The Estate and Gift Tax Bulletin                                                                                 June 24, 2001

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This week's bulletin features an article on the newly enacted estate and gift tax provisions by John Buckley, a member of the House Ways and Means Committee Democratic staff.

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1. Estate and Gift Taxes: What Will Congress Do Next?    by John Buckley

The recently enacted estate and gift tax provisions are a remarkable end to this year's debate on the issue. But the debate is far from over. The provisions provide only modest short-term estate and gift tax relief, and the decision regarding the ultimate fate of the estate and gift tax system has been postponed to a future Congress. Moreover, state legislatures will have the ultimate say as to whether even the promised modest short-term marginal rate relief ever will actually be realized.

This year's estate and gift tax provisions are quite different from those that have passed the Congress in recent years. In this article, I intend to focus on the major differences and their implications. The major differences are:

1. The inclusion of a provision that terminates (or sunsets) all the tax reductions promised in the conference report (including the repeal of the estate tax).

2. The total repeal of the state death tax credit before the scheduled repeal of the estate tax.

3. A permanent retention of the gift tax (notwithstanding the one-year repeal of the estate tax), and a lower gift tax exemption than estate tax exemption prior to repeal of the estate tax.

4. The increases in the exemption amount during the phase-in period (and less substantial rate reductions than in prior legislation).

5. A dramatic rewriting of the carryover basis provisions.

Sunset of the Tax Reductions

The tax reductions in the tax bill sunset after December 31, 2010. After that date, the rules that existed before the enactment of the bill will be reinstated. With respect to the estate and gift tax rules, the sunset provision means that individuals dying after 2010 (as well as gifts and generation-skipping transfers made after 2010) will be subject to the rates and exemption levels that existed before the enactment of the new legislation.(1)

Even without the sunset provision, there would be a great deal of uncertainty over whether legislation promising repeal nine years into the future ever would take effect. The current Congress cannot bind future Congresses.

Changing political and budgetary factors easily could result in a future Congress reversing course. Inclusion of the sunset provision exacerbates the uncertainty for individuals and estate planners (discussed later in this article).

It is difficult to understand exactly what the proponents of repeal have accomplished after several years of bitter debate on this issue. With a sunset provision, the proponents of repeal will find themselves in the same position that they were in before the enactment of the new bill. Once again, they will have to push for new legislation that the president will have to sign. In effect, Congress has done little more than promise to return to the issue of estate and gift taxes at some time in the future.

Some have asserted that Congress was forced to include the sunset provision because of an obscure Senate rule named after its author, Senator Robert Byrd of West Virginia. Personally, I give little credence to that argument. Congress is in the business of changing laws and rules, and it complies with procedural rules only when it chooses to do so. The Senate bill contained the sunset provision even though it passed by a majority more than sufficient to waive the Byrd Rule. The sunset provision permitted Congress to reduce the cost of the legislation by enacting legislation that remains in effect for only nine years (while, under budgetary rules, providing an estimate of the legislation's cost over 10 years).

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Repeal of State Death Tax Credit

Last year's version of the estate tax repeal (2) reduced the state death tax credit during the period before the promised repeal in a manner that was proportionate to the rate reductions during that period. The Bush administration's proposal regarding the repeal of the estate tax included a similar proportionate reduction approach.(3) The version in the conference report, however, has a four-year phase out of the credit, with total repeal taking effect on January 1, 2005.  

The debate over repeal of the state death tax credit has been somewhat confused. Repeal of that credit will result in substantial reductions in state revenues if the state legislatures choose by their inaction to permit that result. During the Senate Finance Committee debate on this issue, Senator Phil Gramm correctly pointed out that there is nothing in the tax legislation that prevents states from retaining their current estate or inheritance taxes.

Most have assumed that states will not be able to retain their current "pickup" taxes because of political opposition. (4) However, the growing fiscal problems facing many states may put that assumption in doubt. Such a tax would affect a relatively small segment of the population, and because the conference report would make such taxes deductible, the federal government would bear approximately half the burden of the state tax. Taking those factors into account, states may find that retaining the pick-up tax maybe the least-bad choice available to them.

