Estate and Inheritance Taxes: How Do They Impact Entrepreneurs?

Does having to pay an inheritance tax discourage someone who might have built an empire, from doing so?

Does having to pay an inheritance tax discourage someone who might have built an empire, from doing so? Or does an estate tax make a business owner retire earlier?

MP900400332Forbes recently provided an analysis of a research paper examining the impact of estate, wealth transfer taxes and other inheritance taxes on entrepreneurs and those considering starting a business in “How Do Estate And Inheritance Taxes Affect Entrepreneurs?” Do entrepreneurs spend a lot of time worrying about the impact of federal estate tax on their life’s work? Does reducing the number of taxpayers who will need to pay federal estate taxes, which recently occurred, mean an increase in new start-ups? The answers are not that simple.

The research shows two primary effects of wealth transfer taxes. One, by reducing the size of after-tax bequests, it makes heirs less likely to start or maintain a business. Two, the prospect of future estate or inheritance taxes appears to speed up a business owner’s retirement date, but also discourages labor force participation for wage earners. This indicates that there’s no simple way to characterize the effect of the estate tax on entrepreneurship.

The estate tax might impact the decision to start a business or keep it going, if business owners are looking ahead and want to leave the company to their heirs. However, the evidence on this is surprisingly ambiguous.

For example, most wealthy people don’t take full advantage of opportunities to transfer limited amounts of wealth through tax-free gifts during their lifetimes, which is a very basic tax avoidance strategy. The estate tax also impacts heirs by decreasing the size of after-tax bequests.

The current federal estate tax applies to a fairly exclusive class with a generous exemption from the unified estate and gift tax—$11.2 million for singles and double that amount for couples. Many deductions reduce the amount of wealth subject to the tax, including unlimited deductions for charitable donations transfers to spouses and “valuation discounts” that reduce the amount of family-owned business and farm assets that are subject to the estate tax.  However, anything over the exclusion limit and deductions is taxed at 40%.

The research finds that receipt of an inheritance raises the likelihood of having active business income by about 13%. The size of the inheritance is also a major factor but is usually less important than the fact that an inheritance exists. In addition, the thought of future estate taxation reduces the likelihood of remaining self-employed, but not because people elect wage employment over self-employment.  It is actually because it makes employment less attractive. Taxing bequests reduces the payoff to working (and saving) for those with bequest motives, which makes both self-employed people and wage earners slightly more likely to retire.

Therefore, the research shows that the impact of wealth transfer taxes on entrepreneurship appear to be small.  However, the researchers point out that there are several important caveats to their conclusions. One is that self-employment is not the same as entrepreneurship, and most survey data can’t distinguish between entrepreneurs who innovate and take risks, from business owners who don’t.

There are other factors that must be considered before any real conclusions can be made. If your parents or grandparents were successful business owners, you would be more likely to consider starting a business than someone whose parents were employees. You might also have the option of entering the family business, which children of employees do not have.

It is not clear that estate and inheritance taxes are any more burdensome than any other taxes. Regardless of your economic bracket, an appointment with an estate planning attorney to review your tax liability under the new tax law should be on your to-do list for the first part of 2018.

Reference: Forbes (March 7, 2018) “How Do Estate And Inheritance Taxes Affect Entrepreneurs?”

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