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FULL TEXT: CRS REPORT ON ESTATE TAX AND 'CONTRACT.'

JAN. 13, 1995

95-167E

DATED JAN. 13, 1995
DOCUMENT ATTRIBUTES
  • Institutional Authors
    Congressional Research Service
  • Subject Area/Tax Topics
  • Index Terms
    estate tax
    small business
    tax incentives
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 95-1533
  • Tax Analysts Electronic Citation
    95 TNT 22-60
Citations: 95-167E

                       CRS REPORT FOR CONGRESS

 

 

                      THE ESTATE TAX EXEMPTION

 

                  AND THE HOUSE REPUBLICAN CONTRACT

 

 

                          SALVATORE LAZZARI

 

                    SPECIALIST IN PUBLIC FINANCE

 

                          ECONOMICS DIVISION

 

 

                          January 13, 1995

 

 

                            CRS 95-167 E

 

 

                               SUMMARY

 

 

The estate tax exemption is that part of the Federal estate and gift tax system that prevents small estates from being taxed. The current exemption is $600,000, which means that up to $600,000 of the wealth owned by a decedent at death is not taxed under the estate and gift tax. Decedents whose taxable estates are valued at no more than $600,000 would have no Federal tax liability and therefore would not have to file a return. At $600,000 nearly all decedents in the United States, 97.5 percent, are exempt from tax. Exempting small estates contributes toward greater equality in the distribution of wealth, and a facilitates administration of the estate and gift tax. A $600,000 exemption is equivalent to a unified estate and gift tax credit of $192,800.

In 1916 -- the year the estate tax was enacted -- the exemption was $50,000, and, by 1975, it was still only $60,000. Increases in the exemption were enacted in 1976 and 1981, with the exemption increasing to $175,625 in 1981, and to $600,000 in 1987. The $600,000 has declined in real terms since 1987; the exemption has increased somewhat more than the rate of inflation since 1981. The House Republican proposal assumes that the current exemption level is too low, and proposes 1) to increase it to $750,000 by 1998, and 2) to index it to inflation thereafter. Indexation would keep the $750,000 exemption from losing real value after 1998, but it would still be lower in real terms than the 1987 exemption of $600,000. An exemption of about $800,000 would be required in 1995 in order to maintain the real exemption at its 1987 level. An exemption of about $900,000 would be required in 1995 in order to maintain the real exemption at its 1916 level of $50,000.

Available data suggests that 1) the current estate tax does not burden farms and small businesses more than other types of assets, 2) those estates between $600,000 and $750,000 of wealth, which are taxed at the lowest rates, generally have enough liquidity to pay estate taxes and other expenses, 3) larger estates, which are taxed as high as 60 percent, are more likely to have liquidity problems, and 4) liquidity problems that exist today are not widespread, pose no general problems, and are not likely caused by the current exemption level. The Federal estate tax does not impose higher tax burdens on family farms and small businesses, which also benefit from two special tax provisions -- special use valuation and tax payment deferral. These were enacted to minimize the potential for adverse effects of inflation and high marginal estate tax rates on family farms and other illiquid estates.

Once the appropriate exemption level is determined, a case can be made for indexing the exemption and the wealth categories -- the beginning and ending tax rate classes -- for inflation. The House Republican proposal would reduce the number of estate tax returns by an estimated 15,000, reducing the proportion of decedents taxed from 2.5 percent to about 2 percent. However, the analysis suggests that the proposed estate tax relief may not reach those estates more likely to have a liquidity problem and more likely to have to dispose of business assets to pay the estate tax.

                              CONTENTS

 

 

INTRODUCTION

 

 

BRIEF EXPLANATION OF THE ESTATE TAX EXEMPTION

 

 

THE EXEMPTION AND THE UNIFIED TRANSFER TAX CREDIT

 

 

IMPORTANT FEATURES OF THE EXEMPTION

 

 

PURPOSE UNDERLYING THE EXEMPTION

 

 

BRIEF HISTORY OF THE EXEMPTION

 

 

THE HOUSE REPUBLICAN PROPOSAL

 

 

INFLATION AND THE REAL EXEMPTION LEVEL

 

 

THE FEDERAL ESTATE TAX AND FAMILY-OWNED BUSINESSES

 

 

FURTHER ANALYSIS

 

 

    Inflation

 

    Liquidity

 

    Special Tax Preferences for Farms and Small Business

 

      Special Use Valuation

 

      Deferred Payment of Tax Liability

 

 

POLICY IMPLICATIONS

 

 

THE ESTATE TAX EXEMPTION AND THE HOUSE REPUBLICAN CONTRACT

INTRODUCTION

The House Republicans "Contract with America" includes a proposal to increase the estate and gift tax exemption from $600,000 to $750,000 by 1998, and to index it for inflation thereafter. 1 This proposal was introduced as a Congressional bill, (H.R. 9) on January 4 by Congressman Archer, Chairman of the House Committee on Ways and Means. This report discusses the estate and gift tax exemption, describes important features of the exemption, its history, and its justification. This report examines the rationale for increasing the exemption and analyzes some of the effects of the Republican House proposal to raise it to $750,000, and to adjust it for inflation.

