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Will Estate Tax Repeal Open Income Tax Loopholes?
by Robert Moshman, JD
significant loophole in the capital gains tax may be created by a repeal of transfer taxes. A carryover basis is one answer, but alternatives exist. However, additional income tax loopholes will emerge as well.
A new flurry of proposals to repeal or reform the estate, gift, and generation-skipping taxes began before President George W. Bush could finish unpacking. Where the Clinton Administration promised to (and did) veto the last two attempts to repeal transfer taxes, the Bush Administration arrived in office with estate tax repeal high on its list of objectives and it has been referred to as a "centerpiece" of the proposed tax cuts.
The proposal is often looked at in terms of a historic shift in our entire transfer tax system and its impact upon the way society accumulates and transfers wealth to heirs. However, a critical piece of the plan that still needs to be addressed is how these transfer tax changes will affect the income tax system. All during the Presidential campaign, the Bush plan for estate tax did not address the fate of capital gains on property transferred at death. Since the carryover basis was proposed as part of both of the previous transfer tax repeal packages, it would be reasonable to assume that the same provision would find its way into the latest proposals as well.
Yet, in light of the number of estates so burdened by such a provision, and the difficulty in establishing the basis for many types of assets, and the insignificant amount of tax revenues generated by such a tax, a Republican Administration, being traditionally associated with the opposition of capital gains tax, might also lean toward a new tax bill that does not dampen enthusiasm for tax cuts with an unwieldy new tax, especially one affecting the estates of investors.
However, consider the many unintended income tax consequences of a system that does not impose any tax on transfers between people, and which continues to provide for a stepped-up basis for assets passing at death.
Example: Assume there is a complete repeal of transfer taxes but the stepped-up basis continues to apply to assets transferred at death. Charles, 50, is the owner and president of a closely held manufacturing company. He owns stock and other assets that have appreciated in value, but he is most concerned with a commercial property that has a basis of $200,000 and which is now worth $5.2 million.
To avoid $1 million of capital gains tax (assuming a 20% rate applied), Charles could hold the property and transfer it to his heirs at death with a stepped-up basis. However, Charles has another 20 or 30 years of life until that can happen and he'd like to sell the building far sooner. Thanks to the repeal of transfer taxes, Charles can transfer the building to his father, who is 85 and whose will would devise the property back to Charles. At his father's death, Charles would receive the building, but now it would have a stepped-up basis.
"Boomerang trusts" would undoubtedly arise to guide appreciated assets to a relative and back while providing supervision and other benefits. Such a system would not be flawless, of course:
A relative receiving property could have a change of heart and devise the property to other family members.
Charles' father could incur unanticipated liabilities which could consume more of the property than the taxes that are avoided. Liens and
litigation could encumber property for years.
Charles could predecease his father.
The father could die in less than a year, thereby disqualifying the step-up in basis under §1014(e).
The building could decline in value or create liabilities on its own during the father's remaining years.
The father could be blessed with another 20 years, leaving Charles with unrequited plans for the building and profound guilt at planning to benefit from his father's earlier demise.
As tax devices go, it can be an effective technique. Unfortunately, it is cast in a shadow in that it is a form of "asset laundering" that is reliant upon another person's death occurring sooner rather than later to achieve the step-up in basis-a death by proxy as it were. Yet other financial plans are based on the life expectancies of the participants, and, if such a loophole comes to pass, taxpayers will seek to exploit it.
A carryover basis, even one with a relatively large exemption for which a stepped-up basis would apply, would curtail the use of such boomerang strategies for larger estates.
Under previous proposals, a married individual would have been able to use a $1.3 million stepped-up basis exemption for a transfer to an individual and a $3 million exemption for a transfer to a spouse. On $4.3 million, capital gains of $860,000 could be saved, making the strategy more than justifiable for at least certain assets. However, larger estates would benefit most if the current stepped-up basis is not amended. If that is the case, estates with much larger assets, and huge capital gains of $25 million, $100 million, etc., could benefit from such a strategy on a grand scale indeed.
Alternatives to a Carryover Basis
Considering the difficulties associated with a carryover basis, several alternatives may be implemented. A throwback rule, or perhaps a recapture approach much like §2032A for special use valuation, could be used to limit the availability of the stepped-up basis where assets are transferred within a certain time period to family members.
A special rule to govern transfers to family members at death could be imposed in the same manner as Chapter 14. For example, just as §2702 limits transfers with retained interests to "family members" but allows other transfers to non-family members, a new law could allow a stepped-up basis for gifts outside of the family, and impose a carryover basis only where transfers boomerang between family members.
A Smorgasbord of Loopholes
Regardless of how capital gains are addressed, the repeal of transfer taxes by itself would create a veritable smorgasbord of income tax loopholes with serious repercussions for federal and state tax revenues.
Transferring appreciated assets (without gift tax) to an individual with a negative income would also lead to a situation where the assets could be sold and the capital gains would then be offset by the recipient's losses or depreciation.
Assets could also be transferred (without gift tax) to individuals in one of the seven states that do not have a state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. (Note: New Hampshire and Tennessee do not tax income in general, but do tax dividend and interest income.) Future capital gains would then avoid state income tax. This would add to the loss of tax revenues states already face due to the repeal of the estate tax, since many states based their state death tax entirely on the Federal state death-tax credit.
And in the simplest scenario, just transferring appreciated assets (without gift tax) to multiple heirs who qualify for the 10% capital gains tax rate would cut the tax liabilities of selling the property in half.
Actions often have unintended consequences and it is clear that the repeal of transfer taxes would have many other ramifications that go well beyond the few mentioned here.
Watch Your Step!
Having watched many tax proposals go by the wayside, experienced professionals have learned that if you spend too much time looking over the horizon or over your shoulder at what might happen, you can end up tripping over what's right in front of you. You want to anticipate, but you have to plan for the way rules actually are in the present.
Robert Moshman, JD, can be reached at bmoshman@optonline or (800) 572?2468 with any questions, comments or suggestions. He authors the Estate Analyst.
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