The Legal Intelligencer Blog

Congress Might Vote on Estate Tax, or Might Not

The Democrats are divided into their usual factions, and the Republicans aren’t sure whom they represent.

It’s possible that the House will vote for an extension of the current estate tax rates shortly, but as usual, no one is sure until it actually happens.  The Democratic leadership, and President Obama, would like to extend the current $3.5 million (per person) exemption indefinitely.  Some Democrats want to reduce the exemption, while others want to increase it to $5 million; and others want to do that and index it for inflation (in case we ever have any).

The Republicans are divided. Business owners and their lobbyists like the $5 million exemption, especially with indexing, and the reduction to 35 percent in the flat rate. A $5 million exemption means that a husband and wife could, with some planning, pass $10 million of assets free of tax.  That would eliminate the tax for nearly everyone.  But there are others still holding out for complete repeal of the tax, which benefits the very rich, or a reduction in the rate to 15 percent, which would be far more costly that the Democratic proposal, at a time of exploding deficits.  The Republicans are divided, in a sense, between the Main Street party, representing the owners of small to midsized businesses, and the wealthy contributors for whom a $5 million exemption is pocket change. 

It’s also possible that no change in the law will occur, which means that 2010 will be a year of no estate tax.  This would be a nonsensical and fiscally irresponsible result.  Trust and estate practitioners, who seem to be represented in both parties, would like to see certainty, so that efficient planning could take place.  It certainly won’t happen this year, but a sensible change to the estate and gift tax, one that encourages business growth and the passage of wealth to younger generations, might include the following: 

• An exemption of at least $3.5 million rising fairly soon to $5 million, and indexed to inflation.
• A rate that is settled on, either 35 or 45 percent, or perhaps 35 percent up to $20 million and 45 percent thereafter.
• An expansion of the gift tax exemption from $1 million to the amount of the estate tax exemption, to promote lifetime gifts.
• Portability of the estate tax exemption, so that if one spouse can’t use the full amount, the surviving spouse can use the difference.

Family Business Planning in High Gear

The combination of continued low interest rates, a struggling economy and uncertainty about taxes makes planning important right now.

IRS interest rates used in valuing various kinds of gifting techniques fell again in November, making the use of Grantor Retained Annuity Trusts, for example, more valuable. And compared to the situation a few years ago, they are far more effective. Many commentators suggest that interest rates will begin to rise, and it's difficult to see how they could go any lower. Eventually, we'll return to an interest rate regime that is closer to normal, if we still know what normal is. The hope is that rates don't fly past normal to the levels seen in the late 1970s. But for now, methods of transferring business interests, which are generally done within family units, are more efficient with the current historic low rates.

Valuations of business interests are also low right now. Few businesses have escaped the economic downturn. A valuation done now will certainly emphasize the most recent past, and that will lead to lower valuations. Lower valuations mean that more business interests can be transferred within the constraints of the limits imposed by the federal gift tax. Lower interest rates also lead to lower valuations. Many believe that the recession has ended, and that there is reason for belief that next year will bring a strong recovery. That is, of course, similar to what President Hoover said in 1930, but perhaps history won't repeat. But right now, for most businesses, valuations have probably hit lows that won't be seen again for many years. So healthy businesses suffering a cyclical downturn are ideal candidates for transfers right now.

The bizarre result enacted into the federal estate tax law, repeal for 2010 and then a return of the tax at higher rates and a lower exemption in 2011, is now about six weeks away. No one believed that this taxation scheme made any sense, or that Congress wouldn't fix it long before now. We now hear discussion of a one-year fix in the statute, continuing the 2009 law into 2010. But that needs to happen soon. And, although there have been some general proposals regarding changes in the federal estate, gift and income tax law, we have yet to see anything really concrete from the administration. It might be that change is coming in 2010, but for now we have the existing law, with many good planning techniques, intact. So, for a third reason, balancing the certainty of current law against the uncertain future, now is the time for family business planning. 

Robert H. Louis
Saul Ewing
http://saul.com

What Philadelphia Has Plenty Of

It's family businesses. Actually, it's a worldwide phenomenon.

Throughout the world, family ownership is the predominant form of business operation. This is true in India, Australia, Germany and, of course, in the United States. The Philadelphia area, including New Jersey, Delaware and southeastern Pennsylvania, has many thousands of family-owned businesses. They are the primary engine of business and employment growth in this region.

