Ms. Powell authored this article in 2000 for the National Bar Association Journal. She discusses little-known facts about the federal estate tax and the impact of its repeal.
In this article focusing on the repeal the federal estate tax ("FET"), the author's sole purpose is to highlight [i] little publicized facts about, [ii] structural aspects of, and [iii] implications of repeal of the current U.S. death transfer tax system in view of the lack of critical debate on the impact of FET repeal in hopes of enabling the reader to take an "informed" position on this very important issue.
The U.S. estate tax first appeared in 1797 as a stamp tax on decedents? inventories to finance the U.S. Navy. A federal "inheritance" tax next appeared between 1862-1870 to finance the Civil War. The estate tax again appeared in 1898 to finance the Spanish-American War, followed in 1916 by the current federal estate tax which was passed, in part, to finance World War I.
Another policy reason for the FET was to protect the U.S. from the instability of societies in which great amounts of wealth become and remain concentrated in a very small number of families. Thus, it was not coincidence that the 1916 FET closely followed the rise of America 's first astronomical fortunes amassed during the industrial revolution. Since the FET was always intended to tax only wealthy taxpayers, estates valued at less than $600,000.00 were exempt from 1987 to 1997, when the exemption was made graduated and scheduled to peak at $1 million by the year 2006. Today, graduated FET tax rates range from 18-55%. All western industrialized countries impose death transfer taxes for revenue.
Despite that the FET is intended to burden only the very wealthy, it is an entirely voluntary tax. I.e., federal tax law abounds in advance planning avoidance mechanisms by which taxpayers can minimize or completely "zero out" FET liability. In fact, the FET is the only federal tax that can be avoided entirely, such that only 2.3% of the estates of the 2,337,256 American taxpayers who died in 1998 filed FET returns.
The first implication of FET repeal is related revenue loss, projected to be $236 million over 10 years. If the goal is to maintain a revenue-neutral tax system, revenue loss from FET repeal would require either that other taxes be increased to offset the shortfall or that services be cut to account for the shortfall.
The U.S. death transfer tax system is intricately comprised of several components: (1) the FET, (2) the federal gift tax ("FGT"), (3) the federal capital gains tax, and (4) the federal generation-skipping transfer ("GST") tax. Reflecting this complexity, no less than 18 bills have been proposed to date -- some would repeal only the FET on an immediate vs. phased-in schedule, some proposing to increase the unified credit, some proposing FET repeal with continuation of the basis step-up, some with elimination of basis step-up, etc.
Given the constitutionality and on-going need for revenue from the FET, the FGT was passed in 1924 to close the loophole whereby taxpayers reduced the size of their estates by making inter vivos gifts. Generally, gifts that don?t exceed $10,000.00 in value per donee per year are excluded from the FGT regime. In 1976, the GST tax was passed to close another transfer tax system loophole through which taxpayers evaded taxes by transferring wealth to long-term family trusts for the benefit of grandchildren and third generation heirs. The GST tax provisions seek to impose the same amount of tax that would have been imposed if property had been transferred only one generation. Generally, the GST exemption allows each taxpayer to pass $1 million to grandchildren GST tax-free.
As a result of the interrelationship between these three taxes, repeal of the FET necessarily requires repeal of the FGT and the GST (since both of the latter taxes exist only to make the FET more effective). Consequently, revenue loss due to FET repeal would be increased by the losses associated with repeal of the FGT and the GST. This additional loss would require further increases in other taxes or further cuts in services, where the FET, FGT, and GST in 1999 generated $27.782 billion in revenue.
Wealth transferred at death in the U.S. is not subjected to both the above-listed transfer taxes and also to capital gains tax on built-in growth of capital assets due to the step-up in basis provisions. The step-up in basis of capital assets transferred at death allows appreciated assets to pass to the beneficiary with a date-of-death fair-market value, effectively excluding built-in capital gain from taxation. Only those congressional bills that would repeal both the FET and the step-up in basis would be revenue-neutral by replacing revenue lost from FET repeal with capital gains tax revenue.
Federal transfer tax law provides a credit for payment of state death transfer taxes, with the result that each of the 50 states and the District of Columbia collect transfer tax revenue in tandem with the federal transfer tax system. Because the state transfer taxes are collected as a consequence of the federal tax, most states have no separate procedures in place to collect this revenue. Thus, repeal of the FET would cause resulting shortfalls in state revenues, with a greater impact on states with (a) no income tax -- like Texas and Florida , (b) no separate inheritance tax, and (c) many wealthy retirees.
Repeal of the death transfer tax system will increase taxpayers' never-ending efforts to further thwart the entire federal and state tax system by such schemes as income-shifting. For example, with repeal of the gift tax, a taxpayer subject to a state income tax could shift income-producing assets to a trusted relative or friend in a state with lower or no income tax, where the latter would return the tax-free income less an agreed-upon percentage.
Similarly, a wealthy taxpayer wishing to sell an appreciated asset and evade capital gains tax could convey the asset to a lower-tax- bracket relative who could sell the property with no or lower capital gains tax liability and at a subsequent date, return the proceeds -- less a "commission" -- to the former. States which do not impose income tax on trust assets may see taxpayers from other states gifting or transferring income-producing assets to trusts in the former states. Without a gift tax, countless holes will appear in the dike that comprises the entire income tax system. Given all of the areas where FET repeal would result in revenue loss, the total cost of FET repeal has not been calculated.
One non-tax implication of FET repeal related to the consequential FGT repeal would appear in the area of spousal impoverishment. Without a gift tax or some other reporting mechanism to track substantial gifts, a spouse wishing to disinherit the less wealthy spouse could easily give away assets to children or lovers and thus, thwart the state impediments to spousal impoverishment.
FET repeal will result in wealth becoming more and more concentrated in the hands of fewer and fewer families. To wit, those states -- Maryland , included -- that have repealed the Rule Against Perpetuities now allow the formation of "dynasty" trusts that would allow a family's wealth to be concentrated into infinity. Given the current controversy over campaign finance reform, it is predictable that more concentration of U.S. wealth would result in wealthy persons exerting an even greater control and influence over Congressional representatives.
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