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Why Do Estate Exemptions Exist?

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One of the major breakthroughs in the new tax law surrounds the estate and gift tax system. For the first time in over a decade, we have some clarity over what is going to happen with estate tax rates, exemptions and the “portability” of those exemptions, as we outlined here previously.

One of the hot topics of the fiscal cliff debate was the estate exemption level. This amount was scheduled to be reduced to $1 million in 2013, but the new law kept the existing exemption of $5 million on the books permanently moving forward. While these changes directly affect a very small part of the population, the impact will ultimately be far more widespread.

In this article, we will explore why exemptions exist in the first place, and our next post will discuss why the planning implications will filter down to a much larger number of taxpayers than it may appear on the surface.

Estate taxes tend to stir up all kinds of emotions and misconceptions with people. Typical arguments from those with strong feelings fall into two camps: (1) it is an easy, no-brainer way to tax and redistribute wealth, or (2) this money has already been taxes when it was earned, so it shouldn’t be taxed again. People in the latter camp often call for an outright repeal of estate taxes altogether, while those in the former camp can’t quite figure out why any of an estate is exempt from taxation at all!

Regardless of your position on this subject, it is extremely important to recognize that this issue about far more than the redistribution or taxing of accumulated wealth. There is a much bigger and more important issue at stake here – preservation / continuity of small businesses, and in particular, small family businesses.

(To highlight the importance of this, the state of Minnesota created a special $5 million exemption for qualifying family businesses in 2011, compared with the standard exemption of $1 million.)

A small business seeking to remain a small business after the existing owner dies faces major obstacles at low exemption levels. As a simple example to visualize, lets consider the case of a small family business – the family farm.

Take a hypothetical farmer that owns $5 million of cropland and keeps, say, $1 million of cash in the bank…enough to continue to operate the farm through 3-4 bad seasons. He has a son that has been raised on the farm, worked on it his entire life and is the natural successor to take over.

While it may seem like the farmer is quite wealthy on a net worth statement, that value is almost entirely tied-up in the family business. If he and his wife were to die in with no estate exemption and a flat 40% estate tax rate, their $6 million estate would owe $2.4 million in Federal estate taxes, plus an additional sum to the state. Since there is only $1 million of cash available, the son will be forced to sell the property (or a portion of it) to cover the tax liability.

While this is a simplified example, it absolutely reflects the reality of a small business. Regardless of size, most small business owners have the majority of their wealth tied-up in the business. Not only it is reality for a self-employed farmer, but it is reality for a $5 million manufacturing plant that employs 100 people, as well as the small town convenience store that employs 5.

Estate taxes are due nine months after death, so the assets of “illiquid” estates are often forced to be sold quickly at below market values to bigger companies or investment groups with deep pockets. Either way, the employees are the biggest losers, as that local small business rarely remains a local small business after a sale.

Estate tax exemptions exist to protect the continuity of the small businesses that employ the overwhelming majority of American citizens far more than they exist to ensure the wealthy can keep their investment portfolio in-tact. Certainly, folks with large estates benefit from these laws as well, because it is extremely difficult to create different exemptions for different groups of people.

While the new law has provided greater clarity around Federal estate taxes moving forward, it does not address anything at the state level. Some states have retained lower exemption levels (Minnesota is $1 million), while others (ie. Florida) have not had an estate tax for many years as they waited to see what the Federal government was going to do.

In light of the new law being permanent, we will likely see individual states begin to revisit this in the year(s) ahead. A great deal of estate tax planning is likely to shift to the state level moving forward, but the importance of estate planning, in general, remains unchanged. We will discuss this in more detail in the next post.

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