The Estate Tax Remaineth

Interview With The Estate Tax

ow in the sixth year of its long goodbye, the estate tax seems to have successfully fought off any possibility of repeal. Reform is now the only storyline, and the final chapter appears to have been written.

On March 24, 2007, the Senate voted 97-1 in favor of a budget amendment that reserves sufficient funding to extend tax cuts and which would ultimately retain the estate tax with a top rate of 45% and an exemption of $3.5 million after 2009.

When reached for comment, the estate tax reportedly said, "news of my demise was greatly exaggerated."¹ [The full interview appears below.]

The Repeal Unravels

The reason those numbers sound familiar is because they are the penultimate level of reform short of repeal, the final estate tax. It's the last stop before repeal (and the unluckiest year to die for estate tax purposes).

By a 51-48 vote, the Senate specifically rejected a separate amendment offered by Senator Jon Kyl (R-Arizona) which would have increased the estate tax exemption to $5 million and lowered the top estate tax rate to 35%. Last year Senator Kyl had made a similar proposal with a top rate of 15%.

Caveat: This is not a "done deal" by any means. A Senate vote on amendments to a budget bill certainly isn't the final word on anything; it is a non-binding blueprint for a long-term plan in a town of shifting alliances and could get edited out of the final compromise between Congress and the White House on the budget. And even then, the budget merely makes financial allowance ($200 billion) for estate tax reforms (and other tax relief) that have not yet been enacted. But for the estate planning community, the Senate's vote stands as the clearest sign that a consensus has now been reached.

And from an evaluation of the impact of the estate tax phase out on estates, as well as the costs in terms of tax revenues lost, in the current context, it appears that this penultimate stage of the phase-out plan was always designed for this purpose: To establish a reformed estate tax that does not confiscate small farms and businesses, nor impose a disproportionate share of the tax on small estates in general, yet still generates revenues and encourages philanthropy and sound estate planning.

How secure is this conclusion?

Let's just say that if, for some strange reason, you were throwing a gala soiree to celebrate the return of the estate tax and were designing a big festive banner, you would probably be safe wording it, "Welcome Back Estate Tax at 2009 Levels."

But this is more than just a hunch. Those 2009 levels, i.e., $3.5 million exemption and 45% tax rates are not randomly chosen. Let's have a closer look at the factors influencing the decision makers.

A Political Context

Once upon a time, the repeal of the estate tax was an improbable and somewhat mischievous dream that Congress could scratch its collective chin about. Repealers might as well have been reaching for the moon. It was all harmless posturing since President Clinton would always be there to veto such legislation, right? That was back in the endless economic expansion of the 1990s when there was blissful ignorance of what was to follow.

It was shocking when the estate tax was repealed in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Yet with an arrival date for repeal set for 2010, most analysts declared the repeal dead on arrival. There were just too many intervening elections and events that could take place to throw the repeal off track over such a long phase out of the tax.

One such event followed almost immediately. On September 11, 2001, an act of terrorism not only leveled the famed Twin Towers of New York City, but also changed our world. The stock market fell. Wars were launched. Our nation's first budget surplus in many a long year promptly vanished and became as scarce as a Tasmanian tiger.

And due to an obscure parliamentary rule there has also been the amazing twist of having an alternative ending! That is, after a year with no estate tax during 2010, a zombie-like estate tax from the year 2000 was to reawaken in 2011! Leave it to Congressional tax draftsmen to come up with the best science fiction. No, rest assured that Congress is not going to allow us to revert back to the $1-million exemption and the 55% top estate tax rate in 2011.

Still, the concept of estate tax repeal hung in there for six years and we are less than three years from the final phase in. But repealers lacked the votes in 2005, lost momentum after hurricane Katrina, and that was all before a new partisan majority took control of Congress this year. And now the Senate has voted 97 to 1 to support an ongoing estate tax with a $3.5 million exemption and a top rate of 45%. It may not be official yet, but this is the time of the game where the fans head for the exits.

