Eliminating the death tax has received great attention lately. Critics of the tax claim it unfairly taxes dollars that have already been taxed and that it forces many family enterprises (businesses and farms) to be sold in order to pay the tax.
Unfortunately, repeal of the death tax involves much more than eliminating those claimed inequities. It involves the elimination of an entire wealth transfer tax system that both supports certain social policies and coordinates specific estate taxes, gift taxes, generation-skipping transfer taxes and income taxes. It will not only eliminate $50,000,000,000 per year of allegedly unneeded revenue for our federal government, but it will also wipe out over $5,000,000,000 per year of revenue from our state governments' budgets, billions of dollars in needed charitable contributions and billions of dollars in budgeted income tax revenues. These ripple effects of the repeal, which have received little attention in the media, will ultimately trigger new taxes that will quickly transform this alleged tax "cut" to a tax "shift."
This article will not address the many social issues related to the wealth transfer tax system.1 Rather, it will simply focus on how few people are currently taxed, how even fewer people would be taxed under proposed reforms instead of repeal and why almost all taxpayers will end up paying more taxes as a result of the indirect costs associated with repeal.
Only 2% Are Currently Affected
Only 2% of American taxpayers will benefit from a repeal of the death tax because only 2% are subject to wealth transfer taxes. Here is why:
First, anyone married at the time of his or her death can completely eliminate death taxes.2
Second, unlimited wealth can be transferred to qualified charities without any wealth transfer taxes.3
Third, on top of the above exempt transfers to spouses and charities, everyone can transfer $675,000 in value before being subject to death taxes. This amount is gradually increasing until it reaches $1,000,000 in 2006.4
This means with basic planning a married couple can currently transfer $1,350,000 and will soon be able to transfer $2,000,000 without wealth transfer taxation.
Fourth, additional tax-free transfers are allowed during life for certain gifts.5
Why Reform Would Decrease the 2%
Reforming the wealth transfer tax system instead of repealing it will undoubtedly increase the above exemptions thereby reducing those affected to less than 2% of the taxpayers. Current reform proposals include measures that would immediately increase the existing $675,000 exempt amount to as high as $3,000,000 and eventually increase the future exempt amounts from $1,000,000 to as high as $5,000,000. This type of reform could effectively (with some planning) eliminate all wealth transfer taxes on couples with net worths under $10,000,000.
Special Rules Already Exist That Provide Preferential Treatment for Family Enterprises
In addition to the above exemptions from current wealth transfer taxes, many special rules presently exist to help qualified small businesses and farms. These are specifically designed to either avoid forced sales or reduce the taxes upon sale. Current special preferences include: (1) reducing the value of qualified real estate (farm) interests by up to $750,0006, (2) extending the time to pay taxes for up to 14 years at minimal interest rates for qualified family businesses7, (3) allowing a reduction in value to qualified family-owned business interests of up to $675,0008, and (4) allowing favorable income tax treatment for stock redemptions required to pay estate taxes.9
Why Repeal of the Wealth Transfer Tax System Will Create the Need for New Taxes
Even if the federal government does not need the $400,000,000,000 in revenue that has been projected to be raised by federal estate and gift taxes during the next decade,10 the loss of state tax revenue and charitable contributions, along with new income tax manipulations (which are currently prevented by the wealth transfer tax system), will require new taxes. The new taxes will effectively shift taxes from the 2% currently paying transfer taxes to many others who do not pay transfer taxes. Here are three examples that have received little or no media attention.
1. The loss of state tax revenues. The federal estate tax grants a credit for state death taxes up to certain amounts.11 Because of that credit, each state has adopted what is called a "pick-up" estate tax.12 This means that they tax their residents, upon death, in an amount equal to the largest credit allowed against the federal estate tax. This way the states generate revenue without making their residents pay additional taxes (in essence, they take part of the federal estate tax revenue). This loss of revenue to the states is significant. It is estimated that the states received approximately $5,500,000,000 from these taxes in 2000. For example, estimates show Michigan revenue losses at $187,000,000 and Florida revenue losses at $779,000,000.13 All states will need to generate replacement tax dollars for this loss of revenues. The replacement revenue will most certainly come from sources beyond those benefitting from estate tax repeal. For example, before Michigan became a "pickup" estate tax state, it had an inheritance tax which was applied on a per beneficiary basis, and generally taxed amounts in excess of $10,000, with different rates applying depending upon the relationship between the decedent and the beneficiary. Reenactment of a similar inheritance tax, or the creation of new estate taxes, to replace this significant loss of tax revenue will surely be collected from more taxpayers than just the wealthiest 2% that are currently subject to wealth transfer taxes. To wit: Shift #1.
