My wealthy (and very conservative) client called after the election results were apparent and asked, “What is Biden going to do to me?” He didn’t want a wait-and-see answer. And he didn’t want me to say, “go see your estate attorney.” He wanted my opinion — perhaps to weigh against the attorney’s opinion. I know that you’re facing the same problem with your clients. Here’s an opinion piece for you.
There are two basic assumptions applied in the following discussion on President Biden’s estate tax proposals. Our country has run up a big Covid-related deficit, and we will have to pay the deficit down someday. Our economy is fragile because of Covid-19. We need to consider the immediate impact on our economy of all proposed tax increases. Maybe short-term or mid-term impact will result in a delay to what might otherwise be good tax policy.
Assets are included in the estate at their fair market value. They are subject to 40% federal estate tax if the estate assets’ total value is over the exemption amount (currently $11,700,000 for each individual). Inherited assets receive a step-up in basis to fair market value at the date of death. The gift exemption is currently the same as the estate tax exemption encouraging many wealthy people to maximize gifts in anticipation of President Biden’s success in reducing the exemption amount.
President Biden has made four proposals to increase taxes on the transfer of wealth.
- Reduce the estate tax exemption
- Reduce the gift tax exemption and decouple it from the estate tax exemption
- Increase the rate on taxable estates from 40% to 45%
- Eliminate step-up in basis at inheritance
Reducing the exemption
President Biden has suggested that the estate tax exemption should be lowered to $3,500,000 per individual, and the exemption amount for gifts lowered to $1,000,000. How likely is this change? Considering that the Republicans wanted the estate tax repealed and settled for a doubling of the exemption amount when they enacted the Tax Cuts and Jobs Act, a drastic reduction would be a battle. The compromise is likely to be the pre-TCJA number of $5 million adjusted for inflation after 2011 (resulting in about a $5.7 million estate tax exemption effective for 2022). Would this change endanger our economy when it is suffering from Covid-19 shutdowns and slowdowns? The Tax Policy Center estimates that this change would result in 55,000 additional taxable estates and $60 billion of increased revenue over ten years. Those numbers seem small compared to our deficit and our GDP and should have little negative impact on our economy.
Decoupling the gift tax exemption from the estate tax exemption
In 2011, the gift tax exemption was increased from $1 million to equal the estate tax exemption ($5 million in 2011). Is it likely that the gift tax exemption will be decoupled from the estate tax exemption? Yes. Why? Because it affects only those, who can gift large amounts (let’s say $11,700,000 in 2021) and still have enough assets remaining to enjoy a luxury life. Will it really drop to $1 million? It’s possible, but politicians are involved in drafting legislation, and their wealthy constituents are large donors. Expect a compromise at some higher amount. Perhaps $2 million? This change should have little negative impact on our economy.
Federal estate tax rate
The current rate is 40% for taxable estates. The rate was 55% in 1997, 45% in 2007, and 35% in 2011. The rate increased to the current 40% in 2013. While it is not likely that the rate will increase to its 1997 high of 55%, a compromise might result in a 45% rate, especially if the exemption amount is also compromised at the pre-TCJA $5 million amount.
Step-up in basis
We’ve tried this before. The Tax Reform Act of 1976 eliminated step-up in basis on all inherited assets, but the provision was repealed before it took effect. For a moment (the year 2010), the estate tax was repealed, and carryover basis was required for most inherited assets. The estate tax law went back to “normal” in 2011.
President Biden, and other progressives, believe that the step-up in basis increases generational wealth transfer and contributes to income inequality. Because of step-up in basis rules, wealthy taxpayers can permanently escape capital gains taxes by passing appreciated assets from generation to generation.
If step-up in basis is eliminated, capital gains tax would apply between the decedent’s basis and the asset’s sales price (generally the fair market value at the date of death if sold promptly.) In addition to this change, the President also proposed that capital gains be taxed as ordinary income for upper-income taxpayers, meaning that the tax to the beneficiaries on inherited assets would be substantial.
There are two immediate problems with the elimination of the step-up in basis:
- Estate tax and capital gains tax would be paid on the same asset, albeit, estate tax on the asset’s fair market value and capital gains tax on the appreciation of the Federal taxes could be 50 or 60% or more, and those rates could be a disincentive to invest.
- The repeal of step-up in basis would be a compliance Basis records would be required for everyone unless exceptions (and their complications) are added to the repeal.
This change could negatively impact our economy and is thus less likely than some other estate tax proposals to be included in successful legislation. The step-up in basis on inherited assets is very entrenched.
Valuation discounts and GRATs
Although not part of President Biden’s campaign proposals, others have suggested that valuation discounts in the form of lack of control and lack of marketability should be limited. (President Trump withdrew IRS proposed regulations that would have curtailed discounts.) Grantor retained annuity trusts (GRATs) provide an annuity to the grantor for the term of the trust. For gift tax purposes, the grantor makes a gift equal to the remaining value of the trust. The gift amount is based on the “remainder” amount determined based on the annuity payment and a factor published monthly by the IRS. The computation can result in a heavily discounted value for the gift. Proposals on GRATS have included a ten-year minimum annuity period and a retained interest that would produce a taxable gift equal to some amount (one proposal is the greater of 25% of trust assets or $500,000). These proposed changes should have little negative impact on our economy.