Tag Archives: Basis

What’s Up With The Estate Tax?

That’s the $5 mil­lion question.

More pre­cisely, for 2012, it’s the inflation-adjusted $5,120,000 question.

If you’ve fol­lowed the wran­gling over the estate tax for the past 10 or 15 years, you know that it is a highly-charged polit­i­cal issue.  It lies directly along the fault line that sep­a­rates the anti-tax enthu­si­asts in Congress from those who believe that the wealthy aren’t pay­ing enough taxes.

The life­time exclu­sions from the fed­eral gift and estate taxes have increased con­sid­er­ably over the past sev­eral years.  As a result, for the present time at least, fed­eral gift and estate taxes have been elim­i­nated as a con­cern for the mid­dle class.  A mar­ried cou­ple may now trans­fer $10,240,000 to their chil­dren with­out pay­ing fed­eral gift or estate taxes.  I assume that to most Americans, cou­ples who have $10 mil­lion to pass along to their chil­dren aren’t exactly mid­dle class.  Others may define “mid­dle class” more broadly and argue that a cou­ple own­ing $10 mil­lion in assets is merely “com­fort­able,” but not wealthy.

In any case, whether you believe that today’s $5 mil­lion per per­son life­time exemp­tion ($10 mil­lion per mar­ried cou­ple) is too high, too low or “just right,” those fig­ures are des­tined to expire at the end of 2012.  Unless Congress acts, the gift and estate taxes will revert to the laws that were in effect in the year 2001.  That means only a $1 mil­lion per per­son ($2 mil­lion per mar­ried cou­ple) life­time exemp­tion from the fed­eral gift and estate taxes.  (The life­time exemp­tion from the third wealth trans­fer tax, the Generation-Skipping Transfer Tax (GSTT), will be a some­what larger num­ber, since the $1 mil­lion GSTT exemp­tion was indexed for infla­tion under the law in effect in 2001.)

What is espe­cially dis­con­cert­ing about the fluid state of the wealth-transfer taxes is that plan­ning to reduce or avoid the taxes is chal­leng­ing at best.  Anecdotally, many fam­i­lies have resisted updat­ing their estate plans for years, wait­ing for Congress to agree on and stick to life­time exclu­sions and tax rates (which have them­selves declined sub­stan­tially since 2001) for the gift and estate taxes and the GSTT.

A bit of his­tory is in order.  In 2001, Congress passed and President Bush signed into law the Economic Growth and Taxpayer Relief Reconciliation Act (EGTRRA).  EGTRRA grad­u­ally increased the life­time exemp­tions from the estate tax and GSTT until they reached $3.5 mil­lion in 2009.  The rates for both taxes were like­wise grad­u­ally reduced from mar­ginal rates that could reach as high as 60% for the estate tax to a max­i­mum mar­ginal rate of 45% for each tax.

Under EGTRRA, the estate tax and GSTT were slated to expire in 2010.  Because of bud­getary con­straints and Senate bud­get rules which would have required an unat­tain­able 60 votes to per­ma­nently repeal the taxes, the repeal was for one year only.  In 2011, the pre-EGTRRA taxes would be rein­stated as they existed in 2001, as though EGTRRA had never been signed into law.  The evi­dent inten­tion was that both taxes would be per­ma­nently repealed by a later and more sym­pa­thetic Congress.

EGTRRA did not repeal the fed­eral gift tax.  This omis­sion was intended to pre­vent fam­i­lies from gam­ing the sys­tem for income tax pur­poses by gift­ing assets to those best able to uti­lize the assets’ income tax attrib­utes, espe­cially unused cap­i­tal gains and losses.

Of course, there was lit­tle doubt that Congress would revisit the wealth-transfer taxes to avoid the absur­dity of a one-year repeal of the estate tax and GSTT, fol­lowed by their revival in 2011 with much lower exemp­tions and much higher tax rates than had been in place in 2009.

Congress sur­prised every­one by fail­ing to effec­tively address EGTRRA prior to 2010.  Only in December of that year did Congress act, serv­ing up a leg­isla­tive hash that gave the estates of per­sons who had died in 2010 the option of pay­ing an estate tax or pay­ing income tax on untaxed cap­i­tal gains in the decedent’s estate.  In other words, car­ry­over basis would replace the basis step-up at death.