2. The loss of charitable contributions. The unlimited charitable deduction currently allowed against wealth transfer taxes creates a large incentive for charitable giving during life and at death. Recent studies show that in 1998 the average charitable bequest (deductions) from the 595 estates with more than $10,000,000 was $8,000,000; and in 1997 the average charitable bequest (deductions) from the 182 estates with more than $20,000,000 was $41,000,000.14 Charitable contributions of this magnitude will, in all likelihood, substantially decrease without the tax incentives. David Joulfaian, a Treasury Department tax analyst considered a top expert on the estate tax repeal's impact on charity, projects a $3,000,000,000 per year decline in charitable donations and $2,000,000,000 per year less bequests without the estate tax.15 Price Waterhouse estimates a $5.2 billion per year decrease in charitable donations without the estate tax.16 This loss of charitable giving will substantially reduce the flow of nongovernment dollars available for the numerous educational, medical, scientific and other similar needs presently covered by charities. In turn, this will create greater demands for government spending in these areas, again requiring new sources of revenue. These will also most likely be collected from more taxpayers than just the wealthiest 2% that are currently subject to wealth transfer taxes. Towit: Shift #2.
3. Income tax changes and manipulations. One way to reduce the revenue lost from the repeal of death taxes involves a simple change in capital gains taxation. Currently assets transferred at death get a step-up in basis which eliminates certain built-in capital gains that would otherwise apply to those assets.17 By simply eliminating the step-up-in-basis rule, assets transferred at death would remain subject to large capital gains.18 This, in and of itself, effectively creates taxation on all estates, not just the wealthiest 2%. Even if these step-up-in-basis rules are not changed, the wealth transfer tax repeal will undoubtedly create new tax planning techniques that will cause income tax reductions in addition to the loss of wealth transfer taxes. For example, our current gift tax prevents giving substantial assets to related taxpayers in order to shift income to lower tax brackets. Allowing tax-free transfers of wealth to taxpayers in lower income tax brackets will undoubtedly cause significant reductions in income tax revenues. New revenues will have to be generated to replace these losses. Similar to the capital gains taxes that will apply without a step-up-in-basis rule, the replacement revenues will be borne by more taxpayers than the wealthiest 2% that are subject to the current wealth transfer tax system. To wit: Shift #3.
Bait and Shift
The claim of fundamental unfairness is the bait. The ripple effect of repeal is the shift. The above examples represent just three of the ways that the repeal of the death tax will evolve from a "tax cut" to a "tax shift." The repeal of the so-called death tax is clearly more complicated than simply wiping out an allegedly unfair tax. More important, it is not a move that will simply benefit those currently paying death taxes. Rather, the indirect ripple effect of repealing the death tax will ultimately have a negative affect upon the majority of all taxpayers, especially those who are not currently subject to death taxes.
1For example, see "Dozens of Rich Americans Join in Fight to Retain the Estate Tax," New York Times, February 14, 2001, where Warren Buffet; William Gates, Sr.; and other wealthy individuals (who would economically benefit from the repeal of the death tax) explain their position against repeal with rationale including economic, capitalistic, aristocratic and other social concerns.
2See, IRC Section 2056.
3See, IRC Section 2055.
4See, IRC Section 2010.
5See, IRC Section 2503 allowing gifts of $10,000 per donor, per donee, per year (indexed for inflation) and unlimited amounts for qualified educational and medical expenses.
6See, IRC Section 2032A.
7See, IRC Section 6166.
8See, IRC Section 2057.
9See, IRC Section 303.
10This is the projection of the Congressional Budget Office and Joint Tax Committee.
11See, IRC Section 2011.
12All 50 states have a "pickup" estate tax, with 15 of those states carrying additional inheritance or estate taxes. Michigan is one of the 35 states that relies solely on a "pickup" estate tax.
13See statistical data from the Center on Budget and Policy Priorities at www.cbpp.org.
14See the Brookings Institute/University of Michigan Study and the Chronicle of Philanthropy report referenced at www.ombwatch.org.
15See Christian Science Monitor report at www.csmonitor.com.
17See, IRC Section 1014.
18Those gains can either be deferred until the asset is sold or, if the Canadian system is adopted, the gains would be triggered by death causing an automatic capital gains tax at death instead of an estate tax.
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©James J. Steffel, Esq.--Mr. Steffel received his law degree from the University of Toledo and his advanced law degree in Estate Planning from the University of Miami. He is a partner at Warner Norcross & Judd LLP. He can be reached at 231.727.2621 or email@example.com.