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ACTEC Journal - Summer 2005
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Washington Report

by Ronald D. Aucutt and John M. Bixler
Washington, D.C.

Many would say that the big news in Washington— other than Major League Baseball!—is that on April 13, 2005, the House of Representatives passed the “Death Tax Repeal Permanency Act of 2005” (H.R. 8), eliminating the 2011 “sunset” that limits repeal to just the year 2010. The vote was a more or less bipartisan 272-162, thus setting up a showdown in the Senate reminiscent of the showdown in June 2002, in which the identical measure fell six votes short of the necessary sixty votes. In the Spring issue, we discussed what we called the “Senate math” that makes a new vote in a new Congress so interesting, so unpredictable, and possibly so dependent on how President Bush “spends his political capital.” In this column, we would like to awaken the math skills of Fellows both to consider the fiscal cost of making repeal permanent and to analyze the interrelationship of rates and exemptions that Congress must confront if it fails to make repeal permanent.
The Cost of Repeal
In 2001, when the estate tax was “repealed” (albeit only for the year 2010), Congress anticipated large budget surpluses. There was debate over how large the surpluses might be, there was debate over how much of the projected surpluses should be “given back to taxpayers” in the form of tax cuts, and there was debate over what form those tax cuts should take. Congress decided on tax cuts, over a ten-year period, of one and one-third trillion dollars. Even that would not fund every tax cut Congress wanted to confer, however, and it was necessary to set priorities and make trade-offs—the equivalent of “spending political capital”—even in 2001.
Fellows all know that Congress was able to “repeal” the estate tax in 2001, within its $1.35 trillion tax cut budget, in large part by postponing the complete repeal to the year 2010. In fact, since the estate tax is due nine months after death, the revenue effect of complete repeal will not be significantly felt until October 1, 2010, the first day of fiscal 2011. Thus, the 2001 estate, gift, and GST tax changes were projected to decrease revenue by a total of $84 billion for the ten fiscal years 2001 through 2010, but to reduce revenue by $54 billion in fiscal 2011 alone. In contrast, it has been estimated that making repeal permanent now by repealing the 2011 “sunset” provision of the 2001 Act would cost at least $270 billion over the next ten years, even though it would not change the law until 2011. As time has passed since the enactment of the 2001 Act, more revenue loss is projected as more fiscal years (2012, 2013, 2014, and 2015) fall within the tenyear budget window. By the measure of the ten-year budget window, making estate tax repeal permanent in 2010 is simply more expensive today than it would have been in 2001.
Fellows also know that Congress mitigated the federal revenue loss from the 2001 Act by repealing the state death tax credit and thereby shifting a significant part of the burden to states whose estate taxes were tied to the federal credit and have therefore been phased out. Since the state death tax credit is now fully repealed, that is a technique that Congress cannot use again. Again, that means that permanent estate tax repeal is more expensive today than in 2001.
Alternatives to Repeal
If the political or fiscal costs of permanently repealing the estate tax prove to be too great, the question will be what Congress might do instead. Clearly the current statutory regime of repeal for one year is too unstable to be left intact. After President Clinton had vetoed the “Death TaxElimination Act of 2000” (H.R. 8), Congressman JohnTanner (D-TN) introduced the “Death Tax Relief Now Act of 2000” (H.R. 5315), which President Clinton was reportedly willing to sign. This bill would have lowered all rates by 20% and increased the exemption equivalent to $1.3 million, both in 2001, but it was not taken to the floor by the Republican congressional leadership. In contrast, the legislation enacted by the Republican Congress and signed by President Bush in 2001 has lowered only the top rate by 18% (from 55% to 45%) by 2007, but it has increased the exemption equivalent to $1.5 million last year and this year, $2 million next year, and $3.5 million in 2009. Thus, while Republicans are thought to traditionally favor lower rates while Democrats favor higher exemptions or credits, politics caused the roles to be reversed in 2000 and 2001.