BRIEF EXPLANATION OF THE ESTATE TAX EXEMPTION

Many different types of taxes -- income taxes, consumption taxes, value added taxes -- provide for the exemption of minimum levels of otherwise taxable base to achieve certain distributional, administrative, and other tax policy objectives. For the Federal estate tax, the $600,000 estate tax exemption serves this purpose.

Very simply, the estate tax exemption is the amount of a decedent's wealth exempt from tax. It is the minimum level of property or assets that a decedent may exclude from the estate tax. The current exemption is $600,000, which means that up to $600,000 of a decedent's wealth is not taxed. All decedents, or more accurately, all decedents' estates, are permitted to claim this exemption against their taxable estate-tax wealth. 2

The $600,000 estate tax exemption is also a filing requirement. 3 Decedents whose taxable estates are valued at no more than $600,000 would have no Federal estate tax liability and therefore would not have to file an estate tax return. Conversely, decedents whose estate are valued at more than $600,000, would have to file a tax return and pay tax on taxable wealth above the $600,000 threshold.

The estate tax exemption is thus the basic mechanism under the estate tax system that determines which decedent/estates are subject to the estate tax and, conversely, which estates are exempt from tax. 4 As the data will show, the vast majority of decedents in the United States -- 97.5 percent -- have estates below $600,000 and are not subject to Federal estate taxes. Only the top 2.5 percent of all wealthy decedents have estates larger than $600,000 and therefore are subject to the estate tax.

THE EXEMPTION AND THE UNIFIED TRANSFER TAX CREDIT

With the exception of the filing requirements of IRC section 6018, the estate tax statutes do not provide for an exemption per se. They provide for a "unified transfer tax credit," which is currently $192,800. It is the unified credit that is actually claimed on estate tax returns rather than the exemption. The unified transfer credit is subtracted from estate tax liability, thus eliminating any tax up to $192,800. The formula for computing estate tax liability, for example, uses the "credit against tax," rather than the exemption, as the method for reducing the Federal estate tax liability on wealth below $600,000 (see figure 1, p. 5). However, the unified transfer tax credit is, for many legislative proposals and as well as many practical purposes, translated into its exemption equivalent: the $600,000. This equivalency is due to the fact that under the current estate and gift tax rate schedule (called the unified rate schedule), a credit of $192,800 reduces estate tax liability by the same amount as a $600,000 exemption. 5

IMPORTANT FEATURES OF THE EXEMPTION

Three aspects of the estate tax exemption (or more accurately, the transfer tax credit) are important to discuss. First, the exemption applies to both gifts (lifetime transfers) as well as estates (transfers at death). This is because the exemption is integrated and unified with the gift tax. To the extent the exemption is used against the gift tax, it cannot to be used against the estate tax. 6 Also, lifetime transfers and estate transfers are cumulated and taxed at the same rates, which begin at 18 percent on taxable transfers up to $10,000 and rise to 60 percent cumulative transfers between $10,000,000 and $21,040,000. 7

Secondly, note that the exemption relates to the amount of the table estate rather than to the GROSS ESTATE. Taxable estate is gross estate -- the market value of all the financial, real, and personal assets -- less deductions for administrative expenses, debts, funeral expenses, charitable donations, and for transfers to spouses. 8 The effect is to create zero tax liability for all estates below $600,000 of wealth and for those estates above $600,000 that have sufficient deductions to offset any additional wealth. For example a gross estate of $750,000 would have no tax liability if its deductions are $150,000. However, because the gross estate exceeds the $600,000 filing threshold, an estate tax return (form 706) would have to be filed.

Thirdly, the unified transfer tax credit is non-refundable -- it is only available up to the estate tax liability. So, for example, an estate with a pre-credit tax liability of $100,000, would not be able to have the difference ($92,800) refunded.

Figure 1 shows the basic formula for computing the estate tax liability.

