Repeal of the Estate Tax - More Election-Year Hype

Introduction:

Transfer Tax Basics:

The U.S. government extracts a tax for the privilege of transferring wealth, whether during life or at death. Lifetime transfers are subject to the gift tax and transfers that occur because someone dies are subject to the estate tax. The rates for the gift and estate taxes are the same, and there is a unified credit amount for both estate and gift taxes.

Note: The tax is levied against the "transferor" or "donor," for the "privilege" of transferring property to the donee. Thus, the donee receives the property tax-free, except in those circumstances where there is a gift or estate tax due and the transferor did not pay the tax. Under those circumstances, the donee becomes liable for the tax.

Gift Taxes:

Essentially, a transfer during life or at death are treated the same from a tax standpoint, except that each taxpayer has an annual gift tax exclusion of $10,000 per beneficiary. This means that a taxpayer may transfer up to $10,000 in money or property (husbands and wives may give $20,000) per donee, per year, without incurring a gift tax. With respect to gifts greater than $10,000 per year, taxpayers may elect to apply their unified credit (currently worth $675,000 in 2000) to the gift. For instance, if a single person makes a gift of $25,000 to another individual, the annual exclusion will apply to the first $10,000 and the unified exception would apply to the remaining $15,000, thereby reducing the taxpayer’s unified credit to $660,000. Note: the unified credit will increase to $1 million after 2006.

Estate Taxes:

The estate tax is a transfer tax that occurs at death. The decedent’s assets are revalued at the fair market value on the date of death (or 180 days after the date of death if the fair market value of all assets is lower on that date). Thus, the decedent’s tax basis in his or her assets are either stepped-up or stepped-down to the fair market value on date or death (or 180 days thereafter).

Each taxpayer has a unified estate and gift tax credit worth $675,000 in 2000 and climbing to $1 million after 2006. Thus, if a taxpayer died in 2000 with assets worth $675,000 or less, there will be no estate tax. For married couples, in addition to the unified credit, assets left to a surviving spouse are not taxed on the first spouse’s death, although those assets will be taxed on the surviving spouse’s death. Thus, there is generally no estate tax payable until the surviving spouse dies.

The "stepped-up basis" rule eliminates income taxes on the appreciation of assets held by the decedent. Thus, many taxpayers hold highly appreciated assets until death, which eliminates income taxes on those assets.

For example: If John dies owning IBM stock worth $150 a share and a basis of $10 a share, the stock is valued at $150 a share and his beneficiaries will receive the stock with the new stepped-up basis of $150 a share. A later sale of the stock for $160 a share will produce a $10/share gain, whereas, if John sold the stock for $150 the day before he died, his gain would have been $140/share.

The stepped-up basis concept is important because it gives all assets a fresh basis measured on the date of death (or 180 days thereafter). John’s beneficiaries do not have to be concerned with the historic basis of the assets. In contrast, if John made a gift of the stock during his lifetime, then the beneficiary would receive a carryover basis in the asset and would pay tax on the appreciation. When the stock is sold, the beneficiary would have to determine John’s basis in the stock at the time the gift was made and pay income taxes on the appreciation.

Under California community property laws, the entire asset receives a stepped-up basis upon the death of the first spouse, thus income taxes on appreciation are eliminated for both the surviving spouse’s 50% share of the community property as well as the decedent’s 50% share.

Currently, when John dies, his estate is revalued at the fair market value and any gain in those assets is eliminated. However, John’s estate is subject to estate tax rules. John has a unified credit of $675,000 so if his estate is under this amount, he pays no estate tax and his heirs will pay no income tax on assets they receive. Approximately 98% of estates pay no estate tax; therefore, the current estate tax affects the wealthiest 2% of the population.

The estate tax raises less than 2% of federal taxes and raises less money than the gasoline tax. Approximately 50% of estate tax is paid by estates greater than $5,000,000 and only one in one thousand estates are this large.

The Congressional Legislation:

On July 14, 2000, the Senate voted to approve the "Death Tax Elimination Act of 2000." This legislation, after a complicated 10-year phase-in period, would eventually eliminate gift, estate and generation-skipping taxes on wealth transfers. Essentially, the top gift and estate-tax rates would be reduced from the current 55% to 42.5 percent in 2009; all estate taxes would be repealed beginning in 2010.

The current unified credit regime ($675,000 in 2000 and rising to $1 million in 2007) would be designated a unified exemption. This change will reduce the tax rate paid on estates exceeding the unified exemption. Under the current system, the estate tax rate begins at 37%, whereas with this change, the tax rate will begin at 18%.

After 2009, the stepped-up basis rule would be replaced with the complex "carryover-basis" rule used for gift-tax transfers. Designated assets worth 1.3 million would receive a stepped-up basis ($3,000,000 for assets transferred to a spouse). Note: These amounts will be indexed for inflation after 2009. The decedent’s executor would choose which assets would receive the basis step-up. Obviously, assets with no appreciation, such as cash and bank deposits would not be likely candidates.

Note: As described above, under California’s community property laws, the spouse currently receives a basis step-up on her share of the assets, so this carryover basis provision could harm Californians with estates exceeding $4.3 million.

President Clinton vetoed this legislation and the Senate failed to override the veto.

The Democratic Proposal:

The Democrats have proposed raising the unified credit, providing an exemption for the decedent’s principal residence and providing additional credits for closely-held farms and businesses. This proposal would have exempted estates of $4 million and under.