Federal Estate Tax Repeal — Not Such a Good Deal for the “Small Rich”

Finally, someone has written about the not so hidden but not well known gotcha buried in the estate tax repeal that President Bush wants to make permanent in 2010. Writing in the Washington Post today, Allen Sloan, the Post’s Business Columnist and Newsweek’s Wall Street editor, points out the negative impact of the change from stepped up basis to carry over basis for what he calls the estates of the “small rich.”

Most folks don’t understand that the much ballyhooed estate tax repeal carries a nasty surprise. Under current law, when someone dies, the estate pays a tax if it’s over a certain size, but the tax basis of inherited property for the heirs is the market value at the date of death (stepped-up basis). Under the law after full estate tax repeal, the estate won’t pay a tax if it’s small enough but the tax basis of inherited property for the heirs will be the same as the tax basis for the person from whom they inherited (carry-over basis).

Here’s Sloan’s example that illustrates the adverse impact of this change coupled with current and future exemptions:

Under current law, when you die your heirs get stepped-up tax basis. That means the assets you bequeath are valued for income-tax purposes at what they were worth the day you died — not what you originally paid for them. Say you paid $50,000 for stock that’s worth $500,000 when you die. Your heirs can sell it for $500,000 and owe no tax on the $450,000 gain. As long as your total estate doesn’t exceed the exemption limits, there’s no estate tax, either.

Now watch. Under the 2009 rules, estates of up to $3.5 million ($7 million for a married couple) would be exempt from federal estate tax. The tax rate on assets above that level would be 45 percent. Inheritors would be able to step up the basis of $3.5 million (or $7 million) of inherited assets to their value the day they inherit them. Fast-forward to 2010, when the estate tax is repealed. Yes, the estate tax would be gone. But heirs would be able to step up only $1.3 million in assets to their value on the day of death. (Don’t ask why; that’s just how it is.)

Assets beyond $1.3 million would be valued for tax purposes at carry-over basis — their cost (for income-tax purposes) for the person who died. So any estate with $1.3 million to $3.5 million in assets ($2.6 million to $7 million for a married couple) is worse off under full repeal in 2010 than it would be in 2009. Inheritors in the $1.3 million-to-$3.5 million range would face higher taxes if they sold inherited assets than they would under the 2009 rules. At the very least, they would have complicated paperwork to deal with. They’d be much better off inheriting in 2009 than in 2010. But if you’re dealing with an estate of $3.5 billion rather than $3.5 million, you’d be far better off inheriting in 2010.

How many folks will get the fuzzy end of this lollipop delivered to you by lobbyists paid largely by the mega-estate folks? Sloan says that a Joint Tax Committee study estimates that only 7500 people will have estates over $3.5 million in 2009, but 63,900 will have estates between $1.3 and $3.5 million.

Now, if we do nothing and we revert to the law before temporary estate tax repeal, the estate tax exemption will go back to $1 million in 2011 which will hurt a lot of small businesses and family farms. None of us should want that to happen.

But, as Sloan says, that doesn’t mean that we should make permanent the 2010 rules that will subject 63,900 estates to higher taxes while helping out only the 7500 people with mega-estates.

His recommendation?

It seems to me that adopting the 2009 rules, indexing the exemption for inflation and allowing stepped-up basis would get us back to the original intent of the estate tax. Taxing 7,500 estates a year doesn’t seem unfair. And it would generate significant revenue.

Makes sense to me.

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7 responses to “Federal Estate Tax Repeal — Not Such a Good Deal for the “Small Rich””

  1. Larry Gross Avatar
    Larry Gross

    Why do folks put up with this system?

    Our elected officials will profess that things like this were never their intent and that they are working to “undo” the damage. (the same elected officials who have time to meet lobby folk for lunch but not constituents).

    Do we think some lower-level gnomes write these rules either knowlingly or cluelessly?

    People who have significant money – have paid experts on retainer who function much like limosine drivers using the fastest, quickest… “sorta legal” ways to get them to their destination while folks who don’t have significant money get blind-sided regularily never knowing what happened – only that they owe a bunch of money all of a sudden.

    It’s a game. You have to have enough money to play and if you don’t have enough money – you get to pay.

    It’s the reason why most folks think our tax system favors the rich at the expense of the middle class.

    Methinks that folks who are against a progessive flat tax – are those that would lose their ability to evade taxes not those that just want to pay their fair share.

  2. James Atticus Bowden Avatar
    James Atticus Bowden

    Larry Gross: What is a
    progressive flat tax? Thanks.

  3. Larry Gross Avatar
    Larry Gross

    progressive flat tax – It’s a progressive tax (the more you make the more you are taxed) but each
    level is “flat” and you owe what you owe without further deductions.

    In other words, do away with 99% of the tax code and no amount of “legal” or “professional” help will
    “buy” you less taxes than you actually owe for your income group.

