August 2001

New Tax Law Brings Challenges and Opportunities to Small and Family Businesses

Tax breaks for businesses took a back seat this year in Washington as Congress and the White House finalized a tax cut package aimed at individuals. While public attention gravitated to the advance rebates and other provisions targeted to individuals, the Economic Growth and Tax Relief Reconciliation Act of 2001 will also impact businesses, particularly small and family-owned ones, and require reevaluation of estate and succession plans for family businesses.

One proposal—repeal of the federal estate tax—was championed by many in the small business community and is part of the new law. Another provision important to the small business community is the reduction in the top individual marginal tax rate. By 2006, the top marginal rate will drop from 39.6 percent to 35 percent, at which point it will achieve parity with the federal corporate tax rate.

Estate Tax Repeal

Elimination of the estate tax by way of the new law is neither immediate nor simple. Over the next six years, the highest rate, currently at 55 percent, will gradually decrease. For the 2007 through 2009 tax years, the highest rate will be 45 percent for amounts over $1.5 million. Only the highest rate will go down. The other rates, from 18 to 43 percent, are left untouched by the new law. Full repeal of the estate tax only enters the picture in 2010 and only for that year. In 2011, unless Congress acts, the estate tax returns with a top rate of 55 percent.

Contemporaneous with the drop in the highest rate, the exclusion amount increases. Starting in 2002, the exclusion rises to $1 million and peaks at $3.5 million in 2009, but drops back to $1 million in 2011 if the estate tax reappears. For only one year, 2010, the exclusion is inapplicable since the estate tax disappears. For the 2010 tax year, however, a new regime of carryover basis will govern. Carryover basis, even with several exemptions in place, will add complexity to estate planning by making death an income tax problem for heirs, beneficiaries and executors.

The new law moves forward the increase in the exclusion amount, which had been scheduled to rise to $1 million in 2006, but the highest revised exclusion amount, $3.5 million, is not applicable until 2009. Taxpayers with businesses valued between $1 million and $3.5 million must rethink estate planning, keeping in mind the slowly increasing exclusion between now and 2009, the carryover basis regime of 2010, and the sharp drop to an exclusion of $1 million in 2011. Inflation likely will erode the value of the exclusion in 2011 to approximately $900,000.

QFOBI Deduction Departs

One item that flew under the radar during debate on Capitol Hill is elimination of the qualified family-owned business interests deduction (QFOBI). This deduction appeared in 1997, was overhauled in 1998, and, now, will be abolished effective for estates of decedents dying after Dec. 31, 2003. However, under the new law’s sunset provisions, it appears the deduction will return in 2011.

The QFOBI deduction was not without its detractors. The 1998 overhaul attempted to clarify how it would interact with other provisions of the code, such as the exclusion under IRC §2010(c). Generally, estates satisfying the complex qualifications for the deduction would be entitled to a total exclusion of $1.3 million when the deduction and exclusion are both taken into account.

Under the old law, a decedent’s estate satisfying QFOBI deduction criteria would have been able to exclude $1.3 million in 2004. This represents the maximum exclusion amount that was scheduled for that year and a corresponding QFOBI deduction. Under the new law, the same estate will be entitled to exclude $1.5 million, the scheduled applicable exclusion amount for all estates for that year. In 2011, however, the exclusion falls back to $1 million. Consequently, some potential tax savings may be negated.

Traditional strategies such as life insurance to cover potential estate tax, or income tax problems for heirs when carryover basis replaces the estate tax, and exploring the merits of family limited partnerships to provide valuation discounts for estate or gift tax purposes will still have roles to play. Techniques to transfer family businesses from one generation to the next also will need fine tuning in an environment in which a modified gift tax will remain even if the estate tax is repealed beyond 2010.

Recapture also will continue to be a concern for estates that qualify under the QFOBI rules. If property ceases to satisfy the qualifications for the QFOBI deduction, IRC § 2057(f) imposes a recapture tax. The new law keeps this provision in effect after termination of the QFOBI deduction and phase-out of the estate tax.

Marginal Rate Cuts

Estimates of the number of businesses that pay the personal and not the corporate income tax rate range from 80 percent to 90 percent. Before the Tax Relief Act of 2001, the top individual marginal rate was 39.6 percent. The top rate declines to 39.1 percent in 2001; 38.6 percent in 2002 and 2003; 37.6 percent in 2004 and 2005; and 35 percent in 2006.

The decline in the highest marginal rate makes sole proprietorships, S corporations and partnerships more attractive business vehicles for tax purposes. With the difference between the corporate tax rate and the individual tax rate narrowing and then disappearing, entrepreneurs will need to weigh carefully the advantages and disadvantages of incorporation versus operation as a pass-through entity. Business owners also will need to investigate tax-friendly strategies to invest savings from the lower rates back into their operations.