PURPOSE UNDERLYING THE EXEMPTION

There are two basic tax policy objectives underlying the estate and gift tax exemption. The exemption prevents the estate tax from imposing a financial burden on the poorer decedents -- those with relatively small amounts of wealth. Having no estate tax burden implies that more of the wealth of these poorer household remains intact. Conversely, for those wealthier decedents subject to the estate tax, paying an estate tax reduces the wealth available for younger generations to inherit. Thus, along with the graduated rate structure, the exemption serves a wealth "equalizing" function: the wealth of poorer households is maintained, while the wealth of richer households is diminished by the amount of the tax. This is the distributional function of the estate tax exemption, consistent with the distributional role of the estate and gift tax system in general.

The second objective underlying the estate tax exemption is tax code simplification. Due to the skewness or concentration in the distribution of wealth, the individual wealth of the vast majority of the roughly 2 million people that die every year in the United States (about 98 percent) is well below the $600,000 threshold; many decedent's have little or no property, and many also have negative net worth. Taxing poorer decedents would generate considerably less revenue per return than taxing richer decedents. Wealthier decedents have not only proportionately more wealth to tax, but -- due to the graduated estate tax rate schedule -- such wealth would be taxed at higher tax rates, thus generating proportionately more revenue per return.

In addition to administrative costs, there would be compliance costs to the taxpayers in relation to the small amounts of tax liability paid. Exempting small estates, thus, keeps the administrative and compliance costs of the overall estate tax system low relative to the revenue generated (or tax burden imposed), and thus simplifies tax administration and compliance, which is an important principle of tax policy.

FIGURE 1. THE ESTATE TAX FORMULA [figure omitted]

BRIEF HISTORY OF THE EXEMPTION

The current estate tax exemption has been $600,000 since 1987, and was the final installment of a phased-in increase under the Economic Recovery Tax Act of 1981 (P.L. 97-34) that began in 1982 and ended in 1987. In 1981, the exemption was $175,625, the last installment of a phased-in increase under the 1976 Tax Reform Act (P.L. 94-455), which also restructured the Federal estate and gift tax system, unified the separate estate and gift taxes, and replaced the specific exemption ($60,000 in 1976) with the unified transfer tax credit (at higher levels, beginning in 1977).

Table 1 shows the nominal statutory estate tax exemption (in current, unadjusted dollars) since the introduction of the estate tax in 1916.

In recent years, there have been proposals to scale back the $600,000 exemption, motivated largely by revenue needs -- additional revenue was needed to help reduce large Federal budget deficits. One congressional bill (H.R. 4763, 100th Congress) proposed a lower estate tax exemption as a way of funding catastrophic long-term health care for the elderly. In addition, the estate tax generally, and the exemption level specifically, is viewed as a distributionally progressive way of generating additional revenue. Some in Congress have felt that the $600,000 exemption is too high; that decedents with that level of wealth are considered to be "wealthy" and should not be exempt from tax; and that the exemption increases under ERTA were excessive. A typical exemption level proposed was $300,000. 9 On the other hand, some in Congress are completely opposed to estate and gift taxation and have proposed the repeal of these taxes.

THE HOUSE REPUBLICAN PROPOSAL

The House Republican proposal, as discussed in the "Contract With America," would increase the estate tax exemption from $600,000 to $750,000 in three stages: $700,000 in 1996, $725,000 in 1997, and $750,000 in 1998. Beginning in 1998, the $750,000 would be adjusted for inflation. These exemption levels would be equivalent to unified transfer tax credits of $229,800 in 1996, $239,050 in 1997, and $248,300 in 1998. 10

                          TABLE 1. ESTATE TAX

 

                          EXEMPTION, 1916-1994

 

 

                          YEAR         EXEMPTION

 

                                         AMOUNT

 

 

                         1916-25         50,000

 

                         1926-31        100,000

 

                         1932-34         50,000

 

                         1935-41         40,000

 

                         1942-76         60,000

 

                         1977           120,667

 

                         1978           134,000

 

                         1979           147,333

 

                         1980           161,563

 

                         1981           175,625

 

                         1982           225,000

 

                         1983           275,000

 

                         1984           325,000

 

                         1985           400,000

 

                         1986           500,000

 

                         1987           600,000

 

                         1988           600,000

 

                         1989           600,000

 

                         1990           600,000

 

                         1991           600,000

 

                         1992           600,000

 

                         1993           600,000

 

                         1994           600,000

 

 