Family-owned businesses offer many advantages. A business school professor told a client's son who was in one of his classes: "There's nothing like a family business." But there are challenges in family-owned businesses. The ability of a family-owned business to continue for succeeding generations is dependent upon finding the right leadership qualities in the next generation and also navigating family relationships to minimize discord.

There are many areas of family business that benefit from the help of lawyers, as well as accountants, financial advisers and business planning consultants. The services that lawyers offer include business counseling, gift and estate planning, buy-sell agreements, retirement planning and other assistance in helping the older generation feel secure in turning over the business and the younger generation feel confident in taking over.

One organization that helps lawyers and others to understand family business issues and to serve the needs of business owners is the Family Firm Institute. This national and international organization provides books, courses and Web site information to help business advisers throughout the world understand and guide business owners. A group of lawyers, accountants, financial advisers, psychologists and other consultants has decided to establish a chapter of FFI in the Philadelphia area, and FFI has approved the formation of the Mid-Atlantic Chapter. We plan numerous kinds of programs in Pennsylvania, New Jersey and elsewhere in the coming year. If you would like more information about the new chapter of FFI, contact me at rlouis@saul.com.

Let’s Take Grandpa on a Roller Coaster

Some fun, eh, Grandpa? Grandpa?

We are now within a few months of the effective date of perhaps the craziest tax scheme ever passed by Congress (although there are many competitors for that title).  Beginning Jan.1, 2010, there will be no federal estate tax due with respect to decedents dying on or after that date, until the end of the year.  Then, when 2011 arrives, the tax is reinstated, but the exemption falls back to $1 million and the maximum rate rises to 55 percent.  So, under the current tax scheme, people who die next year will, in some sense, be performing a selfless financial act for their families.  Or, as suggested by the title, they might be encouraged.

It sounds funny, but that’s the method of taxation passed by the Congress and signed by the president in 2001.  Everyone assumed that the law would be changed long before 2010, but that date is fast approaching.  All that needs to happen for this bizarre tax situation to come into effect is that the Congress does nothing.  And, as we have seen, that’s one of their specialties.

Numerous proposals have been made to remedy this situation.  Those proposals include: reducing the exemption to $2 million for an indefinite period; increasing the exemption to $5 million; allowing a surviving spouse to use any portion of the exemption not used at the first death; and re-unifying the estate and gift taxes, so that people could give away the full amount of the estate tax exemption during life, rather than being limited to $1 million.  The president has recommended making the $3.5 million exemption and 45 percent rate apply for 2010 and future years.

It’s still very likely that the law will be changed by Dec. 31.  In the meantime, the only sensible planning assumption can be that the tax will remain in effect, and probably with the exemption and rate now in effect.  But, while we’re waiting to see what happens, this is an ideal time to do lifetime planning.  Interest rates used by the IRS in valuing various kinds of transfers remain low, and asset values have also remained at low levels.  For those interested in transferring homes or businesses, this is the time to act.

Robert H. Louis
Saul Ewing
http://saul.com

Criminals I Have Known

Not the high-class kind with a mask and a gun, but the financial type.

Much has been written about the psychology of people like Bernard Madoff, who apparently can invite people to invest with them in the knowledge that their money will eventually disappear. None of my clients dealt with Madoff, but I have met with advisers who, at a later date, were accused of having used client funds for their personal expenses. The two I have in mind presented themselves as intelligent and savvy investment advisers. I'm not sure they intended to convert funds from the outset, but it's alleged that that was their eventual course. Both spoke knowledgeably about the market, in a way that impressed less sophisticated investors, which is just about all of us. This came to mind over the weekend. On a flight from Munich to Philadelphia, I was the third-party beneficiary of a passenger who spent about three hours telling the person next to him that his adviser was the greatest and had exactly predicted the market downturn. (For the record, I have one wealthy client who, on his own, correctly anticipated the market decline and suffered no losses. I'm fairly sure that he finished high school.)

What is the lawyer's role in dealing with investment advisers? It's certainly not to give investment advice to the client, but it's also not to remain silent. I have written before that these uncertain times have led many to consider investing through large organizations, because of their deep pockets and internal protective procedures. Others prefer individual or small firm guidance. In either case, it is the lawyer's task to ensure that all of the necessary paperwork has been completed and copies given to the client. It's important to remind the client to have regular meetings to review investment strategies and results. It's also appropriate, if the adviser is achieving investment results that are significantly better than others are achieving, to ask how this is being done. That is, due diligence. In some cases, it might be advisable to bring in another adviser, just to review what the first one has done. I once suggested this to the board of an industry pension plan, because its adviser had done extremely well with investments no one on the board could understand, and unwitting uncovered a massive fraud and theft by the adviser. So, the lawyer is not an investment adviser, but he or she should be asking the client if steps are being taken to ensure that what is promised or advertised is in fact happening.

