Dick Patten
President
American Family Business Institute
1920 L Street NW, Suite 200
Washington, DC 20036

Testimony to:

The U.S. Senate Finance Committee
Hearing on “Alternatives to the Current Federal Estate Tax System”
March 12, 2008

Chairman Baucus, Ranking Member Grassley, and Members of the Committee: I am honored to present testimony on behalf of the American Family Business Institute and the family-businesses and farms we represent. I want to explain why the inheritance tax is no “alternative” to the existing federal estate (or rather, death) tax.

This hearing, though thought-provoking, may miss the point. Any alternative to the existing system should reduce the overall burden placed on family businesses and farms. The inheritance tax, as I will explain, would increase the overall burden. Moreover, the arguments for this proposal are predicated on the same wrong notions about earned wealth as those of the arguments for maintaining our existing death tax. Family-businesses and farms create economic opportunity for all and should not be punished as though their success came at the expense of other Americans. Abolishing the death tax is the policy most in the interest of America’s family-business owners, farmers and the economy as a whole.

I. Problems with the Inheritance Tax

There are three specific problems with the inheritance tax in her proposal as proposed by panelist Lily Batchelder, who made the clearest case in support of such a tax. Taken together, these problems make the inheritance tax an unacceptable “alternative” for the existing estate tax.

First, the effective rate of the inheritance tax would be somewhere between 65% and 69.6%, much higher than the current rate of 45% and even the scheduled 2011 rate of 55% . Ms. Batchelder recommends using the income tax to establish the base level of taxation, the highest rate of which is currently 35% (but slated to increase to 39.6% in 2011 when the 2001 tax relief expires). Next she would add a “surtax” of 15% , bringing the current total to 50% and the 2011 total to 54.6%. Finally, she implies that stepped-up basis for capital gains should be eliminated, resulting in yet another 15%.

When today, farms and family-businesses are already facing financial ruin due to a rate of 45%, what sense does it make to increase it by 50%?

Second, the Batchelder inheritance tax would encourage the disintegration of family-farms and businesses through fragmented ownership. The inheritance tax provides an exemption on the basis of inheritances received, meaning the only way around the onerous rate is to bequest to enough owners as to take advantage of the full exemption amount (Ms. Batchelder recommended an exemption of $2 million ). For many family-business and farmers, this would mean making bequests to non-children and even non-relatives, who may or may not have an interest in the business’s long-term viability.

For instance, if the owner of a farm valued at $10 million dies and has no cash to pay the inheritance tax, he would be encouraged to make 5 bequests (each at the $2 million exemption rate). However, if he does not have 5 children or other suitable heirs, then he would have to bequest a fifth of the ownership (or more) of his farm to an outside heir. This person may very well have more interest in immediate cash rather than preserving the farm’s character and viability. Giving this person ownership of the farm would place the rest of the family in conflict, rather than ensuring the long-term sustainability of the farm.

Proponents of the inheritance tax claim that it would make tax-planning less complex, but the incentive for disintegration of family-enterprises will make tax-planning only more difficult.

Third, the inheritance tax as proposed by Batchelder would provide a “deferred” payment plan for family-businesses and farms, which in reality, would only shackle them with burdensome debt. Under this plan, heirs who receive illiquid assets such as a business or farm and lack cash, could defer the tax indefinitely until the asset is sold. On face value, it almost sounds like a plausible solution to the problem faced by family businesses and farms.

However, there are two very important problems posed by this “solution” which make it untenable. First, annual interest would accrue on the amount of the tax owed by the heir. This means that within a number of years, a family inheriting a business or farm could theoretically owe 100% of the value of their enterprise to the government in taxes.

Moreover – as with any federal debt – until the tax is paid, the business would become a “borrower” of the federal government, making the IRS a silent partner in the business’s operations, secured by an IRS lien. As any executive is aware, the complications of nonproductive loans can wreak havoc with a business’s ability to borrow money for growth. This “deferment” plan does not work on paper and it would ruin family-businesses in real life.

I know of many business-owners and farmers who are strained by the burdens of the 10-year loan plan offered for the current death tax. Congress would not accomplish much for them by simply offering infinite debt and the consequent financial strains. Business-owners and farmers who have worked hard do not deserve an IRS loan-shark as the “compromise” to immediate confiscation.

II. Ideological misconceptions common to both the death tax and the inheritance tax

The reasons for an inheritance tax, based on its proponents own words, are very similar to those used in support of the current death, or estate tax. This belies the notion that the proponents of the inheritance tax are actually interested in dealing with the problems created by the current death tax. The reality, as explained below, is that these individuals are looking for a more aggressive way to accomplish their goal: the redistribution of wealth in America.

The primary misconception is the notion that income inequality in America is an undeniable crisis of moral proportions. Certainly, no just society can tolerate the subjugation of any class. However, there is nothing wrong with discrepancy in economic net-worth, insofar as that discrepancy is not static. And the evidence from a recent Treasury Department study finds that income in America is incredibly dynamic.

