Current law also provides for special valuations, deductions, and credits which can reduce estate taxes and grants a 15-year extension of time to pay estate taxes attributable to closely-held business interests owned by a decedent.

Family-Owned Business Deduction

The IRS Restructuring and Reform Act of 1998 amended the Taxpayer Relief Act of 1997 and created a new estate tax deduction for family-owned business interests. Although an executor can elect to claim a deduction for a portion of interest included in the estate of an owner, the deduction is limited to $675,000, yielding a maximum saving of $371,250.>⁶> Furthermore, the law integrates the deduction with the estate tax exemption, in effect limiting the exemption to $625,000 if the election is made, notwithstanding increases that would otherwise apply.⁷

To qualify for the family-owned business deduction:

• the owner's interest, including prior gifts of stock, must exceed 50 percent of the value of the owner's estate (plus gifts);⁸
• one family must own 50 percent of the business; two families, 70 percent; or three families, 90 percent;>⁹>
• the owner's family must own at least 30 percent of the business;>¹⁰>
• the owner's family must have owned and operated the business for five of the eight years prior to death;¹¹> and
• the family must continue to own the institution and participate in its management for 10 years after the death of the owner.¹²>

Installment Payments

If more than 35 percent of the value of an estate consists of interests in closely held businesses, including a community bank, an executor may elect to extend the payments of the estate tax on those interests over a 15-year period.>¹³T> The estate may pay interest only on the deferred tax for the first five years and then must pay the tax in 10 annual installments starting in the sixth year. To qualify for installment payments, the business must be active. In any case, the tax deferral is not available for the business's passive assets>¹⁴> (defined as assets other than those used in the trade or business).

The interest rate on the first $1 million of value in excess of the exempted amount is 2 percent, and the interest rate on the balance of the tax attributable to the interest is 45 percent of the regular interest rate.¹⁵ The deferred tax is accelerated if the executor fails to make a payment, the business is sold or otherwise transferred, or in other limited circumstances.¹⁶

Effect of Current Law on Community Banks

Estate and gift taxes are especially onerous for community bankers because the interests they hold in their banks often represent a significant and illiquid portion of their estates. The low exemption amount and high estate tax rates can force community-banking families to sell their interests in their "family" banks to meet estate tax obligations.

The scheduled phase-in of the exemption amount makes estate planning difficult. Community bank owners are compelled to annually restructure their overall estate objectives to protect their heirs' interests in the family-owned bank. Furthermore, the high tax rates encourage many individuals to try to minimize the amount of property subject to the tax. Too often this means that estate-planning decisions are made based on tax issues, rather than the true wishes of the bank owner or the family. In addition, the complicated rules force community bankers to invest significant dollar amounts for advice and counsel regarding minimization of estate and gift taxes.

Family-Owned Business Deduction

A significant number of community banks are family-owned and eligible to elect the family-owned-business deduction. In the Grant Thornton 1999 Sixth Annual Survey of Community Bank Executives, 67 percent of the respondents indicated that their banks are privately held. For banks less than $50 million in assets, the percentage jumps to 84 percent.¹⁷ Families or groups of families are the principal owners of many privately held banks.

The onerous requirements of the family-owned business deduction, especially the requirement for 10 years of family ownership and management after death limits its attractiveness and reduce the family's future options. The rule can force a community banker's heirs to make decisions regarding disposition of the bank based on tax consequences rather than their interest in, and skills for, continuing family ownership. Decisions to sell a family-owned bank are personal and should be made within the family structure, not forced from the outside by the tax code.

The statutory requirement that family interest in the bank exceed 50 percent of an estate makes it difficult for owners to qualify if they have accumulated significant other assets during their lifetime. This may coerce the owner to transfer other assets prior to death. It may also encourage the family to overvalue their interest in the bank, further complicating their ability to plan for estate taxes.

