After William Applegate died about five years ago, the Internal Revenue Service presented his son, Michael, with a large inheritance tax bill that he couldn’t pay. The younger Applegate, who had already been running Sacramento, Calif.-based Applegate Drayage for some time, depleted cash reserves and diverted money he had planned to use for expansion to tax payments, but it wasn’t nearly enough.
Today, Applegate says he still owes the Internal Revenue Service about $1 million on the tax bill, which he is paying off over 10 years. He considers the estate tax not only unfair but also shortsighted. The expansion that the tax forestalled, he says, would have meant more trucks and more drivers, which would have increased company revenues and payroll and, therefore, meant more money for the IRS.
Without his father’s estate planning, Applegate’s story might have been worse. Applegate says his father did everything right, such as putting his assets in a trust and gifting the maximum amount each year. “The federal government still came in and took half the business,” he says.
Even with careful estate planning, the financial nature of most trucking companies – lots of money tied up in equipment, real estate and receivables and very little cash in reserves – can make it difficult to transfer businesses without liquidating assets or foregoing investment. It was the effect on small, family-owned trucking companies that led the American Trucking Associations to make repeal of the “death tax” a high priority.
Just over a month ago, Congress came through – sort of. The $1.35 trillion tax cut package includes reductions in the estate and gift taxes through 2009 and a full repeal in 2010. Due to the asset-intensive nature of trucking, the so-called “death tax” has been a big issue for many company owners and has been a target of the American Trucking Associations.
ATA hailed the action. “We have now taken another step toward assuring that these made-in-America businesses, which make up the majority of the U.S. trucking industry, will be able to stay in business and continue to serve their communities and create jobs,” said then-President Walter McCormick.
But like much else that occurs in Washington, the repeal of the death tax isn’t so simple. Although the federal estate tax dies at the end of 2009, it will rise from the dead a year later unless Congress takes steps to make sure it stays dead. A “sunset” provision in the new tax law will erase all the law’s changes on Jan. 1, 2011. In the absence of any further legislation, the tax laws in effect in May 2001 – including the estate tax – will return.
The sunset of the death tax repeal means that any estate holder who thinks he might live beyond 2010 must continue to plan for transfer of his estate as if nothing has changed. The political environment is dicey, and there’s no guarantee that a future Congress or White House will extend the repeal.
Under the old law, estates were subject to a federal estate tax of up to 55 percent. Estate owners could, in 2001, shield the first $675,000 of their estates from the tax. Moreover, by employing living trusts, couples could take advantage of both spouses’ exemptions. By 2006, the exemption would have risen to $1 million under the old law.
Under the new tax law, the amount exempted from estate taxes rises to $1 million in 2002, and the highest tax rate is capped at 50 percent. The exemption grows to $1.5 million in 2004, to $2 million in 2006 and to $3.5 million in 2009. At the same time, the top tax rate drops 1 percentage point a year until it reaches 45 percent in 2007. Beginning in 2010, the estate tax goes away altogether.
There is a tradeoff for the repeal, however. Under the old law, an heir received his inheritance on a fair market value, or stepped-up, basis. That meant that if an heir sold an asset soon after inheriting it, he would pay no capital gains tax. Had the original owner sold the asset just before he died, however, he would have paid a capital gains tax based on the increased value since the date he acquired it. The fair market value basis, therefore, helps avoid double taxation and soften the blow of the estate tax for heirs.
But with the estate tax gone in 2010, legislators decided that a fully stepped-up basis no longer is appropriate. So the new law carries over the estate owner’s basis in the property, although it provides for an exemption of $1.3 million for property passing to a non-spouse beneficiary and $4.3 million for property passing to the surviving spouse.
Even with the exemption, an heir selling a highly appreciated asset that had been held for a long time might incur capital gains taxes as large as the federal estate tax would have been, says Paul Honeycutt, a principal of La Jolla, Calif.-based financial consulting firm Honeycutt-Smith and Associates. Such treatment will be a nightmare to administer, Honeycutt says, noting that Congress tried it once before and repealed it as unworkable.
