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In part one of The Trust Fund Loophole, I described the proposed capital gains tax at death and the return to 2009 law as to estate taxes – a reduction of about $2,000,000 in the exemption and an increase in the estate tax rate of 5 percent, plus a return to a $1,000,000 lifetime gift tax exemption.

Additional information on budget proposals

A capital gains tax will draw many more taxpayers into the transfer tax system, including many middle class taxpayers with investment portfolios or other appreciated assets. The estate tax change will impact more than the estimated 0.2 percent of taxpayers requiring sophisticated estate tax planning under current law – perhaps in the range of 1.5 percent to 2 percent would require estate tax minimization planning.

Other proposals carried over from prior years include a $50,000 per year limit on gifts to trusts, even if qualified for the annual exclusion via Crummey demand rights and a requirement of a minimum 10-year term for Grantor Retained Annuity Trusts (GRATs), with two new twists requiring a minimum remainder value of 25 percent (the gift portion), which eliminates the “zero-out” gift strategy and a maximum term of life expectancy of the grantor plus 10 years, which is aimed at early terminations of long-term, e.g. 99-year GRATs in order take advantage of valuations that decrease the price of the term interest if purchased prior to the termination of the GRAT.

Most commentators do not see these changes as having much of a chance of passage, although compromises are possible, e.g. repeal of the estate tax with a capital gains tax at death. A repeat of the last-minute 2012 changes is always possible – most were surprised that the $5,000,000 exemption was reinstated in return for tax increases that the president wanted.

Policy background

Early in my career, George Cooper, a law professor, characterized the estate tax as a “Voluntary Tax” in the sense that with proper planning taxpayers could significantly reduce the taxes by valuation reductions strategies or by charitable dispositions ("A Voluntary Tax? New Perspectives on Sophisticated Estate Tax Avoidance," 77 Colum. L. Rev. 161 (1977)). This was written in the context of the 1976 changes that lowered the maximum rate from 70 percent to 50 percent, and increased the exemption to $125,000 (lifetime or deathtime) from only a $30,000 lifetime gift exemption and a $60,000 deathtime exemption. Throughout most of my career, strategies to accomplish tax reduction have been implemented with regularity and with significant tax savings for the beneficiaries of clients. Opponents of these strategies (many are “wealth redistribution” proponents) have from time to time initiated efforts at reforms to limit estate tax reduction. Nevertheless, over the last nearly 40 years the trend has been to decrease estate taxes and enhance the ability to transfer funds to succeeding generations with a smaller and smaller tax cost.

Cooper pointed out that among the various loopholes at the time, the ability to avoid capital gains tax on inherited property was one of the largest, but one through which most taxpayers were not willing to jump – death is a high cost in relation to the benefit that isn’t enjoyed by the one who paid the “ultimate price.”

At the annual Heckerling Institute of Estate in January, another professor, David Cay Johnston, proposed a number of changes – all tax increases – in the context of the need for revenue and the well-established, increased gap between those with low income and low net- worth and those with high income and net-worth, often referred to as income inequality and the wealth gap. While his is a compelling policy argument, there are many whose taxes would increase and inheritances decrease dramatically who will not be persuaded as to the ideas supporting these policies. In meeting the general welfare purpose of government, Johnston suggested that dead people and billionaires are not in need of welfare, in the sense of a tax benefit from the new basis in inherited assets.

Thus, it should not be a surprise that with most people falling in to the non-taxed class as to estate taxes and still enjoying the benefit of a new basis for the inherited property, that the president would see the imposition of a capital gains tax at death as a perfect mechanism to redistribute wealth by eliminating this double benefit. As many have commented – dead people don’t vote (although their beneficiaries do). From a policy standpoint, the new basis at death was intended to limit a potential double tax – a capital gains tax incurred at the time assets were sold to raise the cash to pay the estate tax. That policy objective has been eliminated for those who will not pay a Federal Estate Tax due to the high exemptions, and the urgency to sell to pay estate tax is likewise eliminated for all but a few.

Observations on the proposals

There are at least two levels of difficulty with the proposal – one is predictability and the other is complexity.

The amount of the tax will not be knowable until the death of the taxpayer. This also impacts revenue projections – in down markets, tax payers will not likely have large capital gains taxes to pay leading to decreased revenue. While reasonable estimates can be made for an individual based on the present value of any asset, with hard to value assets, valuation will be more difficult, and in those cases, basis may also be more difficult to determine plus the market for those assets may be limited. This would be especially true as to collectibles, closely held business interests that are not eligible for the special treatment under the proposal, and real estate. With an investment portfolio held in a brokerage or other custodial arrangement, basis and value will be more easily determinable. However in volatile markets, post death declines may result in tax on gains that have disappeared between the date of death and the sale date. In the estate tax context, the alternate valuation date election (valuing at six months after death or based on the sale price between the date of death and the alternate valuation date) has provided relief in declining markets. I suspect a similar procedure may be available, but the new tax will place pressure on a fiduciary or direct beneficiary to act promptly and wisely – which assets should be sold in the context of some beneficiaries preferring to receive the inherited assets that the decedent owned.

As to complexity, a capital gains tax adds a lifetime task of keeping better records than many are inclined to do. This may be overstated since most investments are held by institutions who will have a fairly accurate history of the cost basis. Implementation and compliance reporting should not be that much different than with an estate tax, which includes the determination of the new basis allowed under the existing law for any estate whether or not an estate tax is payable. Investor behavior may add to the complexity and unpredictability, e.g. will “buy and hold” be less advantageous which could lead to increased sales volume in the financial markets. A possible advantage could come from selling before death to minimize capital gains tax payable by beneficiaries, especially as to those still subject to the estate tax, since paying capital gains tax before death would remove the tax paid from the remaining estate subject to estate tax.

It is difficult to guess how this may influence investor behavior – it would seem to favor more active trading to realize gains gradually and to offset losses – and acceleration of revenue, maybe. It might also influence less wealthy individuals to defer gains in order to preserve property for as long as possible to meet the expenses of retirement and let the beneficiaries pay the tax. There may be a “silver-lining” in that selling assets to cover the inherent gains will only require a sale to cover the 28 percent tax plus expenses – we’re still not looking at a 100 percent tax.

Estate Planning

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