A Moment of Zen

If you were one of the few who still believed repeal was going to happen, take a moment to reflect. A large, zen-friendly blank page right here might be an appropriate expression of the estate-tax-less nirvana that was almost was. A huge void of nothingness might also represent the complete futility of having concerned ourselves with repeal for the past six years.

Consider the context of the recent vote in the Senate, tinkering with amendments to a pork-laden, $2.9-trillion budget bill. Let us quantify the irony here. The estate tax revenues at stake, given the current $2-million exemption represents less than half of one percent of the budget and less than the $18 to $20 million of "pork barrel" legislation that Congress is accused of adding to the budget.

The net message: We have to tighten our belts and impose an estate tax…so that we can loosen our belts and have personalized appropriations for the home districts of influential members of Congress.

Estate tax revenues had reached $24 billion in 2003 when the exemption was only $1 million and when only 1.3% of estates were taxable. According to data from the IRS and a study by the Urban-Brookings Tax Policy Center, the $2-million exemption currently in effect means that only .5% of estates are currently taxable. That's less than one quarter of the 2.2% level of taxable estates in 2000 when the exemption was $675,000.

When the exemption goes to $3.5 million (i.e., the level at which the tax exemption will now likely stay rather than proceed onto the total repeal) only .3% of estates will still be taxable.

A deeper irony still, is that if the repeal had been implemented in conjunction with a carryover basis rather than the current stepped-up basis that now applies at death, the loss of estate tax would, in theory, be more than made up for by additional capital gains revenues. A study by the CONSTAD Research Corporation concluded that the carryover basis would produce $38 billion more revenues over ten years than the estate tax.

So if the return of the estate tax is not really about belt tightening nor about net tax revenues, why is the estate tax so resilient?

Going back to our earliest history as a nation, there were two competing visions of who we are and how our history would play out. Thomas Jefferson envisioned an agrarian nation minding its own farms and supported states rights. Federalists such as Alexander Hamilton envisioned a strong central government with a National Bank, big public works projects to build the national road system, a vibrant economy, and taxes to raise revenues. Guess whose vision prevailed?²

Today, we have a huge Federal government that is ravenous for revenues, hence the current $2.9 trillion budget and an immense national debt.

Revenues: Every little bit helps. With the ever-growing need for revenues and long-term threats to the viability of programs such as Social Security and Medicaid, no revenue source can be abandoned easily. Even if estate tax revenues fell to a few billion dollars a year, "a billion here and a billion there, and pretty soon it adds up to real money."³

Psychology: Why do couples break up, then make up? Why do salmon migrate? Why do we keep reenacting estate taxes? Are we genetically predisposed to tax ourselves at death? Perhaps there is a simpler explanation. Legislators are drawn to what they are familiar with because they reflect the comfort level America has with estate tax. A new tax approach is no more welcome than the metric system. America is used to having an estate tax.

Sociology: America is the land of opportunity and upward mobility between social strata. But the large middle class portion of the population has shifting levels of prosperity. The theory about public acceptance levels for the estate tax is that in good times, with high values for real estate and retirement plans, the middle class has a wealthier self-image and wants to avoid any tax on their large potential estate. But in bad times, the middle class resents the wealthy and embraces any tax that soaks the rich.

Demographics: The benefits of the 2001 "repeal" of the estate tax have already been fully achieved for most taxable estates. By 2006, 80% of the tax changes that had been phased in benefited estates smaller than $5 million. But then the laws of diminishing returns set in. According to "The State of the Estate Tax as of 2006" by the Center on Budget and Policy Priorities, the remainder of changes to be phased in benefit primarily larger estates.⁴

Note: Last year, on July 29, 2006, the House approved H.R. 5970 by a vote of 230-180. That bill would have increased the estate tax exemption to $5 million by 2015, allowed surviving spouses to carry over unused exemptions and would have coordinated the first $25 million of estates with capital gains rates.