  4. Ray Hyde Avatar
    Ray Hyde

    And keep the sales tax, too. For most folks, the more you make, the more you spend, and it is the only way to get at money that is ill-gotten – either through gray market, illegal means or by gaming the income tax system.

    The only money that counts, is the money that flows. Everything else is tied up in investments, one way or another, and it is investments that make money flow. In turn, investments are made with the idea that you will be able to keep your investment, and not have it stolen or expropriated.

    That is why land rules that are ostensibly for “the public good” but which reduce an investments value ultimately work against us. Investments of any kind, not just land, depend on a strong basis of property rights. If you invested in the stock market, and then the government came along and told you that they wanted ten percent of your stock for the public good, then it might inhibit your willingness to invest. Likewise if you bought stock and then the government came along later and said that now you are only allowed to sell 10% of your stock, you have to either keep the rest or sell it as one block.

    Same goes for the inheritance tax. Here an investment still exists but it’s ownership is tranferred, which is not quite the same thing as income. Eventually the investment will either produce income which will be taxed or, if it fails to produce income, it will be liquidated. At that point the difference between the sales price and the basis becomes income, and it gets taxed anyway. The best thing we can do in the meantime, is to leave it alone.

    People seem to like to make their children rich, and we should encourage them to do so. Making them poor and them supporting them at public expense does not seem to be a good alternative.

  5. Ray Hyde Avatar
    Ray Hyde

    Jim’s comments on basis are a hoot. What do you do with property thaat has been in the family for generations, or even worse, if parts of it have been in the family for differing numbers of generations?

    Part of your inheritance was purchased by your grand father, part was purchased by his grandfather. What is your basis? good luck figuring that one out. That is why we use the stepped up basis, otherwise we don’t know when to set the clock.

    What are these people thinking?

  6. Charles Avatar

    Current law would require the OWNER to have all those records to correctly PAY the tax due if they sold the asset before their death, so it should NOT be much harder to determine that basis on the day OF their death.

    Forget who gets helped and hurt. That’s the WRONG way to set good policy.

    The ability to take stepped-up basis deductions, or inherit at stepped-up basis, is a FLAW in our current system. If we are taxing gains, we should TAX them, not forgive them if someone dies before realising them.

    Someone inheriting an appreciated asset should have two choices — have the ESTATE pay the capital gains due on the asset, and inherit it at the new cost basis, OR inherit it at it’s original cost basis, and then pay capital gains at THEIR rate when they sell the asset.

    BTW, under the 2010 rules, those between 1.3 and 3 million only come out worse if they immediately SELL the asset. If they keep the asset around, they don’t have to pay the tax, and when they do sell, it may be taxed at only 5%.

    So the new rules are more fair then the existing rules, which previously taxed the stepped-up basis at HIGH rates after the exemption in exchange for getting the stepped-up basis. Note that under the old rules, you’d be better off claiming the original cost basis as the inherited value to avoid the high inheritance tax and instead pay cap-gains, but you couldn’t do that.

    The only question I have is why they didn’t kick this rule in as soon as they started raising the exemption. It’s fair, and it would have made the inheritance tax phase-out cheaper.

  7. Ray Hyde Avatar
    Ray Hyde

    The law can require the owner to have those records, but what if he doesn’t? Most people would have them, but in the situation I described the facts could be very muddy, especially if they are a hundred or more years old.

    By contrast, it is easy to establish the value on the date of death: look it up in the stock tables, use the latest assessment, etc.

    I disagree that you should not consider who gets hurt and who doesn’t. Most policy changes create winners and losers. If the winners can compensate the losers and still come out ahead, then it is good policy, otherwise it is just wealth transfer. Wealth transfer is a polite way of saying stealing and it is detrimental to making investments.

    Where your argument falls apart is the statement “If we are taxing gains”. We should not be taxing gains until they are converted to income. It is the same problem with real estate assessments: while the property becomes more valuable that value is in no way associated with the owners ability to pay, which depends on income. Therefore the only way the tax on this imputed gain can be paid is to take it out of the economy someplace else. If you think that you can increase tax revenue that way, you are just kidding yourself.

    The reason most people sell an inherited asset is that either they don’t need or want it, or else they can’t afford to pay the tax on it. In that case the new owner gets the stepped up basis anyway. Why should the fact that cash changed hands change the way the asset is taxed?

    As for the person who sold the property, he has now got all this cash which he will either spend or invest. If he spends it, you collect sales tax from him and icome tax from the vendor, so it is taxed twice. If you tax him for inheriting it, then it is three times. How many times do we need to tax the same money?

    If he invests it in some other property, then he gets the new stepped up basis anyway. Why force him to make a choice like that, just so he can pay the inheritance tax?

    Both the existing rules and the new rules are unfair, unneccessary, and counterproductive in the long run.

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