Installment Payments

The requirement that 35 percent of the value of an estate consist of interest in a closely-held business makes it difficult for owners to qualify if they have accumulated significant other assets during their lifetime. Similar to other restrictions in the estate tax law, this provision may force the owner to transfer other assets prior to death for the estate to qualify. This prevents community bankers from prudently diversifying their assets, putting them at an unnecessarily high level of investment risk.

Relief Being Sought

Repeal estate and gift taxes: Reduce the estate and gift tax rates ratably over six years until eliminated.

Reduce estate tax rates: Reduce the highest estate tax rate to 25 percent and apply it only to estates in excess of $20 million.

Accelerate phase-in of $1 million exemption amount: Accelerate the complete phase-in of the $1 million exemption by tax year 2000.

Increase size of exemption amount to $2 million: Increase the size of the exemption to $2 million beginning in the year 2000 and index it to inflation thereafter.

Increase the size of the family-owned business deduction: Increase the size of the family-owned business deduction to $4 million without integrating it with the general estate tax exclusion. Index the deduction annually for inflation.

Decrease required percentage of assets to qualify as family-owned business: Reduce from 50 percent to 25 percent the value of the estate that must be closely held to qualify for the family-owned business deduction.

Decrease the percentage in the estate the interest in the community bank must represent to qualify for delayed payments of the estate tax: Reduce the percentage of assets required from 35 percent to 25 percent to qualify for the extension of time to make the payments.

Projected Benefits of Relief

Repeal of estate and gift taxes: Heirs will no longer be forced to sell a family-owned bank to satisfy federal estate taxes. Family-owned banks will be assured to be a part of the banking industry far into the future. Community bankers will continue to fully serve their communities and effect an orderly transition to management by the next generation.

Reduce estate tax rates: Reducing the estate and gift tax rates will allow more community bankers to pass interests in their family-owned bank to their heirs in the manner they choose, rather than in a manner that is designed specifically to result in the lowest tax obligation.

Accelerate phase-in of $1 million exemption amount: Many community bankers own stock in their banks valued up to, and in excess of, $1 million. Phasing in the $1 million exemption level faster will promote the continuation of the family-owned bank tradition and avert sales for the primary purpose of meeting tax obligations.

Increase size of exemption amount to $2 million: Increasing the size of the exemption to $2 million will further promote the continuation of family ownership of small banks. Bankers will be able to focus on daily banking activities, rather than succession issues, secure in the knowledge that the next generation will be able to continue the family banking tradition.

Increase the size of the family-owned business deduction: An increased family-owned business deduction of $4 million could save community bankers as much as $2.2 million¹⁸ and will encourage families to continue to invest in banks that provide financial services to their towns and neighborhoods. With this deductible amount, family-owned community banks are more likely to remain family-owned and the viability of independent community banks will be further enhanced.

Decrease required percentage of assets to qualify as family-owned business: This change will significantly increase the number of estates with significant amounts of community bank investments eligible for the family-owned business deduction. The result will be more families retaining their historical interest in the community and continuation of the family tradition of serving the financial and economic needs of their communities.

Decrease the percentage in the estate the interest in the community bank must represent to qualify for delayed payments of the estate tax: This change will make more estates eligible for the extension of time to pay the tax, while still requiring the interest in the community bank to be a significant part of the owner's estate. Community banking families will be able to spread their payment of inheritance taxes over a number of years, while they continue their family tradition in community banking.

Summary

Inheritance taxes and estate and gift taxes disrupt family ownership of community banks and hamper the ability of community banks to remain independent. Community banking is built on family ownership. The banking family is part of the community, lives in the neighborhood, and works side by side with other community members to make the community grow. At the same time, the community bank is a principal funding source - for businesses and for employers in the community.

At a time in our national economic history when the nation is experiencing a rash of mega-mergers, family-owned community banks are integral to the survival of many communities, particularly those in rural areas. Competition is one of the factors making community bank owners rethink the economic feasibility of continuing family ownership. But estate taxes - "death taxes" - should not be the deciding factor leading to the demise of the family-owned community bank.