Nearly a month ago the House of Representatives voted to extend indefinitely the repeal of the estate tax. At the time, CJR Daily reported on the “carryover basis” (or repeal of “step-up in basis”) provision that would introduce new capital gains taxes on tens of thousands of Americans if the repeal is signed into law. On Wednesday, the Wall Street Journal‘s “Tax Report” feature (subscription required) by Tom Herman investigated the implications of the “carryover basis” provision.
Herman wrote, “Tax advisers who have studied the fine print say one important question is what will happen to a provision in current law known as ‘step-up in basis.’ This provision affects how much, if anything, heirs have to pay in capital-gains taxes when they sell shares of stock and other inherited property. For instance, suppose your aunt dies this year and you inherit stocks and other assets that have risen in value over the years. Under current law, your tax cost typically is the fair market value of those assets on the day she died or, in certain circumstances, six months later. You don’t need to know what your aunt originally paid for those assets eons ago.”
Come 2010 when the estate tax is set to disappear (if it isn’t permanently repealed by the pending legislation), “the provision will be replaced with new rules that generally allow only a limited amount of step-up ($1.3 million plus an additional $3 million for property going to a surviving spouse), rather than allowing all appreciated assets in the estate to be stepped up.” In other words, an heir would owe taxes on the amount the asset has increased in value since it was first acquired, way back when, by Aunt Nellie. To be sure, that tax would be a 15-20 percent capital gains tax, not a 47 percent estate tax — but, in certain circumstances, because of those changes, the beneficiary of the estate could end up paying more tax than under the old rules.
The Journal, however, slights the issue by limiting the discussion to the “one important question” of the carryover basis (To be fair, CJR Daily itself only addressed the “carryover” question when we reported on this a month ago.)
There is also the issue of how individual states are dealing with changes in the law. For many years, up until the 2001 tax cut (aka the Economic Growth and Tax Reconciliation Act of 2001, or EGTRA), most states imposed a “pickup” tax on estates. Taxpayers effectively paid a portion of their estate taxes to the state, and received credit for that payment against whatever federal tax they owed. For example, let’s say you had an estate worth $10 million and owed an estate tax of 50 percent (In practice, the highest bracket owes 47 percent.) Your total taxes due would be $5 million. Now let’s say that the “pick up” tax imposed by state was $1 million. You would pay the state $1 million, receive a tax credit for that payment from the federal government, and then owe the federal government the remaining $4 million.
But EGTRA gradually phased out that credit by one-quarter each year. Now, in 2005, the credit has been replaced by a deductible that can be taken against the taxable estate. With the credit no longer on the books, many states, such as Illinois and New York, decoupled their estate taxes from federal law and created their own inheritance taxes. Taxpayers are able to deduct the taxes paid to the state from the value of their gross estate as reported to the feds — but, in some cases, they’re going to end up paying more in taxes than before, not less (at least between now and 2010, and longer if the house legislation is signed into law).
Let’s take our example from above. You still have your $10 million estate and you still owe the state $1 million. You pay that $1 million to the state, and then deduct it from the gross value of your estate. Then you pay the 50 percent federal tax due on the remaining $9 million estate, or $4.5 million. Thus, your total tax bill has grown from $5 million under the old system to $5.5 million under the new system.
And don’t forget the new “carryover basis” currently being considered by Congress that prompted our discussion in the first place. Should that become law, in some cases, the combination of the capital gains owed because of the new carryover rules and the new state taxes will be a double whammy.
When one door closes, another opens. In this case, eliminating the estate tax opens the doors not just to increased capital gains taxes but also to increased state inheritance taxes. It’s up to the press to make sure we know what’s behind the open door, before we close the door on the estate tax.
–Thomas Lang
Thomas Lang was a writer at CJR Daily.