It is rare to hear from the President himself about inheritances. It is rarer still when a White House document gets the analysts and pundits on cable news talking about inheritances for a whole weekend. But on January 17-19, 2015, it happened, creating an unusual environment for the President’s State of the Union Address and the anticipated release of the Administration’s Fiscal Year 2016 Revenue Proposals. And on February 2 – Ground Hog Day – the Proposals brought some familiar stories, but the unusual sound track the White House had created sharpened the focus of much of the analysis. Meanwhile, even with some of the same proposals we saw last year, there was one walk-back, one important clarification, and one surprising change, each of them delivered in just a single sentence or less.
The White House Tease
On Saturday, January 17, 2015, three days before President Obama’s State of the Union Address, the Office of the White House Press Secretary previewed one of the themes in the Address when it released what it called “FACT SHEET: A Simpler, Fairer Tax Code That Responsibly Invests in Middle Class Families.” The first page of the Fact Sheet highlighted three bullet points:
- “Close the trust fund loophole – the single largest capital gains tax loophole – to ensure the wealthiest Americans pay their fair share on inherited assets. Hundreds of billions of dollars escape capital gains taxation each year because of the “stepped-up” basis loophole that lets the wealthy pass appreciated assets onto their heirs tax-free.
- “Raise the top capital gains and dividend rate back to the rate under President Reagan. The President’s plan would increase the total capital gains and dividends rates for high-income households to 28 percent.
- “Reform financial sector taxation to make it more costly for the biggest financial firms to finance their activities with excessive borrowing. The President will propose a fee on large, highly-leveraged financial institutions to discourage excessive borrowing.”
The label of “trust fund loophole” was an odd way to describe the stepped-up basis for appreciated assets at death, when assets in typical ancestral trusts are not subject to estate tax and do not get a stepped-up basis.
And the idea that “[h]undreds of billions of dollars escape capital gains taxation each year” seemed implausible because any such gain that escaped income tax, and indeed the entire principal as well, would have to be subject to estate tax (if it didn’t pass to the surviving spouse), and estate tax collections just aren’t at all close to the levels that transfers of “[h]undreds of billions of dollars … each year” would suggest. (According to IRS statistics, the total net estate tax reported on all estate tax returns filed for 2012, for example, was about $8.5 billion.)
The possible explanation that these huge gains escape both income tax and estate tax by passing through estates that are under the basic exclusion amount was belied by the Fact Sheet’s observation that “99 percent of the impact of the President’s capital gains reform proposal (including eliminating stepped-up basis and raising the capital gains rate) would be on the top 1 percent, and more than 80 percent on the top 0.1 percent (those with incomes over $2 million).”
In short, it was hard to view the White House Fact Sheet as serious. It was hard to believe that it had been written or read by anyone who understood trusts or inheritances. That was a shame, because the issues are important and have been seriously debated for nearly a half century or more. The Fact Sheet itself argued that treating nonmarital and noncharitable gifts and bequests as deemed realization events would:
- “Address a basic unfairness in the tax system. Most middle-class retirees spend down their assets during retirement, which means they owe income taxes on whatever capital gains they’ve accrued. But the wealthy can often afford to hold onto assets until death – which is what lets them use the stepped-up basis loophole to avoid ever having to pay tax on capital gains [the “equity” argument].
- “Unlock capital for productive investment. By letting very wealthy investors make their capital gains disappear at death, stepped-up basis creates strong “lock-in” incentives to hold assets for generations [sic], even when resources could be reinvested more productively elsewhere. The proposal would sharply reduce these incentives, making it a pro-growth way to raise revenue [the “lock-in” argument].”
The implication that the lock-in effect persists “for generations” when the step-up in basis occurs at the death of the owner continued the “what were they thinking?” theme of the White House Fact Sheet. The accuracy of the factual generalizations might be questioned more broadly as well. But the underlying policy arguments are compelling and deserve a hearing. Unfortunately, they are unlikely to get a hearing when they are packaged as implausibly as they were in the Fact Sheet.
