Estate Tax: Tax Rates, Carryover Basis and Stepped-Up Basis: Watch Out!

The federal estate tax Law is a mess, its structure vacillating over the past three years and its future is uncertain. It is not worth the effort to go through all the changes but there a few important things to note.

First of all the federal estate tax does not impact all that many estates even though the estate of every U.S. citizen is subject to tax upon death. Impact in the sense the decedents estate has to cough up addition dough to the government for dying and having property. However, there is a lurking income tax issue out there that goes along with it and it is a sneaky one.

Some background on the estate tax is in order. The federal estate tax is currently set at 35 percent on estates over $5.12 million. If nothing changes, on Jan. 1, 2013, the estate tax exemption will drop from $5.12 million to $1 million, and the estate tax rate will jump from 35 percent to 55 percent, the tax regime of pre-2001 changes.

Many conservatives refer to the estate tax as the ”death” tax and would like to abolish it. Liberals, of course, believe everything belongs to the state and would like to have as high a tax rate and lowest exemption level as possible. There are also a few in the middle, like me. I have no problem with a reasonable tax rate on very large estates. The dirty secret is that these very large estates through private foundations, charities and other such devices can largely blunt the effect of the tax and still more or less control the money from the grave.

As noted, the current law expires at the end of the year and with most of the other expiring tax provisions so it is all a guess on what will happen. As an illustration of what is being considered, U.S. Sen. John Thune (R-SD) introduced the Death Tax Repeal Permanency Act (S. 2242), permanently abolishing the federal estate tax. The bill would also repeal the federal generation-skipping transfer tax and lock in a $5 million lifetime gift tax exemption and 35 percent gift tax rate. (Gift taxes and estate taxes are somewhat interrelated) This Senate bill mirrors HR. 1259, introduced by U.S. Rep. Kevin Brady (R-TX). More importantly and this is the key and much more important than the tax rate is the legislation maintains the stepped-up basis. STEPPED-UP BASIS what is that?

Every asset has a basis, usually its cost. If I buy a tractor for $100, it has a basis of $100 and I use this amount for depreciation in my business. Under the gift rules, if my aunt gives me a share of stock, which she paid $100 for 10 years ago but now worth $1000, my basis is $100, and if I sell it for $1000, I have a $900 gain which would be included in my income taxes.  This is called ‘carryover basis’.

Under the estate tax, an asset acquired for the same aunt from her estates is “stepped-up.” That is to say, the assets in an estate and the subsequent beneficiaries receive a new income tax basis equal to the fair market value of the assets on the date of the decedent’s death, (or on an alternate valuation date an estate may elect on the six-month anniversary date of a decedent’s death.) Accordingly, a beneficiary will pay income taxes on any recieved assets sold based on the difference in value of the assets between the date of death value and the sales price. In the above example instead of gifting the stock the aunt conveys it at her death, the beneficiary gets a basis of $1000 and upon it sale of $1000, pays no income tax because there is not gain. What a great system. One of the few ways to avoid tax on appreciated property but, of course, someone has to die. 

The Federal Treasury forfeits a substantial amount of revenue by not taxing the gain on assets held until death. In fact, according to the Office of Management and Budget, it is the fifth-largest existing “tax expenditure.” The entire concept drives liberal crazy. Most revenue estimates put the loss to the Treasury of around $60 billion a year, although it really not possible to know with more certainty as data from all people who receive property from a decedent is not verifiable particularly where an estate tax return is not required to be filed.

Tax reformers, do-gooders and assorted liberals have been trying to ace out stepped-up basis for year. They succeeded in Tax Reform Act of 1976 but installing a type of carryover basis regime and eliminating stepped-up basis. However, led by Senator Harry F. Byrd Jr. (I-VA), the provision was suspended and eventually repealed. There is a litany of reasons carryover basis advocates want to repeal of stepped-up basis. Equally there are arguments on the other side. However, it all gets down to the money. Government desire for more and more money is insatiable.

I would argue preserving stepped-up basis is much more important to the average taxpayer than what ever the tax rates are on mega-estates. This is an income tax issue after all. Normal taxpayers who inherit property do not always know what the basis is to the property received and why subject the property to the estate tax and then to the income tax?

These are uncertain times but any big tax expenditure is in jeopardy. Repeal of stepped-up basis is not necessarily an immediate tax hike that can be felt by everyone but it is a tax increase.  It is possible the repeal or the modification of the stepped-up basis rules will be in play when Congress gets serious about tax issues.