Wednesday, August 10, 2005

Federal Estate Tax Compromise Solutions - One opinion from the NY Times

<Category: Estate and Inheritance Tax

A New York Time editorial dated August 8, 2005 entitled The State of the Estate Tax highlights issues in the current estate tax repeal to date. The editorial takes the position that in an era of huge federal deficits, a total repeal of the federal estate tax would be unlikely. The editorial goes on to describe how the US Senate plans to take up the debate on the repeal of the federal estate tax when they return from summer break in September, and focuses on a critique of the compromise solution offered by Sen. Jon Kyl of Arizona (Republican).

Mr. Kyl's approach is two-fold:

  • An increased personal exemption from federal estate tax to $3.5 million (which would in effect be $7 million per married couple).

    The editorial states that "With an exemption of $3.5 million, only the top 0.3 percent of estates would be subject to the tax. Huge estates are precisely those that should be taxed most heavily, because the larger the estate, the more likely it is to be made up of investment gains that were never taxed during the owner's lifetime."

    This comment refers to the little publicized fact about the "step-up in basis" available at death. Under Section 1014 of the Code, when a person dies, their heirs receive a "stepped-up" basis in inherited assets (with some key exceptions, such as retirement plan assets). The heirs' basis is the fair market value of the assets on the date of death (ie: the basis is "stepped-up" in value to the fair market value). Section 1014 thereby effectively wipes out any tax on unrealized appreciation during the person's lifetime. In this light, it can be argued that the estate tax acts in lieu of the capital gains tax.

  • A reduction in the estate tax rate to 15%, to make it equivalent to the capital gains tax rate. In the limited context of describing the purpose of the estate tax as replacement to the capital gains tax, this makes sense. However, the editorial goes on to point out that:

      "Mr. Kyl contends that a 15 percent estate tax rate is fair, because it is the same as the capital gains tax rate that is applied to investment profits during one's lifetime. That's a false comparison. The capital gains tax law does not allow you to exempt a huge portion of your profits before the tax rate is applied. The estate tax law does. Once the $3.5 million exemption and other deductions were factored in, a 15 percent tax rate would translate into a mere 6 percent levy on a $20 million estate."

    Another concern with describing the estate tax as replacement to the capital gains tax is that it oversimplifies the role of the estate tax. There are other theoretical underpinnings of the estate tax such as acting as a backstop to lower income tax rates during lifetime (allowing you to spend more during your life, and saving the timing of the tax until your death and basing it on what you did not spend during your life), as well a belief in a progressive tax system where the share of those with more dollars is greater.

The editorial misses another underlying benefit of Mr. Kyl's solution over outright repeal. If the federal estate tax were repealed, Section 1014 and the "step-up" in basis would no longer function in the relatively simple manner they do today. Under current law, your basis in inherited property in the fair market value at date of death. If an estate tax return is prepared, this is a simple matter of looking up the basis, even years later. If there is no federal estate tax, then Section 1014 would not wipe out unrealized gains during lifetime (subject to a blanket granting of basis under the law - ie: at death you can apply $1 million of basis to any estate assets, or something along those lines). This means that when you go to sell the inherited GM stock, you may need to figure out what the decedent paid for it - which will often be an impossible task. The result is that people may end up paying more capital gains tax then should be assessed if they cannot prove the basis of the assets sold. Most estate planners see this as a nightmare waiting to happen as people will need information that only a dead person may have. By keeping the federal estate tax, but tying it more closely with the capital gains tax, Mr. Kyl's proposal avoids the basis tracking issues.

Having said that, the estate tax repeal debate should really be stripped of all ideological underpinnings and approached from a practical and business-like manner. Fact: The estate tax brings in dollars today. Fact: The government needs those dollars to operate today - there is an astronomical federal deficit. Question: If the government no longer takes dollars from the estate tax, and given that it still needs those dollars to operate, how are those dollars being replaced? You can be sure the dollars will come from somewhere - just because the estate tax is repealed doesn't mean that taxes are repealed. These are the questions that need to weighed. From this approach, some people may find they prefer a tax that focuses on what you didn't spend before you died.


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