By Lowell L. Kalapa
Regardless of how you feel about the upcoming repeal of the federal estate tax, there are some technical points to consider amidst all the political rhetoric.
First some basic elements of the estate tax repeal are in order. Beginning in 2002, the estate tax rates begin to disappear along with the 5% surtax which phases out the benefit of graduated tax rates. The rates in excess of 50% will be repealed in 2002. The top rate then falls by one percentage point for each of the next five years until the top tax rate is pegged at 45%. It remains at that rate until the estate and generation skipping transfer taxes are repealed in 2010.
Similarly, the unified credit’s effective exemption of estate property rises, first to $1 million from its current $675,000 of value in 2002. The credit is then increased on a periodic incremental basis to $1.5 million in 2004, then to $2 million in 2006 and finally to $3.5 million in 2009. Of course, the credit is no longer necessary once the estate tax is repealed in 2010.
However, the tax on gifts remains but instead of special tax rates, the top gift tax rate will be the top individual income tax rate. Transfers to a trust will be treated as a gift unless the trust is treated as wholly owned by the donor or the donor’s spouse under the grantor trust provisions of the law.
Probably the biggest “poison pill” of the much heralded repeal of the estate tax is the loss of what is known as the “stepped-up” basis for valuing property received from a decedent or estate. Under current law, whenever property passes from a decedent, the beneficiary records the value or his or her basis as the value of the property at the time of death of the donor.
However, once the estate tax law is repealed in 2010 – except for an initial amount of property – the basis for the property passed on becomes the lesser of the adjusted basis of the decedent’s interest in the property or the fair market value of the property on the date of the decedent’s death. More often than not, the basis will be the decedent’s adjusted basis, especially if the property has been held for a long time.
Thus, while the current scheme outlined in the new tax bill gets rid of the “death” or estate tax, the loss of the stepped-up basis for inherited property means that beneficiaries will end up paying substantial taxes on the capital gains when the property is disposed. Given the fact that taxes will be due on the capital gains if the property is sold, the bill does achieve what was the driving force behind the legislation, to allow small and family businesses to retain the business without having to sell it. Conversely, the impact of the capital gains taxes on appreciated value provides a disincentive to liquidate the inherited property.
So while some may be cheering the repeal of the federal estate tax, believe it or not, the federal government may actually get more in capital gains taxes than it will lose in the federal estate tax. The other point to note is that the tax reductions and eventual repeal of the estate tax is phased in over ten years. With a change in the control of Congress, all bets could be off.
Several observers have asked whether or not this was the right thing to do with the estate tax. Was the repeal of the tax justified and just what is the intended outcome of repealing the estate tax?
One should remember that the impetus behind the repeal was to save families who owned small businesses from having to liquidate their businesses just to meet the federal estate tax obligations. By repealing the estate tax, large estates and small estates will benefit, but in return, inherited property will be taxed on the full appreciated value of the property.
Thus, where an estate may be comprised of a family home and perhaps some savings all of which currently fall within the effective exemption would pass tax free from the estate tax and where the home is subsequently sold, there would be little capital gains because of the stepped-up basis. That same situation under the repeal may end up paying thousands of dollars in capital gains taxes because there is no stepped-up basis.
Instead of an outright repeal of the estate tax, lawmakers should have considered just increasing the credit’s effective exemption and index the credit to keep up with inflation. With the repeal, a whole slew of new tax problems will occur for all taxpayers. Not only that, the repeal of the federal estate tax will create a problem for state officials as well. We will take a look at that problem next week.