Under current law, large estates have a combined state-federal liability of 55 percent of the net estate. The federal government's share of the combined liability is 39 percent, the state's share is 16 percent. Under the conference report, large estates in states that retain their pick-up tax will never receive more than very small reductions in their overall marginal rate, and in some years will face marginal rate increases compared to current law. The table above shows the pattern of the combined federal-state marginal rate that could be faced by these large estates.

The entire debate for the last several years largely has been a debate about whether the wealthiest estates will receive tax reductions. There was broad support for relief for the estates of moderate wealth. It is ironic that the ultimate decision on the level of relief for wealthy estates has been delegated by the Congress to the various state legislatures.

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Retention of Gift Tax

One of the most surprising aspects of the new law is its retention of the gift tax. Retention of the gift tax is an attempt to prevent widespread income tax avoidance. The fact that the new law provides a lower gift tax exemption than estate tax exemption also is a response to potential income tax avoidance.

In my opinion, there is a great deal of doubt as to whether retention of the gift tax in an environment with no estate tax is a politically viable answer to the income tax avoidance issue. It will be very difficult for a member of Congress to explain to a constituent that as a result of the "tax relief" provided by this legislation, the constituent has to wait until death to give his farm or small business to his children.

The retention of the gift tax has another interesting, long-term consequence. Repeal of both estate and gift taxes, even for a short period of time, effectively would eliminate the federal government's ability to impose an estate tax for the foreseeable future. Wealthy individuals could take advantage of the temporary repeal by making large gifts of their assets to their children. It would not be difficult, for example, to devise a structure where the transfer of assets would be treated as a completed gift, but the donor would retain significant control over the assets. By retaining the gift tax, however, Congress has made it more likely that the estate tax will be a permanent feature of our tax laws.

Increases in the Exemption

During the last several years, the proponents of estate tax repeal have opposed strenuously any increase in the current estate tax exemption. The bill vetoed by President Clinton last year contained no increase in the exemption. H.R. 8, as introduced in this Congress, provided an increase in the estate tax exemption. That increase was removed from the bill when it was reported by the Committee on Ways and Means.

The new tax bill provides for increases in the exemption. The increases are relatively modest in the early years, substantially less than what was provided in amendments offered by Democratic members in the House and Senate. There is a large increase in the exemption effective in 2009 that results in a $3.5 million exemption being in effect in the year immediately preceding the scheduled one-year repeal of the estate tax.

The increase in the exemption to $3.5 million would repeal the estate tax for somewhere between 80 to 90 percent of all estates currently subject to the tax. When Congress is forced to return to the estate and gift tax issue, the constituency for repeal will be dramatically smaller than it is today.

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Carryover Basis Rules

The carryover basis provisions that were contained in last year's legislation would have applied only when an estate had a net value (after debt) of $1.3 million or more. This restriction was an attempt to restrict the carryover basis rules to circumstances where there would have been estate tax liability under current law. However, its treatment of debt permitted easy avoidance of the carryover basis rules.

The carryover basis rules contained in this year's legislation are quite different in their treatment of debt. The provisions do not exclude estates based on their net value, but provide a $1.3 million ($4.3 million where there is a surviving spouse) basis adjustment. It is possible that some estates, those with debt levels in excess of tax basis, actually could have net tax increases under repeal when compared to current law. Those circumstances would be rare and would occur when the estate has a net value under $1 million, debt in excess of the tax basis, and net unrealized appreciation in excess of $1.3 million.

The carryover basis provisions contained in the new law and the treatment of debt under those provisions are puzzling given the increase in the exemption discussed above. If an individual without a surviving spouse and with a net estate valued at less than $3.5 million dies in calendar year 2009, his estate will have no estate tax liability and his heirs will enjoy full step- up in basis. If the individual dies in 2010, his estate also will have no estate tax liability, but his heirs will have capital gain liabilities if the net unrealized appreciation in the value of his assets exceeds $1.3 million. It is possible that more estates will be disadvantaged, than benefited, by the repeal of the estate tax in 2010.