Of particular interest has been the impact of the 2001 tax changes on family farms and small businesses. The example of a family farm being sold to pay estate taxes has long been cited as a critical problem that estate tax reform or repeal needed to address. According to the Congressional Budget Office, increases in the estate tax exemption have already accomplished this.

Interview With the Estate Tax

We caught up with the estate tax on the eve of what is apparently the end of repeal efforts. Surprisingly, it did not appear relieved about not being repealed. In fact it was surprisingly blasé about the whole thing. It granted us the following interview.

Q: How does it feel to be back?

A: Does it look like I ever left? Hello, I'm still here. I haven't had a break since 1916! I'll have you know, sir, that the first time I was repealed, I was out on holiday for three score years between the repeal of the Death Stamp Act in 1802 and the Civil War Inheritance Tax of 1862. Frankly, I could have used some time off right now. Then I'd have returned with a BANG! (I always had a flair for the dramatic.)

Q: Were you ever worried that the repeal would actually take place?

A: Good sir, don't you know to whom you are speaking? I was one the certainties that Ben Franklin wrote so famously of, you know, death and taxes? That's me! I'm one of the only certainties around! And between you and me, that other one, the Grim Reaper…zero charisma. Anyway, what do you get if you combine death and taxes? That would be ME, death taxes…duhh!

Q: Does it bother you that with such a high exemption, hardly anyone actually pays estate tax anymore. People worry more about gas taxes than estate taxes.

A: Thanks a lot, rub it in. Yeah, I'm a shadow of my former self. It hurts, frankly, to lose that "zip" when you can put the fear of tax into someone. Back in the day, 1941, when my top rate hit 77%, I had people's full attention, let me tell you! Booya!

Q: But now, with an exemption of $2 million, you affect less than 1% of the population.

A: Oh the pain, the pain. I've been marginalized. Well don't cry for me my large lovely estates, fatten up for a few years while I take it easy. I didn't cause the quasi-war with France of 1797, the Civil War, the Spanish American War of 1898, or the World Wars, but mankind continues to require my esteemed services. War isn't a certainty…it wasn't on Ben Franklin's list; but, it looks like war and estate tax will both be around for a long time.

The tide of history demonstrates the connection of the nation's estate tax with the revenue needs of warfare.⁵

1797-1801: The first estate tax arrives to help finance an undeclared naval war against France, which was seizing American ships that were trading with the British under the Jay Treaty of 1794 because they felt it violated the Treaty of Alliance of 1778. The war ended and the estate tax was repealed in 1802.

1862-1870: Civil Wars expenses prompt President Lincoln to impose an estate tax.

1894: A national death tax arrives but is determined to be unconstitutional.

1898-1902: Spanish American War estate tax.

1916-Present: World War I: The Emergency Revenue Act of 1916 includes an estate tax a decade after an inheritance tax was proposed by President Theodore Roosevelt.

1941: World War II-Revenue needs prompt the top estate tax rate to spike up to 77%.

2007: With an undeclared "quasi-war" in progress, Congress is once again ready to keep the estate tax in place. It's 1797 all over again.

TECHNICAL REFERENCES

¹"The reports of my death are greatly exaggerated." -Samuel Clemens ("Mark Twain"), Cable from London to the Associated Press (1897).

²Politically, Jeffersonian views prevailed and the Federalist Party became extinct. But after the war of 1812, even Jefferson acknowledged the economic need for Federalist philosophy. His party co-opted Federalist positions, and the American economy took off and never looked back.

³U.S. Senator Everett Dirksen (1896 - 1969).

⁴Friedman and Aron-Dine, reporting on data from the Internal Revenue Service, Congressional Budget Office and Urban Institute-Brookings Institution Tax Policy Center (June, 2006).

⁵Luckey, The History of the Federal Estate, Gift, and Generation-Skipping Transfer Taxes, a 34-page report prepared for Congress, updated 2003, available online.

© R. Moshman 2007.