The prospects of significant tax legislation this year are low. Nevertheless, when the President proposes “tax reform” it makes headlines. The Obama administration’s latest tax proposals for fiscal year 2016 would increase dramatically both the rates of transfer/income taxation at death and the number of people subject to those higher taxes in the event of a family member’s death.
Since 2011, the lifetime federal estate tax, gift tax, and generation-skipping transfer (“GST”) tax exemption equivalents applicable to each individual have been set at $5,000,000, adjusted each year for inflation ($5,430,000 per person in 2015). For the few individuals who make taxable gifts or who have taxable estates in excess of $5,430,000, the federal estate, gift, and GST tax rates have been set at 40%.
As now in effect, far less than 1% of decedents’ estates are subject to federal estate tax. Thus, under current law, the vast majority of Americans would be able to transfer to their children or other loved ones whatever wealth they may have left at their death, free of any federal estate tax.
I. Decreasing Estate/Gift/GST Tax Exemptions and Increasing Tax Rates
The Obama administration proposes to decrease estate tax and GST exemption equivalents from the 2015 level of $5,430,000 (adjusted for inflation) to the 2009 level of $3,500,000 (with no inflation adjustments). By not indexing the estate tax and GST tax exemptions for inflation, the effect would be to increase taxes each subsequent year in which inflation “eroded” the value of the unadjusted exemption.
Further, it is proposed that the estate/gift/GST tax rate would be increased from its current 40% level to 45%.
Finally, the administration proposes to decrease the gift tax exemption from the current “unified” level of $5,430,000 to the 2009 level of only $1,000,000 (also with no inflation adjustments). This proposed “disconnection” of the gift tax exemption from the estate/GST tax exemption would have the effect of discouraging lifetime gifts.
For example, if a surviving parent had net assets of $2,500,000 and wished to make lifetime taxable gifts totaling $1,500,000 to his or her children (for instance, to help them buy homes), such gifting would attract a tax of $225,000, 45% of the $500,000 by which the gifted amount exceeds the proposed $1,000,000 gift tax exemption. But if that parent simply held on to his or her net assets and had them pass to his/her children at death, the $2,500,000 (even if the values grew modestly) would pass entirely estate-tax-free, even under the proposed, reduced estate tax exemption equivalent of $3,500,000.
II. Increasing Death Taxation by Imposing a Capital Gains Tax at Death
Under current law, if someone inherits a capital asset, such as a rental property or a stock portfolio, the inherited property receives an income-tax-basis adjustment so that its “cost basis” for income tax purposes generally is adjusted to be equal to its value on the date of the decedent’s death. Such income tax treatment (commonly referred to as the “step-up” in basis, although in some cases it can result in a “step-down”) allows the assets of a decedent’s estate to be sold without incurring any substantial, built-in capital gains taxes. For example, this becomes quite important if the decedent had any significant debts, since it allows a decedent’s assets to be liquidated to pay debts and expenses without being subject to additional income tax.
The Obama administration proposes a general increase in long-term, capital gains tax rates (and tax rates on qualified dividends) from 20% to 24.2%, while retaining the “high-income taxpayer” net investment income surtax of an additional 3.8%, so the top effective tax rate on capital gains would increase to 28%. In addition, all capital assets with built-in appreciation at a decedent’s death would be deemed to have been sold immediately prior to the decedent’s death for their then-fair-market value.
In effect, the Obama administration is proposing to institute a Canadian-style “deemed income taxation at death” approach. However, unlike Canada, which imposes only an “income tax at death,” the Obama administration proposes to impose both the “income tax at death” and an estate tax.
The effective, combined rate of federal “taxation at death” rate on inherited highly appreciated capital assets would be as high as 60.4% for decedents with taxable estates above $3,500,000 who fall into the highest income tax rate brackets: 45% proposed new estate tax rate, plus the 28% proposed new effective capital gains/ investment income tax rate, less the “value” of having the capital gains tax at death treated as a liability payable in connection with the decedent’s final income tax return (45% x 28%, an effective reduction of 12.6%).
The only proposed “exclusions” applicable to the new capital gains tax at death would be (i) $100,000 per decedent (portable to a surviving spouse, so $200,000 per couple); (ii) a $250,000 “residence” exclusion (also portable, so a surviving spouse would enjoy an effective $500,000 exclusion); and (iii) the exclusion now available for certain “small business stock.” Also, the proposal includes a suggestion that the capital gains tax would not be imposed on a “small” family-owned business until the business was sold or ceased to be owned and operated by the family.
Consider a middle-class retiree (surviving spouse), age 85, who worked and saved for 40 years and managed to accumulate a net worth of $1,000,000 (an $800,000 stock portfolio with built-in gain of $500,000, and a modest $200,000 residence with built-in gain of $150,000).
If the retiree died, leaving the property to his or her children, the new Obama proposals would result in a capital gains tax of at least $96,800 at the survivor’s death (24.2% capital gains tax on $400,000 of “net capital gains” after applying the $100,000 “exclusion” to be available). Without any sort of “income averaging” available, the new proposal likely would cause the retiree to be a “high income” taxpayer on his or her final income tax return, since the entire lifetime accumulation of appreciated capital investments all would be “deemed to be sold” and taxed on the decedent’s final income tax return.
Finally, consider what happens if the retiree “downsizes” and moves to a small apartment, reinvesting the $200,000 that had been “locked up” in the principal residence. If that amount gets reinvested and grows to $300,000 at the death of the retiree, an additional $24,200 “income tax at death” would be imposed (and more likely a $28,000 “income tax”).
The Tax Group of BakerHostetler closely tracks key legislative developments and will be paying close attention to these proposals, as well as any offered by members of the House of Representatives or the Senate, as the public debate regarding fundamental tax reform unfolds.