Overriding all the changes, however, is the sunset provision. The estate tax repeal itself is drafted as if the repeal is permanent. The sunset provision applies to the entire tax cut legislation. According to the report drafted by the tax bill’s negotiators, the sunset was necessary so that the legislation would comply in the Senate with what’s called “the Byrd rule” – a package of budgetary restrictions adopted in 1990.
One of the requirements of the Byrd rule is that a budget reconciliation measure can’t raise the deficit for a fiscal year beyond those covered by the legislation. For a tax increase, this is no problem. But a tax cut, by definition, raises deficits. So in the Senate, legislators were forced to put a termination date on all the changes made by the tax law. Without the sunset, supporters of the tax cut legislation would have needed more votes – votes they didn’t have – so they could waive the rules.
The sunset creates an odd situation. The death tax doesn’t go away completely until 2010, and then it reappears in 2011. An estate transferred in 2010, therefore, might fare far better in 2010 than in either 2009 or 2011. For most heirs, the change from 2009 to 2010 is negligible because the $3.5 million exemption is tantamount to a repeal for many, if not most, estates. Regardless, the clock is ticking. Estates not transferred by Jan. 1, 2011, are at risk of incurring the old estate tax.
Although Congress may feel pressure by 2010 to renew tax cuts enacted this year, the state of the U.S. budget and programs like Social Security and Medicare could be bigger issues for legislators and voters by then. Or legislators may have other tax priorities than helping one in every 450 voters, notes Ron Smith, a principal of Honeycutt-Smith & Associates. In addition, potential political changes make the future of the estate tax repeal and other tax cuts uncertain.
Indeed, control of the Senate has changed hands since Congress passed the tax cut, and business groups don’t expect much favorable tax legislation enacted. Democratic control of the Senate has disrupted the Republican strategy of passing an individual tax cut first and a corporate tax cut later.
“We don’t expect there would be any movement in business taxes throughout the 107th Congress,” says Rich Curtis, executive director of ATA’s National Accounting & Finance Council. Not only is a further repeal doubtful, but ATA doesn’t hold out much hope for some of its other tax priorities, such as accelerated meals deduction and a reduction in the federal sales tax on new trucks.
Staying the course
Curtis sees some minimal relief from the repeal on a gradual basis, but the legislation also has made estate planning more challenging. “[The law] is kind of a boondoggle for CPAs and lawyers,” Curtis says. “It has become a lot more complex.”
An estate owner has two choices: count on Congress to extend the repeal or continue with estate planning as if nothing had changed. That choice is a no-brainer, says Smith.
“It’s more important than ever under the new law to make sure you have the proper type of shelter, like the living trust,” says Honeycutt. He points to the “stair-stepping” increases in the exemption from $1 million next year to $3.5 million in 2009. (See table on page 37.)
Although the increased exemptions would become moot in 2010 when the repeal takes effect – and again a year later when the old law is resurrected – heirs could benefit greatly over the next eight years, Smith says. A living trust avoids probate and preserves the exemption of the first spouse to die – an exemption that otherwise goes wasted under a simple will.
There’s a lot more reason now than ever to do some planning,” Smith says. If an estate holder dies between now and 2010 without following through on estate planning, he probably is leaving significantly more for the federal government than he needs to. And, of course, no one can know for sure that he will live to 2010. Honeycutt and Smith point to actuarial tables that show the odds of a 55-year-old dying within 10 years are one in six. For a 65-year-old it’s one in three.
The importance of cash
In preparing his own estate for the next generation, Michael Applegate has learned one simple but important lesson. If the value of your estate greatly exceeds the allowable exemptions, the only way to avoid the disruptions of the estate tax is to ensure that the estate has cash to cover the tax bill.