This study found that over the last 10 years, income mobility has not been static, but instead incredibly dynamic. In fact, more than half of the lowest income earners have moved into a higher income bracket in the 10-year span and nearly a quarter of the lowest income earners have moved into middle or upper-middle income brackets. The only income bracket to see a drop in real income over the last ten years was the top 1%.

Not only is wealth dynamic, but it is particularly so among those in the lowest wealth brackets. A study in 2003 found that within five years, one-third of households in the bottom wealth quintile move up to a higher quintile.

Moreover, the notion that wealth between generations in a family is static stands in stark comparison to the evidence. A paper published in the Journal of Political Economy found that two thirds of children of parents in the poorest wealth quintile ended up in higher quintile than their parents. And the children of parents in the wealthiest quintile? They had a 64% chance of being in a different (lower) wealth quintile than their parents.

Only those who are ideologically committed to Marxist egalitarianism can find fault with these trends. Real humanitarians are interested in improving the lot of all Americans, and have no problem with a “wealth divide” so long as there is nothing preventing anyone from moving up. And leading economists have found that inheritances have little impact on such inequality.

Alan Blinder, a former member of President Bill Clinton’s Council of Economic Advisers, stated that only 2 percent of inequality is due to the unequal distribution of inherited wealth. Joseph Stiglitz, chairman of President Clinton’s CEA, stated inheritances might actually reduce income inequality.

Supporters of death tax repeal know that inheritances do not hold anyone back. In fact, they allow everyone to move forward faster than they would otherwise. Beyond helping the heirs move into higher income brackets, inheritances enable economic growth which brings better jobs for everyone, particularly in the case of family businesses. A death tax hampers this growth and slows the economy, holding everyone back.

III. The Truth about the Family Farm

Ms. Batchelder repeated the oft-cited but patently false claim that the death tax has not resulted in the sale (or destruction) of any family-farms. This common lie holds continued weight only due to the shallow analysis with which most policy-experts and academics approach it. You see, it is unlikely that any farms have been sold the day after the death tax levy, or any time close to it. However, there are plenty of instances of farms which have been sold in advance of the tax, as the aging owners realized that their children would be burdened with a major tax liability and subsequent fire-sale if it was not addressed sooner. Selling the farm provides liquidity to pay for the tax, and leaves some inheritance for the children, though hardly in the form that the family intended.

In other cases, family farms are forced to take on burdensome loans in order to pay for the tax. In these cases, it often is just a matter of time before the debt loan becomes an unmanageable loss, and the farm is sold. Allow me to share with you a few examples of both scenarios.

For instance, consider the story of Lex McCorvey a resident of Santa Rosa, CA.

In the late 1800’s my Swiss born grandfather Antonio Ghisletta immigrated to the United States in search of new opportunities. It was the classical story of him arriving with no money in a new land where hope and hard work would somehow fulfill a life’s dream

My grandfather Antonio was a dairyman, as his family before him was in the old country. Through his hard work and determination he saved and borrowed money to purchase a dairy farm in the Chileno Valley of Petaluma, California. My mother Lorraine was born on the ranch in 1914 and milked cows by hand before and after school, harvested hay, potatoes and grains and did other routine chores. Antonio even donated land on the ranch to create Laguna School, a new rural one room elementary schoolhouse so the three children could be closer to the farm.

With over 70 years of a farming legacy in the community, Antonio passed away in the mid 1960’s. His children and their families faced the daunting task of dealing with his estate. What took a lifetime for my grandfather Antonio to build disappeared as his children were forced to sell both farms to simply pay the inheritance taxes. The family farm was no more. Even more damaging was that the properties had to be sold quickly to meet the inheritance tax obligations. As a result, both farms brought less than the market value adding insult to injury for the heirs as they saw there family farming legacy swept away in a few short months.

To this day, those farms would still be in the family had it not been for an injustice that is served by unfair inheritance laws in this country. It is difficult enough for generations of new or aspiring farmers to buy or even rent land for agriculture. I hope that Congress will act soon to repeal the death tax before more farm families suffer the same fate.

Another sad case is that of Tim Koopman, whose family has operated a ranching operation in two locations since 1889. Tim had long planned to be the fourth generation of his family to run the farm. However, with this grandfather’s unexpected and unprepared death at the age of 80, his plans quickly changed:

As a simple hardworking man, he had prepared just a simple Last Will and Testament. After several years of meetings with accountants, appraisers, IRS officials and attorneys, the IRS prevailed in establishing a non-agricultural appraised value on the Sunol ranch [one of two ranches owned by the Koopmann family]. The result was an inheritance tax liability of over $125,000…

…In 1973, in order to generate sufficient cash to settle the death tax liability, the family had to sell the Turlock ranch. The family ranching operation was reduced in scale to adapt to the loss of the Turlock ranch, additionally, at that time 150 acres of the leased share crop farm ground was lost due to residential development. As a result of the death tax liability and the costs associated with attorneys and appraisers, cash reserves were reduced to nothing. The reduced scale of operations, in conjunction with increasing expenses, provided for meager income flow. To compound an already dismal economic condition, came the weather conditions of 1975 through 1977. The lack of rainfall for these two years was classified as the most severe drought in over 100 years in northern California….