In the 2010 tax act (the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010) (TRUIRJCA), President Obama agreed with Republican lead­ers to rein­state all three of the wealth trans­fer taxes, each with a life­time exemp­tion of $5 mil­lion (adjusted for infla­tion begin­ning in 2012) and a max­i­mum tax rate of 35%.  As indi­cated above, for 2012, the inflation-adjusted exemp­tions are set at $5,120,000.  The TRUIRJCA accord, how­ever, expires at the end of 2012.  At that time, as was the case with EGTRRA, the wealth trans­fer taxes will revert to year 2001 life­time exemp­tions and tax rates.  Will Congress finally act and give us the sta­bil­ity in the law that will per­mit American fam­i­lies to plan for reduc­ing and pay­ing the wealth trans­fer taxes?

It’s been a long road get­ting from 2001 to where we are today.  Sadly, how­ever, that’s not the fin­ish line you see up ahead; it’s the start­ing line.  We’re back to where we began, not know­ing what the law is going to be from one year to the next.


Gifts, Bequests and Basis

The Internal Revenue Code (IRC) con­tains numer­ous pro­vi­sions relat­ing to the income tax basis of prop­erty.  Touched on below are cer­tain basis pro­vi­sions that are closely inter­twined with the fed­eral gift and estate taxes.

By way of pred­i­cate, the most famil­iar type of income tax basis is prob­a­bly “cost basis” (IRC §1012).  If you have ever sold a home, you know that the price you paid for the home — its cost basis — is your ini­tial basis in the home.  If you made improve­ments to the home over the years, they were prob­a­bly required to be “cap­i­tal­ized,” or added to your home’s basis.  Absent some over­rid­ing pro­vi­sion of law (e.g., struc­tural changes to accom­mo­date a dis­abil­ity might qual­ify for the income tax med­ical deduc­tion), you were not per­mit­ted to deduct those expenses from your cur­rent income.  Instead, the income tax sys­tem took account of the cost of the improve­ments by increas­ing your basis and thereby reduc­ing your cap­i­tal gain (if any) on the even­tual sale of the home.

Moreover, IRC §121 excludes from income $250,000 ($500,000 in the case of a mar­ried cou­ple) of the gain (if any) on the taxpayer’s sale of his prin­ci­pal res­i­dence.  The exclu­sion may not be claimed more than once every two years.

The gen­eral rule for gifts, as set forth in IRC §1015, is that the recip­i­ent of a gift (the “donee”) takes the same basis in the trans­ferred prop­erty as the indi­vid­ual mak­ing the gift (the “donor”).  This is so-called “car­ry­over basis.”  On the even­tual sale of the gifted prop­erty, the donee-seller’s gain is cal­cu­lated with ref­er­ence to the basis car­ried over from the donor.

For that rea­son, it is advis­able to make gifts with as high a basis as pos­si­ble.  In this way, the gift’s value will not be unnec­es­sar­ily dimin­ished by cap­i­tal gains taxes if it is later sold.  Dollars, inci­den­tally, always have a basis equal to their face amount, in whoever’s hands they may be.

There is one impor­tant qual­i­fier to the car­ry­over basis treat­ment that usu­ally applies to gifts.  If the fair mar­ket value of the prop­erty at the time of the gift is less than the donor’s basis, then the donee’s basis for deter­min­ing loss is the lesser amount (the fair mar­ket value).  As a result, the donee’s loss (if any) when he sells the prop­erty will be less than if car­ry­over basis applied.

Under IRC §1014, prop­erty trans­ferred at death will gen­er­ally have a basis equal to its fair mar­ket value as of the date of the owner’s death.  (Alternatively, if the value of the decedent’s estate has in the aggre­gate declined on the date that is six months after the date of death, the execu­tor may elect to have the later val­ues apply.)  On the opti­mistic assump­tion (and com­mon expe­ri­ence) that prop­erty trans­ferred at death has increased in value since it was acquired by the dece­dent, the basis of each item of prop­erty will be “stepped up” to its fair mar­ket value.  As a con­se­quence, there will be less cap­i­tal gain if the item con­tin­ues to appre­ci­ate in value and is later sold.  On the con­trary, if prop­erty has declined in value since it was acquired by the dece­dent, the basis must be “stepped down” to its fair mar­ket value at death.  This, of course, results in greater cap­i­tal gain on the later sale of the property.

Technically, only per­sonal prop­erty (not real prop­erty) that passes under a Will is a “bequest.”  Although the title of this post refers to bequests specif­i­cally, the basis rules of §1014 apply to all of the prop­erty included in a decedent’s estate for fed­eral estate tax pur­poses.  Without (for the moment) dwelling on the par­tic­u­lars, a decedent’s estate may be com­posed of many types of prop­erty other than per­sonal prop­erty pass­ing under a Will.

Purchase of prop­erty = cost basis (§1012)

Gift of prop­erty = car­ry­over basis (§1015)

Bequest of prop­erty = basis step-up (§1014)