The Staff of the Joint Committee on Taxation has released JCX-23-08, Taxation Of Wealth Transfers Within A Family: A Discussion Of Selected Areas For Possible Reform. This document, which was prepared in conjunction with an Apr. 3, 2008 hearing conducted by the Senate Finance Committee, explains the estate and gift tax system’s current state of flux and explores ways to reform it. The full-text document can be viewed at http://www.house.gov/jct/x-23-08.pdf.
Observation: Estate planning has become unduly difficult in the face of uncertainty posed by the current regime, which calls for a one-year repeal of estate tax followed by a return to harsher rules. While it is a fairly good bet that estate tax won’t be permanently repealed, it seems certain that some types of changes will be implemented even before 2010. For example, there is a pretty good chance that a fully unified system will be restored with a higher exemption level.
Background. As noted in JCX-23-08, the Federal estate and gift tax rules are in a state of flux. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), the estate tax and the gift tax are partially unified: a single tax rate schedule applies under the estate tax and the gift tax, but after 2003 the exemption amounts differ. The highest rate of estate and gift tax has decreased in steps from 55% in 2001 to 45% in 2007 through 2009. The estate tax exemption amount is increasing in several steps from $1 million in 2002 to $3.5 million in 2009. The gift tax exemption amount has remained at $1 million. The credit against Federal estate tax liability for State estate and inheritance taxes was phased down from 2002 through 2004 and replaced by a deduction starting in 2005.
For 2010, the estate tax is repealed, but the gift tax remains in effect with an exemption of $1 million and a maximum rate of 35%. In 2010, property transferred at death generally has the same basis in the hands of the heir as it had in the hands of the decedent (that is, a carryover basis). By contrast, under the estate tax that apply currently, the heir’s basis generally equals the property’s fair market value (FMV) at the time of the decedent’s death.
Estate tax repeal lasts only for one year. In 2011, the estate and gift tax rules are scheduled to be the same as those that would have been in effect without enactment of EGTRRA. Under pre-EGTRRA law, the estate and gift tax was fully unified: a single rate schedule and exemption amount applied to gifts made during life and to transfers at death. Consequently, unless the rules are changed, starting in 2011 the estate and gift tax exemption amount will be $1 million, and the highest estate and gift tax rate will be 55%. The credit for State estate and inheritance taxes will return, and property acquired from a decedent will take an FMV rather than a carryover basis.
Possible areas of reform. Against this backdrop of changing estate and gift tax laws, Congress is exploring ways of reforming transfer taxes. The Senate Finance Committee is holding a series of public hearings to examine the current system and possible changes to, or replacements of, it. A Nov. 14, 2007 hearing addressed broad design issues such as rates, exemption amounts, and the treatment of farms and family businesses. A hearing on Mar. 12, 2008 studied alternatives to the present estate and gift tax system. JCX-23-08 was prepared in connection with the hearing conducted on Apr. 3, 2008, which included a discussion of possible reforms to the existing Federal estate and gift tax rules.
JCX-23-08 is divided into two parts. The first part examines the present partially unified credit and possible reforms to it. The second part looks at liquidity to pay estate tax when estates consist largely of farms or other businesses.
Unified credit. Under present law in effect through 2009 and after 2010, a unified credit is available with respect to taxable transfers by gift and at death. The unified credit offsets tax computed at the lowest estate and gift tax rates. Before 2004, the estate and gift taxes were fully unified, such that a single graduated rate schedule and a single effective exemption amount of the unified credit applied for purposes of determining the tax on cumulative taxable transfers made by a taxpayer during his or her lifetime and at death. For years 2004 through 2009, the gift tax and the estate tax continue to be determined using a single graduated rate schedule, but the effective exemption amount allowed for estate tax purposes is increased above the effective exemption amount allowed for gift tax purposes. Therefore, under present law for the years 2004 through 2009, estate and gift taxes are not fully unified because the estate and gift tax effective exemption amounts differ.
One possible reform to present law’s partially unified credit would be to make the credit fully unified. Under this approach, a common rate schedule and a single exemption amount would apply to gifts made during life and transfers at death. It has been argued that this would simplify planning and that the current credit distorts behavior by encouraging taxpayers to hold onto property until they die to take advantage of the higher exemption amount under the estate tax.
JCX-23-08 notes that the extent to which making this change would counteract the gift tax’s role in preventing income tax avoidance is unknown. In the absence of a tax on gifts, income tax liability may be reduced when high-income individuals make gifts to lower-income individuals. A fully unified credit also could encourage gifts over bequests. Also, a gift tax is not imposed on funds used to pay the gift tax while an estate tax is imposed on funds used to pay the estate tax. This difference in treatment causes the effective rate of tax on gifts to be lower than the effective rate of tax on bequests, which, in turn, could favor giving over making bequests.
A second possible reform to the unified credit, which would result in portability, would allow a surviving spouse to benefit from the unused exemption amount of the first spouse to die. As for a fully unified credit, a principal argument for portability for an unused exemption is that this approach would simplify wealth transfer tax planning. Portability, however, raises concerns about IRS’s ability to administer the transfer tax rules. Certain design features, such as the treatment of multiple marriages, also may create difficulties.
Estate liquidity. The second part of JCX-23-08 discusses liquidity to pay estate tax when estates consist largely of farms or other businesses. A particular concern has been that if the value of an estate is largely attributable to a farm or other business, heirs may be forced to sell to pay the tax.
Specifically, the second part of JCX-23-08 describes three provisions intended to mitigate the effect of the estate tax on farms and other family-owned active businesses.
- Code Sec. 2032A permits real property to be valued for estate tax purposes at its current-use value (for example, as a farm) rather than at a higher market value (for example, the price that could be received in a sale to a developer).
- Code Sec. 6166 allows payment of estate tax attributable to certain family businesses to be deferred for five years and then made in installments over the succeeding ten years.
- Code Sec. 2057 (terminated after 2003 but scheduled to be in effect after 2010) grants a deduction from the value of the gross estate for the value of certain family-owned business interests.
The discussion then evaluates criticisms of those provisions. In addition, to help assess the extent to which the estate tax creates cash flow problems for family businesses, the discussion presents data showing relative liquidities of estates with farms and other closely held businesses and certain characteristics of estates for which benefits have been claimed under Code Sec. 2032A, Code Sec. 6166, or former Code Sec. 2057. The data suggest that many estates that are comprised largely of farms or other closely held businesses have enough liquid assets to satisfy estate tax liabilities. Nonetheless, JCX-23-08 notes that the decreased liquidity attributable to payment of estate tax may impair a business’s ability to function and grow.
Appendix with earlier proposals. JCX-23-08 includes an appendix that reprints previous Joint Committee on Taxation staff options for reforms of certain estate, gift, and generation-skipping transfer tax rules including a proposal to limit perpetual dynasty trusts, one to limit various transfer tax discounts, and another to limit the ability to use Crummey powers to exempt property from gift tax.
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