Two reasons are provided for the proposed increase: (1) the exemption of $600,000 has declined in real terms, resulting in the taxation of gradually more decedents whose real wealth may not have increased. A higher NOMINAL exemption would raise the REAL exemption level to the $600,000 1987 level, taking account of inflation since 1987; (2) the estate tax imposes a disproportionate burden on estates comprising significant small business or farm assets, which induces the sale or dissolution of these assets in order to pay the estate tax and prevents these types of entities from being retained in the family. According to the argument, a higher exemption would diminish these problems and facilitate the intergenerational retention and ownership of family businesses. 11

INFLATION AND THE REAL EXEMPTION LEVEL

Figures 2,3, and 4 show the trends of 1) the NOMINAL statutory exemption (the nominal dollar amount specified by the estate tax law), 2) the REAL statutory exemption (the nominal adjusted or deflated by the increases in the GDP deflator over a specified base), and 3) a constant real exemption level (the nominal dollar level in three different years increasing by the rate of inflation). Each figure assumes a different base period: 1987, 1982, and 1916 respectively. 12

In figure 2, the hashed line shows the nominal statutory exemption -- $600,000, through 1995, and the levels proposed by the House Republicans thereafter. The dotted line shows the real statutory exemption -- the hashed line levels deflated by increases in the GDP deflator. The solid line shows what the nominal exemption level required to maintain a constant real 1987 exemption of $600,000.

Note the decline in the real exemption from $600,000 in 1987 to about $466,000 in 1994. This was due to a 33-percent increase in inflation over that seven-year period. By 1995, the real exemption is projected to decline to about $450,000 from its 1987 base, assuming a 3.5-percent increase in the GDP deflator over 1994. 13 Under the increases proposed by the House Republican Contract from 1996 to 1998, there is a real increase projected for 1996 but not for 1997 and beyond. In figure 2, the hashed line for 1995-98 shows the exemption level under the House Republican plan. Note that this line is still below the constant real exemption level (the $600,000 adjusted for inflation since 1987). This means that the House Republican proposal would not completely eliminate, the real losses to the exemption since 1987. By 1996, House Republicans exemption of $700,000 would be about $130,000 below the level required to keep the $600,000 constant in real terms. Moreover, this difference would continue to grow -- in absolute terms -- even after the proposed inflation adjustments are enacted. Of course, without the inflation adjustment, the absolute difference would grow as would the relative difference.

Figure 3 is the same as figure 2 except that it uses 1982 as the base year (when the exemption was $225,000). 14 Figure 3 shows that the real statutory exemption (hashed line) grew substantially from 1982 to 1987 but began to decline in 1987. In other words, USING 1982 as the base year, the exemption increases in the 1980s were, at least initially, real increases, substantially greater than the rate of inflation. But the current exemption is negligibly larger than the exemption required to maintain a real level at $225,000 (dotted line), so that, by this standard, the increases under ERTA were not excessive. Note also that the inflation adjustments have the effect of maintaining the real exemption level at about $225,000 beyond 1998.

Finally, figure 4 makes these same comparisons using 1916 as the base year, when the exemption was $50,000. First, note that the current exemption level in real terms (about $39,000) is less than the original $50,000-level enacted in 1916 (hashed line). The same idea can be illustrated by comparing the nominal statutory exemption (dotted line) with the $50,000 adjusted for inflation since 1916 (solid line). The nominal statutory exemption would have to be about $920,000 -- about $320,000 above the current level -- in order to achieve the same real exemption as in 1916. In this regard, note that the 1982-86 increases legislated in 1981 under ERTA attempted to correct for the real losses in the exemption, but, since 1987, once again the real exemption has lagged behind. It is important to note once again that the increases proposed under the House Republican plan do not raise the exemption to the level required to maintain the real exemption at $50,000 in 1916 terms. By 1998, the proposed exemption will be about $300,000 less than necessary to prevent real decline in the 1916 exemption.

FIGURES 2 THROUGH 4 OMITTED

THE FEDERAL ESTATE TAX AND FAMILY-OWNED BUSINESSES

The underlying rationale for the proposed increase in, and indexation of, the estate tax exemption, according to the Contract With America, is:

"to make it easier for small business owners and family farmers to keep their shops in the family."

Although the precise role the exemption plays in the break-up of small business and family farms is not discussed in the House Republican proposal, the mechanism is probably that the estate tax has a disproportionate burden on illiquid estates. This proposition dates back to the 1950s, and was widely believed during the 1970s and 1980s, due to the burdensome effects of a fixed exemption combined with increasing inflation on farms and small business estates. The belief in the validity of the proposition is probably what led to the exemption increases of 1976 and 1981.