This is a little off the point, but my recent travels also took me to Vilnius, the capital of Lithuania, a country where the protection of rights by lawyers was, until recent years, subject to the control of an overbearing Communist regime. I had an opportunity to visit a KGB prison, where I saw cells used for torturing political opponents. The Lithuanians have opened these cells to public view, so that they will not forget the horror of living under a regime that condoned and practiced torture.

Robert H. Louis
Saul Ewing
http://saul.com

‘People Are Funny’

This was a classic TV show in which people did humiliating things for money. Sound familiar?

Sometimes, you can suggest to a client a very sensible course of action in deciding on the future of a family business, but find that the client doesn’t want to do it.  Often, it’s because lawyers are acting in a logical way to think of a solution to a problem, taking into account tax and corporate law.  But the client is thinking in a different way, adding in the cost in personal relationships in doing or not doing something.  The client might agree that the proposal makes sense, but know that members of the family will view it from an emotional viewpoint, with the baggage of family relationships that have developed over many years.  So the lawyer might find that carefully made plans go nowhere, for reasons that aren’t always clear or clearly explained by the client.

A situation of this type was faced by a client a few years ago.  The client had a son and a daughter working in the business.  He had hoped that both of them would be successful in the business, but that didn’t happen.  One child was a hard worker, in at 6 a.m., while the other drifted in at 9:30 a.m.  The right planning technique would have been that the industrious child be recognized as the business successor, but the parent didn’t want to do that.  The client loved and cared for both children and didn’t want to hurt either of them.  The problem this created, obviously, was that the more industrious child began to feel that hard work was not paying off.  It took several years of talking around the point for the client to understand that two paths were necessary.  The children could be treated fairly equally from a financial standpoint, but one would become the business owner, while the other would be guided into another endeavor.  Was this entirely fair?  Perhaps not, but it reached a resolution that allowed a family-owned business to continue on and to prosper, which surely would not have happened if both children had remained in the business.

The psychological aspects of family business planning were brought home in a recent meeting in Philadelphia.  A group of lawyers, bankers, investment advisers, accountants and other professionals is organizing a chapter in this region of the Family Firm Institute, an international organization for family business advisers that sponsors research and study on the issues facing family businesses and how to resolve them.  At the meeting, which featured members of a family who described their history of forming a business, growing it and selling it, there were a large number of psychologists, psychiatrists and family business consultants in attendance.  In discussions at the meeting, they brought home the value of bringing their expertise into the mix of family advisers for the express purpose of helping businesses to run more smoothly and their transition to be accomplished successfully. 

Lawyers often act as counselors to family businesses, stepping a little beyond the task of telling clients the law.  But there are circumstances in which psychological/family issues interfere with carrying out worthwhile planning ideas in ways that go beyond the lawyer’s ability to help.  It’s here that the lawyer might consider bringing in, and sharing the stage with, professionals trained in a different discipline who can help clients reach an understanding of personal and family concerns that interfere with the success of a family business.  In doing so, the lawyer can increase the likelihood that the clients will adopt the lawyer’s planning suggestions and improve the chances of family business success.

Robert H. Louis
Saul Ewing
http://saul.com

In Lieu of a Tax Refund, a Chevy Nova

OK, that's not part of the president's tax proposals, at least not yet.

The Obama administration has released some of its tax proposals and, under the rubric of closing "sort of" loopholes, there is a suggestion that grantor retained annuity trusts, or GRATs, must have a minimum length of 10 years. GRATs of two years' duration had become popular, as a technique that improves on the benefits of long-term GRATs, and commentators had suggested that even greater benefits could be obtained with very short-term GRATs. GRATs are a useful technique for transferring wealth, but some in Washington apparently thought the technique was being pushed beyond its intended level of tax benefit. Similarly, a proposal has been made to limit the kinds of discounts that may be obtained in transfers to family-limited partnerships, or FLPs. FLPs are also a popular transfer technique, and an important part of the value proposition is the reduction in value that results from restrictive provisions in the partnership agreements. Again, it is apparently someone's view that discounts based on provisions of the partnership agreements are not always supported by reality.

