Looking at this year's Oscar nominees list, I was drawn to the name of a live short nominee, "A Concerto is a Conversation," because it was the premiere of Kris Bowers' Violin Concerto. Fascinated, I decided to watch the film. While this short film didn't win an Oscar, it shouldn't be missed.
From the title, I expected the film to be Bowers, who wrote the score for The Green Book when he was 29. The LA Philharmonic's premiere of Bower's Violin Concerto "For A Younger Self" is the catalyst for the film. But the film is structured like a conversation between Kris Bowers and his 91-year-old grandfather Horace Bowers Sr., who, according to Kris Bowers, was "instrumental" to its success.
It's Horace, not Kris, who's the star of the film. Horace Sr. was born in Florida as one of 13 children and left Jim Crow South after high school. He started hitchhiking and eventually made his way to Los Angeles, where he pretended to be an employment agency (but really represented himself) and found a job as a presser in a dry cleaner.
In just a few years, Horace met his wife Alice, whose family worked in dry cleaning. After getting married in 1950, they bought their own dry cleaner.
Because of his race, Horace was unable to get funding to expand his dry cleaning business. Always resourceful, he got bank loans in the mail. Because Horace was a successful business owner, he had no trouble obtaining loans to buy real estate – as long as the loan officers didn't know he was African American.
In the 1960s, Horace and Alice owned an entire block on Central Avenue in south Los Angeles. And in 2019, the 2500 Block of Central Avenue was inaugurated as the Bowers Retail Center.
Upon viewing the film, it is evident that Horace and Alice have overcome discrimination and built a family legacy through persistence, hard work and ingenuity. Although he's not into dry cleaning, Kris continues that legacy by breaking stereotypes in Hollywood and the classical music world.
I'm not familiar with Horace and Alice's financial situation or estate plans, but it's likely that they also built a second type of family legacy – a significant fortune. Many small business owners and real estate investors in their position want to pass their financial legacies on to future generations. However, tax changes in the American Families Plan could make it more difficult for middle-class Americans to build wealth and pass it on to the next generation
This article is part of a series that discusses how the American Families Plan could affect real estate investments. A previous article discussed how the American Families Plan proposes to change the taxation of long-term capital gains and carried-over interest. This article discusses lowering the unitary estate and gift tax exemption and increasing the base.
Primer for estate taxes
Inheritance taxes tax the transfer of property due to death. Transfers of ownership are taxed whether or not they are in someone's estate. Basically, anything an individual owns, including "death" accounts and certain trust assets not included in the estate, are part of the "gross estate". Inheritance tax is based on the fair value of the gross estate without taking into account the purchase price, depreciation or book value of the deceased.
The gross estate is reduced through deductions for debt, funeral expenses, and estate administration expenses to determine the “taxable estate”. However, the entire “taxable estate” is not always taxed.
Under the unlimited marriage allowance, property that goes to a surviving spouse is not taxed. Most charitable contributions to an estate are also not taxed. Also, in 2021, the first $ 11.7 million of the remaining amount (after accounting for some lifelong gifts) will not be taxed. This is known as the "unitary exemption" because the exemption applies to aggregated lifelong gifts and transfers due to death.
It is also possible to pass an unused exemption on to the surviving spouse. So if someone surrenders all of their assets to their spouse or qualified charities, the surviving spouse can give up to $ 23.4 million to the next generation without paying federal estate taxes.
The exemption has not always been that high. It was less than $ 150,000 in the 1970s. That exemption gradually increased to $ 1 million in 2002. In 2010 there was a big jump to $ 5 million. In 2017, the tax exemption increased significantly to $ 11.18 million and has increased gradually since then.
With such a high inheritance tax exemption, few estates pay taxes. However, the increase in the inheritance tax exemption for 2017 was only temporary and is expected to expire at the end of 2025. So the exemption will drop to $ 5.6 million – still a high number, admittedly, especially if spouses can combine their exemptions.
How the reinforced base works
Although the taxable estate at the time of death is based on fair value, the deceased's “book value” is often different (usually lower) for their business or real estate investments. Often times, the deceased bought their business or investment at a lower price many years earlier. The book value of the deceased may also have been reduced by depreciation or amortization.
The question is whether the heirs "inherit" the tax base of the deceased. Currently, heirs are instead given a new, reinforced foundation for the property they have inherited. This increased base is the fair value at the time of death – the same value used to determine the taxable estate.