According to the historical version of the argument, the estate tax is particularly burdensome on family farms and other small family businesses, particularly during periods of inflation, because these types of estates are typically very illiquid -- they do not have the liquidity from which to easily pay the estate tax liability. The less is the liquidity of the estate, the more difficult is the financing of the estate tax liability, probate expenses, and funeral expenses. The burden of paying an estate tax when assets are illiquid could possibly necessitate that the owner, or the executor of the estate, dispose of the business in order to generate enough cash to pay the tax. In some cases, the small family-owned enterprise is sold to, or merged with, a larger competitor, including domestic and foreign conglomerates. This has the consequence of not only eliminating the family business as a separate entity but also of increasing business concentration and perhaps severely affecting the degree of inter-firm competition in the product markets.

Proponents of a higher exemption also argue that the dissolution of family-owned and operated farms and small businesses, in turn, may have additional adverse economic, political and social consequences. The destruction of small family businesses affects not only the family itself, but may be extremely disruptive to a local community. Such a community may be better served by locally centered business than by a branch whose corporate headquarters is remote. Finally, society as a whole may benefit from a perpetuation of the family as a basic social and economic entity. The social and economic fabric of the United States may be better served by a tax system that encourages rather than destroys family owned enterprises.

FURTHER ANALYSIS

There is no doubt that, in theory, the estate tax system can induce the sale or merger of family-owned businesses. The combined effects of a low and fixed exemption, high estate tax rates, high inflation, low liquidity, can create a large enough tax burden that would necessitate the sale of business assets to pay expenses, the Federal estate tax, and state death taxes. There is empirical evidence that the estate tax had such effects during the 1960s and 1970s, (particularly for estates with a large fraction of business property) although the magnitude of these effects were often exaggerated. 15

Under a general price inflation, a fixed exemption will decline in real value over time (as was discussed above); the longer it remains fixed, the greater the losses in its real value. Inflation, in other words, erodes the real value of a fixed exemption. This causes the proportion of decedents subject to the estate tax to increase. Figure 5 verifies this effect using estate tax data from 1920-1991, the latest available. Note the relatively flat trend at about 1 percent of decedent's through the early 1940s, but a rising proportion from the early 1940s to mid 1970s, when over 11 percent of decedents were taxed -- the highest ever. This corresponds to a period during which the exemption was fixed at $60,000 (table 1) and when inflation was high and accelerating. Econometric analysis of this ratio supports the theory that the ratio is negatively related to the nominal exemption level (as the exemption goes down the number of estate tax returns, relative to the number of deaths, goes up) and positively related to the rate of inflation and the rate of real economic growth (as inflation increases and as the economy grows, the proportion decedents subject to the estate tax increases). With respect to the inflation variable, the econometric estimates shows that as the rate of inflation increases by 1 percentage point, nearly 17,000 more decedents are taxed although they may have no increase in their real wealth.

Inflation also tends to increase the price of farmland, real estate, small business assets, and other real assets relatively more than other types of property such as financial assets, subjecting gradually more decedents to the estate tax. 16 Owners of farms and small businesses will have a larger share of their estates subject to the estate tax under these conditions.

FIGURE 5. ESTATE TAX RETURNS AS A PROPORTION OF DECEDENTS [figure omitted]

Inflation, when combined with graduated tax structures, also causes rising estate tax burdens. Within the Federal income tax system, this is a well known phenomenon and is the reason for the indexation of the system. 17 Under the graduated estate tax structure, inflation also leads to gradually increasing asset values and estate tax burdens as decedents are bumped into gradually higher tax rates. These inflationary effects are worse for estates with a significant share of farm and small business assets and other illiquid assets. 18

The effects of inflation on the estate tax burdens can be illustrated with a simple hypothetical example using actual tax rates. Consider a decedent with an estate wealth valued at $1,200,000 and deductions and expenses at $100,000. After the $600,000 exemption, this decedent will have a taxable estate of $500,000 and a tax liability of $155,800 -- 31.2 percent. Now assume that the value of this hypothetical decedent's wealth increases by the same rate as the rate of inflation, assumed to be 5 percent over one year. This raises the value of the estate wealth to $1,260,000. Now this decedent will have a taxable estate of $560,000, and an estate tax liability of $178,000 -- 31.8 percent. This illustrates that the estate tax burden has increased by 0.6 percentage points although there has been no increase in real wealth.

If preserving the real value of the estate tax exemption is desirable public policy, this suggests that, once the appropriate exemption level is determined, the exemption should be indexed for inflation. It also suggests that the wealth categories -- the beginning and ending categories corresponding to the different tax rates -- should also be indexed for inflation.