It is hard to see how the timid rate reductions enacted in 2001, especially in “decoupled” states, have made estate tax opponents very proud. Thus, although estate tax “compromises” are usually discussed in terms of further increases in the unified credit, Fellows should not be surprised to see the current Republican leadership reasserting the historical Republican commitment to lower rates in giving meaningful rate reduction more attention.
Significant estate tax rate reduction could have the corollary effect of discouraging tax-avoidance techniques that the IRS might frown upon, simply by lowering the stakes. For example, if the estate tax rate approximated the income tax rate on capital gains, a valuation discount would be nothing more than an elective deferral of the tax until the property is sold, reflected in a lower basis in the property. Indeed, if those two rates were comparable, there would be no conceptual reason not to generally allow taxpayers to elect out of the estate tax and accept a zero basis for hard-to-value assets.
Rate reduction might be an occasion for Congress to consider pro-taxpayer simplifications, such as the widely-touted “portability” of the unified credit (or exemption), and to examine the issues identified in the 2004 report of the Task Force on Federal Transfer Taxes, comprised of representatives from ACTEC, the American Bankers Association, the American Bar Association Section of Real Property, Probate and Trust Law and Section of Taxation, the American College of Tax Counsel, and the AICPA. The Task Force Report discusses issues arising under present law (long phase-out, one-year repeal, and sunset), carryover basis, the retention of the gift tax system, the existing federal estate, gift and GST tax system, and alternatives to a transfer tax system.
Meanwhile the price of meaningfully lower rates might be a lower-than-imagined estate tax unified credit. While discussions of “compromise” and “reform” have often mentioned exemptions as high as $10 or $15 million, there could be questions about the long-term stability of an estate tax system with such high exemptions, even apart from the fiscal strain that would place on rate reduction. For example, a higher estate tax unified credit would mean that still fewer taxpayers will pay estate tax in exchange for a steppedup basis for appreciated assets for everyone, which could make it harder in the long term to justify a stepped-up basis, even though history teaches that Americans are reluctant to accept either carryover basis or taxation of capital gains at death.
Moreover, an estate tax paid by fewer people might look more confiscatory and might only foster unrest over the need for and fairness of such a tax.
A lower unified credit might also facilitate the restoration of the state death tax credit. It is obvious that the state death tax credit—unchanged from 1926 until 2001—served more than a revenue-sharing role. It discouraged disorderly competition among states, made it less likely that changes in domicile were driven by estate tax considerations, and simplified estate planning for clients with property in more than one state. Its repeal has created much more complexity than could have been anticipated. For example, since 2001, some “decoupled” states have “frozen” the hypothetical federal unified credit used in calculating the state tax—in some cases at exclusion levels of $1 million or less. Those states might reconsider, if the state death tax credit is revived, they are marginalized by the reinstatement of largely identical tax regimes in most other states, and the federal exclusion they need to implement for full conformity is not too high.
“Reform” Options
Besides the dampening effect of significant rate reduction on possibly questionable tax planning, rate reduction historically is an occasion for direct attempts at "base-broadening," and there is no reason for the estate tax to be an exception. Such reforms inevitably create work for Fellows. As if on cue, in January 2005, the Staff of the Joint Committee on Taxation published a 430-page Report entitled “Options To Improve Tax Compliance and Reform Tax Expenditures.” The Report had been requested in February 2004 by Chairman Grassley and Ranking Member Baucus of the Senate Finance Committee. It is not intended to reflect anyone’s current “proposal”; it is simply a collection of options that might be used in the future, perhaps to plug a revenue gap created by some tax cut measure. The Report presents options, for example, for simplifying the “kiddie tax,” tightening the governance of private foundations and other charities, and limiting the benefits of conservation easements, especially involving residential property. Under the heading of Estate and Gift Taxation, the Report presents five proposals, estimated to raise revenue by $4.2-4.7 billion over ten years.
Limit Perpetual Dynasty Trusts (secs. 2631 and 2632).” This proposal would prohibit the allocation of GST exemption to a “perpetual dynasty trust” that is subject either to no rule against perpetuities or to a significantly relaxed rule against perpetuities. If an exempt trust were moved to a state that had repealed the rule against perpetuities, the inclusion ratio of the trust would be changed to one. (Presumably this latter rule would apply only if the relocation of the trust produced a change in the governing law, and a similar rule would also apply if the situs state changed its governing law.)