These views, of course, were not formulated since Jan. 20. They have been percolating in Washington for years and represent the tension between those who want to push the envelope of tax planning techniques and those who view most tax planning as somehow unfair or undemocratic. When these proposals are taken up in earnest later in the year, there might be additional restrictions placed on planning techniques. In fact, that's just about certain to happen. For now, the proposals being made are stated to become effective on enactment. It is possible for changes to be made retroactive to the beginning of the legislative session but, for now, that's not the stated intent. For that reason, there is now a flurry of planning taking place.

One item that Congress still hasn't taken care of is the federal estate tax or, in PR-speak, the death tax. Under the current law, the exemption from tax is $3.5 million and the tax rate is 45 percent. In 2010, the tax disappears, but for one year only, then comes back in 2011 with a graduated rate up to 55 percent and an exemption reduced to $1 million. The administration has proposed continuing the 45 percent rate and the $3.5 million exemption indefinitely, but attention seems about to turn to the health care reform bill, with the hope that a bill will be passed by Oct. 1. Will this effort, on top of the variety of other issues now before Congress, including one or two wars, a Supreme Court nomination and the financial crisis, give adequate time to amend the estate tax law by the end of the year? As noted above, Congress could make the change next year and have it retroactive to Jan. 1, 2010, but that would only add more uncertainty to what is becoming an uncertain federal tax system.

The next six months are likely to see significant changes in how our clients and we are taxed, as well as how we receive and pay for health care. It's not too early to think about a moon roof with that tax refund.

Robert H. Louis
Saul Ewing
http://saul.com

Congressional Conferees Decide Probable Future of Estate Tax

Although it's not a binding decision, we have a good idea of the legislation that will eventually be passed.  Estates lawyers will live long and prosper.

For the past almost eight years, the federal estate tax has been, to use a technical term, crazy.  The exemption was increased and is now $3.5 million, and the rates were compressed to a flat 45 percent.  But under the current law, the tax is to disappear in 2010, prompting a lot of "let's take grandpa on the roller coaster” jokes.  Then, in 2011, the tax was to come back at the pre-2001 rates and exemption level.  It's difficult to find a tax policy in such a law.  Numerous efforts were made to abolish the tax altogether, mainly for political reasons, but the last significant effort failed just after Hurricane Katrina, when congressional leaders noticed that budget deficits had ballooned and decided that we might need the tax revenues. The change in control of Congress in 2006 and the election of a new president last year takes repeal off the table for a long indefinite future.

But the legislative scheme of 2001 has remained on the books. Now, congressional conferees have agreed on a blueprint of how the estate tax law will be amended. There must still be legislation to carry out the decision, but the substantial Democratic majorities in the House and Senate (the latter recently enhanced) make it likely that such legislation will be passed and signed by the president.

The change will be a simple one -- to extend the 2009 rate and exemption indefinitely. Such a change provides certainty in the tax law, which is a valuable attribute for clients who are doing planning. For example, when the future of the estate (and gift) tax was uncertain, planners were reluctant to suggest to clients that they make gifts that would generate a gift tax liability, postponing planning that could have been beneficial to families in the transmission of wealth.

We won't know the exact terms of the legislation for some time, but there are two aspects of the federal estate tax law that deserve some careful consideration. First, the $3.5 million exemption should be indexed for inflation, assuming we have some in future years. This avoids the necessity of further legislation, with its attendant delays, when higher exemption levels are appropriate. Second, there has been much discussion of portability, which means that if the estate of the first spouse to die can't use the entire exemption amount, the balance can be used by the estate of the second spouse to die. Such a change would simplify planning.

The federal estate tax, in addition to raising needed revenue from those most able to pay, has the effect of promoting careful planning of the passage of wealth through generations, and the claim that it destroys farms and businesses is without a basis in fact. Farms and businesses are lost through poor planning or the absence of planning, and the recent conferees' decision should help promote more and better planning.

Robert H. Louis
Saul Ewing
http://saul.com

Planning for Parents' Expectations or, I Was A Co-Star of Beach Blanket Bingo

I read an obituary for Jody McCrea, son of famed movie star Joel McCrea. How quickly they forget.