Although not the thoughtful policy hearing that issues like this deserve, the capital gains proposal received plenty of media attention, some of it cringe-worthy, in the build-up from Saturday to the State of the Union Address on Tuesday evening, January 20. And President Obama did reinforce the proposal in his Address.
A More Conventional Package: Treasury’s “Greenbook”
On February 2, 2015, the Treasury Department released its annual “General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals” (popularly called “the Greenbook”). The Greenbook articulation of the capital gains proposal (pages 156-57), labeled “Reform the Taxation of Capital Income,” under the general heading of “Reforms to Capital Gains Taxation, Upper-Income Tax Benefits, and the Taxation of Financial Institutions,” avoids the anomalies in the White House Fact Sheet and presents a much clearer and more complete picture.
Believing that “[p]referential tax rates on long-term capital gains and qualified dividends disproportionately benefit high-income taxpayers” but using more moderate language than the White House Fact Sheet, the Greenbook explains:
Because the person who inherits an appreciated asset receives a basis in that asset equal to the asset’s fair market value on the decedent’s death, the appreciation that accrued during the decedent’s life is never subjected to income tax. In contrast, less-wealthy individuals who must spend down their assets during retirement must pay income tax on their realized capital gains. This increases the inequity in the tax treatment of capital gains [the “equity” argument]. In addition, the preferential treatment for assets held until death produces an incentive for taxpayers to inefficiently lock in portfolios of assets and hold them primarily for the purpose of avoiding capital gains tax on the appreciation, rather than reinvesting the capital in more economically productive investments [the “lock-in” argument].
The Greenbook clarifies that the proposal would increase the top rate on capital gains and qualified dividends to 24.2 percent, which, with the 3.8 percent tax on net investment income, would produce a rate of 28 percent (math that wasn’t clear from the White House Fact Sheet).
Gifts or bequests to a spouse or charity would not be taxed, but the spouse or charity would take a carryover basis in the asset.
Gain on tangible personal property such as household furnishings and personal effects would be exempt, but gains on “collectibles” are explicitly removed from that exception and thus taxed.
Each person would be allowed an additional exclusion of capital gains at death of up to $100,000 (indexed for inflation after 2016), and each person’s $250,000 exclusion of capital gain on a principal residence would be extended to all residences. Both of these exclusions would be portable to the decedent’s surviving spouse. The White House Fact Sheet had said “automatically portable,” implying that no election would be needed, but the Greenbook states that this portability would be “under the same rules that apply to portability for estate and gift tax purposes.” The exclusion under section 1202 for capital gain on certain small business stock would also apply.
Taxation of the appreciation in the value of certain small family-owned and operated businesses (no further details are given) would be deferred until the business is sold or ceases to be family-owned and operated. And a “15-year fixed-rate payment plan” would be allowed for the tax on appreciated illiquid assets transferred at death, perhaps comparable to the deferral of estate tax under section 6166.
The Greenbook clarifies that the income tax on capital gains deemed realized at death would be deductible for estate tax purposes. (The White House Fact Sheet did not make that clear.) That would make the effective top rate on capital gains realized at death not 28 percent, not 20 percent, but apparently 16.8 percent (0.28-(0.40×0.28)) (ignoring state taxes). Although deferral itself is attractive, that would make the ultimate lifetime and at-death rates technically the same, because a 28 percent tax reduces the taxable estate by the same amount whether it is paid at death and deducted from the gross estate or paid during life and excluded from the gross estate.
Showing awareness of the complexities involved, the Greenbook adds the following:
The proposal also would include other legislative changes designed to facilitate and implement this proposal, including without limitation: the allowance of a deduction for the full cost of appraisals of appreciated assets; the imposition of liens; the waiver of penalty for underpayment of estimated tax if the underpayment is attributable to unrealized gains at death; the grant of a right of recovery of the tax on unrealized gains; rules to determine who has the right to select the return filed; the achievement of consistency in valuation for transfer and income tax purposes; and a broad grant of regulatory authority to provide implementing rules.
