Estate Taxes

“Tis impossible to be sure of any thing but Death and Taxes”  – Christopher Bullock (1716)

Federal estate taxes, gift taxes, and generation-skipping taxes compose our current “transfer” tax system.  Estate taxes are imposed upon and paid by the taxable estate before distribution (or transfer) to the beneficiaries.  In contrast, inheritance taxes are imposed upon and paid by the beneficiaries for assets inherited. The federal tax system has used each method in the past but currently uses the “estate” tax system, while the states generally use the “inheritance” tax system.

A brief history of the estate tax…

Estate or death-related taxes began as a temporary means to raise revenue during times of war or crisis and evolved into a permanent fixture of our tax code for both revenue and political purposes. The Death Stamp Tax of 1797 raised revenue to strengthen our navy as a result of trade disputes with France. This act was short-lived and was repealed in 1802.  The Civil War led to the Revenue Act of 1862, which created an inheritance tax that was repealed in 1870.  The War Revenue Act of 1898 imposed a death tax to finance the Spanish-American War and was repealed in 1902.  World War I caused a reduction of tariff revenue and led to the Revenue Act of 1916, which reintroduced the estate tax. The Great Depression inspired the Revenue Act of 1932, and World War II ushered in the Revenue Acts of 1934, 1935, 1940, and 1941, which expanded the tax base and increased estate tax rates.

Other than increases to the marginal estate tax bracket, the transfer tax system was generally static until the Tax Reform Act of 1976, which unified the gift and estate tax systems and created the generation skipping tax (GST).  The 1976 Act also made a significant change to the cost basis rules for inherited assets, eliminating the cost basis adjustment (or basis step) to the fair market value upon death and instead requiring the decedent’s basis to be carried over to the beneficiary.

To illustrate the significance of this change in law, assume the following: Jessica’s mother bought 1000 shares of XYZ stock at $1 per share ($1000 cost), and Jessica inherited the shares 30 years later when the shares were trading at $20 per share ($20,000 value).  Under the carryover basis rules, Jessica’s cost basis would equal that of her mother’s, $1 per share. Under the step-up (or step-down) basis rules, the cost basis of the inherited shares would be adjusted to the fair market value (FMV), which is $20 per share. In either case, when Jessica sells the shares, she will owe capital gains taxes on the difference between the cost and the sale proceeds, but from Jessica’s point of view, adjusting the cost basis to the fair market value would be significantly more favorable.

The carryover basis rules did not last long.  The Revenue Act of 1978 suspended the effective date for the carryover basis rules until 1980, and then an amendment to the Crude Oil Windfall Profits Tax Act of 1980 retroactively repealed the carryover basis rules.  One rationale for the basis step-up is to avoid double taxation.  Why should one’s estate be assessed an estate tax and a capital gains tax?

Where are we now…

The Tax Cuts and Jobs Act (2017) increased the basic exclusion from $5,490,000 to $11,180,000 for individuals (~$22.4 million for married couples) with the current exclusion growing to $11,700,000 for 2021 due to inflation adjustments.  In the absence of new legislation, the estate tax exclusion amount will increase with inflation until 2025, when it reverts back to the 2017 level of $5,490,000 plus inflation adjustments. If we presume an annual 3% inflation adjustment, the 2026 exclusion amount could be near $7 million per individual and $14 million for married couples.

Looking forward…

The Biden administration proposes three changes to the current transfer tax system:

  • Reducing the estate tax exclusion amount to the 2009 levels ($3.5 million per person, $7 million per married couple)   
  • Increasing the highest marginal estate tax rate from 40% to 45%
  • Ending the basis adjustment for gains in excess of $1 million per person ($2 million per couple), thereby creating a hybrid system in which the basis of certain assets would receive a basis adjustment, while the basis of the remaining assets would carry over from the decedent.

As we have seen from history, an estate tax is here to stay, but its details are prone to change significantly along with power shifts in Washington. If you don’t have an estate plan or haven’t reviewed it in several years, please contact us to review your unique situation.