Aftermath in the afterlife

If caught unprepared, Washington’s estate tax may threaten family-owned businesses

Almost 90 percent of businesses in the U.S. are family-owned, but statistics show only 30 percent survive to the second generation, 12 percent to the third generation and just 3 percent to the fourth generation. These succession rates may be due to a number of factors, including poor business planning, selling off to outside interests or a lack of interest from younger generations. Among the many threats, according to family-business owners and professionals, are estate taxes.

Businesses not properly prepared can find themselves in a difficult situation when asked to pay up on an estate following the death of a family member. For a Washington resident that passes away in 2006, a state tax would be assessed on estates exceeding $2 million at a rate between 10 percent and 19 percent, depending on the size of the estate.

Family affair
Irene Flowers owns Camp Kalama on the Kalama River near Interstate 5. She bought the 15-acre property, which includes an RV park, campground, convenience store and café, 25 years ago with her husband. Flowers, 73, is now a widow, and when she dies, she would like to pass Camp Kalama on to her three kids, who are all involved in the business.

"This is a business that people will continue to come to," she said. "The idea is to keep it in the family."

Flowers estimated the value of the land alone at $5 to $6 million. If she passed away today, Flowers said her kids would be unable to come up with the taxes that would be due within nine months of her death without selling the business.

Flowers said she has begun planning to have ownership of the business transferred to her children. She figures she would have to live 20 more years to fully transfer ownership to her children and avoid a detrimental estate tax.

"I don’t want to sell it," said Flowers. "We worked all these years so our kids would have something."

Estate taxes are not new, but with changes to how they are applied at the state and federal levels in recent years, the situation has become much more complex. Business owners are now faced with new circumstances that take years to properly plan for.

Federal changes
In 2001, the Economic Growth and Tax Relief Act began the phase out of the federal estate tax that culminates in a full year-long temporary repeal in 2010. But unless further legislation is passed, the federal estate tax will be reinstated a year later at 2002 levels. In 2002, estates of more than $1 million were subject to the federal estate tax, which has grown to $2 million this year and will reach $3.5 million in 2009. Also phased out from 2002 to 2005 was the federal estate tax credit, to which state estate taxes were tied. Prior to its phase-out, a portion of funds collected from the federal estate taxes were paid to states under this credit. So while both a state and federal estate tax were paid, the total never exceeded the maximum federal estate tax owed.

Since Washington no longer shares in the federal estate tax, the legislature took action to make up for lost revenue by implementing a new, separate estate tax last year. And even though state estate taxes can be deducted when calculating federal estate taxes, the combined cost to taxable estates has increased.

Sixteen other states plus the District of Columbia retained estate tax revenue by creating a mechanism to collect taxes from estates of residents following the phase-out of the federal estate tax credit.

Opposition mounts
Camp Kalama is not alone in its desire to defeat Washington’s estate tax. Opponents in the legislature are gathering signatures in an attempt to get Initiative 920, which seeks to repeal the estate tax, in front of voters in November. Estate tax proponents – largely state Democrats and the very wealthy who have planned around it – say the tax is necessary to redistribute wealth and fund state services, such as education programs. The progressive tax raised $83 million in 2000, $115 million in 2002 and $140 million in 2004. Furthermore, the estate tax encourages charitable giving.

Those against the estate tax say it is not the wealthy that end up paying the estate tax. Vocal opponent Rep. Ed Orcutt, R-Kalama, said the very wealthy can avoid the tax through long and expensive planning, but business owners like Irene Flowers at Camp Kalama with assets tied up in land value and busy working to keep the business afloat, will be hurt.

"These folks are trying to take care of business on a day-to-day basis," he said. "They are not executives … only looking at finances."

Heirs of a family-owned business are left with few good options, said Orcutt. They can take on debt by borrowing money, sell business assets, which could threaten profitability, or sell the business.

But with enough foresight, professionals say there are ways to lessen the burden and maybe avoid the tax all together.

Getting around it
Finding ways to decrease the value of the estate to fall below taxable levels or creating liquidity to pay any taxes an estate may face are key ways to protect a family-owned business.

The transfer of assets before death to reduce the size of an estate is one option. For example, each parent can gift up to $12,000 annually to each heir tax free, and individuals can gift up to $1 million in their lifetime without owing a gift tax. Charitable gifts are tax free and can also reduce the size of an estate.

Life insurance policies create liquidity at the time of death and allow heirs and business partners to pay estate taxes and other expenses. And trusts can be established to shield assets from estate taxes.

There is not a one-size-fits-all solution, as the structure of every business and family is different. The consensus among professionals, however, is to start early.

"It’s something people put off, but shouldn’t," said Patricia Eby, a CPA with Peterson and Associates.

Being too busy running the business and not wanting to consider planning for their own death are reasons Eby said many begin estate planning too late.

Estate planning involves a mix of tax, business and personal planning. Attorneys, business consultants, financial planners and tax professionals can help create a succession plan that takes the goals of the family and business into consideration.

"An estate plan has to be consistent with the business plan," said Lisa Lowe, managing shareholder of the Vancouver office of Schwabe, Williamson and Wyatt.

Knowing who will take over and manage the business – and having them involved in the business early – tends to make succession of family-owned businesses more successful.

Vancouver’s Evergreen Memorial Gardens Cemetery and Funeral Chapel has three generations involved in the business today. Will Carlson, 83, is the chairman and largest shareholder of the business. His three children also own portions of the business. His oldest son, Brad Carlson, 53, is president of the company and the only child involved in operations. And before the transition to the second generation is complete, Brad Carlson’s daughters, aged 24 and 25, recently began working at Evergreen Memorial Gardens.

"Around the corner is the transition to the third generation," said Brad Carlson, "which they say is the toughest."

Carlson said the family has gone through some estate planning, including buy/sell agreements. The estate tax has been considered in the planning. The third generation has slowly become involved in the business, said Carlson, but he would like to see the business continued to be passed on in the family. Carlson sees the estate tax as a possible barrier to that occurring.

"I am not in favor of the Washington state death tax at all," he said.

How it’s done at home
Washington’s estate tax went into effect May 17, 2005. The law allowed an exemption of $1.5 million for people dying in 2005 and $2 million for people dying on or after Jan. 1, 2006. Estate tax rates start at 10 percent on estates exceeding $2 million and increase gradually to 19 percent on estates exceeding $9 million. The estate tax return is due nine months after the date of death.

The value of farms and timberlands meeting certain requirements are deducted from the taxable value of an estate as long as certain requirements are met. The farm must comprise at least 50 percent of the estate’s value and must pass to specified heirs.

Repealing the federal estate tax
The federal estate tax is on its way out – for now. Until 2010, the value of estates subject to exemption will grow while the tax rate decreases. Unless further legislation is passed, in 2011, the federal estate tax will be reinstated at the 2002 level.