As everyone knows, Joel McCrea was a well-known movie star of long ago. His son, Jody, who died recently, had roles in beach movies of the 1960s that starred Philadelphia native Frankie Avalon and Annette Funicello. In later years, he became a cattle rancher in New Mexico. I hope he had a satisfying life and did what he wanted after retiring from the silver screen. There's a lesson here for those who help successful families plan their futures.

The aim of many business owners is that the business will continue after the founder has passed on. Men and women who start businesses and make them a success have characteristics that aid in their work, such as determination to succeed, diligence and a willingness to take intelligent risks. It's not always the case that the children share those characteristics. They may have been sheltered from risk and disappointment in ways their parents were not. That doesn't always mean that the children can't succeed in the business. I can think of many examples where second, third and fourth generations continued successful businesses. But there's clearly an art to raising children and helping them to carry on a family business.

How can lawyers and other advisers help with this process? We can offer suggestions on how children can start with a business, perhaps in ways that allow them to back out if working in a family business isn't for them. We can advise parents not to assume that a child or children will want to be in a family business. Rather than a child committing fully to the family business at a young age, we can suggest a "training wheels" approach to working in the business. If the children decide that they don't want to take part in the family business, we can suggest alternatives for the business, such as a sale to inside management, to an ESOP or to outsiders. Mostly, we can listen, ask a few questions about the parents' intentions and be ready to share our experiences and advice on the future(s) of family businesses.

A family business can benefit families in a variety of ways, providing a comfortable income to the extended family and a source of employment for future generations. But if children are not meant to be part of a family business, it's a mistake to push them into it. And it's a mistake to think that if a family business doesn't continue in the family, it's not a success. Family businesses can be a source of wealth that permits succeeding generations to follow other paths. Perhaps Jody McCrea's salary from Beach Blanket Bingo helped to pay for his cattle ranch.

Robert H. Louis
Saul Ewing
http://saul.com

He Signed Into Law One of the Largest Tax Increases in History

And his initials are RR. No, it wasn't Roy Rogers.

For many years, retirement account balances were exempt from federal estate tax. This was a valuable benefit, as retirement accounts grew to become a large portion of people's wealth. During the Reagan administration, these assets were gradually subjected to federal estate tax and are now fully taxable (with some grandfather provisions that are fading away). But retirement benefits are generally also subject to ordinary income tax (with more grandfathering and recent provisions on Roth benefits, which can be free of income tax). This means that these benefits are frequently subject both to income tax and estate tax. The combination of those two taxes can wipe out most of the value of the retirement accounts (that portion that the stock market hasn't already wiped out). A very useful planning program from Steve Leimberg, which calculates the amount left after paying both taxes, is aptly titled "Confiscate."

Many people, of course, will need their retirement benefits for support in retirement. But it probably makes sense to spend savings that do not generate income tax first, which means postponing the withdrawal from retirement accounts as long as possible. Withdrawals must begin shortly after reaching age 70 1/2, but the required distribution amount is small enough in early years that the account could continue to grow, at least in normal times. So, for some people, at least, there's a good chance that amounts will remain at the participant's death.

For those people who are married, most will be well-advised to name the surviving spouse as the beneficiary. This will avoid federal estate tax, and it's possible that in the spouse's remaining lifetime, the benefits will be withdrawn, taxed and spent. But in an era of second marriages, that won't always be the favored choice: benefits may instead be divided with children from a first marriage. In this case, it may be necessary to use part of the estate tax exemption, which is $3.5 million this year and seems likely to remain there for future years. That relieves the benefits from federal estate tax.

Another technique that has been suggested, for people with charitable interests, is to leave retirement benefits to a charitable entity. This relieves the benefits from both federal estate tax and income tax. At the death of the account owner, the balance is simply paid over immediately. There's no need to worry about minimum required distributions. A similar technique names as the beneficiary of the retirement benefits, at the owner's death, a charitable remainder trust. But this won't always be the best result. Why? Because in naming a charity as the beneficiary, the ability to postpone withdrawals of taxable benefits over a long period of time is lost. Studies have been done by commentators that show the significant benefits of being able to postpone the distribution of benefits over very long periods of time (such as by naming grandchildren as the beneficiaries). Neither technique is always correct.

There is no one correct method of dealing with the problem of double taxation of retirement benefits. It is an important part of the estate planning process, and it illustrates the necessity of considering spending patterns during life as part of the estate plan. Estate planning, in this context, is the process of planning wealth transmission and its estate tax and income tax consequences during the working years and the retirement years, as well as at death

Robert H. Louis
Saul Ewing
http://saul.com