April 14, 2005

April 14, 2005 | Testimony on Taxes

How Federal Death Taxes and the Alternate Minimum Tax Challenge America's Small Businesses

William Beach

Director of the Center for Data Analysis

The Heritage Foundation
before the

Subcommittee on Tax, Finance and Exports of the
Committee on Small Business of the
House of Representatives
Washington, D.C.

April 14, 2005

My name is William W. Beach, and I am delighted to present the following arguments in support of estate tax repeal and repeal of the Alternative Minimum Tax (AMT) to the Subcommittee on Tax, Finance and Exports of the House Committee on Small Business. I am the John M. Olin Senior Fellow in Economics and Director of the Center for Data analysis at the Heritage Foundation, a Washington based public policy research organization. The following remarks constitute my own opinions, and nothing in this testimony should be construed as representing the views of The Heritage Foundation or support by the Foundation for any legislation pending before the Congress.

It hardly exaggerates the importance of small businesses to U.S. economic performance to state that economic activity would be substantially less without a deep and healthy layer of small businesses. We have only to look at other economically developed countries that tax and regulate their smaller sized businesses more heavily to know what ill health in that sector leads to. Relative to the United States, they have higher unemployment rates, lower levels of investment, and slower rates of per capita economic growth.

While the U.S. provides a friendlier economic environment today for small businesses, it has not always been so. High individual income tax rates after World War II discouraged small, non-corporate business and encouraged the growth of ever larger business organizations. Regulations governing the application of new technologies, particularly in telecommunications, computing, and transportation reduced efficiencies in these sectors that could have been provided by small businesses competing in freer markets.

Thanks to the tax reforms that began in 1981 and continue to this day and the steady deregulation of key aspects of the U.S. economy, those bad old days are fading from memory. However, there is nothing inevitable about the process of liberalization of economic life. Continued progress requires the relentless attention and pressure of economic liberals in the Congress and the larger policy community to further expand economic liberties by reducing the burdens of taxation and regulation.

The Congress again is challenged to support the growth of small businesses by addressing two enormously damaging components of current U.S. tax policy: federal death taxes and the Alternative Minimum Tax. Death taxes (estate, gift, and generation skipping taxes) cut deeply at the central, core values of American economic life. Indeed, as I shall argue shortly, they are taxes on economic virtue and deserve immediate repeal if for no other reason than the immoral policing activity they sanction. The AMT compliments the devastation wreaked by death taxes. At a time when average tax rates are falling for many Americans, an increasing number of taxpayers find themselves thrown onto the AMT rolls, where tax burden is rising. The growth in the number of AMT taxpayers means that their capital and labor are more heavily taxed, which in turn increases the costs of labor and capital to small businesses. 

It is time that the Congress repeal both of these taxes.


Repeal Death Taxes

The Economic Growth and Tax Relief Reconciliation Act of 2001 increased the amount that taxpayers can exempt from estate and gift taxes and slowly reduced the rate over the period 2002 through 2009. Then, the Act repealed death taxes for one year, 2010, before restoring them at their 2003 levels in 2011.

Congress created this bizarre fiscal hiatus in order to enact all of the tax policy changes given the amount of money it had set aside through its budget resolution for tax relief. Compounding this difficult task was a last-minute estimate by the staff of the Joint Committee on Taxation (JCT) of how much federal revenue would decrease if Congress permanently repealed all federal death taxes. By using static rather than dynamic scoring and by making assumptions about how federal income and gift tax payments would interact, the JCT significantly increased the "cost" of repeal, thus forcing congressional tax writers to create this on-again, off-again tax policy.

When President Bush signs legislation eliminating this peculiar hiatus and making death tax repeal permanent, taxpayers will likely do two things:

  1. Cease economically wasteful federal estate tax planning,
  2. Focus more on running their businesses and personal affairs knowing for certain that they do not have to look over their shoulder for the death tax collector.

Good tax policy is known for its certainty, if for no other characteristic. Without predictability, tax policy can create confusion and have a lethal effect on economic activity.

Permanent repeal would eliminate a number of death tax threats posed to economic activity. The death tax hinders economic activity in the following ways:

  1. Discourages savings and investment;
  2. Undermines job creation and wage growth;
  3. Prevents economy from achieving investment potential;
  4. Contradicts central promise of American life: wealth creation.