It is difficult to determine the extent to which the estate tax in general, or the size of the exemption in particular, causes the owners of family farms and small businesses to dispose of their small business or farm assets just to pay the estate tax. The data are not available that would permit one to estimate the magnitude of this problem, to the extent that it may exist. There are no data on the origin of funds to pay the estate tax, nor on the type of assets that have to be sold to pay the estate tax burden or to achieve other objectives. Such data as are available, however, suggest the following: (1) the estate tax, generally, does not appear to disproportionately burden farms and small business as compared with other types of assets. (Actually, the tax probably confers advantages to farms and small businesses, relative to other types of assets, as will be discussed below.) (2) to the extent there is a problem with the tax burden on illiquid estates, it is not an extensive one; it affects only a very limited number of estates.

Regarding the role of the exemption, however, it is not likely that the current exemption level plays a significant role in inducing the break-up of the family farms and small businesses. Any disproportionate tax burden on illiquid estates is not largely caused by the exemption.

INFLATION

To begin with, the rate of inflation, as measured by the GDP deflator has been low, averaging 3.6 percent annual rate over the last 12 years, and has not exceeded 4,4 percent per annum. 19 These rates of inflation are too small -- indeed, they are considered to be normal for the U.S. economy -- to cause significant increases in estate tax burdens.

LIQUITY

Recent estate tax returns (1991) show that most estates appear to have enough liquidity to pay both the estate tax and the various probate expenses. Table 2 shows the cash ratio and the general liquidity ratios for estate tax returns filed in 1991. The cash ratio is defined as the ratio of cash to estate tax liability. The general liquidity ratio is defined as the ratio of the value of liquid assets to probate expenses and death taxes. These ratios are presented according to the gross estate categories reported by the Internal Revenue Service.

Note first that the cash ratio exceeds 5 for the lowest wealth class and exceeds 1 for estates between $1 and $2.5 million, and is below 1 for all the classes above $2.5 million. This shows that the average "small" estate has enough cash to pay the estate tax and that it is the larger estates that do not have enough cash, on average, to pay the estate tax. It is these estates that might have to sell assets to pay the estate tax.

The general liquidity ratio shows the extent to which estates in 1991 had sufficient liquidity in addition to cash to pay the estate tax and other death expenses. 20 Note, first of all that the ratio is greater than 1 for all wealth categories, suggesting that the estate of the average decedent has enough liquidity to pay the Federal estate tax, State death taxes, and probate and death expenditures. In other words, while the average estate might have to sell or dispose of some assets, the assets do not have to include any of the real assets. Note, in particular, for the first gross estate category -- $600,000 to $1,000,000 -- that the liquidity ratio is five: on average these estates have 5 times as much liquid assets as taxes and expenses. This, again suggests that liquidity is not a problem for the smaller estates.

Note also, however, that the liquidity ratio declines to below 2 for the largest estate categories -- those above $5 million. This suggests that the smaller estates generally have ample liquidity, but that some larger estates might encounter some liquidity problems to pay the death taxes and expenses. If, for example, the average liquidity ratio of decedents whose wealth is between $10 and 20 million is 1.7 (table 2), and assuming a normal distribution of this ratio about its average within its category, some estates within this range might not have ample liquidity to cover taxes plus expenses (the ratio would be less than 1). However, assuming that most of these 351 estates are concentrated about the mean for the category, very few are likely to have liquidity ratios substantially less than 1. In any event, as the third column of table 2 shows, the number of taxable estates in these categories is relatively small in absolute terms; they are virtually imperceptible in relationship to the 15 million small businesses (sole proprietorships, partnerships, and small corporations) active in the United States.

For those estates that do have liquidity problems, there are numerous solutions that do not involve the disposition of business assets and the dissolution of the family farm/small business. These include: (1) proper estate planning; (2) making gifts before death; (3) underwriting life insurance, which adds liquidity; (4) charitable trusts in which the owners or beneficiaries may control the enterprise; and the (5) deliberate accumulation of liquid assets.

 TABLE 2. RATIO OF LIQUID ASSETS TO ESTATE TAX PLUS EXPENSES FOR 1991

 

 ____________________________________________________________________

 

                                                   # of Estates

 

       Size of Gross        Cash       Liquidity      With Tax

 

         Estate ($)        Ratio         Ratio       Liability

 

 ____________________________________________________________________

 

 

    600,000 -  1,000,000     5.0         5.348         10,875

 

  1,000,000 -  2,500,000     1.1         2.627         10,325

 

  2,500,000 -  5,000,000     0.5         2.109          2,161

 

  5,000,000 - 10,000,000     0.4         1.708           864

 

 10,000,000 - 20,000,000     0.3         1.692           351

 

 20,000,000 or more          0.2         1.851           205

 

 

      Source: U.S. Department of the Treasury. Internal Revenue

 

 Service. Statistics of Income: Compendium of Federal and Estate Tax

 

 and Personal Wealth Studies. pp. 69-72.

