In 1973, the great racehorse Secretariat pulled away by an incredible 31 lengths to win the Belmont Stakes. That win made him the 9th Triple Crown winner, a feat which had not been accomplished within the past 25 years. As exciting as that racing legend is, Secretariat’s story also dramatizes the potential cruelty of the federal estate tax. You see, the 70s were particularly bad years for estate taxes. As the story goes, when Christopher Chenery, the owner of Secretariat, lost his fight against Alzheimer’s, the remaining family members had to figure out a way to pay the impending $6 million estate tax (roughly $33 million in today’s dollars). Not wanting to sell the farm or the horse, the family raised the cash by putting together a syndication for Secretariat’s breeding rights and selling 32 shares at $190,000 each. Sadly though, Secretariat was put out to stud and never raced again.
So why is there an estate tax and what are some current thoughts on its destiny? The imposition of an estate tax dates back nearly 3,000 years. In medieval times, heirs who wished to use inherited property were required to pay the king an estate tax. In 17th century European countries, the prevailing opinion emerged that property transfer rights were not inherent but instead were granted by the government and therefore the government had the right to tax transfers of property.
In the United States, the tradition of taxing the transfer of assets goes back to the Stamp Act of 1797. This Act placed a federal stamp on wills in probate and raised revenue to pay off debts incurred in a war against France. When the war ended, the Stamp Act was repealed. Over the next hundred years estate taxes were used as a sporadic and temporary way to finance other wars. When a war ended, the tax was repealed. To help finance the Civil War, the Tax Act of 1862 imposed a federal gift and estate tax. After the war ended and the need for additional revenue subsided, the inheritance taxes were repealed once again.
A champion of taxing large estates, Theodore Roosevelt often argued that the estate tax was a means of preventing a concentration of wealth. In 1916, he said “The man of great wealth owes a particular obligation to the State because he derives special advantages from the mere existence of government”. Passed in the Emergency Revenue Act of 1916 in preparation for WWI, a graduated estate tax with a rate of one to five percent was imposed on the value of an estate over $50,000 (roughly $1,150,000 in today’s dollars). However, this time when WWI ended, the estate tax did not go away.
More recently, the estate tax rates have bounced from a high of 77% for large estates of decedents dying in the years between 1941 and 1977 to 0% for estates of decedents dying in 2010. At the end of 2010, Congress passed legislation that reinstated the federal estate tax. The new law set the exemption for U.S. citizens and residents at $5 million per person and provided a top tax rate of 35 percent for the years 2011 and 2012. On January 1, 2013, Congress again passed legislation which permanently established an exemption of $5 million per person indexed for inflation, with a maximum tax rate of 40% for the year 2013 and beyond.
Now, with a new administration taking over in 2017, all indicators point to some changes to the current estate tax laws. Is repealing the tax just a class war debate (the wealthy as the winners and the poor as the losers) and what are the relevant issues?
Theodore Roosevelt and others have argued in favor of the estate tax as an effort to redistribute concentrated wealth. However, studies have shown that the U.S. economy is fluid enough to generate wealth creation and wealth loss without the imposition of an estate tax. Further, according to the Joint Committee on Taxation, 99.8 % of Americans owe no estate tax at all. Among the few estates that owed any tax in 2013, the effective tax rate was only 16.6% (significantly less that the statutory rate of 40%).
Many allege that the estate tax constitutes “double taxation” because it applies to assets that have already been taxed as income. However, the larger estates tend to consist to a great extent of “unrealized capital gains” on stocks or real property that have never been taxed. The estate tax can be viewed as a backstop to the income tax, taxing the income of wealthy taxpayers that would otherwise go untaxed.
Let’s remember Secretariat. A resonating position is that the estate tax jeopardizes the legacy of small family farms and businesses. However, with exemptions of more than $5 million, very few of these business owners are subject to an estate tax at all and for those that are subject to the tax, options exist to help them, including special exemptions and alternatives to spread out the tax.
As far as the impact on charitable giving, the arguments can flow both ways. Some allege that without an estate tax, the wealthy would have more after-tax money to give to charities. Others fear that without the benefit of an “estate tax deduction”, charitable bequests will decline.
Even with the small number of estates that actually pay an estate tax, approximately $20 billion is raised annually. The costs associated with estate tax compliance are within the general range of compliance costs for other taxes. The budget is an important long term consideration and one can wonder what further cuts in federal spending or other tax increases will be necessary if there is no estate tax revenue.
President Trump has proposed a repeal of the estate tax. However, whether this will happen still remains uncertain. Trump’s proposal states that “capital gains held until death and valued over $10 million will be subject to tax to exempt small businesses and family farms.” A likely meaning of these words is that under Trump’s plan, for those estates over $10 million, there would be no step up in the cost basis for appreciated investments for the portion of estates that exceed $10 million. For the vast majority of estates below $10 million, there will still be the same step up in basis as before.
It is also unclear whether the gift tax will be repealed. If the estate tax is repealed, the gift tax is no longer needed as a backstop to the estate tax. However, without a gift tax, a taxpayer could transfer highly appreciated assets to someone in a lower tax bracket or with unused losses to sell who would then transfer the sales proceeds back to the original owner. The gift tax may remain as an important backstop to prevent these maneuvers.
Current procedural rules could also prevent an immediate repeal of the estate tax. It takes 60 votes in the Senate to stop a “filibuster”. The Senate must also abide by the “Byrd Rule” which requires a 60-vote majority to pass a bill that has a negative impact on revenue outside of a 10 year revenue window. Notwithstanding these rules, if the bill becomes part of a “budget reconciliation act”, the bill is not subject to filibuster. The bill could also be made revenue neutral (for those years outside the 10 year window) by adding a sunset provision like the one in the Bush 2001 tax act.
Estate Planning is never only about tax issues. So while there is currently a great deal of uncertainty surrounding the future of the estate tax, planning for incompetency, asset protection, divorce, and issues surrounding children still remain. For those who have taxable estates under current law, you may wish to review your estate plan and make certain the provisions still work as intended if the estate and generation skipping tax is repealed. Others who are contemplating but have not begun wealth transfer techniques may wish to wait and see.