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Small Business | At Issue

Attack on Tax Deductions Has Family Firms Up in Arms

April 15, 1998|VICKI TORRES

It's no surprise that Californians--especially Southern Californians--are more likely to be audited by the Internal Revenue Service than are taxpayers in other parts of the country.

Figures recently released by a New York watchdog group and reported Sunday in The Times show that 1.59% of taxpayers in the IRS' Los Angeles district went through face-to-face audits, compared with 0.66% nationwide.

Various explanations were advanced: California has a tradition of tax avoidance; immigrants here may not fill out returns properly; the state's high earners and entertainment industry workers have been targeted by auditors in the past.

But another factor could be at the heart of the matter: The state's army of entrepreneurs is made up not only of creative business owners, but probably creative tax filers. What a business owner sees as a legitimate deduction the IRS may view as tax avoidance.

A case in point is the ongoing attempt by the IRS to eliminate certain deductions used by family-owned businesses to pass on assets to subsequent generations. Known as the "Crummey exemption" and family partnership discounts, these obscure and complex estate-planning tax rules will be scaled back if Congress adopts President Clinton's budget resolution this year.

"Those particular planning techniques are very important for family and business reasons," said Russ Nager, a certified public accountant and an editor at the Family Business Advisor, a monthly newsletter affiliated with the Arthur Andersen Center for Family Business in Houston. "When proposed, they caused considerable uproar in the estate-planning community. Family-owned businesses should be aware of what is proposed."

These rules are viewed as tax loopholes by Treasury Department officials, who for more than two decades have tried to get Congress or the president to ban them, Nager said. The effort this year is particularly galling to small-business activists, who just last year celebrated tax breaks received under the 1997 Tax Reform Act. The changes proposed by Clinton would nullify some of those hard-won gains, Nager and others say, because family-owned businesses rely on these tax provisions for estate planning.

Here's what the rules are and how they work:

* The Crummey exemption, named for taxpayer D. Clifford Crummey, whose case created the rule, allows parents to start trusts for their offspring and avoid paying estate taxes on up to $10,000 each year by taking advantage of the gift tax exemption. Although that exemption applies only to "current" income and not "future" money sent to trusts, it can still be used with trusts as long as children are permitted to withdraw the cash from the trust in 30 to 90 days.

* Family partnership discounts allow parents to transfer business assets--not only pieces of the business, but partial ownership of stocks, land and even artwork--to their offspring. The value of the business assets is reduced 10% to 60%, and along with it, transfer taxes. The reasoning is that such assets would be hard to sell because buyers have little control over them.

The IRS views these rules as loopholes and tax-avoidance measures. But without them, small-business owners say, they would be taxed for success, said David Flamer, a Woodland Hills CPA with Lasher, Flamer & Associates.

"My clients complain about the estate tax more than anything else," Flamer said. "If you have money in a bank or a home that's appreciated in value, that's after-tax money. Somebody paid for that house with after-tax money, so why does the government have to tax it again?"

The number of family-owned businesses that use these measures is small because parents can already transfer, tax-free, $650,000 in assets over their lifetime. That amount will increase to $1.3 million over the next few years. But family-owned businesses with inventory and property, such as car dealerships, restaurants and manufacturing companies, can use up that tax-free transfer limit rapidly, so accountants and lawyers have increasingly counseled their clients to take advantage of the other tax-reduction measures.

The IRS has accordingly increased its scrutiny with audits and court cases, as well as pressure on politicians to scale back the exemptions, according to those who keep watch over tax matters. Treasury officials succeeded in narrowing one of these so-called loopholes in 1988, when Congress outlawed the Crummey exemption's use by grandparents to pass on money to grandchildren through trusts.

Clinton's tax change proposals, the most recent attempt to eliminate these exemptions, were not picked up by the Senate when it passed its current budget language. The changes probably won't be approved by the House. Still, small-business advocates and estate-planning professionals are concerned and say they are keeping an eye out for language that could be attached to other bills.

"Funky tax riders get attached to almost anything," Flamer said. "It can crop up, and we need to be aware of it so our clients are aware of it when changes arise."

*

Times staff writer Vicki Torres can be reached at (213) 237-6553 or vicki.torres@latimes.com

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