To facilitate the transition to taxing gains at death and gift, the Secretary would be granted authority to issue any regulations necessary or appropriate to implement the proposal, including rules and safe harbors for determining the basis of assets in cases where complete records are unavailable.
The Greenbook states that the proposal would take effect on January 1, 2016, and is estimated to raise revenues by $207.884 billion over 10 years. That revenue estimate is the final word on the catchphrase in the White House Fact Sheet that “[h]undreds of billions of dollars escape capital gains taxation each year.”
The “financial sector” proposal (Greenbook page 160), by the way, would impose on any financial firm with assets over $50 billion a fee equal to 7 basis points applied to the firm’s liabilities. It would become effective January 1, 2016, and is estimated to raise revenue by an $111.814 billion over 10 years. ($111.814 billion divided by 7 basis points for 10 years would be about $16 trillion of liabilities, but there may be more to the analysis than that.)
As stated above, the treatment of unrealized appreciation at death, and for that matter the taxation of capital itself, has been seriously debated for nearly a half century or more.
For example, on February 5, 1969, less than two weeks after the inauguration of President Nixon, Congress published a multi-volume Treasury Department work entitled “Tax Reform Studies and Proposals,” reflecting work that had been overseen by Assistant Secretary of the Treasury for Tax Policy Stanley Surrey during the Kennedy and Johnson Administrations. Although the Tax Reform Act of 1969 that followed made no estate tax changes except with respect to charitable deductions, these studies included a number of proposals in a section entitled “Estate and Gift Tax Proposals.” The first of these (although not strictly an estate or gift tax proposal) was “Taxation of Appreciation of Assets Transferred at Death or by Gift.” The introduction identified three problems: “taxpayer inequity, revenue loss, and lock-in effect.” STAFF OF HOUSE COMM. ON WAYS AND MEANS & SEN. COMM. ON FINANCE, TAX REFORM STUDIES AND PROPOSALS: U.S. TREASURY DEPARTMENT, 91ST CONG., 1ST SESS., PT. 3, 331-51 (1969).
“Blueprints for Basic Tax Reform” was published by the Treasury Department January 17, 1977, during the last week of the Ford Administration. In the context of proposing a comprehensive model of income taxation that depended on a dramatically (and at points esoterically) broader tax base, “Blueprints” assumed that transfers by gift or at death would be recognition events. Such capital gains, whether by gift, at death, or otherwise, would be fully taxed at ordinary income rates, with adjustments to the basis of corporate stock for retained earnings and to the basis of all assets for general price inflation. Pre-enactment gain would be excluded, following the precedent of the “carryover basis at death” rules that had been enacted in 1976. DEP’T OF THE TREASURY, BLUEPRINTS FOR BASIC TAX REFORM 75-83, 204 (1977). “Blueprints” was not embraced by the incoming Carter Administration.
The current Administration proposal, like almost all of the Administration’s budget proposals, is going absolutely nowhere in this Republican Congress. Its exaggerated political roll-out in the initial White House Fact Sheet, in contrast to the much more objective analysis in the Greenbook, left little room for sober deliberation anyway. But, seriously, increasing estate tax exemptions have made it harder to view a stepped-up basis as “paid for” by the estate tax. Adventures with carryover basis in the late 1970s and in 2010 were not well received as such, although electing out of the estate tax for 2010 was appealing. Some cite the Canadian example, but others point out that Americans are not Canadians and that seems to be the end of the analysis. Keeping records of basis is still intimidating to many. And any tax calculation that depends on valuation in a non-arm’s-length context – yes, including the estate tax – is bound to be high-maintenance.
But someday the time and context might be right to have the serious discussion this issue deserves.