Discourages savings and investment. For those Americans who think that their estates may one day pay federal death taxes, the tax sends a signal that it's better to consume today than invest and make more money in the future. Instead of putting their money in the hands of entrepreneurs or investing more in their own economic endeavors, the unmistakable message of federal estate taxes is to consume it now, not pay it later.

Undermines job creation and wage growth. Not only does this message have a corrosive effect on the virtue of savings and prudent investment, but also it directly undermines job creation and wage growth; and these latter effects make death tax repeal everyone's concern. Heritage Foundation economists estimate that the federal estate tax alone is responsible for the loss of between 170,000 and 250,000 potential jobs each year. This additional employment never appears in the U.S. economy because the investments that would have resulted in higher employment are not made.

Prevents economy from achieving investment potential. Further, the effect of the estate tax on preventing the economy from achieving its investment potential holds down wage growth. Workers are more productive when they have new tools, machines, and factories; and increased productivity boosts wages and salaries. It is through productivity growth that enhancements to economic and social well-being are and the virtues of our form of economic organization are most abundantly seen.

Contradicts central promise of American life: wealth creation. Indeed, the support for permanent repeal of federal death taxes stems generally from the appreciation of this last feature of our economy. Most Americans oppose death taxes because they seem so un-American. The death tax appears to many people as a clear contradiction to a central promise of American life: that if you work hard, save, and live prudently, you will be assured the enjoyment of your economically virtuous life. There are few other places on the planet where this promise is made (let alone kept), and it along with companion promises of political and religious freedom has attracted millions of immigrants to the United States.

Death taxes eat away at this promise. Some Americans, like farmers, ranchers, homeowners, face the threat of death taxes because they have improved the land upon which their other assets sit or because factors beyond their control, like the population growth of cities, drive up the price of their property. Many Americans save in their businesses in order to pass an asset along to their children; and, for millions of African-Americans and others for whom the economy is not always benign, the threat of seeing their life savings absorbed in a single tax bill is reason enough to demand permanent repeal.

Still others are just starting out or, like many women, returning to the labor force after raising families or taking care of other obligations. There before them is an economy that welcomes their enterprise and creativity, that promises a living in exchange for meeting the needs of people in their community. Small businesses offer a way around the corporate glass ceiling, and the language barriers that immigrants face in larger organizations are seldom-insurmountable obstacles in a business you own yourself.

What About Small Business Carve Out Legislation?[1]


Narrowly aimed family business estate tax relief has been attempted in the past--it has failed miserably every time. The most recent Code section aimed at family business estate tax relief was recently repealed IRC Section 2057. Section 2057, before its demise on January 1, 2004, was commonly known among estate planning attorneys as the single most complicated estate tax Code section ever drafted. The legislation contained page after page of definitions and tests that had to be interpreted, applied, and deciphered in order to determine whether a taxpayer even qualified for potential relief. In addition, the Code section relied upon numerous cross-references and definitions throughout the Code. Many law firms refused to consider applying Section 2057 because of the potential malpractice of applying it incorrectly.

On January 7, 2003, with Section 2057's repeal imminent, S.34, the so-called "Estate Tax Repeal Acceleration for Family-Owned Businesses and Farms Act" was introduced. It quickly became known as the Section 2057 replacement, and quickly became as unpopular as Section 2057. The bill died before ever being brought to a vote. 

In its simplest form, Senate Bill 34 was designed to give an executor the option of deducting the full value of what would be known as the "carryover business interest" ("COBI") from the taxable estate. The COBI would then take a carryover basis (a basis equal to the decedent's basis), or the COBI would take a basis equal to the property's fair market value, whichever was less.

The simplicity stopped at that point. The threshold determination of whether a family business interest qualified as a COBI interest depended upon how many families owned an interest in the business, and the percentage interest owned by each particular family. If multiple generations are involved in a family business, which is often the case, and certain family members want to diversify and sell their interest, it becomes questionable whether the business will meet the required definition of "family business." 

The proposed legislation then listed certain business interests that were expressly excluded:

  • Business interests attributable to cash or marketable securities, or both, in any amount in excess of the "reasonably anticipated business" needs of such entity;
  • Business interests in any entity that is readily tradable on an established securities market or secondary market at any time (whether currently or in the past); and
  • that portion of a business interest in an entity transferred by gift within 3 years before the date of the decedent's death.