 

 

SPECIAL TAX PREFERENCES FOR FARMS AND SMALL BUSINESS

It is important to underscore that the Federal estate and gift tax statutes do not single out (or discriminate) against family farms or small businesses: statutory estate tax rates do not vary by type of asset -- only the aggregate value of all the assets combined determine the tax rate according to a graduated schedule; there is no provision of the Federal estate and gift tax structure that singles out family farms or small businesses for a greater tax burden than other type of assets. In fact, the Federal estate and gift tax structure includes two provisions that confer preferential tax treatment -- they are designed to reduce the estate tax burden -- for family farms and small businesses: special use valuation and deferral of the payment of estate tax liability.

SPECIAL USE VALUATION

IRC section 2032A provides for farming property or small business property to be valued according to its "use value" rather than its market value, if it (the real and personal property) comprises at least 50 percent of the adjusted value of the gross estate. Since actual use value is generally below market value, especially for farms, the estate obtains the benefit of not paying an estate tax on the difference. The reduction in fair market value cannot exceed $750,000, essentially conferring a relatively greater tax benefit to the relatively smaller farms and non-farm enterprises. 21 This provision was enacted under the Tax Reform Act of 1976, at a time when, due to a fixed exemption and rising inflation, more and more decedents were being taxed and their effective estate tax rates were increasing.

DEFERRED PAYMENT OF TAX LIABILITY

The second estate tax preference for farms and small businesses relates to the period of time over which to pay the tax. Generally, the estate tax liability is paid at the time for filing the return, which must be filed within 9 months after the date of death. Under IRC section 6161, an extension of time may be granted by a district director for up to 10 years if reasonable cause is demonstrated, which generally means insufficient liquidity. In addition, under IRC section 6166, when the estate has more than a 35-percent interest in a farm or closely held business, i.e., small family-owned enterprises, an executor may elect to defer all payments of tax corresponding to those assets for five years, and thereafter pay the tax plus interest (at below market interest rates) in equal installments over the next 10 years. 22

POLICY IMPLICATIONS

The proposed exemption increase to $750,000 is estimated to reduce the number of estate tax returns by about 15,000, reducing the proportion of decedents taxed to approximately 2 percent (it is currently about 2.5 percent), about the same as in the early 1950s. (In other words, the proposed exemption would increase the proportion of decedents exempt from taxation from about 97.5 percent to about 98 percent.)

The proposed inflation indexing of the exemption should keep the proportion of decedents taxed constant at about 2 percent, although the proportion would tend to increase as the economy's real output grows.

The analysis suggests that the proposed estate tax relief may not reach those estates empirically found more likely to have a liquidity problem and more likely to dispose of business assets to pay the estate tax. The higher exemption proposed in the 'Contract' is of greatest help to those decedents with wealth between $600,000 and $750,000, who do not generally have a liquidity problem. They have enough cash and other liquid assets, in relation to their tax liability that generally it would not be necessary to liquidate farm or small business assets. The proposed exemption increases would be of little or less benefit to the larger estates generally, which might have a liquidity problem.

 

FOOTNOTES

 

 

1 This proposal is part of section 8 -- The Job Creation and Wage Enhancement Act -- of the "Contract."

/2 The estate tax is a WEALTH TRANSFER TAX, an excise tax on the transfer of wealth at death above $600,000. It is considered a TRANSFER tax because it is imposed without regard to the amount transferred to any one beneficiary and without regard to the relationships between the decedent and the beneficiaries. Thus, it is not an inheritance tax. For a detailed explanation of the current estate and gift tax system, as well as a history of death and wealth taxation in the United States see: U.S. Library of Congress. Congressional Research Service. Federal Estate and Gift Generation Skipping Tees: A Legislative History and Description of Current Law. CRS Report #90-635A by John R. Luckey. December 28,1990. Washington, 1990.

3 Internal Revenue Code section 6018(a)(1).

4 In this respect, the estate tax exemption is analogous to the combined effects of the personal exemptions and standard deduction under the income tax. To prevent a minimum level of income, needed for basic subsistence, from being taxed, the current income tax provides for a personal exemption of $2,450, and a standard deduction of $3,800 (single person, not head of household). Thus, $6,250 of annual income of a single person is not subject to the income tax. The standard deduction varies depending upon filing status whereas the estate tax exemption is the same for all decedent's. The $2,450 personal exemption is adjusted annually for inflation, as are other elements of the income tax.