A new Administration proposal in 2014, entitled “Simplify Gift Tax Exclusion for Annual Gifts,” included a definition of a new $50,000 “category of transfers (without regard to the existence of any withdrawal or put rights).” The proposal was analyzed and commended as real simplification in Capital Letter Number 35, which viewed the new category, based on the text of the 2014 Greenbook (pages 170-71), as $50,000 per year of “mad money” free from the $14,000-per-donee limit.
Capital Letter Number 35 acknowledged that “[s]ome may be inclined to interpret the proposal only as allowing up to $50,000 of annual exclusion gifts (also subject to the $14,000-per-donee limit) to avoid the tightened outright-or-tax-vested requirement [in the 2014 proposal].” It turns out that those with a such an interpretation apparently included the drafters of the proposal. Informal indications of that began to surface as early as last spring. Confirmation came in a new sentence in the 2015 Greenbook (pages 204-05): “This new $50,000 per-donor limit would not provide an exclusion in addition to the annual per-donee exclusion; rather, it would be a further limit on those amounts that otherwise would qualify for the annual per-donee exclusion.”
The 2015 Greenbook goes on to say, however, like the 2014 Greenbook, that “[t]he new category would include transfers in trust (other than to a trust described in section 2642(c)(2)), transfers of interests in passthrough entities, transfers of interests subject to a prohibition on sale, and other transfers of property that, without regard to withdrawal, put, or other such rights in the donee, cannot immediately be liquidated by the donee.” That is what made the proposal attractive last year: in exchange for a monetary cap, it would apparently eliminate all the controversies about withdrawal rights and restricted interests in entities represented by the cases cited in Capital Letter Number 35. And it would apparently eliminate, prospectively, the headaches of documenting “Crummey notices” and keeping track of lapses of withdrawal powers, including lapses based on annual values.
The new, presumably intentional, reference to “amounts that otherwise would qualify” now raises doubts about whether those controversies and headaches would be avoided after all.
Much depends on how any statute, and perhaps the implementing regulations, are written. But now it appears possible, for example, that “transfers in trust” (the first example in the Greenbooks of the new $50,000 category) would still have to have a mechanism for identifying the donees whose $14,000 annual limits would be charged. And the likely way to do that, especially in existing irrevocable trusts (gifts to which would be covered by the proposal) would be with Crummey powers after all.
The 2015 Greenbook adds a provision that the $50,000 limit would be “indexed for inflation after 2016,” thus ensuring that our headaches would not remain level but would increase each year.
So Capital Letter Number 35 was wrong. This proposal might not be a simplification.
The GRAT Proposal, 2009-2014
We have all watched with interest and some amusement the evolution of the Administration’s proposal regarding grantor retained annuity trusts (GRATs). Amid rumors of a required minimum remainder value (perhaps 10 percent), the 2009 Greenbook instead would require only a minimum 10-year term.
Suggestions then arose that if the annuity payments were “front-loaded” as, say, 90 percent of the initial GRAT value in the first year and 1 percent of the initial GRAT value in each of the next nine years, there would be minimal estate tax exposure under Reg. §20.2036-1(c)(2) after the first year, the GRAT would work great if the appreciation “home run” came in the first year, and the grantor would get almost all of the property back to try again if it didn’t. Then the 2010 Greenbook added a prohibition of any decrease in the annuity payments and also a requirement of some remainder value for gift tax purposes (which would trigger a gift tax return reporting requirement).
Next we heard speculation about a very long-term GRAT, sometimes identified with a two-digit number of years close to a hundred, conceding inclusion in the gross estate but again with a limited inclusion under Reg. §20.2036-1(c)(2). And the 2012 Greenbook added a maximum term of the grantor’s life expectancy plus 10 years.
