Estate-Tax Repeal: Bad for Small Business?

Full repeal is great for billionaires, but could hurt most business owners

Even before Hurricane Katrina blew a hole in the fall Congressional agenda, it was becoming clear that full repeal of the federal estate tax was not likely to pass the Senate. Despite what many small business groups have led their members to believe, this could be a very good thing. Not only is full repeal enormously costly, it would actually hurt most small business owners.

That is the analysis of the Small Business Council of America, a non-partisan lobbying group that has represented small business owners on tax issues for 25 years. According to the group’s chair, Paula Calimafde, full repeal only benefits the very wealthiest American families and wiping out the estate tax, rather than reforming it (a move supported both by Republicans and Democrats) could cause serious harm to heirs of business owners.

How so? If Congress eliminates the estate tax, it also eliminates a key feature of the law, the step-up rule. Under the current law, when an individual dies, the value of his or her assets are “stepped up” for tax purposes to whatever they were worth on the date of death. This is critically important for inheritors, because when they sell the business, they will pay capital gains taxes only on the increase in value that occurs after the founder’s death. Without the step-up, the basis for calculating the capital gain would be whatever the founder put into the business when he started, perhaps decades ago. Indeed, Calimafde testified before Congress last spring that many heirs would be unable to document how Mom and Pop capitalized the company and would wind up paying capital gains on 100% of the sale price of the business.

Repeal would also wind up hurting small business owners in another way: As middle-class and upper middle class taxpayers, they would most likely be called upon to pay higher income taxes to fill the budget hole that repeal would produce. How big a hole? Over the summer, the Congressional Joint Committee on Taxation estimated that if full repeal were to take place in 2006, it would cost $260 billion in lost revenue through 2015. Joel Friedman, a senior fellow at the Center for Budget Policy Priorities, a foundation that studies the impact of tax policies on the poor, says the true cost would be nearly $1 trillion, because the amount of missed revenue rises in later years; by 2015 it will be an estimated $72 billion annually, Friedman says. Between 2012 and 2021, according to CBPP estimates, the lost revenue would amount to $745 billion and the additional borrowing expense incurred by the government would add up to $245 billion.

According to Calimafde and other critics of full repeal, the impact of estate taxes on owners of farms and family-owned businesses has been greatly exaggerated. In 2000, according to the Congressional Budget Office, only 485 estates containing a family-owned business--those that used the qualified family-owned business-interest (QFOBI) deduction—actually paid estate taxes. And that was when only $675,000 (per individual) was excluded from estate tax. Since then, the exclusion has more than doubled, to $1.5 million, and the number of small businesses affected by the tax has fallen further.

While the estate tax has been back-burnered since Katrina, the issue is likely to return soon. Like other portions of the 2001 tax law, the estate-tax rules will sunset in 2010. So, after nearly a decade of raising the exclusion (to $3.5 million in 2009), and after one year of full repeal, in 2010, the law would take a giant step backward: Without new legislation, the estate tax returns in 2011 with just a $1 million exclusion and a top rate of 55 percent.

Nobody wants that. But total repeal raises an array of issues. In addition to the budget implications, full repeal would reverse a policy that was expressly designed to prevent the establishment of a European-style moneyed aristocracy in the U.S.—a policy first put forth nearly a century ago by Republican Presidents Theodore Roosevelt and William Howard Taft, in response to the excesses of the “Robber Baron” era.

Repeal has passed the House, most recently in the Bush Administration-supported H.R. 8, in April. In the Senate, however, the measure has never reached the floor. Senator Jon Kyl (R-Ariz.), who began pushing for full repeal just months after the 2001 tax cuts passed, this summer began floating ideas for a reform proposal instead.

Higher Exclusion, Lower Impact
(estimated number of estates where the majority of assets are a farm or small business that would be taxed in 2011 at different exclusion levels)
Exclusion	Small Business/Farm Estates
$1 million	760
$2 million	210
$3.5 million	50
Source: Center for Budget Policy and Priorities

As the outlines of a reform compromise emerge, say Friedman and Calimafde, the interests of the very wealthy and most small business owners will likely be in conflict. The key area to watch is the trade-off between tax rates and exclusion levels: Most small businesses are far better off with a higher exclusion, since that will exempt all or most of their wealth from any taxation. “For the big guys, it’s the rate that really matters. Cutting the tax rate for a billionaire from 45 percent to 15 percent gets you a hell of a lot,” says Friedman. “For a small business owner, it’s just the opposite.”

The outlines of a compromise have been shifting in recent weeks. According to Congressional Quarterly, Kyl has floated exclusion rates as high as $10 million per person and, more recently, as low as $3.5 million. What he has not budged on is an estate tax rate of 15 percent, the same as the current capital-gains rate. According to the CBPP, Kyl’s costliest option would only recapture 7 percent of the $1 trillion that would be lost in full repeal. With the 15 percent rate and a $3.5 billion exclusion (rising gradually to $5 million to reflect inflation), the CPBB projects that the treasury would still lose out on $770 billion between 2112 and 2021. According to an analysis by the Tax Policy Center, a joint venture of the Brookings Institution and the Urban Institute, if the exclusion is $3.5 million per individual and the tax rate is 45 percent (the rate now slated for 2009), 220 estates containing small businesses and farms in them would be subject to federal estate tax in 2011. Of those, only 10 would have gross estates in the $3.5 million to $5 million range. With a $5 million exemption, a total of 150 small business and farm estates would be subject to estate tax, the group estimates.

The SBCA favors raising the exclusion to $3.5 million (and then gradually to as much as $5 million to reflect inflation). Under that proposal, Calimafde notes, less than 8,500 estates in the whole country would be subject to estate tax in 2011—that’s just the richest 0.3 percent of Americans who will die that year.

Those are the die-hard proponents of repeal. “If you’re a billionaire, you just can’t raise the exclusion enough,” Calimafde notes. For them, repeal is the best deal and they have not given up. “The folks behind repeal have been planning this for 12 years,” Calimafde says. “It took a lot of disinformation to get to this point. What is very frustrating to us is to see small business owners carrying water for billionaires.