Estate tax repeal would mean higher taxes for most.
Everyone knows the federal tax code is complex. One of those complexities is the relationship of the estate tax and the income tax.
The estate tax taxes a deceased person's assets. The current federal estate tax exemption amount is $5,490,000 per person, or almost $11 million for a married couple.
So if a couple's estate is less than $11 million, they will not owe any federal estate tax. The Congressional Research Service estimates that currently, only about 0.2 percent of the population is exposed to the federal estate tax.
The income tax taxes profits. Profits are generally determined by subtracting a thing called "basis" from the sale price. Very simply, you can think of basis as your cost. The formula is sales price minus basis equals taxable profit. You know this: You know that if you purchase a share of stock for $1 and sell it for $2, you pay income tax only on the $1 of profit.
Under current law, because we have a federal estate tax, when someone dies, their basis in most items is "stepped up." This is tax jargon meaning the deceased person's "cost" basis is adjusted to become the fair market value at the date of death.
Assume Dad and Mom purchased a ranch in 1951 for $150,000. They both die in a car accident in 2017. The ranch is appraised at $850,000 at that time. There will be no federal estate tax, because the ranch's value is below the almost $11 million federal estate tax combined exclusion amount.
Under the stepped-up basis rules, the kids inherit the ranch with a basis of $850,000, its fair market value at the date of death, not the $150,000 Dad and Mom bought it for. This means if the kids then promptly sell the ranch for the appraised value of $850,000, there will be no profit and thus no income tax. This is why inheritances are currently generally free from income taxes.
Under proposed tax legislation, if the federal estate tax is repealed, the stepped-up basis will also be repealed. This means that inheritances would become subject to income tax.
The character of the tax, ordinary income or capital gain, will be determined by the character of the asset (ordinary or capital).
Under the above example, the kids would have to pay income tax on $700,000 of gain when the ranch is sold (the $850,000 sales price less Dad and Mom's basis of $150,000). This income tax would apply to stocks, bonds, rental properties, personal residences and other items that the 99.8 percent of the population not exposed to federal estate tax currently receive tax free. Accordingly, repeal of the federal estate tax would remove a tax from the wealthiest 0.2 percent of the population while creating a currently non-existent income tax on most inherited items for the other 99.8 percent.
Current statements do not show an intent to retain the stepped-up basis if the estate tax is repealed.
This will raise a practical problem for many taxpayers who did not keep records of their basis because they expected their estates to pass income tax free. How many of you have kept records of the stock you bought in 2007? Do you know how much your parents paid for the remodel they did on their home in 2006? Or the money they paid for adding a garage to their rental? All those would impact basis, but only if you have records to support them. This will be a serious compliance issue for many taxpayers.
Based on simulations done by the Economic Research Service of the Department of Agriculture using farm-level survey data from the 2011 Agricultural Resource Management Study, when the federal estate tax exemption amount was lower at $5 million per person, only about 2.7 percent of family farms (about 65 farms) would file an estate tax return. And of those, only about 0.6 percent (about 14 farms) would owe any estate tax.
The impact varies based on the type of farm. The study showed that larger family farm estates, only about 5 percent of all family farm estates, account for 73 percent of total family farm estate taxes paid.
The numbers are similar for family businesses. A 2015 CRS study estimated that only about 94 estates per year, that have at least half their assets in a small business and who expect their heirs to continue the business, are projected to be subject to the estate tax. With the currently higher estate tax exemption amounts, this number is probably even lower now.
It just goes to show that under a complex tax code, items promoted as a tax cut can actually be massive tax increases.
Lee Kersten of Eugene is an attorney and an accountant.