In theory, the estate pays tax on the entire value of the deceased's estate (minus exceptions). If the estate tax has been paid on 100% of the property's value, it makes sense to reset the heirs base to match the value on which the estate taxes were paid. Admittedly, if inheritance tax has not been paid on real estate, the increased base does not seem to make that much sense at first.
However, the reinforced base can benefit a small business like Horace and Alice Dry Cleaning. Such a deal could entitle the heirs to a substantial base increase. After that, all real estate and equipment was likely to have been completely written off over the years. And the company likely has high intangible value from the goodwill it has created through years of excellent service.
Unfortunately, most small businesses don't have large amounts of cash. The owners either use the money to support themselves and their families. Or they invest the money back in the business so that it can grow. Without cash, the heirs cannot pay estate taxes – unless they sell the company to pay those taxes. For these heirs, the reinforced base enables the family heritage to be maintained.
How the plan would change estate taxes and the reinforced base
The American Families Plan provides many state benefits designed to help middle-class families. The plan also includes changes in tax law. Tax increases are needed to fund coronavirus relief and support post-pandemic social and infrastructure programs. However, some proposed changes to tax law could make it more difficult for middle-class Americans to build wealth and pass it on to the next generation.
Although President Biden had originally proposed reducing the single exemption and removing the reinforced base. The American Families Plan does not change the exemption, but does remove the reinforced basis for some estates. The plan maintains the charity donation waiver.
The American Families Plan suggests limiting the augmented base to a $ 1 million increase over the deceased's base. The limit would be $ 2 million for married couples. If the couple also had certain real estate profits, the limit could go up to $ 2.5 million. Family businesses and farms would be exempt – but only if the heirs continued to run the business or farm.
Details of how the $ 1 million would be calculated are not clear. It is also unclear whether a family business or a farm would only be exempt from tax if all heirs continued to run it. And it's not clear how much work the heirs will have to do in the business or how long the heirs will have to run the business. If passed, the laws and regulations must specify these critical details.
As proposed, heirs to estates greater than the uniform exemption ($ 11.7 million today and $ 5.6 million after 2025) will be double taxed under the American Families Plan. You first pay estate tax of up to 40% of the estate over the exemption amount.
Then, although they paid a heavy tax burden on that part of the estate, the heirs have a transfer base rather than a reinforced base. If the heirs sell their inherited wealth, they pay capital gains tax, which under the American Families Plan could be up to 43.4% of profits (39.6% for income taxes plus 3.8% capital gains tax under the Affordable Care act) . For a fortune that goes to an heir who sells their investment, federal taxes could be up to 83.4% of their inheritance. And they may also have to pay state estate or income taxes. Although this would only be done with considerable wealth, heirs to great estates are not necessarily rich. This high rate of tax could affect heirs who are neither high net worth nor high income but who have a high income for a year on the sale of an inherited asset.
Political Considerations and Intergenerational Prosperity
Tax policy serves both the purpose of raising funds for government programs and the purpose of shaping behavior. The social aspects of the American Families Plan focus on equal opportunities. No wonder, then, that the economic aspects of the plan focus on wealth inequality, as well as paying for coronavirus and social programs and reducing national debt.
The American Families Plan also promotes the cross-generational transfer of family businesses and farms that is part of the American Dream. But if the skills or passions of the next generation could be elsewhere. Heirs who follow their passions instead of taking over the family business may find they have a large tax bill that they would not have had if they had stayed with the family business.
Horace and Alice built two kinds of wealth – economic wealth and character, which is evident in their hard work, ingenuity, and persistence in the face of discrimination. Though Kris hasn't (yet) inherited the economic fortunes of Horace and Alice, their wealth of character is evident in Kris' work and success in an industry that historically has not welcomed African Americans.
As suggested, the American Families Plan would encourage high net worth individuals to limit the transfer of wealth between generations. It might also encourage them to make more community contributions. However, by limiting the intergenerational transfer of people with economic prosperity, people can change their estate planning. Instead of transferring significant financial wealth to the next generation, they could focus on charitable giving, leaving the next generation an intangible legacy of character and charitable giving.
This series draws on Elizabeth Whitman's background and passion for classical music to illustrate creative solutions to legal challenges facing businesses and real estate investors.