President Trump’s Proposed Repeal of the Federal Estate Tax
On September 27, 2017, the Trump administration released a summary of its tax reform proposals entitled “Unified Framework for Fixing Our Broken Tax Code”. One of the goals of the proposal is to repeal the Federal estate tax, which the President calls the “death tax.” What might a repeal of the Federal estate tax actually look like, and who will it affect?
The Current Federal Estate Tax
The Federal estate tax is a sizable tax of 40%. However, only about 5,500 individuals pay an estate tax each year due to the generous exemptions built into the scheme. Under the “American Taxpayer Relief Act of 2012” each individual is allowed an exclusion from the Federal estate tax of $5M , as periodically adjusted for inflation. For 2018, the individual federal estate tax exemption amount will be $5.6M, or $11.2M per couple (the “exemption amount”). In other words, very few people die with estates large enough to be subject to a Federal estate tax.
Significantly, this exemption amount is a “unified” credit that applies to both lifetime gifts and transfers upon death. Specifically, the tax is levied upon the total amount that an individual gifts during his or her life (over the $14,000 annual gift exemption) combined with transfers at death (i.e. by Will, trust, life insurance, or otherwise). If the combined amount of lifetime and death transfers exceeds the exemption amount, then an estate tax is levied on that excess. By way of a rough example, if Taxpayer, an unmarried individual, gifts her children $3M during her life and dies with a remaining estate of $4M, then an estate tax will be levied on $1.4M, which is the excess of her unified gifts ($7M) over the exemption amount ($5.6M).
Tax Basis and Inheritance
Internal Revenue Code § 1014 provides that when an asset is transferred by reason of death, the recipient receives a “stepped-up” tax basis equal to the value of the asset at the date of death. In contrast, if an asset is gifted during the owner’s life, the recipient receives a “carry-over” tax basis equal to the transferor’s basis. For assets that have appreciated significantly (e.g. real estate, stocks), the recipient’s capital gains tax liability crucially depends on whether the asset was gifted or inherited. The rationale behind the hugely beneficial step-up in tax basis for property passing by reason of death is that such property has already been subject to the Federal estate tax, even if no estate tax was due!
Here’s an example. Suppose that Taxpayer from the example above purchased her personal residence in 1968 for $50,000. At her death in 2017, that property is worth $800,000. Taxpayer’s Will leaves the property to her children, equally. At Taxpayer’s death, then, her children inherited that property with a stepped-up basis of $800,000. When they sell it in 2018 for $850,000, they will pay capital gains tax on their $50,000 gain.
In contrast, suppose that in 2016, after reading a DIY estate planning article online, Taxpayer gifted the property to her children because, according to the article, she had to “get rid of” her estate to avoid a “death tax.” Taxpayer dies in 2017 and her children list the house for sale. Because they acquired the property by lifetime gift, Taxpayer’s children have a “carry over” basis equal to Taxpayer’s own basis (i.e. her $50,000 purchase price). When the children sell the property in 2018 for $850,000, they will pay capital gains tax on their $800,000 gain.
The Trump Proposal
How does the gift tax and the step-up in basis concern the Trump proposal? First, the Trump proposal is silent on the gift tax, which could still subject affluent individuals to a tax for substantial lifetime gifts. More importantly for the 99.9% of us who do not have Federally taxable estates, there is a lot of talk that the revenue shortfall created by elimination of the Federal estate tax will be made up by eliminating the step-up in basis. Anyone who inherits property might receive a carry-over basis and be faced with substantial capital gains tax. In other words, the revenue burden will be shifted from the estates of the wealthy few to large capital gains tax paid by the many.
It is particularly worth noting that the proposed repeal of the Federal estate tax does not alter the fact that many states – Massachusetts included – levy their own estate tax.
Repeal of the estate tax has been a visible conservative battle cry for a long time, and proposals to repeal have come and gone in the past. Repeal appears to be an easy political target (see, e.g., administration reference to the “death tax”). Taxpayers often do not understand how they are – or are not – affected by the current regime. Estate planners and their clients will have to stay closely tuned to the administration’s current proposal.
 Tax Policy Center Urban Institute and Brookings Institution, http://www.taxpolicycenter.org/briefing-book/who-pays-estate-tax
 I.R.C. § 2035 provides that transfers made during the three years prior to death are includable in one’s taxable estate. The rule prevents deathbed taxpayers from attempting to skirt the estate tax by unloading their estate in anticipation of death. Capital gains consequences aside, Taxpayer’s scheme would not have worked.