Senate Bill 34 also required a fact-specific inquiry into the family's business activities during the 8 to 10 year period preceding the decedent's death. The bill required "material participation" in the business by certain family members or a "qualified heir," but failed to provide guidance on what constituted "material participation."  

The shortcomings of S.34 were evident almost immediately through its repeated cross-references to other Code sections. The numerous cross references to Section 2032A were reminiscent of flawed Section 2057. Including the cross-referenced pages, the 9 pages of proposed legislation easily turned into 20 pages of statutory games, which would have provided little if any relief. As such, the bill died.

As fresh and progressive as this economic picture appears, at the end of a life of economic struggle still stands the nightmare of the American dream. Without swift and decisive action by Congress, the death tax withers over the next decade but does not die. The uncertainty in tax planning will grow, the economy will consistently under perform, and the hypocrisy of the economic promise of American life will reverberate louder than ever. Now is the time to bring this sorry chapter in U.S. tax policy to a close.

The estate tax relief stemming from family business carve out legislation is uncertain at best. However, the enormous legal fees, accounting fees, and appraisal fees that such proposed legislation would generate are most definite. Legislation like S.34 and former Section 2057 would undoubtedly incorporate and cross reference other complex Code sections--2032A, 6166, and 267. Use of such proposed legislation would be dependent upon a lawyer's interpretation of the statute and quantitative calculations run by accountants. It would be impossible to attempt to even qualify for relief under such proposed legislation without professional assistance. It would generate thousands upon thousands of dollars in professional advisory fees, which would likely result in a finding that a decedent's business does not qualify for tax relief. Why generate the need for professional advisory fees when a permanent repeal of the estate tax effective January 1, 2005, would provide more realistic and practical relief.

Family business carve out legislation creates and invites more tax related litigation. As with S.34, such legislation would find business-owned liquid assets inherently offensive. In S.34, the definition of COBI excluded cash or marketable securities to the extent that the cash or marketable securities exceeded the "reasonably anticipated business needs" of the family business, as determined by the Service (if such a determination is even possible). Despite a justified business reason for owning significant liquid assets, relief would not be available for the portion of the business that the Service determined to be excess liquid assets. Proceeds from a corporate division or divestiture, or capital needed for improvements or future investments (i.e., capital for purchasing equipment or real estate) would be considered suspect, and if the Service determines it is "too much," tax relief would be thwarted. Why are liquid assets inherently offensive to the drafters of family business carve out legislation? 

It is expected that many family businesses would not satisfy the "material participation" requirements of S.34 type legislation through the use of a "qualified heir." A qualified heir has been defined as a non-family member who has managed the business for 10 years preceding the decedent's death. Because many families have transitioned management of the family business and have employed a series of "outsiders" to run the business, those businesses would likely fail the requirement that one person had to have been in charge for 10 years. A ten-year tenure, such as the one required under S.34, is unusually long for an outsider. In addition, there is no definition of what constitutes "material participation" by a "qualified heir." Even if such definition were provided, it would be highly complex and require professional advice for interpretation.

Such a ten-year period required for outside management would also strangle traditional business decisions. For example, an inefficient executive manager would find comfort in knowing that his lack-luster performance is protected by family business carve out legislation because his ten-year tenure is required by the legislation in order for the family to pass the business to the next generation. Over inflated compensation packages would become the norm in order to prevent a manager from leaving just prior to the ten-year tenure period, which would make relief unavailable. An outsider's desire to perform poorly or leave a position should not create multi-million dollar estate tax consequences for the family business owner's family. 

Businesses that contemplate becoming public businesses, either permanently or temporarily, would be forced to change their long-range business plans. Legislation such as S.34 prevented the use of public funds as a means of raising capital or expanding the business, even temporarily. The definition of COBI excluded businesses that had ever been "readily tradable on an established securities market or secondary market." The proposed legislation would certainly stifle economic business growth and development, along with the additional jobs that come with such growth.

Simply stated, legislation such as S.34 and former Section 2057 discriminates against family businesses that do not fit complicated statutory molds. Those statutory business molds fail to address the practicalities of operating a business. A business's Capital needs, employee and management issues, and stock percentage ownership decisions, cannot be confined to an inflexible and complicated set of arbitrary rules in order to save the business from liquidation to pay estate taxes.  If such legislation is passed, family businesses will fail to qualify for relief, liquidations will inevitably occur, jobs will be lost and economic development will suffer. Below are two case studies.

