AgDM newsletter article, September 2005

The debate over repeal of the Federal Estate Tax: The income tax basis issue

Neil HarlRoger McEowen By Neil E. Harl, Charles F. Curtiss Distinguished Professor in Agriculture and Emeritus Professor of Economics, Iowa State University, Ames, Iowa. Member of the Iowa Bar, 515-294-6354, harl@iastate.edu and Roger McEowen, associate professor of agricultural law, 515-294-4076, mceowen@iastate.edu

Overview

The drive to repeal the federal estate tax and the generation skipping transfer tax (GSTT) almost totally ignored the matter of income tax basis until recently. Ironically, for more than 98 percent of U.S. citizens, income basis is actually more important to them economically than either federal estate tax or GSTT. Unfortunately, many do not fully understand – (1) the concept of income tax basis and (2) the long-term consequences of abandoning the commitment to a new basis at death. The U.S. House passed an estate tax repeal bill on April 13 that eliminates the rule that assets take on a fair market value basis at death in the hands of the heirs. In its place, the bill creates a modified carry-over basis rule – the heirs receive an income tax basis equal to the decedent's basis in the assets with the estate executor having the authority to allocate additional basis (up to fair market value)of up to $1.3 million per estate and $3 million for property passing to a surviving spouse. Some groups advocating for permanent repeal have claimed that this modified carry-over basis rule sufficiently protects farm and ranch families from transfer taxes at death. That claim is unfounded. The issue is critical because the Senate is scheduled to vote on repealing the federal estate tax in September.

The key question is whether agriculture is better served with a repeal of the federal estate tax with a modified carry-over basis rule, or retaining the tax with higher exemptions and maintaining new basis at death.

The 2001 Tax Act Provisions

Under the 2001 Tax Act, the new income tax basis at death is scheduled to end, for deaths after December 31, 2009 , with repeal of the federal estate tax. In its stead will be a one year system of “carryover basis” with the decedent's basis (or the fair market value of the property, whichever is less), carrying over to the estate and thus to the heir or heirs of the decedent. The executor of the estate, under rules scheduled to be in effect for deaths in 2010, would have authority to allocate up to $1.3 million per estate and an additional $3 million for property passing to a surviving spouse, to increase the income tax basis of eligible property but not above fair market value. Most property of a decedent, other than property producing income in respect of decedent, would be eligible for the adjustment in basis. However, some other categories of assets are also not eligible for the adjustment. In any event, the provision for a $3 million basis increase for a surviving spouse if there is no surviving spouse, and if the $1.3 million and $3 million allowances are exceeded, carryover basis rules apply. That is likely to occur in many farm estates.

The Reason for Congressional Action

Because of Congressional budgetary rules, the carryover basis system (along with repeal of the federal estate tax (and the generation skipping transfer tax) is scheduled to end for deaths after December 31, 2010, with the system returning to a new income tax basis at death for deaths thereafter. That result is not expected to happen and current efforts to reach an agreement in Congress over the future of the federal estate tax and generation skipping transfer tax are directed toward either repeal of the two taxes or continuation of the taxes at lower rates and with a larger exemption. The House-passed bill that the Senate will consider in September permanently repeals the federal estate tax (and GSTT), but would also make permanent the modified carryover basis rule. Thus, the discussion now occurring in Congress concerning repeal of the federal estate tax also involves the income tax basis issue.

Income tax basis is tied to the other two taxes (federal estate tax and GSTT) only because of two features of the current system - (1) the adjustment in basis occurs by reason of death and uses fair market value at death (or the value used for federal estate tax purposes if different from fair market value) and (2) repeal of the federal estate tax would result in the loss of approximately $20 billion of federal tax revenue, and a completely new basis at death would cost approximately the same amount. The impact on the Treasury is why Congress cannot repeal the federal estate tax while at the same time retaining new basis at death. The revenue loss would be too severe unless, of course, Congress increases taxes somewhere else to make up for the shortfall. That move would be politically unpopular. However, IRS data indicates that the federal estate tax can be retained with an exemption of between $3 million and $4 million along with the longstanding rule of new basis at death, and preserve almost all of the revenue presently generated by the tax.

Conclusion

Federal estate tax is paid by estates of fewer than two percent of the decedents, and an even smaller percentage of the estates of farmers and ranchers, under current law. Yet gain on assets held at death is ultimately taxed to everyone who inherits property, up and down the income and asset scale. Therefore, the issue is more than revenue collected or not collected. A major change in the federal estate tax and the determination of gain on property after death, as has been proposed, represents a significant shift in who bears the overall federal tax burden. The House-passed bill shifts this burden to the heirs of the relatively smaller-sized estates.

Unquestionably, agriculture (and the economy as a whole) will be better served if the Congress retains the federal estate tax (albeit with a higher exemption and, perhaps, a lower top rate (which is currently 47 percent for taxable amounts exceeding $2,000,000)) along with new basis at death.

This is an excerpt taken from the new Ag Decision Maker Information File C4-26. The full text of is available at www.
extension.iastate.edu/agdm/wholefarm/html/c4-26.html
.

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