The Hidden Heir

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The Hidden Heir Powered By Docstoc
					      The
  Hidden
     Heir
  How Estate Taxes
Are Swallowing Up
  Family Businesses
     And Farms -
         And How
    We Can Stop It
The
Hidden
Heir
How Estate Taxes
Are Swallowing Up
Family Businesses
And Farms - And
How We Can Stop It




    The Public Policy Institute
     of New York State, Inc.
          Albany, New York
              May 1992
Executive Summary


Overview. The Taxman Is Part Of The Family
    Heavy estate taxes make the government the “hidden heir” to many family businesses
    and farms, While federal estate taxes are a problem for businesses anywhere in the
    country, New York’s state-level estate and gift taxes create a major additional burden
    beyond those found in any other state. That extra burden - with combined top rates
    reaching 76 percent - often forces owners of family businessesand farms to flee New
    York when they retire, taking valuable assets with them.
                                                                                    Page 1

Section 2. The Estate Tax By The Numbers
     More thnn half of the 50 states add nothing to estate tax bills, but simply take some of
     the tax that otherwise would go to the federal government. Among the 22 states that do
     levy estate or inheritance taxes, New York collects more revenue than any other and has
     the highest top rates on bequeststo children. And while the nationwide trend is for states
     to repeal their death taxes, New York instead has been expanding its estate tax.
                                                                                       Page 7

Section 3. Reducing The Burden
     To eliminate such a major competitive problem, NW York must reduce its rates to
     eliminate the 350 percent “bracket creep” that has taken place since existing estate tax
     brackets were created in 1959. The state must also reduce the burden of the stategift tax;
     conform estate tax credits to the federal level; and make technical changes that can ease
     the transfm of family businessesfrom one generation to the next.                 Page 17

Section 4. A New York Family Business Fund
     New York could go beyond simply reducing its disadvantages, and create an actual
     incentive for famify businessesto locate in the Empire State, by establishing a New York
     State Family Business Fund. The fund would loan family businessesand farms money
     to pay federal estate taxes. It would be capitalized with a small share of existing estate
     tax revenue flow - so that revenues from the rich would pay for keeping family
     businesses and their jobs in New York State.                                      Page 24
      Overview


              The Taxman Is
              Part Of The Family
              Let’s say you decided some years back to go into business for yourself.
To work
and die       You opened a convenience store, took over the family farm,     or began
in New York   making high-quality woodwork. Business was good, and           over the
              years you expanded by plowing profits back into operations.    Now the
              company is an important employer in your community,            and has
              significant sales in other areas as well.

              Your son and daughter, who began working in the business when they
              were teenagers, are showing interest in taking over when you retire.
              Now, in advancing middle age, you think more and more about that
              prospect - and how best to arrange things so that the business can
              keep operating, and providing jobs to your family and others, for
              years to come. You finally arrange that long-overdue session with the
              accountant and the lawyer to make plans.

              That’s when it hits you.

              Leaving the business to the next generation is going to cost you-for
              a lot of reasons. One of the biggest problems: your estate tax. Uncle
              Sam will take a major piece of your legacy, with a top federal estate
              tax rate of 55 percent. Then you have to add the bite from New York
              State’s estate and gift tax, which tops out at 21 percent. A tax champ
              in so many other ways, the Empire State leads the nation in the tax
              burden that it imposes through its estate and gift tax.

              After hours of discussion and running the numbers, your accountant
              finally gives you the discouraging bottom line: Your heirs will have to
              sell the business to pay the tax. If you’re going to have any hope of
              preventing that, you’ll have to move out of New York State. Or, like
              some larger corporations, the company may have to be leveraged into
2                                                                 THE    HIDDEN       HEIR



              a debt burden that would severely hamper its growth and employ-
              ment.

              You think about what it would mean to leave the state. By now, your
              company has become not only a major employer, but a top community
              booster in other ways as well. You sponsor the big Fourth of July
              fireworks at the Town Park; you helped pay to restore the Little
              League field after last summer’s bad storm; you match employee
              contributions to local charities. Yet, if you stay in New York, your
              heirs are likely to have to sell to a competitor, who may prefer to close
              your New York operation down. Either way, your home community
              will be the loser.

