Repeal of the Estate Tax

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, September 17, 2000.

Copyright 2000  Robert L. Sommers, all rights reserved.

Repeal of the Estate Tax

Part 1 of a 2-part series

The Proposal

Although the Republican-dominated Congress approved the "Death Tax Elimination Act of 2000," (Act) President Clinton vetoed the Act August 31st and Congress failed to override his veto. Because estate tax reform will be a potent political issue for this fall’s elections, let’s examine what the legislation provided:

After a 10-year phase-in, the Act would eliminate gift, estate and generation-skipping taxes on wealth transfers. Essentially, the gift and estate-tax rates would be reduced an average one percentage point per year (however, the top tax bracket would be reduced by five percentage points in the first two years); by 2010 all gift, estate and generation-skipping taxes would be repealed.

After 2009, the stepped-up basis rule would be replaced with a complex "carryover-basis" rule. Designated assets totaling $1.3 million would receive a stepped-up basis ($3 million for assets transferred to a spouse). Note: These amounts would be indexed for inflation after 2009. The decedent’s executor would choose which assets receive the basis step-up. Obviously, assets with no appreciation, such as cash and bank deposits, would not be likely candidates.

Although promising estate tax elimination, the Act was deceptive on two major counts: It would have reduced estate-tax rates by approximately one percentage point per year over ten years, which means that for a decade, taxpayers would still have needed to plan for estate taxes under today’s estate tax system.

The Hidden Traps

However, the catch that politicians neglected to mention was that the estate tax would be replaced with an income tax on all appreciated assets distributed to beneficiaries, including surviving spouses. The Act would have resurrected carryover basis rules, which impose a new capital gains tax on the decedent’s assets when the beneficiary sells them. This very approach was tried and abandoned as unworkable about 20 years ago.

Although the new capital gains tax might be less than the current estate tax, the expensive administration involved in tracking an asset's adjusted basis, over many years and through multiple deaths, could be a nightmare.

For instance, if your Great Aunt Millie inherited AT&T stock 70 years ago and she died and left it to you, you would have to reconstruct her stock basis and make adjustments over the 70-year period she held the stock, if her dividends were reinvested or she made new purchases.

With current estate tax rules, all assets are stepped-up or down to fair market value, usually at death, so there is a fresh-start as to the value of those assets. In contrast, the carryover basis concept could cause beneficiaries to trace the adjusted basis of assets over decades.

Californian Married Couples Get the Shaft

Now the really misleading part: Under the Act, only $1.3 million of the decedent’s assets would receive a stepped-up basis ($3 million on transfers to a spouse).

Beneficiaries receiving inheritances with a carry-over basis would suddenly be subject to capital-gains taxes imposed by the states. For instance, California, which does not levy a separate estate tax, taxes capital gains at the same rate as ordinary income. Therefore, for California residents, the Act would create a state income-tax obligation where currently none exists! How many California residents would embrace this legislation if they understood that it would cost them additional California taxes?

Note: Under current law both halves of community property receive a basis step-up on the death of the first spouse. Thus, a surviving spouse in a community property state (including California) may sell assets without incurring an income tax on appreciation realized prior to the death of the first spouse.

For example: Suppose a husband and wife had one asset, the husband’s "founder’s" stock in a publicly held company, owned as community property, worth $10,001,000, which had a $1,000 basis. The husband dies leaving the entire asset to his wife. Under current rules, if his wife sells the stock the next day, she would pay no capital gains tax because the stock would have received a stepped-up basis of $10,001,000.

However, according to the Act, if his wife sold the stock the next day, she would pay a capital gains tax (both federal and California) on $7 million since only $3 million would receive a basis step-up (assuming California adopts this stepped-up basis rule). Using a combined 27.5% tax rate for federal and California, his wife would pay a whopping $1,925,000 in taxes!

Minimizing Estate Taxes

Under current law, while the highest estate tax rate is 55%, the wealthy usually wind up paying a fraction of this amount. In fact, many estate planners believe the estate tax is essentially voluntary because there are so many opportunities to plan around it. The key is to begin the process before an estate becomes taxable.

For starters, many married couples form an irrevocable life-insurance trust funded with second-to-die life insurance. These policies pay out on the second death, when the estate tax is levied. Because these policies take into account both lives, the cost is extremely low -- generally between 5-25% of the estate tax -- depending on the couple’s age. Thus, because the estate tax is a known liability, taxpayers can plan to pay it with steeply discounted dollars.

For businesses, farms and real estate holdings, formation of a family limited partnership or family limited liability company can substantially reduce the value of these holdings. In addition, gifting of assets using the annual gift-tax exclusion further reduces the size of an estate.

Also estate-freezing techniques effectively shift the growth of assets to the next generation. For instance, if a husband and wife lend money to a venture owned by their children, then the venture’s appreciation belongs to the children. Thus, that portion (the loan amount) of the taxpayers’ estate is frozen in value for estate tax purposes.

Finally, many charitable-giving opportunities eliminate estate taxes, while allowing the taxpayers to live off the earnings for the rest of their lives.

Next week: My proposals to modify the current estate tax without eliminating it.

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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.