GRAND RAPIDS — One of the more interesting financial planning challenges today might seem to be the federal estate tax.
After all, Congress — in its wisdom — is causing the estate tax to disappear slowly, only to reappear in full force early in the next decade.
But because the tax’s fade is illusory, families must recognize that the tax probably will be levied against their estates.
And according to Paul Hense, whose practice focuses primarily on small business, the tax is potentially devastating to families in what might be called the upper middle class and almost irrelevant to the very wealthy.
Hense says the disparity of impacts by the estate tax is due primarily to one factor.
“Estate tax lawyers and CPAs — the people who really get into this area — are very, very expensive,” he said, “because it’s a very expensive process to set up trusts and foundations and all of that.
“But in our government’s eyes,” he added, “the worst place to fall is in the $80,000 to $150,000 range. At that income, you’re getting clobbered on taxes, and yet, you don’t have the capability to do the things that put you in that tax-blessed state where the IRS can’t get you.”
The long and the short of it, he said, is that the very wealthy can afford the high-cost expertise to set up tax-advantaged trusts and tax-exempt foundations.
People with a modest family fortune can do little to protect it from estate taxes other than buy very large insurance policies dedicated to payment of those taxes. And by the time such people see the need for such insurance, they’re often past middle age and at a point where insurance can be unaffordable.
Hense said that even though Congress has substantially raised the estate tax exemption, the impact of the estate tax still can be ruinous for a family business or a family farm.
“If your wealth is tied up in something like a farm,” Hense said, “you don’t have the liquidity to go to one of the big law firms and see that none of it gets taxed. So when grandma dies,” he said, “you’ve got to sell the farm to pay the taxes.”
He said that not only is the cost of setting up a trust or a foundation high, but so is the cost of administering it.
“But if you’ve got $10 million or $11 million, then you probably can afford it,” Hense said.
A think tank called the National Center for Public Analysis argues that nonprofit foundations are routinely used to defend a family’s fortune against the estate tax, while preserving access to those fortunes through salaried positions with the foundations. The same organization says the estate tax, because of its interaction with income taxes, probably nets out little revenue for the government.
Hense agrees with both assertions.
“It’s my understanding of the estate tax that it is a very inefficient tax,” Hense said, “because it really doesn’t generate that much revenue, but requires a great deal of administration.
“It’s certain that an incredible waste of time and energy goes into avoiding the estate tax — in defense against it. There’s a whole industry built around avoiding this tax: the financial planning industry.”
According to the center, a recent study estimates that two-thirds of the wealth of the nation’s richest families goes untaxed. At the same time, the center reported that for 1997, more than 50 percent of all estate tax revenue came from estates under $5 million while the effective tax rate actually fell for estates above $20 million.
A disproportionate burden of the estate tax often falls on what might be called new estates consisting of recently acquired, modest wealth: farmers, small businessmen and the like.
“Federal taxation really hits those who have done good,” Hense said, “but not those who have done great.” He said the estate tax makes it very hard for small businesses to become big ones, and for modest wealth to become great wealth.
Hense said there’s no question that the estate tax affects the way people in high middle-income brackets act.
“One of the biggest problems with the estate tax,” he said, “is that it causes people to do things they otherwise wouldn’t.”
His remarks echoed a comment in which economist Douglas Holtz-Eakin recently concluded that the estate tax has a much greater distortion effect on entrepreneurs than previously thought.
The economist argues that the threat of the tax causes entrepreneurs to cut back on labor, investment and risk-taking.
“Let’s face it,” Hense said. “Taxes can affect how you act, depending upon how much wealth you have. And federal taxation is applied disproportionately.
“Take a couple earning $135,000 to $140,000 and trying to put kids through college. If the government takes $35,000 in taxes, it really, really hurts.
But he said assessing a $5 million tax against a billionaire family, and it wouldn’t even change their buying habits.
“If your estate is worth $3 million and the government takes $500,000, that’s quite an impact, especially if you have to sell the business to raise the money.
“If you’re worth billions and the government takes $500 million, nothing in your life is going to change. When people reach that level of wealth, the numbers become meaningless.”