              There are ways you can lessen the tax bite, of course. But each of those
              avenues has significant limits. And there’s simply no getting around
              the fact that your estate will be subject to taxes that could cripple the
              business or force your family to relinquish ownership.

              But you didn’t build the business by giving way easily to discourage-
              ment. And you wonder what it would take for New York State to
              change - what can be done to reduce the competitive disadvantage
              that New York suffers in relation to other states.


              Fortunately, there are steps New York can take to reduce that
New York      disadvantage. Such steps can play a major part in efforts to keep
a haven for   taxpaying individuals and businesses here. Some reforms can be
family        accomplished with relatively minor changes to the existing tax code.
              For instance, Albany could allow more estates to defer payments over
business?     a number of years, spreading.out the tax burden so that it comes out
              of future profits rather than the company’s existing capital.

              The state could also give strong consideration to reducing the heavy
              estate tax burden, at least where doing so will make it easier for a
              family farm or other business to keep jobs in New York. Ideally, New
              York would join the 20 or so other states that in recent years have
              entirely eliminated their estate taxes except for the amount of tax
              credit that the federal government allows for state death taxes. If that
              is fiscally impossible, New York must, at the very least, substantially
              reduce the estate tax burden on operating businesses. (For details on
              those proposals,~see Section 3.)

              But the    state can go even further, and create an incentive not just for
              existing    family businesses to remain here, but to make New York State
              a family   business haven that will actually attract jobs and investment which
              are now    going elsewhere.

              New York has led the way nationally in developing such creative
              economic development devices as the Urban Development Corp., the
              Job Development Authority, local Industrial Development Agencies
THE     PUBLIC   POLICY     INSTITUTE                                                              3



                          and the New York State Business Development Corp. Using that
                          imaginative approach with regard to estate taxes, this state could now
                          create a New York State Family Business Fund which would help
                          businesses survive the cost of such taxes at the federal level.

                          The proposed Family.Business Fund would provide loans for New
                          York estates to pay part of federal estate tax liability. The loans would
                          be limited to that portion of federal estate tax liability which accrues
                          on an operating business or farm in New York State. Additional
                          qualifying criteria would be designed to assure that loans are granted
                          only in cases where tax liability is a significant share -say, 15 percent
                          or more - of the inherited business value; that the business is main-
                          tained in New York; and so on. (For more details, see Section 4.) While
                          New York’s Constitution includes a provision prohibiting gifts and
                          loans to private corporations, there are a variety of exceptions related
                          to economic development. Maintaining family businesses is important,
                          and the threat to them is real. They should be included among the
                          exceptions.

                          New York has proven it is possible to shape the estate tax in ways that
                          protect vitally important sectors of the economy. Farming businesses
                          can be protected from some of the predations of the estate tax if farm
                          property will continue to be used for farming, rather than being
                          developed for purposes that would bring a higher market value. But
                          those existing protections do not go far enough to keep family farms
                          operating. And they do nothing for non-farming family businesses,
                          which need - and deserve - such protection just as much.


                          In discussing reforms to the estate tax, it is worthwhile to consider the
‘Idle rich’               different ways that the tax affects different kinds of inheritors. This
need not                  report is not intended to seek better treatment for the “idle rich.”
                          While New York’s overall estate tax structure should be reduced
apply
                          because of the “bracket creep” that pushes all taxable estates into ever-
for help                  higher tax brackets, the primary goal of this reform effort must be to
                          address the destructive impact on working, job-providing             family
                          businesses, including family farms. A good case can be made that,
                          rather than encouraging family assets to continue being put to good
                          use, New York’s estate and gift taxes provide a powerful incentive in
                          the opposite direction. (SeeSection 3 jor further discussion.) Reducing the
                          estate tax burden for ongoing family businesses would create an
                          incentive for children of successful entrepreneurs to maintain the
                          business instead of selling it and living thereafter off the proceeds.

