At the current $2 million exemption level ($4 million per couple) only one in every 200 people who die in 2006 will owe any estate tax at all. Among the few estates that do pay the tax, the “effective” tax rate – that is, the percentage of the estate that is actually paid in taxes – will be much lower than the top estate tax rate, which is currently set at 46 percent. According to the Urban Institute-Brookings Institution Tax Policy Center, the average effective estate tax rate on estates that owe any estate tax at all will stand at only 19 percent in 2006 … Why is the effective tax rate so much lower than the top tax rate established in law? First, estate taxes are due only on the portion of an estate’s value that exceeds the exemption level, not on the entire estate … Second, a large portion of the estate’s remaining value can be shielded through available deductions (for charitable bequests and state estate taxes paid, for instance). Additional options to mitigate the impact of the estate tax are available to family-owned businesses and farms, which can take advantage of special “valuation discounts” and can spread their estate tax payments over 14 years. Further, many large estates employ planning devices (such as insurance trusts) to shrink the size of the taxable estate
The first reason is simply the fact that average rates tend to be below marginal rates when there are exemptions ($4 million for a couple). I’d like to expand on the third reason labeled special “valuation discounts” by considering an elderly couple who wish to leave the family business to their four heirs. The business tends to generate $10 million per year in profits and if we reasonably assume a 10% cost of capital, this business is worth $100 million. While the kids are eagerly hoping to get a 25% share of this business and keep $2.5 million per year in income, the estate attorney has calculated that 46% of $96 million (the $100 million minus the $4 million exemption) means the tax man would be looking to be $44.16 million. Oh my – how will the kids deal with this? After all – borrowing to pay the tax man means they’ll have to collectively pay $2.2 million in interest expenses to the banks. Wait a second – each kid will still have $1.95 million in income each year. How will they survive?
But back to the estate attorney who has a Rolodex of appraisers who will give him any whore answer for the right fee. The appraiser/whore that is chosen to evaluate the fair market value of the business has three tricks up his (her) sleeve. First, let’s assume that this S corporation (which pays no income taxes) has to become a C corporation (which of course is hogwash) so we can assume a phantom 40% income tax rate reducing $10 million to $6 million. Next, let’s use some “build-up” approach (aka junk science) to assert a 20% cost of capital putting forth a value estimate of only $30 million. Wow – magic, but we are not done. Remember those “valuation discounts” for fictitious matters like minority owner discount (after all, the parents were all about cheating the kids) – which means we take an arbitrary 30% to 35% discount. So now the business is appraised at $20 million and with the $4 million exemption, the tax bill is only $7.36 million. Wow – an effective estate tax rate less than 8%. But then the kids will have to borrow, which means each has to pay the bank around $90,000 a year in interest out of their $2.5 million per year in operating profits.
Does this seem too easy? Doesn’t the IRS have their own appraisers that can effectively rebut the bogus valuation reports commissioned by the estate attorney? One would think so – but read most of the Tax Court decisions in this area and realize that even the National Review looks smart and honest by comparison.
Aviva Aron-Dine and Joel Friedman are suggesting relatively modest effective estate tax rates are observed in practice. My guess is that they have likely overestimating these effective rates. But when folks like Senator Kyl claim that people have to turn over half of their company to the government or the estate tax forces people to sell the family farm – they are either horribly ignorant or just telling you a pack of lies.