Estate Tax or Step-up in Basis...Pick One! | Ed Slott and Company, LLC

Estate Tax or Step-up in Basis...Pick One!

By Jeffrey Levine, IRA Technical Expert
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@IRAGuru4EdSlott

Believe it or not, taxes related to an inheritance have been around, in one form or another, going back to the 1700s. In 1797, for instance, a temporary stamp tax was enacted that applied to bequests. Even the “modern” estate tax has been around much longer than most people realize. Surprisingly to many, it actually dates all the way back to 1916, making this the 100th year the modern estate tax has been imposed in some manner (if you include 2010, when it was temporarily repealed for a year).

Today, federal estate tax has become a non-issue for all but the wealthiest of American families. As has been the case since the early 1980s, spouses can generally leave an unlimited amount of assets to one another without such a transfer being subject to estate tax. Most transfers to someone other than a spouse also avoid estate tax under current law.

As part of the American Taxpayer Relief Act (ATRA) of 2012 – which was technically not signed into law until January 2013 – an inflation-adjusted exemption amount of $5 million was established. Today, that figure has grown to $5.43 million, meaning that up to $5.43 million can generally be passed to anyone without incurring a single dollar of federal estate tax. Furthermore, since 2011, the estate tax exemption has been “portable” between spouses, meaning that a deceased spouse’s unused exemption can be transferred to a surviving spouse by timely filing an estate tax return. This effectively gives married couples the ability to pass up to $10.86 million to children or other non-spouse beneficiaries without any federal estate tax whatsoever.

Despite both its longstanding inclusion as part of the tax code and the fact that it impacts less than two in every 1,000 Americans, the estate tax is often at the center of policy debates in Washington. Proponents argue that the tax only impacts those who have benefited from our country’s services, infrastructure and laws the most and have used that system to amass the greatest amounts of wealth. Many also believe that the estate tax helps to prevent a growing aristocracy, in which only a few well-off families control a disproportionate share of the nation’s wealth (though how effective the estate tax is at accomplishing this goal can certainly be questioned).

Opponents of the estate tax argue that the tax is unfair, that it penalizes those who have worked the hardest or have been the most innovative, that have created the most jobs, and that have already contributed more in taxes than the rest of society. They also fervently argue that it is simply not right to impose a tax on one’s wealth simply because they have died, which led to the creation of a new term to describe the estate tax... the “death tax.”

Truthfully, both sides have more than their fair share of good points. As a country, we are pretty broke and we need to raise revenue. Even massive cuts to government spending won’t change that. And it does seem fair to try and collect that revenue from those who have benefited enough from our system that they can actually afford to pay those taxes, even if they don’t want to. On the other hand, while some are lucky enough to be born into wealth, many “one-percenters” accumulated their wealth through hard work and innovation. In many cases, they’ve already paid tax on a large portion of their wealth and it does, indeed, seem unfair to tax it again simply because they’ve had the misfortune of dying.

The current estate tax law, described above, is technically “permanent,” but that’s not really the case. Permanent, in Washington parlance, means “permanent until we change our mind.” So with that in mind, since the passing of the “permanent” estate tax law, proponents of the estate tax have pushed hard for higher rates and a lower exemption. Opponents have gone the other way, pushing just as hard for a complete repeal.

And now, as part of his latest budget proposals, President Obama has proposed to modify the estate tax laws once again by largely eliminating what’s known as a step-up in basis (though up to $100,000 of gains plus another $250,000 of gains on a personal residence would be exempt, per person). You can read more about the proposal here. Under the step-up in basis rules, capital assets held outside of retirement accounts generally have their basis increased to their value on the date a person dies. This enables beneficiaries of those assets to sell them without owing any capital gains tax, regardless of how much the decedent initially paid for the investment.

For example, suppose you purchased a stock for $1,000 many years ago and, over time, the value of that stock has grown to $100,000. You’ve accumulated $99,000 of gain, but you haven’t paid any tax on it yet because you haven’t sold your stock yet. This $99,000 is technically referred to as an unrealized gain.  As long as you continue to hold that stock, you won’t owe any capital gains tax. If you sell the stock, however, you’ll owe long-term capital gains tax on $99,000.

What if, though, you died before you sold your stock and left it to your daughter? She could keep the stock too, but she might want to sell it. If she does, would she owe tax on the same $99,000 of gain like you would have incurred had you sold it during your life? The answer, under current law, is no. Your daughter would get a step-up in basis and it would be treated as though she purchased the stock herself for $100,000.

So far, there’s been no indication that the President is willing to trade the estate tax in return for an elimination in the step-up in basis rules. If... and it’s a big if... the President offers some type of compromise in which the estate tax is repealed in exchange for the elimination of the step-up in basis, those that have so ardently rallied against the estate tax for years should overwhelmingly support such a measure.

As discussed above, one of the primary arguments against the estate tax over the years has been that it is not fair to arbitrarily tax wealth just because someone has died. Repealing the estate tax would eliminate this issue. Furthermore, as noted earlier, opponents of the estate tax often argue that it is unfair because it taxes the same money twice. If we can manage to come to an agreement that it’s wrong to do that, we should also be able to agree that never taxing funds is equally as egregious, but that’s exactly what would happen if the estate tax were repealed but the step-up in basis rules remained unchanged.

Take Mark Zuckerberg, for instance. As most people know, Zuckerberg has managed to create unfathomable amounts of wealth as one of creators of Facebook. Most of his wealth, not surprisingly, is comprised of appreciated Facebook shares. Right now, if Zuckerberg were to die, his estate would be subject to estate tax, but the billions he has made in appreciated Facebook shares would never be subject to income tax. If the estate tax was repealed with no other changes, Zuckerberg’s heirs would be able to take those billions of dollars worth of Facebook shares and sell them, all without owing any income tax. In contrast, if you needed to sell a stock worth $100 that you bought for $50 years ago to help pay for your retirement expenses, you would owe a capital gains tax. That certainly doesn’t seem fair.

So should the estate tax be repealed? I’ll leave that as a topic for others to ponder, debate and fight over. But what I do know, with absolute certainty, is that if the estate tax goes, the unlimited step-up in basis has to go with it. Can anyone really argue with that?

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