                          It’s critical that Albany take action as soon as possible. Otherwise,
                          many family business owners will feel growing pressure to consider
                          moving their assets out of state. As is true of its tax burden overall,
                          the cost that New York State imposes through its estate andgijt taxes
                          is the very highest in the nation. Even more ominous: The disparity
                          between the Empire State and other states is getting worse.
4                                                               THE   HIDDEN       HE1.R




              The overall effect of estate taxes is to make government the “hidden
Most states   heir” to many family businesses and farms. That fact makes it less
don’t even    likely that the true heirs to any such business - the family members
have an       and, more broadly, the employees and others who benefit from the
              business - will be able to depend on its ability to continue operating
estate tax    successfully.

              The problem varies substantially from state to state. More than half of
              the 50 states now have no state-level estate or inheritance tax beyond
              the amount that the federal government allows taxpayers to subtract
              as a credit from their federal estate and gift taxes. Many of these states
              are concentrated in the Sunbelt, to which we are losing businesses and
              residents. And among the 22 states that do impose an estate or
              inheritance tax, New York’s top rate on assets passed to children is the
              highest.

              New York is also one of only six states that impose a gift tax in
              addition to an estate or inheritance tax. The gift tax makes it difficult
              or impossible for a business owner, while still alive, to pass company
              assets to the next generation in the family without incurring substan-
              tial lifetime taxes.

              The 1990s will be a critical decade for determining the future of
              family-owned businesses both in New York and nationwide. Thou-
              sands of entrepreneurs who started their careers in the years after
              World War II are now at retirement age and are ready to pass the
              business along to their children or sell it to others, and enjoy the fruits
              of their decades of labor.

              Yet, unfortunately, New York has increased its estate tax burden in
              recent years, even though the trend nationwide is for many states to
              cut or even entirely repeal estate and gift taxes. The result is clear: New
              York State, which a decade ago imposed estate taxes that were in the
              middle of the pack, now is a national leader. That dubious distinction
              will not make it easier to keep family businesses part of the “Family
              of New York” in the 1990s and beyond.

              Coming changes in the federal estate and gift tax structure will further
              exacerbate New York’s disastrous competitive position. For deaths
              after 1992, the top federal tax rate on estates will drop from 55 to 50
              percent. Thus, state-level estate taxes will loom larger in the total
              estate tax picture. For New York business owners, fhat will be a
              negative picture indeed.
THE   PUBLIC   POLICY     INSTITUTE                                                                    5



                        Why are family businesses important?
Why
family                  First of all, because New York cannot afford to lose any businesses.
businesses              The recession has already drained more than 500,000 jobs from the
                        state - the worst loss in the nation.
matter
                        Family businesses tend to be the small to medium-sized companies
                        that produce most new jobs. So they have a crucial role to play if we
                        are ever to break the downward cycle and begin gaining jobs again.

                        Some observers believe family businesses outperform their competi-
                        tors. And they tend to offer better career opportunities for women
                        than other companies, according to a study performed at the Universi-
                        ty of Pennsylvania’s Wharton School of Economics. In addition, most
                        minority-owned businesses are family businesses. New York State and
                        its local governments operate a variety of programs designed to
                        encourage minority- and women-owned companies. Yet, ironically,
                        New York’s estate tax makes it significantly        more difficult for
                        successful entrepreneurs to pass a business along to their children and
                        keep control in the family.

                        At their best, family businesses provide quality leadership as well as
                        economic growth.

                        “As old as America itself, the family business is being rediscovered as
                        the embodiment of the management practices and business values
                        needed to help the nation’s industries regain their competitive edge,”
                        The Nau York Times reported as part of a series on family businesses.
                        ‘The best family companies have long cared about product quality,
                        treated employees with respect and focused on more lasting concerns
                        than the next quarter’s results.“’


                        David E. Harden, chairman of the board of Harden Furniture Co.,
Words from              spoke eloquently of the importance of family businesses during the
one leading             12th Annual Meeting of The Business Council of New York State Inc.,
family                  at which he was presented The Business Council’s Coming Award for
                        Excellence. Harden Furniture is a family-owned business, based in
businessman             McConnellsville, which has a well-deserved reputation for producing
                        some of the nation’s finest traditional furniture for living grooms,
                        dining rooms and bedrooms. The company heritage extends back more
                        than 125 years.