The Grantor Trust Proposal, 2012-2014
Meanwhile, the 2012 Greenbook also added a proposal to subject grantor trusts to estate tax on the grantor’s death, or upon distributions or cessation of grantor trust status during the grantor’s life. The 2013 and 2014 Greenbooks narrowed the focus to property received by the grantor trust in certain sales or sale-like transactions with the deemed owner of the trust and also added a specific proposal for regulatory authority, including “the ability to create exceptions to this provision.” The latter addition was seen by some as very helpful and as an indication that such regulations might be where the real law would ultimately be made, albeit with a chilling effect on these transactions while the regulations are being written.
The grantor trust proposals were critiqued in Capital Letters Number 31 and 33.
The 2015 Surprise
The 2015 Greenbook (pages 197-99) combines the GRAT and grantor trust proposals. The grantor trust proposal is essentially unchanged from 2013 and 2014. The GRAT proposal, however, adds two more requirements:
- “a requirement that the remainder interest in the GRAT at the time the interest is created must have a minimum value equal to the greater of 25 percent of the value of the assets contributed to the GRAT or $500,000 (but not more than the value of the assets contributed)” and
- a requirement to “prohibit the grantor from engaging in a tax-free exchange of any asset held in the trust.”
A minimum gift tax value as such is not a surprise. It was rumored before the 2009 proposal was published. But the 25 percent level is surprisingly high. For example, 10 percent is the minimum remainder value required for the IRS to consider ruling that an interest in a GRAT is a qualified annuity interest under section 2702. Rev. Proc. 2015-3, 2015-1 I.R.B. 129, §4.01(53). In the context of an installment sale to a grantor trust, it is well known that the IRS required the applicants for Letter Ruling 9535026 (May 31, 1995) to commit to “equity” of at least 10 percent of the purchase price. And 10 percent is the equity floor, the minimum value of the common stock of a corporation or “junior equity interest” in a partnership, under section 2701(a)(4), which was enacted at the same time as section 2702.
The alternative minimum remainder value of $500,000 means that 25 percent would not be enough for GRATs funded with less than $2 million. If enacted, these requirements would require a robust investment of gift tax or unified credit that will make many clients think harder about creating a GRAT.
The prohibition of the grantor’s tax-free asset swaps would be similar to the prohibition currently applicable to a qualified personal residence trust. The stated objective is to prevent the grantor from sheltering the appreciation in the GRAT from capital gains tax by reacquiring the appreciated asset and permitting it to get a stepped-up basis when the grantor dies. An unstated objective might be to give the 10-year minimum term real teeth by requiring that the GRAT ride the appreciation potential of a single asset for 10 years. No pulling out assets that have just hit their home run and swapping in assets that are just about to, which in effect would emulate a series of short-term GRATs under the umbrella of a single 10-year GRAT.
The combined and revised GRAT/grantor trust proposal is estimated to raise revenue by $18.354 billion over 10 years, compared to a total of $7.355 billion for both proposals in the 2014 Greenbook.
Over the years, many of the Administration’s revenue proposals have attracted technical criticism, as well as the predictable political resistance. The superficially appealing proposal for consistency between estate tax value and income tax basis (2015 Greenbook pages 195-96) seems to naïvely overlook the significant challenge of binding heirs and beneficiaries in an estate tax audit. The proposal to address the GST tax treatment of Health and Education Exclusion Trusts (page 203) seems to misstate both the problem and the law. The proposals regarding grantor trusts leave technical questions (described in Capital Letters Number 31 and 33), and now it is evident that the annual exclusion proposal does too.
But the GRAT proposal has stayed under the radar of serious criticism. There are ways to deal with a longer term, which isn’t always such a bad idea in a low-interest-rate environment anyway.
Thus, it is conceivable that in a late-night effort by congressional staffs to put together the legislative language to achieve whatever targets the Members of Congress have charged them with, a few billion dollars from a GRAT proposal that has been on the shelf for many years without serious pushback or controversy could be an attractive revenue “plug.” Now such an expedient and understandable choice would have much broader consequences, because it would bring with it the open-ended and chilling grantor trust proposal and because the GRAT proposal itself is significantly more muscular.