The details, not disclosed in the Report, will be important. For example, the proposal states that it would apply in a state that relaxes its rule against perpetuities to permit the creation of interests for individuals more than three generations younger than the transferor. Presumably, the statutory language would be drafted so as not to be more harsh than present law under a classical rule against perpetuities, which easily allows transfers to great-great-grandchildren.
Likewise, rather than an outright prohibition on allocation of GST exemption, as the proposal says, it seems more appropriate to simply limit allocation of the transferor’s GST exemption to a one-time use (permitting a tax-free transfer to grandchildren) and then allow the allocation of GST exemption, again for one-time use, by members of each successive generation also.
Determine Certain Valuation Discounts More Accurately for Federal Estate and Gift Tax Purposes (secs. 2031, 2512, and 2624).” This proposal would require the determination of valuation discounts for transfers of interests in entities by applying aggregation rules and a look-through rule.
The aggregation rules are what the Report calls a “basic aggregation rule” and a "transferee aggregation rule." The basic aggregation rule would value a transferred interest at its pro rata share of the value of the entire interest owned by the transferor before the transfer. The transferee aggregation rule would take into account the interest already owned by the transferee before the transfer, if the transferor does not own a controlling interest. Interests of spouses would be aggregated with the interests of transferors and transferees. The proposal explicitly (and, most Fellows would say, very wisely) rejects any broader family attribution rule “because it is not correct to assume that individuals always will cooperate with one another merely because they are related.”
The look-through rule would require the portion of an interest in an entity represented by marketable assets to be valued at its pro rata share of the value of the marketable assets, if those marketable assets represent at least one-third of the value of the assets of the entity.
The proposal takes a measured approach which appears designed to avoid the uncertain and overbroad reach of previous legislative proposals. Nevertheless, the successive focus on what the transferor originally owned and on what the transferee ends up with—in contrast, for example, to the simple aggregation with the transferor’s previous transfers—could produce some curious results. For example, transferors with multiple transferees, such as parents with two or more children, will apparently have more opportunities to use valuation discounts than transferors with only one transferee. Transfers over time could apparently be treated more leniently than transfers at one time. Likewise, testing valuation discounts ultimately against what the transferee ends up with could encourage successive transfers (retransfers) or transfers split, for example, between a child and a trust for that child’s descendants.
Presumably efforts would be made to “fix” these anomalies, hopefully without expanding family attribution rules beyond spouses and thereby undoing one of the most commendable examples of restraint in the proposal.
Curtail the Use of Lapsing Trust Powers to Inflatethe Gift Tax Annual Exclusion Amount (sec. 2503).” The “powers” in view here, of course, are lapsing Crummey powers. The proposal offers three options for curbing their use—(a) limiting Crummey powers to “direct, noncontingent beneficiar[ies] of the trust,” (b) limiting Crummey powers to powers that never lapse, and (c) limiting Crummey powers to cases where “(1) there is no arrangement or understanding to the effect that the powers will not be exercised; and (2) there exists at the time of the creation of such powers a meaningful possibility that they will be exercised.”
Provide Reporting for a Consistent Basis Betweenthe Estate Tax Valuation and the Basis in the Hands ofthe Heir (sec. 1014).” The idea here is that an heir will be required to use as the income tax basis the same value that is used for estate tax purposes, in the rather noncontroversial name of consistency. To implement this rule, the executor would be required to report the basis to each recipient of property and to the IRS.
The Report adds that if the value of an asset were increased in an estate tax audit, the basis of the asset would not be increased. It is hard for us to see how that is fair.
Modify Transfer Tax Provisions Applicable to Section 529 Qualified Tuition Accounts (sec. 529).” This proposal would essentially subject 529 plans to the transfer tax rules that are generally applicable to transfers, except for the special rule allowing the use of five annual gift tax exclusions for a single transfer, which apparently would not be changed.