                        Unfortunately,   New York has too few companies lie Harden
                        Furniture. All too often, family businesses fail to last beyond the first
                        or second generation. Normal business problems and internal family


                            ’ “Renewing Traditional Values,” The New York Times, June 10, 1986; reprinted
                        with permission in Family BusinessSourcebook, edited by Craig E. Aronoff and John
                        L. Ward, Omnigraphics Inc., Detroit; 1991.
6                                                              T-HE HIDDEN       HEIR



               pressures are part of the reason. But the estate tax burden is often the
               real killer.

               “Business and manufacturing of every shape and size are vital to New
               York State,” Harden said in accepting the prestigious award. “If big
               business provides the research and muscle to compete in world
               markets, and small business is an engine of growth, family businesses
               are an element of stability in a turbulent world.

               “Family businesses and the communities in which they exist are
               usually tied together in a social and economic compact which benefits
               both,” he continued. “Because of these deep community ties, family
               businesses are not apt to move at the promise of a more favorable
               business environment elsewhere.


               “The family business is not without predators, however. And perhaps
Estate tax     the most obvious of these is the estate tax, which can effectively
a ‘predator’   remove us from the scene no matter how successful we may be.
to family      Ironically, the more successful the business, the greater the problem
               becomes, and the more likely a forced sale will occur, with the ex-
businesses     owners leaving New York with all of the resources and talent we so
               badly need. If we are worth saving, and I like to think we are, we
               need a real awareness of this threat to our existence. For New York
               State inheritance taxes are the highest in the nation.

               “While this may sound like just another appeal for our own special
               interest, it is really an appeal for New York State’s help in keeping us
               around. Keeping us around to compete, to employ, to contribute, and
               certainly to pay our fair share of taxes, for the family business,
               perhaps above all, has a huge investment in preserving New York as
               the Empire State.”

               So, too, does the Empire State have a huge investment in preserving
               the family business.
       Section 2


               The Estate Tax
               By The Numbers
The unseen     George Shattuck and Gary Germain describe the government as a
               "senior partner" in any successful family business.
`partner' in
family         Shattuck and Germain, partners in the Syracuse-based law firm of
               Bond, Schoeneck & King and two leading experts in estate planning,
businesses     present clients with a mock "partnership" agreement to make their
               point. Clients agree to give the "senior partner" — the government —
               any share of the profits it desires. The "partnership agreement" does
               not require a signature from the entrepreneurs who are the junior
               partners; it is not voluntary.

               The attorneys are only half-serious, of course, but their point applies
               at both the federal and state levels. Federal tax law changes to protect
               family businesses from forced divestiture are desperately needed, and
               there are proposals in Washington to make those reforms. Whether the
               federal estate tax system is changed or remains the same, however, it
               will always fall equally on business owners in all the 50 states. State-
               level estate and inheritance taxes, obviously, are another matter.

               And New York State is the national leader when it comes to taxing
               estates and inheritances.

               Under both federal and New York tax laws, assets which pass from
               one person to another are subject to two kinds of tax: gift taxes, and
               estate taxes. Gift taxes are levied on the donor, while he or she is
               alive, on transfers above $10,000 to any individual donee, in any single
               year. In other words, a donor can give assets worth $10,000 ($20,000
               for married couples), without paying tax on the transfer. Such gifts can
               go to as many recipients as the donor desires, for as many years as
               desired, without incurring tax liability. In practice, of course, all
               taxpayers have a limited number of recipients to whom they wish to
6                                                              THE HIDDEN HEIR



               pressures are part of the reason. But the estate tax burden is often the
               real killer.

               "Business and manufacturing of every shape and size are vital to New
               York State," Harden said in accepting the prestigious award. "If big
               business provides the research and muscle to compete in world
               markets, and small business is an engine of growth, family businesses
               are an element of stability in a turbulent world.

