One of Monty Python’s more celebrated skits involved an allegedly dead parrot whom the pet shop owner insists is still alive.
Mr. Praline: I wish to complain about this parrot what I purchased not half an hour ago from this very boutique.
Owner: Oh yes, the, uh, the Norwegian Blue … What’s, uh … What’s wrong with it?
Mr. Praline: I’ll tell you what’s wrong with it, my lad. ‘E’s dead, that’s what’s wrong with it!
Owner: No, no, ‘e’s, uh … he’s resting.
With a little more imagination, John Cleese and his boys could have written Bush’s 2001 tax bill, which lowers the top estate tax rate gradually to 45 percent in 2009, following which, in 2010, it magically drops to zero.
Mr. Praline: This parrot is no more! He has ceased to be! ‘E’s a stiff! Bereft of life! If you hadn’t nailed ‘im to the perch ‘e’d be pushing up the daisies! ‘E’s off the twig! ‘E’s shuffled off ‘is mortal coil and joined the bleedin’ choir invisible!! THIS IS AN EX-PARROT!!
In 2011, for political reasons utterly divorced from tax policy, the estate tax rules spring back into being.
Owner: No, no, he’s not dead, he’s, he’s restin’! Remarkable bird, the Norwegian Blue, idn’it, ay? Beautiful plumage!
The president’s under-mis-simplification of the estate and gift tax rules (Hey, I’m making fun. The Dems’ fingerprints are all over this bill) doesn’t stop with rollercoaster rates. The dollar value that can pass through an estate free of estate tax, now $1 million, increases to $3.5 million in 2009. The exclusion for gifts, however, will remain at $1 million (lifetime, not per year), although the rate of tax on gifts will drop to 35 percent.
A remarkable bird, the Internal Revenue Code, id’nit, ay?
The system for taxing transfers of property during life (referred to even among the jargon-averse as inter vivos transfers) and the system for taxing transfers of property at death are together considered a unified system. The unified system is intended to impose a neutral calculus between the decision to give a gift during life and the decision to pass it on at death. Under the unified system, you are supposed to keep count of your inter vivos gifts (and, in fact, file a gift tax return for gifts of more than $11,000 to any one donee). At death, your executor, in calculating your estate tax liability, adds back your lifetime gift — your inter vivos transfers — to determine the applicable estate tax.
This doesn’t mean that inter vivos gifts are taxed again at death. Rather, it is a Congress-engineered bracket creep. An estate worth $1 million will not be taxed at all under the estate tax rules because there is a $1 million threshold for taxable estates. It may in fact be taxed, however, if the decedent had, during his or her life, made, say, a $1 million gift to a relative. Under the unified system, in determining how that $1 million estate is to be taxed, it will be assumed that the $1 million estate is the second of two transfers, the first being the $1 million given away during life. The estate tax rate applicable to the $1 million actually in the estate is determined by assuming a hypothetical $2 million estate.
Here are some important distinctions between the estate tax and the gift tax, unified or not. First, during life, a taxpayer may make a gift in value of up to $11,000 (adjusted for inflation) each year to an unlimited number of donees. (Example: If they behave, the old woman who lived in a shoe can skip the sound spanking and send each of her kids to bed with an annual $11,000 in cash or goodies.) The $11,000 is not added back at death in calculating estate taxes, and does not trigger the requirement of a gift tax return. Husbands and wives, moreover, may each take advantage of the $11,000 exclusion, i.e., $22,000 per donee for joint gifts. (Even if the $22,000 all came from one parent, it’s presumed to be a joint gift.) There is no such rule for estate taxes.
The second point is that while the transfer tax system is unified in important respects, the true tax cost of an inter vivos gift is different from that of a transfer at death. If an estate has to pay $200,000 in estate taxes, that’s $200,000 less available for distribution to heirs. In the case of a gift, however, the donor rather than the donee bears the gift tax burden.
For a good while, the superwealthy avoided the estate and gift tax by conveying property one or more generations beyond the immediate offspring of the donors. A wealthy older parent may have given as much as he or she deemed sufficient to a child or children. If the older generation held on to everything in excess of that given to the children, then, at death, the estate would be subject to the full estate tax. One avoidance gambit, actually copied from medieval England, was to convey additional assets to grandchildren, typically in trust. This was, and still is, termed a generation-skipping transfer.
Absent special taxing rules for generation-skipping transfers, the technique allows for considerable tax savings, because wealth can be transferred through two generations — parent to grandchild — but be subject to one rather than two rounds of wealth transfer taxes. Congress, however, has insisted that wealth pass through the estate and gift tax tollbooth at each generation. The generation-skipping tax is intended to tax the “skip,” the transfer that never took place between the parent generation and their children.
An important vehicle for minimizing the tax on wealth transfers involves family limited partnerships. The parent generation contributes financial assets — either stocks and bonds or an interest in a going business — to a pass-through entity, either a limited partnership or a limited liability company. The parent then gives an interest in the entity to the kids but retains full control over governance. The interest given away is reported as a gift, but at a “discounted” value.
Discounting a limited partnership or limited liability interest means taking account of the fact that the interest cannot be sold on a public market, and the fact that the owner of the interest has no control over the management of the entity or its assets. For example, a 50 percent limited partnership interest in a partnership that owns $1 million of marketable securities is not, under this theory, worth $500,000, but rather only 60 percent or 70 percent of that amount — about $300,000 to $350,000 — because the limited partner can’t easily liquidate his or her position and has no say in management.
Owners of active businesses also engage in “freeze” transactions. The company recapitalizes, creating two classes of ownership, one for Dad and one for his daughter who works in the business. Dad’s interest is a preferred interest, such as preferred stock — the first so many dollars of profits each year goes to Dad. The rest, if there is any, goes to the daughter, who owns the second, common stock-like class of interest.
Family limited partnerships and freezes are kind of like artery shunts and heart bypasses. These are so routine you’d almost imagine they were outpatient procedures. As Bart Simpson wisely observed, however, organ transplants, family limited partnerships and estate freezes are best left to the experts. Don’t even think about letting a generalist do any of them for you.
But an estate plan, no matter how expertly crafted, is but a Norwegian Blue parrot nailed to the perch, if it is prepared without a succession plan — a roadmap for handling the transition from management by the founding generation (only a tiny fraction of family-owned businesses stay in the family for three generations) to the successor generation. Before you shuffle off your mortal coil (that’s Shakespeare, not Monty Python), have your estate planner contact your business lawyer and tie business succession documents into the will.
Remarkable bird, id’nit, squire? Lovely plumage! * *
© Maryland Gazette. Reprinted with permission.