Analysis: The federal estate tax and family businesses
By Lloyd E. Shefsky
As the U.S. prepares for President-Elect Barack ObamaÕs inauguration and the post-Bush era, economic issues have taken center stage. But one important topic remains largely unmentioned: the impact of the federal estate tax on family businesses.
Most developed countries have inheritance taxes, including those affecting family businesses. These laws are generally based on the assumption that death is a convenient time to ÒequalizeÓ the wealth and that society is not best served by the easy transfer of wealth among family members. In the U.S., these assumptions have led to a progressive estate tax, with tax rates accelerating as the estateÕs value increases, to a maximum of 55%.
While thereÕs no disputing the general value of an estate tax, for several reasons I suggest that the current application of the tax to family businesses may not be ideal. For one, businesses owned and/or controlled by families account for the majority of the U.S.Õs gross domestic product. This is in part because family businesses worldwide tend to be substantially more successful than their comparable non-family-owned counterparts. Furthermore, many of the historical factors motivating the application of the estate tax to family businesses are now outdated. Here I present the implications of the federal estate tax for family businesses, the historical factors underlying its application in this domain, potential solutions, and why this issue is particularly relevant now.
How the estate tax affects family businesses
ItÕs important to understand that the estate tax is generally blind to the nature of the assets in question. With minor exceptions, all asset types—including real estate, stock, bonds, commodities, and collectables—are taxable. When estate taxes are levied against liquid, unrestricted assets such as unrestricted publicly traded stocks or T-bills, the family should have sufficient cash on hand or be able to generate it in a timely manner to pay the tax. This is also true for temporarily less liquid assets, such as real estate. When the bulk of the estateÕs assets are shares in a family business, however, the asset may be highly valued (incurring significant tax liability), but the family may not wish to sell it to pay the tax. This is especially the case when the family wishes to reinvest returns into their business to keep it profitable for future generations.
In many such cases, retention of the family businessÕs earnings is the only route to obtaining capital needed for growth, and families sacrifice short- and even medium-term rewards for reinvestment. Ironically this strategy, highly beneficial to society and our economy, often diminishes the familyÕs ability to maintain the business, owing to estate-tax-related issues.
Historical motivation for applying the estate tax to family businesses
Given the challenges the estate tax poses for family businesses, itÕs reasonable to wonder why the tax is applied unilaterally in this domain today. The estate tax laws were first adopted as a means of motivating the sales of family businesses, based on several historical facts or assumptions:
á Most early U.S. family businesses were small farming operations that could not afford expensive equipment to provide greater efficiency. Estate taxes motivated many of these families to sell their businesses to corporations that could modernize them.
á Successful entrepreneurs often created challenges for future generations to succeed in their shoes by intimidating or spoiling their heirs.
á Because family business founders often succeeded based on their idiosyncratic skills, personality or connections, the company was less likely to fare well in the hands of subsequent generations, especially those without management training.
Obviously, times have changed. The number of family farms has declined dramatically. And todayÕs family business heirs can use several resources to improve their management skills, including top-notch business school programs devoted to family business issues, family business consultants, and workshops and books that address family business issues. Additionally, research shows that many large companies that acquired family businesses have done less-than-stellar jobs of integrating operations, transitioning culture and driving returns.
In this context, it may be reasonable to argue that families who faithfully reinvest operating income in their businesses, explicitly choosing not to reward family members without management skills or dedication to the business, may be unfairly penalized by an estate tax that diminishes their growth opportunities. On a more macroeconomic level, itÕs important to remember that the U.S. federal estate tax provides a miniscule amount of government revenue. In recent years the tax constituted approximately 1.3% of the governmentÕs total receipts, with tax revenues on family business assets representing only a fraction of this already small figure.
The future of the estate tax for family businesses
Modifying the estate tax code would naturally raise complications including the question of which specific new rules would be most fair. For example, why should the successor to a family business receive greater tax benefits than the heir of an IPO investor? How can the specific tax code help resolve such issues equitably? The purpose of this article is not to write a new estate tax law but rather to suggest that the current application of the tax may be detrimental to many family businesses. Similarly, simple tax-related provisions could be used to offset potentially ÒunjustÓ benefits. For example, the adjustment of an heirÕs tax basis for future gains determinations could be denied where the estate tax is deferred. Likewise, the deferral could end if the company or stock is sold within a specific timeframe.
This is a particularly timely issue for discussion, because any modifications to the current estate tax must be completed within the next year. In 2001, the U.S. Congress abdicated its role by inserting a sunset provision into the tax law, leaving it to a later Congress to implement changes by 2009; otherwise, the estate tax rate would drop to zero. Subsequent discussion focused on the level of the exemption to the estate tax, with this figure edging up over the years. But more thoughtful modification to the tax code will likely be necessary to enable families to maintain their businessesÕ profitability for future generations, ultimately improving their returns and their contributions to the U.S. and global economy.
Lloyd E. Shefsky is a clinical professor at the Kellogg School of Management, Northwestern University, with extensive experience in counseling family businesses. He is founder and co-director of KelloggÕs Center for Family Enterprises.