               "Family businesses and the communities in which they exist are
               usually tied together in a social and economic compact which benefits
               both," he continued. "Because of these deep community ties, family
               businesses are not apt to move at the promise of a more favorable
               business environment elsewhere.



Estate tax     "The family business is not without predators, however. And perhaps
               the most obvious of these is the estate tax, which can effectively
a `predator'   remove us from the scene no matter how successful we may be.
to family      Ironically, the more successful the business, the greater the problem
               becomes, and the more likely a forced sale will occur, with the ex-
businesses     owners leaving New York with all of the resources and talent we so
               badly need. If we are worth saving, and I like to think we are, we
               need a real awareness of this threat to our existence. For New York
               State inheritance taxes are the highest in the nation.

               "While this may sound like just another appeal for our own special
               interest, it is really an appeal for New York State's help in keeping us
               around. Keeping us around to compete, to employ, to contribute, and
               certainly to pay our fair share of taxes, for the family business,
               perhaps above all, has a huge investment in preserving New York as
               the Empire State."

               So, too, does the Empire State have a huge investment in preserving
               the family business.
8                                                                           THE HIDDEN HEIR



                make such donations. And in the case of a family business, the list is
                likely to be no longer than the number of children in the family. The
                benefit of the gift tax, for purposes of preserving a family business, is
                further limited by the number of years in which a business is
                successful enough for its owners to take out substantial assets.

                Estate taxes are applied against the entire taxable estate after the
                death of the donor. (The taxable estate is the gross estate less adminis-
                trative expenses; bequests to a spouse, which are fully tax-exempt
                under both federal and New York State law; debts; charitable
                contributions; and funeral expenses.) Gift taxes paid during the
                donor's lifetime are credited dollar for dollar (for gifts made after
                December 31, 1982; different rules apply for gifts made previously)
                against estate taxes due at time of death.'

                Unlike New York and the federal government, many states impose a
                tax on bequests through means of an inheritance tax. Such a tax is
                applied not on the estate itself, but on the inheritance that individual
                heirs receive from the estate. One primary distinction which results is
                that inheritance taxes can be applied at different rates depending on
                the inheritor's relationship to the deceased. In Delaware, for example,
                on inheritances of $100,000 each, a spouse pays 2 percent; a child, 4
                percent; other relatives, 7 percent; and other inheritors, 14 percent.


Most states     Finally, 28 states — more than half — have no state-level estate tax at
                all, beyond the "pick-up" of the tax credit which the federal govern-
add nothing     ment allows for state estate and gift taxes. Through the pick-up tax,
to the tax on   states "pick up" a portion of the estate tax revenues that otherwise
                would go to the federal government, without increasing the estate's or
an estate       the heirs' total tax liability. Put another way, the tax is equal to the
                maximum credit allowed for state death taxes under federal estate tax
                laws.

                Even when used without additional state-level death taxes, the pick-up
                tax allows states to collect a significant share of an estate's value. On
                an adjusted taxable estate of $500,000, for instance, federal law allows
                states to claim more than $12,000 in tax revenue that would otherwise
                go to Washington, while the federal government itself takes an
                additional $155,800. That's a combined effective tax rate of more than
                33 percent — applied against assets purchased with income that was
                already taxed during the owner's lifetime. And while that size estate
                might well be found in many middle-class to upper-middle-class
                families, the rates go far higher as wealth increases. The top federal
                rate is 55 percent, applied to estates of $3 million or more. At that
                level, New York's top rate is 12 percent, for a combined rate that


                   2
                     Description is based on that found in Advisory Commission on Intergovern-
                mental Relations, Significant Features of Fiscal Federalism, Vol. 1: Budget Processes and
                Tax Systems, February 1992.
THE PUBLIC POLICY INSTITUTE                                                               9


                reaches a confiscatory 67 percent. Even allowing for the federal credit,
                the top combined rate amounts to about 60 percent. And New York's
                rates go even higher, up to 21 percent, for the truly well-off who leave
                estates of $10.1 million or more.