“The biggest issue for me has been life insurance,” Applegate says. “You have to buy life insurance to cover the death tax.” It’s not cheap, he says. Every $1 million in life insurance, Applegate says, costs $10,000 to $12,000 in premiums a year. “Life insurance is the only thing you can do. At this point in my life, cash isn’t an option.”
Sharon Koch, owner of K&J Trucking in North Sioux Falls, S.D., has set up an insurance trust so her heirs won’t be burdened with finding the money to pay the tax. “Of course, this significantly reduces the amount of money I can leave them.”
The need for cash is one reason why gifting is so crucial. You can give up to $10,000 a year to others without incurring a gift tax. By gifting the maximum to the eventual heirs of your estate, you lower the value of your estate and provide heirs cash they could save now to help pay estate taxes later.
Settling it for good
Vern Garner, owner of Garner Transportation Group in Findlay, Ohio, is just ready for some stability in the law. Like Koch, Garner was one of five trucking company owners who met in March with President Bush and others at White House to rally support for the death tax repeal.
Garner and his wife, Jean, have worked with their attorney, accountant and insurance representative for years, changing their plan as tax laws changed to set up limited liability companies, family limited partnerships and conducting a costly valuation of the business.
Although some of the work, such as succession planning, was necessary anyway “it really puts us on edge when we think we’re prepared – hope we’re prepared – but are always waiting for another shoe to drop,” Garner says. “It takes so much time, energy and money to make these changes – all to protect what we’ve worked so hard to build over the past 41 years.”
Don’t count on stability, however. Smith of Honeycutt-Smith & Associates sees numerous complications, including the fact that states will lose out on their piece of the federal estate tax. In response, states might adopt their own inheritance taxes. And doing away with the fair market value basis may again prove unworkable.
All in all, Smith finds that the new law has muddied estate planning rather than clarified it. “We see it as one of the biggest messes created by Congress.”
ATA’s Curtis is hopeful that Congress will settle the issue, but he has some simple advice. “If you are going to die, wait until 2009 – and then you’ve got a year to do it.”
· You can get a summary of the new tax law at this site.
· For basic information on estate planning options, check out the top 10 estate planning techniques as selected by the American Academy of Estate Planning Attorneys (www.estateplanforyou.com/top_ten.asp).
· For more estate planning information, visit the National Association of Financial and Estate Planning website
Deciding what to do
Many estate planning strategies work only if coordinated with succession planning. One of the major reasons business owners put off estate planning is that they haven’t decided what to do with the business. In a recent survey of Commercial Carrier Journal readers, about 43 percent said they haven’t decided what they ultimately will do with their trucking companies. Indeed, another 13 percent apparently plan to own their companies forever, saying they don’t intend to retire.
Even if a trucking company has decided to keep the business within the family, he may be unable or unwilling to name a successor. Many business owners think estate and succession planning will diminish their control and authority, says Mike Cohn, managing director for succession planning at CFG Business Solutions LLC in Phoenix. In many cases, the roots of procrastination are even deeper: Business owners simply don’t want to contemplate their own deaths.
Trucking company owners are no different, according to the responses of a survey conducted at a recently “Next Generation” workshop by the Truckload Carriers Association’s Truckload Academy. Trucking company owners – as well as their likely family successors – were asked why family firms fail to transfer the business from one generation to the next.
Among the responses from trucking company owners were:
· Reluctance to let go of power and control
· Fear of death
· Personal loss of identity
· Fear of losing activity provided by work
· Easier not to deal with the issue
· Hard to determine stock and payment issues
· Unsure of role – mentor or dictator.
Surprisingly, the next generation responses showed many understood forces like fear of death, fear of losing control and avoiding the issue because it’s easier than dealing with it. Others were less understanding; “dad is stubborn” was one response.
In the end, the next generation needs both financial capital through estate preservation and human capital through training and experience. An estate plan without a succession plan, and vice versa, leaves the next generation with an incomplete solution.