The Coming Estate Tax Debate

3/15/21

Just last week, my wife and I met with a wills and estate lawyer, which I thought of as somewhat of a necessary evil. It’s an annoyance to me the that the tax laws are so convoluted that people should need this kind of attention and customization, but that seems to be the way the world works, given the costs and uncertainties associated with the probate process. Adding to the complexity is the fact that it seems likely that current federal regulations relating to how estates are taxed appear to be under consideration.

The two biggest issues under review seem to be (1) the determination of the starting value of assets in calculating the capital gain or loss realized when inherited property gets sold, and (2) the amount of an estate that can be passed on, exempt from federal estate taxes.

With respect to the first issue, the law currently provides for a step up in the basis, meaning that the capital gains are calculated as the difference between the sales price of the property and the property’s value as of the inheritance date, irrespective of its price when originally acquired. This stepped-up basis allows heirs to monetize assets in the inheritance on Day 1, without any associated tax consequences. That treatment is certainly attractive to any heir, but is it fair? I don’t think so.

For me, it makes sense to treat a transfer of assets as if it were a sale of property between the original owner and the heir, with the sale price reflecting the market value as of the transfer date. Thus, if the asset has appreciated, the estate of the deceased owner would owe the capital gains tax on that appreciation. In effect, the inheritor of the estate would bear this tax liability along with the benefits of acquiring the asset(s). I think that makes more sense than ignoring this tax liability altogether, as happens when using the stepped-up basis effectively wipes out the tax liability, with Uncle Sam taking the hit.

Apparently, Congress will be considering eliminating this step-up treatment. Eliminating it altogether may be a hard lift, but something in this direction would be better than nothing. Thinking outside the box, one possible compromise would be to limit the step-up basis to a finite amount of assets, say $250,000, and to retain the historical basis for all remaining assets.

Moving to the issue of the size of the exemption… The current law allows each individual to bequeath $11.5 million to their heirs, free of federal tax. That’s $23 million for a married couple! This figure boggles my mind. While it’s understandable and reasonable for people to want to pass along cherished possessions and to assure for the financial security of their kids, who could view this current allowance as being anything but obscenely excessive? It reflects a less-than-charitable attitude of “I’ve got mine covered, you and yours are on your own.” Moreover, the current rules have contributed to widening income and wealth disparities that has accelerated over recent years — arguably one of the most serious threats that our democracy may be facing.

As shown in the table below, these exemptions have been generous for some time. The relatively small incremental year-over-year changes in the table reflect inflation adjustments — which, of course are in place in this context, but absent from minimum wage legislation — but the base allowance doubled in 2018 under the authority of the 2017 Tax Cuts and Jobs Act.

Presumably, because of some political wheeling and dealing, that legislation imposed sunset restrictions that will drop the base exemption back down in 2026 to the $5.49 million level that was effective in 2017. This concession notwithstanding, I’m amazed that the exception was raised so dramatically back in 2017. Where were our fiscal watch dogs when we needed them?

At that time, the 2017 bill was passed with support from all but a single Republican Senator (Bob Corker, R-TN) and no Democrats. Was it not apparent that this bill would exacerbate the wealth gap we were already experiencing in the US? Obviously, that was of little concern to the Republicans who lined up behind this legislation — those same people who are now decrying the American Relief Act provisions as being excessive and unnecessary. This diametric positioning is about as blatant an expression of hypocrisy as anything I’ve seen since Mitch McConnel rammed through Amy Barrett as a Supreme Court Justice less than two month before a coming national election. I should be getting used to this kind of malfeasance, but somehow it still sticks in my craw.

Revising the tax treatment for estates will undoubtedly be a challenging effort. The existing provisions have been so overly generous that, inevitably, almost any move toward a fairer and more equitable framework will be viewed as a substantial “loss” for large numbers of households. Unfortunately, it will be difficult to get people to prioritize the greater good over their own parochial self-interests; but that’s what needs to happen. The notion that those who would enjoy the benefits of the status quo are entitled to them is one that has to be challenged and rejected.

Heirs aren’t entitled to tax-free inheritances any more than workers are entitled to tax-free income. One might even argue that it’s reasonable to tax inherited income at a significantly higher rate than normal income since heirs don’t bear any responsibility for generating the wealth of their inheritances. Currently the rate applicable for estates larger than the exempted amount is 40 percent. Were no exemptions stipulated, this rate might possibly be seen as being on the high side… maybe… but in light of the size of the current and even prospective reduced exemptions coming in 2026, 40 percent seems almost trivial. If there were ever a situation where greater progressivity could be employed, this is it.

Current estate tax provisions reinforce a caste system that bestows the largest financial benefits on those who’ve generally lived at the top of the economic pyramid by accident of their birth. These rules serve to pass along the silver spoons from the mouths of one generation to the next. That’s an outcome that deserves to be undone. It’s an open question as to whether the Democrats can rise the challenge. On the other hand, it’s pretty much a foregone conclusion that the Republicans in Congress won’t — unless their constituents muster the necessary political pressure to shame their representatives into acting responsibly.