Repeal the Alternative Minimum Tax

In a private conversation I once had with former Senator Bob Packwood about the AMT, I asked him how many taxpayers he and his House colleagues intended the AMT to affect. While the Senator could not recall that any one number dominated the tax writing deliberations of the Senate Finance Committee, he believed it could not have been more than 150 very high-income taxpayers. 

We are a very far cry from 150 taxpayers today. If we do nothing to rein in the AMT or repeal it, that tax is expected to be paid by nearly 40 million taxpayers in just five years from now. If that forecast holds, the population of AMT taxpayers would have grown by 16times since 2003.

This growth is particularly troubling because of the emphasis it gives to how badly the designers of the AMT built it. Congress originally intended this tax to make certain that taxpayers who could afford clever lawyers and accountants would not escape taxation entirely through innovative uses of tax shelters, credits, exemptions, and deductions. By 2010, however, the AMT will reach down to taxpayers even in the lowest 20 percent of the income distribution. 

Congress's well-intentioned changes to tax law are to blame for this expansion. When Congress turned the income tax into its principal tool for social and economic engineering, it created a host of opportunities for taxpayers to reduce their tax liabilities by taking lawful advantage of exemptions, credits, deductions, and "shelters." However, when Congress began to reduce tax rates in the late 1990s, they also created circumstances where taxpayers would trigger an AMT liability by taking advantage of these tax preferences. Indeed, the 2001 tax cuts alone likely will account for doubling in the number of AMT taxpayers by 2010.

The personal AMT directly affects individuals who file their business taxes through the 1040 income tax form in a number of ways. 


  • First, AMT filers pay generally higher tax rates than regular tax filers: the AMT rates are 26 and 28 percent. Higher tax rates mean that one's own labor and capital costs are higher, thus either driving down overall operating margin or increasing prices.
  • Second, the AMT tax brackets are not indexed for inflation, unlike the regular tax brackets. That means that AMT filers annually face an increase in their taxes just from the effects of inflation.
  • Third, small businesses located in high-tax states are much more likely to incur AMT liabilities than those in low-tax states. According to Leonard Burman and David Weiner,[2] the state and local tax deduction permitted on the 1040 accounts for 51 percent of all AMT tax liabilities. Indeed, taxpayers in high-tax states are "five percentage points more likely to be on the AMT than those in low-tax states."[3]

Congress recently increased income levels below which taxpayers are not subject to the AMT. Currently those levels are $58,000 for married taxpayers and $40,250 for singles. That increase has produced some relief. However, the exemption levels are scheduled to fall in 2006 to $45,000 for couples and $33,750 for singles.

The Center for Data Analysis estimates that this single movement downward in exemption levels will have a significant effect on the number of small businesses subject to AMT taxation. Table 1 below shows the estimated number of small businesses who file their business taxes through the individual income tax system and who also have AMT liabilities. 

Table 1

If Congress does nothing to extend the current exemption levels between now and the end of the year, our analysis shows that small business AMT taxpayers will increase by over 3 times in number, from 1.9 million to 6.4 million.




It is hard enough running an independent, small business. Capital is hard to raise and retain, employees come and go, and the customers are continuously fickle and demanding. It is almost cruel to complicate the everyday difficulties of small business life with onerous taxes. Yet, Congress routinely does just that when it turns away from pleas to repeal death and AMT taxes.

If our country owes a large measure of its current prosperity to the virtuous, industrious, and innovative owners of small and medium businesses, it becomes Congress's duty to do whatever it can to create and advance economic liberty. The current Congress can make a significant step toward a better economic environment for businesses of every size by repealing federal death taxes and the AMT now and for good.

About the Author

William W. Beach Director, Center for Data Analysis and Lazof Family Fellow
Center for Data Analysis

Show references in this report

[1] The following section on small business carve outs draws heavily on a forthcoming essay by William Beach, Harold Apolinsky, and Craig Stephens, "Narrowly Aimed Family Business Carve Out Legislation Fails to Save Businesses from the Estate Tax." (Tax Notes, April, 18, 2005).

[2] Leonard E. Burman and David Weiner, "Suppose They Took the AM Out of the AMT?" (2004): www.taxpolicycenter.org

[3] Leonard E. Burman, Testimony before the President's Advisory Panel on Federal Tax Reform, March 3, 2005.