start planning, no matter how paralyzing the current uncertainty can be. “The worst possible outlook is that estate planning and succession planning is one-time event, that you just sign a document and it just happens,” Purtell stated. “Well, life changes.”
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