Both President Trump and the Republican leaders in Congress have advocated a repeal of the federal estate tax. If that occurs, certain tax concerns facing wealthy families would be wiped away, perhaps forever.
But a repeal, if one is indeed enacted, could come with some strings attached, especially with regard to income taxes. In fact, some families may wind up in worse overall tax shape than before.
The federal estate tax has traveled a circuitous route to this point since its inception in 1916. At the turn of the century, the top estate tax rate had reached a hefty 55 percent, while the unified estate and gift tax exemption could effectively shield assets valued at up to $675,000. After the exemption was hiked to $1 million, Congress enacted the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. And that’s when the fun really began.
Under EGTRRA, the top tax rate was gradually lowered over the ensuing decade from 55 percent to 45 percent, while the exemption climbed from $1 million to $3.5 million. Along the way, the unified estate and gift tax systems were severed, along with other significant changes. And then EGTRRA repealed the estate tax completely, but for just one year – 2010 – before it was immediately reinstated in 2011.
Subsequent legislation imposed a top estate tax rate of 40 percent with a $5 million exemption, indexed for inflation ($5.49 million in 2017), and reunified the estate and gift tax systems.
The latest changes were supposed to be “permanent.” But now the Trump administration is pushing for an outright repeal of the tax. It’s not clear if the gift tax would also be abolished, and that might be a bargaining chip in negotiations. Perhaps even more important, however, would be the provisions relating to the “step-up in basis” for income tax purposes.
Currently, when a decedent dies, the basis in the inherited assets is stepped up to the value of the assets on the date of death, as opposed to a prior regime where the decedent’s basis was carried over. Because of the step-up in basis, the appreciation in value while the decedent owned the assets is never taxed. If an heir sells the assets immediately after inheriting them, it’s likely there will be little or no income tax consequences.
However, the proposed estate tax repeal might include a provision for carrying over basis or a special “date of death” capital gains tax. Assuming carryover basis is included in the reform, the resulting income tax liability could outweigh any estate tax savings for many families.
Let’s look at a simplified example: Suppose John, a widower, dies in 2017 and leaves $5 million in assets to his only child, Mary. John’s original basis in the assets was $1 million. Under existing law, there would be no estate tax when John dies, thanks to the $5.49 million exemption. If Mary then sells the assets for $5 million, she owes zero income tax.
If President Trump’s proposal is enacted effective for 2017, estate tax becomes moot. But now Mary may have to carry over John’s $1 million basis. If she sells the assets for $5 million, their value on John’s date of death, she is showing a $4 million gain. At a maximum long-term capital gains tax rate of 20 percent, she would owe $800,000 in income tax!
Note that Trump has previously proposed a $10 million exemption from the step-up in basis rule for farms and small businesses. Other exceptions (e.g., a $1 million exemption) could be included in any final legislation that Congress passes.
Finally, there are numerous other variables to consider, including state estate taxes, but the potential for a tax disaster is real. We’ll see what kind of compromises can be hammered out in Congress before pushing the panic button.
Ken Berry, Esq., is a nationally known writer and editor specializing in tax, financial, and legal matters. During his long career, he has served as managing editor of a publisher of content-based marketing tools and vice president of an online continuing education company. As a freelance writer, Ken has authored thousands of articles for a...