5 In other words, under the graduated estate tax rate schedule a $600,000 taxable estate would, without the credit, have a tax liability of $192,800.

6 The $600,000 exemption equivalent of the unified transfer tax credit should not be confused with the $10,000 exemption available for gifts. The latter is an annual exemption available to donors, and there is no limit to the number of recipients (donees).

7 The top marginal estate tax rate for estates above $3 million is 55 percent, except that for estates between $10 million and $21.04 million, the top rate is 60 percent. The 60-percent rate for these estates is in lieu of the phase-out of the unified transfer tax credit. The Congress intended that these estates not qualify for a unified credit but rather than disallowing the credit, it imposed a 5- percent higher marginal tax rate.

8 There is a 100-percent deduction for transfers to spouses -- the marital deduction.

9 U.S. Congress. Congressional Budget Office. Reducing the Deficit: Spending and Revenue Options. February, 1992. p.318.

10 $248,300 is the tax liability on taxable transfers of $750,000.

11 There may be additional reasons for wanting to cut estate taxes on farms and small business, not mentioned in the contract with America. For example, some have argued that estates composed of farms and small business assets incur comparatively greater settlement and administration (probate) costs --that the "ability to pay" under the estate tax is less an estate becomes less liquid. The estate tax laws should reflect this interrelationship by easing the tax burden on family enterprises.

12 GDP denotes Gross Domestic Product.

13 The GDP deflator is assumed to increase by 3.5 percent in 1995 and 4.0 percent thereafter.

14 Note that, due to a peculiarity in the program that generates these graphs, the lines in figures 2 and 3 do not represent the same variable.

15 Somers, Harold M. Estate Taxes and Business Mergers: The Effect of Estate Taxes on Business Structure and Practices in the U.S. The Journal of Finance, v. 13, May 1958. pp. 201-211; Boslan, Chelcie C. Estate Tax Valuation In the Sale or Merger of Small Firms. Prepared by the Brown University for the Small Business Administration under the Management Research Grant Program. New York, Simmons-Boardman Pub. Corp., 1963. 289 p; Woods, W. Fred. The Increasing Impact of Federal Estate and Gift Taxes on the Farm Sector: Present Law and Proposed Changes. U.S. Department of Agriculture. Report #242, July, 197; and Lackman, Conway L. Effect of Taxes on Business Mergers. The Antitrust Bulletin, v. 23, Fall 1978. pp. 551-588.

16 This effect is true in the short run because experience has shown that the real rate of interest tends to decline in the short run as the price level (i.e., inflation) goes up. In the long run, the real rate of interest should be neutral with inflation and therefore the price of assets should not increase more than other types of commodities.

17 In addition to the personal exemption and the standard deduction discussed earlier, other elements of the Federal income tax are indexed to inflation: the beginning and ending incomes of the various income tax-rate brackets, the earned income tax credit, the standard deduction for the blind and the elderly, the income level at which the personal exemption is phased-out for wealthier people, and the income level at which the limit on itemized deductions becomes effective.

18 These arguments were prevalent during the 1970s when the exemption was constant at $60,000 level for the longest period (1942- 1976) when inflation began to accelerate subjecting gradually more decedents to the estate tax. The claim has been made more or less regularly since the late 1980s due to the fact that the exemption has been fixed at $600,000 since 1987.

19 This is based on the annual rate of GDP deflator changes. Measured on a quarterly basis the rate of inflation exceeded 5 percent in four quarters of the 48 quarters.

20 Liquid assets are defined as cash, annuities, life insurance, mortgages and notes, bonds, and corporate stock other than closely held stock. Essentially liquid assets include all assets other than real estate and business assets including closely held stock.

21 There are several conditions that have to be met, in order to qualify for special use valuation: (1) the decedent must have been, at death, either a resident or citizen; (2) the real property (land) must comprise 25 percent of the adjusted gross estate; (3) the property must pass to a QUALIFIED HEIR, defined as a member of the decedent's family; (4) the property must have been employed in a QUALIFIED FARM OR BUSINESS USE for 5 of the last 8 years prior to the decedent's death; and (5) there was MATERIAL PARTICIPATION by the decedent or a member of the decedent's family for 5 of the last 8 years prior to the decedent's death.

22 This tax benefit is also subject to certain limitations.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Institutional Authors
    Congressional Research Service
  • Subject Area/Tax Topics
  • Index Terms
    estate tax
    small business
    tax incentives
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 95-1533
  • Tax Analysts Electronic Citation
    95 TNT 22-60
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