Some have suggested that wealthy individuals will be placed on life-support systems until 2010. The story is more complicated than that. Some of those individuals need to die in 2009 to avoid the tax increases resulting from repeal of the estate tax with its carryover basis provisions. The increase in the exemption described above decreases the constituency for repeal of the estate tax. The carryover basis rules conceivably could create a new constituency against repeal.

My introduction to carryover basis rules came in the 1970s as a member of the House Legislative Counsel's Office. I participated in the drafting of the Tax Reform Act of 1976 and in the drafting of the retroactive repeal of its carryover basis provisions. Carryover basis may make sense theoretically, but there are practical problems that make it extraordinarily complicated, create large record keeping burdens, and create potential conflicts of interest for executors in the administration of estates. I doubt that it will ever take effect.

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Related Issues

The estate and gift tax provisions in the new law raise two other issues that warrant further discussion. These issues involve the unbelievable complexity resulting from the new legislation and the role of congressional staff in the process.

Providing estate tax advice in the future will be far more complicated than in the past. The business of practicing law is based on the unstated premise that Congress enacts laws with the intent that the new laws become part of a stable and semi-permanent legal structure. That premise no longer applies in the estate and gift tax area. The probability that the new provisions will take effect as currently written is virtually nil. Therefore, any lawyer who advises his clients based on the law passed by the Congress runs the substantial risk of doing more harm than good.

Estate planners in the future will face a difficult choice. They can attempt to create flexible estate plans that can accommodate a wide range of possible congressional outcomes, or they can review and revise their clients' estate tax plans on a regular basis. Every existing will and estate plan will have to be reviewed in light of the new legislation and its uncertainties. As a result, there could be a fairly significant increase in compliance costs until Congress makes the ultimate decisions in this area. In another irony, the proponents of the legislation touted this legislation as eliminating the need for costly estate planning advice -- in fact, I fear that nothing can be further from the truth. Business is going to be extraordinarily good for estate tax planners.

The second issue involves the legislative process surrounding the estate and gift tax provisions. Last year, congressional staff, including myself, failed to fully inform members of Congress on the consequences of estate tax repeal. As a result, members of Congress operated under the false assumption that the estate and gift tax system could be repealed without adverse consequences to the federal income tax system. The failure of the congressional staff to analyze adequately the consequences of estate tax repeal was in part due to the recognition that last year's legislation was merely a political stunt designed to elicit a veto. It is quite likely that the desire on the part of some staff to please members also played a role in discouraging serious analysis.

This year, due to the efforts of several attorneys outside of government, (5) the staff recognized the adverse consequences of repeal. Unfortunately, it is difficult for members to change their votes on an issue as visible as estate tax repeal even if that vote had been made without adequate knowledge. As a result, the new law satisfies the political need of some to vote for repeal of the estate tax, while at the same time attempting to protect the income tax system. The result is not pretty.

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I hope that future Congresses and their staff will do better when they revisit the issue of estate and gift taxes.

FOOTNOTES

(1) Thus, the exemption amount for decedents dying, and gifts made, during 2011 would be $1 million.

(2) H.R. 8, the Death Tax Elimination Act of 2000, 106th Cong. (2000).

(3) General Explanation of the Administration's Fiscal Year 2002 Tax Relief Proposals, at 14.

(4) For example, in making revenue estimates for the bill, the Joint Committee on Taxation assumes that repeal of the state death tax credit will result in the repeal of virtually all inheritance or estate taxes now imposed by the states. That assumption is the result of revenue estimating conventions and does not reflect a judgment as to how the states will actually respond.

(5) See Jonathan G. Blattmachr and Mitchell M. Gans, "Wealth Transfer Tax Repeal: Some Thoughts on Policy and Planning," Tax Notes, Jan. 15, 2001, p. 393. See also testimony of Lauren Detzel before Committee on Ways and Means, Doc 2001-8293 (18 original pages), 2001 TNT 56-83.

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