Tax Talk—July/August 2003

July/August 2003

Estate taxes have often been described as the one tax no one has to pay but everyone should plan for. Estate taxes are a tax on the assets left by an individual that must be paid after the person’s death before ownership passes to his or her heirs. The goal is to ensure that the assets end up in the heirs’ hands with the smallest tax bite legally possible.

First some definitions: Estate taxes are based on all property transferred at death. Gift taxes are based on all property transferred during life. These two taxes, along with a generation-skipping transfer (GST) tax—which is designed to ensure that property doesn’t skip a generation without being taxed—form the so-called unified transfer tax system. Thus, a “unified” tax is imposed on the total value of an individual’s estate as well as gifts made by the person (above a specified amount) during his or her life. 

To further complicate matters, legislation enacted in 2001 repealed the estate and GST taxes but not the gift taxes, at least for those who die after Dec. 31, 2009.

Thanks to a quirk in our lawmaking process, however, that 2001 repeal will itself be repealed automatically at the end of 2010 under a unique sunshine provision. In other words, unless our lawmakers succeed between now and then in making the repeal permanent, the estate and GST tax situation will return to square one after 2010. Even if the permanent repeal of estate taxes passed by the House this June becomes law, the estate tax rates will continue to fall.

Reviewing the Rules

To manage these legal changes and uncertainties as well as to minimize estate taxes, scrap recyclers should engage in prudent estate planning now. As even the courts have said, ignorance is no excuse for failing to plan to reduce the bite of estate taxes, so here’s some tax background to help your planning efforts.

The estate and gift taxes currently share a unified progressive rate as well as a unique “credit” that shelters a total of $1 million from the estate and gift taxes for decedents dying and gifts made in 2002 and 2003. The applicable exclusion amount for estate (but not gift) tax purposes will be gradually increased to $3.5 million by 2009.

The amount of a deceased scrap professional’s estate that may be excluded from taxes was raised while the top estate tax rates are gradually being lowered over the next several years. For example, the applicable exclusion amount in effect for the years leading up to repeal is $1.5 million in 2004 and 2005; $2 million in 2006, 2007, and 2008; and $3.5 million in 2009.

Meanwhile, the surtax on estates valued at more than $10 million has been eliminated, and the highest estate tax rate was decreased to 50 percent in 2002 (from the old 55-percent rate). That top rate continues to decrease to 45 percent in 2007 through 2009. The generation-skipping tax will also be repealed in 2010. Currently, a transfer tax with a flat rate of 55 percent is imposed on cumulative transfers of over $1 million to so-called “skip persons” (such as grandchildren) during a donor’s lifetime.

Also important to many small business owners are provisions that expand the availability of the installment payment provisions to estates that include holding companies for closely held businesses. Establishing a holding company for a family-owned business or, in a few situations, even a professional practice has traditionally been an effective way for a founder to transfer his or her business over several years to his or her heirs while avoiding the gift tax.

However, if a sizable portion of the holding company hasn’t been transferred before the founder’s death, the heirs historically have had to pay a significant lump-sum estate tax on the portion of the holding company’s assets still remaining in the estate. Under the current rules, they will be able to make installment payments on the taxes owed.

Stumbling Over Step-Ups

Even if a scrap professional expects the value of his or her estate to be less than the exemption amount under the unified credit (which, in effect, exempts up to $1 million from estate and gift taxes) in all years between now and 2009, the scrap professional’s heirs can still take advantage of something called the “basis step-up” rule. Under this rule, any property received from a decedent is valued at its fair market value (FMV) on the date of death of the decedent. Thus, the value of inherited property is “stepped-up” from the basis or book value at which the decedent held it to its FMV. 

The stepped-up basis rules are generally repealed for estates of decedents who die after Dec. 31, 2009, though there are exceptions. This means that, in general, heirs will now benefit from assets with a book value or basis that’s been increased or stepped-up to the property’s FMV on the decedent’s date of death. A lower basis or value on inherited assets, for instance, means a higher tax bill when they eventually sell those inherited assets. Conversely, a higher value on an estate’s assets means higher estate taxes and less to pass on to heirs.

After 2009, the executor of an estate can, in some cases, step up or increase the basis of assets by as much as $1.3 million ($4.3 million in the case of assets passed to a surviving spouse). In most cases, however, the value of those assets passed to heirs will be the same as when in the hands of the decedent. Thus, the heirs will eventually bear the tax bill for appreciated gain thanks to the lower value at which they received the assets or property.

All in the Family

The tax laws currently contain a provision designed specifically to reduce the tax burden of the estates of small business owners.

Beginning in 2004, though, this controversial provision—the qualified family-owned business (QFOB) deduction—will be phased out. In fact, it has been repealed for the estates of those dying after Dec. 31, 2003.

Established in 1997, the QFOB deduction was criticized as being overly complicated and not very helpful to the estates of the small family business owners and professionals it was designed to help.

For a short time, the tax rules contained a highly touted exclusion for part of the value of a person’s interest in one or more family businesses. This amounted to a $675,000 federal estate tax exclusion for eligible estates that were composed of or that contained family-owned business interests.

To qualify for this exclusion, the family-owned business had to meet complex requirements laid down by our lawmakers. When the amount of estate value offset by the unified gift and estate tax credit is combined with the allowable portion of the family-owned business exclusion, the benefit should always equal $1.3 million—regardless of how it is divided.

But remember: Though the law and all of the accompanying hoopla speak in terms of a total $1.3-million exclusion, that isn’t what the law actually provides. The new exclusion is, after all, an exclusion, not a credit. 

As a result, like other tax credits, the new exclusion would come off the top of a scrap professional’s taxable estate and would never exceed $675,000. The unified credit, on the other hand, comes off the bottom and is slated to increase to $1 million by 2006.

Get ’Em Quick Before They’re Gone

Any scrap professional—or his or her business—that waits too long to undertake estate planning may miss out on the repeal altogether.

As mentioned, that 2001 law has a built-in sunset provision that means, without intervention by Congress, the tax law will automatically revert back to the old 2001 version beginning in 2011. And, remember, the last time Congress passed a major tax-break package in 1997, it drastically changed or eliminated those breaks in the 2001 tax bill.

The current situation—in which Congress is talking about escalating the 2001 changes and making the repeal of the estate tax permanent—are good examples of how lawmakers can change their minds.

In the end, everyone is free to will their property as they see fit and free to choose whether to take advantage of provisions that can reduce the bite of estate taxes. Business owners with a significant amount of appreciated property—be it land, investments, or a scrap recycling business—should think about estate tax planning, however. And if possible, try to take advantage of these changes because they may not be available down the road. • 

—Mark E. Battersby, an Ardmore, Pa.-based freelance writer, columnist, author, and lecturer specializing in tax- and finance-related topics.

Estate taxes have often been described as the one tax no one has to pay but everyone should plan for. Estate taxes are a tax on the assets left by an individual that must be paid after the person’s death before ownership passes to his or her heirs.