Tuesday, April 19, 2005

Repeal of the Estate Tax - What new Tax will there be?

Once again Congress is debating repeal of the Federal Estate Tax. The usual reasons are thrown around: "a death tax is unfair", "it kills small businesses and farmers", "it is double taxation". All this over a tax that impacts 2% of Americans to pay.

My questions is this - if the "death" tax is repealed, what will take its place? The tax will generate $750 billion over the next 10 years. If it is repealed, what will take its place. The government is already running record deficits. And the government, being a government, will always find ways to replace revenue. So what happens when the estate tax is repealed - it is essentially replaced by capital gains tax.

As written currently, Section 1014 of the Code essentially allows a step-up in basis for all property included in decedent's estate (with the main exception of assets such as an IRA that shelter un-taxed income). This means that when you die, any unrealized capital gains, or untaxed appreciation, is wiped out, and your heirs start with a clean slate. If there is no estate tax, there is no step-up in basis. If there is no step-up in basis, the heirs receive the decedent's basis in an asset.

This doesn't sound so bad until you have to figure out what the basis is. What did granddad pay for all of his shares of IBM, gathered over the last 30 years? What happens if you can't show basis? Are you taxed on the full value of the assets on sale? What record keeping will suffice?

The federal long term capital gain rate is 15%. New Jersey's capital gain rate is an additional 6.37%, and New York's is an additional 6.85%, for a combined capital gains rate of almost 22%.

Congress has partially addressed this issue under the current law, stating that in 2010 (the current year of estate tax repeal) that a person will have up to $1.3 million of step-up in basis (with an additional $3 million for assets passing to a spouse). The basis in the remaining assets will be the decedent's basis, which may be $0 if it can't be proved.

One thing that the current estate tax has going for it is finality. A person dies, the assets are gathered and valued, tax is calculated and paid, the assets are distributed, and from a taxation standpoint, you don't really need to look to the decedent again - just the estate tax return. With the loss of the step-up in basis, a whole new host of issues will be created as taxpayers who inherit property seek to maximize basis in that property to minimize tax.

Another positive point of the current estate tax is that under current law, there is no tax on assets passing to a spouse. Under the revised law, the spouse will owe capital gains on assets received in excess of $3 million.

Finally, don't forget that even with the repeal of the federal estate tax, New Jersey and New York will continue their own estate tax.

For good or for bad, the repeal of the federal estate tax is going to be a tradeoff where dollars will be coming to the government from one pocket instead of another.

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