…As my college agricultural education tenure neared its end, my hopes of entering into a family agricultural partnership were dashed….I thus became the first Koopmann family member from four generations of California agriculturalists to be “off the land”…

Though unable to make a living as a full-time rancher, Tim continued to be an active participant in the family agricultural operation, and looked for ways to keep the remaining land from being sold. Unfortunately, this ultimately proved to be a futile effort:

In April of 1991, we accomplished a small goal by establishing a family trust for the ranch. It was a beginning to estate planning that we all hoped could be further enhanced. Unexpectedly, my father died of a massive heart attack on July 1, 1991. The family trust that had been established to re-structure ownership proved to be of some benefit. My mother’s health had been poor prior to my fathers’ death and further deterioration occurred. In November 1994, after months of suffering, my mother was hospitalized. After emergency lifesaving surgery due to a cancerous colon rupture, she remained in the hospital until February. On Easter Sunday she passed away.

Following the death’s of my parents I completely utilized all available cash reserves and liquidated assets in order to meet the alleged obligation imposed upon my family by the IRS and state of California for their death taxes. Appraisals, attorney fees, and accounting costs have amounted to thousands upon thousands of dollars. Initially we paid $76,000+ to the state of California for death taxes that the state claims technically not to have. The IRS received $49,000+ as a down payment on our “obligation” of over $300,000.

Following our final estate tax return submission, that we assumed would finalize our term payment plan, we received notice of the IRS intent to audit. Additional legal and accounting fees were needed in order to prepare documentation and respond to the IRS audit. As a result of the audit, it was determined that the ranch had been appraised at below market value at the time of my fathers’ death. The IRS demanded an additional $11,700+ up front (not to be added to the term obligation) and the state of California required an additional $8,000+….

…At the time, I was left with absolutely no alternative than to engage in a sale of real estate. The only buyers that presented themselves were developers and speculators who maintained no desire for operating an agricultural business or maintaining the open space provided by this working landscape. Each January, from 1996 to 2000, I made the required payment in the amount $16,500+ to the IRS for the interest only installment on my “obligation”. In the year 2000, I was invoiced for $36,000 as the amortized payment schedule began. Gross agricultural product sales of $50,000 to $60,000 were not sufficient to service this debt, thus borrowing money was required, pending real estate sales. The sale of two conservation easements on portions of the ranch were finally completed in 2002 and 2005 which allowed the payoff of the loan and estate taxes, however, there remains a capital gains obligation due in April of 2006 estimated at 220,000+. Following the payment of this capital gains tax, there will be a total depletion of the sales proceeds from the conservation easements.

Given this family narrative, how can the Federal Estate Tax be considered fair and equitable treatment?

My grandfather purchased this ranch in 1918 and every payment due to purchase the ranch was made as agreed. Every property tax bill ever presented was paid as agreed and every dime of income tax due for ranch-generated income was paid as agreed. Multi-generational land ownership, the American dream for generations of future farmers and ranchers is officially dead.

Even when the farm isn’t sold, the death tax often results in drastic changes to its composition. These changes are almost always deleterious for the local ecology. Hannah Tangeman-Cheney’s experience is indicative:

Mrs. Tangeman-Cheney’s ranch has been owned by her family since 1862, and run by women since 1914. Hannah’s mother passed away in 1990. Immediately, Hannah found herself working with the IRS, attorneys and appraisers, while her grieving got pushed aside. Her mother had a will and a trust, but there was a still a significant tax burden placed on Hannah and her sister.

It took two years for Hannah and the IRS to come to an agreement on the appraised land value of the ranch since their appraisers came up with different numbers. Mrs. Tangeman-Cheney entered an agreement with the IRS to pay the taxes off over a ten-year period. As part of the agreement, the IRS placed a lien on her ranch until the amount was paid off in full.

With the weight of the IRS lien on her shoulders, Hannah and her sister made a tough decision: they harvested thousands of trees that they didn’t plan on harvesting. 13,157 trees were cut – far more trees than they ever conceived of harvesting under any other circumstances. These trees took over 100 years to grow, and the property had not been harvested since the 1950s. But the burden on the ranch was too much, so they consulted with their local forester to create a timber harvest plan that would have the least environmental impact on the local wildlife and habitat. Moreover, they had to pay capital gains tax on the trees, then turn the rest of the revenue over to the IRS.

This was extremely frustrating for Hannah and her sister because they are environmentally conscious; in fact, the ranch has since been certified as part of the “Green Building” program with the Forest Stewardship Council. Now, Hannah and her sister have the IRS debt paid off, and they have life insurance policies on each other to help with estate taxes in the future. However, if her mother passed away today, Hannah argues they would never be able to pay off the tax burden due to the increased land values.

These stories speak for themselves, and put to rest the lie that the death tax does not affect family farms.

Today’s hearing to consider an inheritance tax is far removed from legislative reality. I know as well as the members present that it is unlikely the Committee would mark up legislation to actually replace the death tax with an inheritance tax. Instead of wasting time on what is a foolish idea and a distraction, Congress return to the work of marking-up legislation to actually repeal or substantially reduce the death tax. While this committee delays, farmers and business owners across America wait in the balance.