                The pick-up tax is so fruitful that, in 1990, it produced $386 million for
                California and $251 million for Florida — without increasing the tax
                paid by residents of those states. (Florida, of course, is the most
                commonly cited tax haven for retiring New Yorkers. In other words,
                New York's high estate taxes are helping increase tax revenue in
                Florida.) New York's estate and gift tax collections that year were $525
                million.

                New York allows a unified credit against estate and gift taxes which
                effectively exempts the first $108,333 of estate or gift assets transferred
                to family members or other recipients. The comparable federal credit
                exempts the first $600,000.



We're No. 1     Among the 22 states that impose an additional, state-level estate or
                inheritance tax, New York's rates create the heaviest estate tax burden
in taxing       in the country. New York's top rate is 21 percent, while the median
family          among all states that do impose such a tax is around 16 percent. And

bequests        the few states that have a top overall rate higher than New York's
                have significantly lower rates for bequests to lineal descendants —
                meaning that a successful business owner who wants to pass the
                company on to the next generation will pay a higher rate in New York
                than in any other state. (See table, next page.)

                New York has another distinction: As the table on page 11 shows, it
                is one of only six states that impose a gift tax. Such taxes are levied on
                transfers of assets during one's lifetime. In those other states, foresight-
                ed business owners who want to leave the company to sons and
                daughters can do so by transferring ownership while they are still
                living. Not in New York, though — at least not without incurring a
                substantial tax bite. Collections from the state gift tax, which was
                adopted in 1982, amounted to $89 million in 1991-92.



The Rule of     Economists increasingly agree with something business people have
                been saying for years — that high taxes in a given state are likely to
Sore Thumb      hamper economic growth. Even more ominously for New York, expert
                opinion is also reaching consensus on what might be called the "Rule
                of Sore Thumb" — that is, if you stick out like one with regard to
                taxes, you're in trouble. Michael Wasylenko of Syracuse University has
                written: "States whose taxation levels are very much out of line with
                those in their neighboring states will have lower employment growth.
10                                                         THE HIDDEN HEIR




                          Top Estate/Inheritance Tax Rates
                        (Ranked by top rate on lineal descendants)


                                          Top rate on
                                          bequests to              Top rate on
       State                          lineal descendants          other bequests

       NEW YORK                                   21.0%                    21.0%

       Mississippi                                18.5%                    16.0%

       Massachusetts                              16.0%                    16.0%

       Indiana                                    15.0%                    20.0%

       New Hampshire                              15.0%                    15.0%

       North Carolina                             12.0%                    17.0%

       Kentucky                                   10.0%                    16.0%

       Michigan                                   10.0%                    17.0%

       Oklahoma                                   10.0%                    15.0%

       Tennessee                                   9.5%                     9.5%

       Connecticut                                 8.0%                    14.0%

       Iowa                                        8.0%                    15.0%

       Montana                                     8.0%                    32.0%

       South Dakota                                7.5%                    30.0%

       Ohio                                        7.0%                     7.0%

       Delaware                                    6.0%                    16.0%

       Pennsylvania                                6.0%                    15.0%

       Kansas                                      5.0%                    15.0%

       Louisiana                                   3.0%                    10.0%

       Maryland                                    1.0%                    10.0%

       Nebraska                                    1.0%                    18.0%

       New Jersey '                                0.0%                    16.0%

     The following states have no estate or inheritance tax, beyond the federal "pick-
     up tax": Alabama, Alaska, Arizona, Arkansas, California, Colorado, Florida,
     Georgia, Hawaii, Idaho, Illinois, Maine, Minnesota, Missouri, Nevada, New
     Mexico, North Dakota, Oregon, Rhode Island, South Carolina, Texas, Utah,
     Vermont, Virginia, Washington, West Virginia, Wisconsin, Wyoming.

     Source: Significant Features of Fiscal Federalism, Volume 1, Budget Processes
     and Tax Systems, 1992, Advisory Commission on Intergovernmental Relations,
     Washington, D.C., February 1992.



         New Jersey exempts parents, grandparents, children, children's descendants.