An Estate Tax Deal: Pay Now, Die Later

By :: May 19th, 2010

News reports suggest that the Senate may soon consider restoring the estate tax with an option allowing people to prepay their tax before they die. Details are apparently still in flux as senators negotiate. We—and maybe they--don’t know yet what they’ll propose for the basic estate tax but it’s unlikely to be harsher than the 2009 version.

Right now, we have no estate tax. When the Senate failed last year to extend the 2009 rules—a $3.5 million exemption and 45 percent tax rate—the tax disappeared as scheduled by the 2001 tax act. But when the full 2001 law sunsets at the end of this year, the estate tax will reappear in all of its pre-2001 glory—a $1 million exemption and a 55 percent top rate. Those who favor the smallest possible estate tax don’t have the votes to repeal it entirely and hope instead to shrink it. They also know that deficit hawks will oppose changes that increase the deficit, so they have to find palatable tax increases to offset the reductions they want. And, according to Tax Notes, they’re limiting their search for offsetting revenue to the estate tax itself.

That may explain why Senator Jon Kyl (R-AZ) is reportedly mulling a prepaid estate tax that would generate tax revenue within the 10-year budget window but lose tens of billions of dollars beyond that.

We don’t exactly how the proposal would work, but here’s one version: People could create “prepayment trusts” into which they could transfer any assets they choose (subject to the assets not having an overall capital loss). Over five years, the trust’s owner would pay a 35-percent capital gains tax on the accumulated gains of the transferred assets and the assets’ bases would become their values at the time of transfer. When the owner dies, the trust would go to the heirs without incurring any estate tax. Because the trust pays tax up front but nothing when the owner dies, revenue gains show up in the 10-year budget window while much of the revenue loss doesn’t occur until the distant future where it doesn’t count under PAYGO rules. The option provides two big tax breaks: there’s no tax on the owner’s basis of assets transferred to the trust and any subsequent profits are taxed at the preferential capital gains tax rates. What’s not to like?

A couple of things. As my colleague Joe Rosenberg points out, the prepayment option would benefit people with liquid assets who could pay the capital gains tax on assets put into the trust. But small businesses and family farms—the groups for whom opponents of the estate tax express greatest concern—would be hard pressed to pay the tax on their illiquid assets. And, as long as the top tax on long-term capital gains is less than 35 percent, the wealthy could realize gains on their assets, pay the gains tax, and transfer the assets tax-free to a prepayment trust. TPC colleague Eric Toder notes that the way around that problem is to raise the tax on gains to 35 percent. Doing so would deal with lots of tax problems—but that’s a topic for another day.

Keep in mind, too, that Kyl only has to pay for part of the lost revenue. Congress has already agreed to ignore any cost of extending the 2009 rules for two years—a tab of about $15 billion over this year and next. topping $30 billion.

A pre-paid estate tax would not only save the wealthy lots of money; it would also continue the full employment of estate tax lawyers. Plus many wealthy families would have to hire financial analysts to help pick the assets to put into the trusts. It surely won’t simplify the tax. And, at a time when the U.S. faces huge future deficits, it would produce a windfall for a few thousand of the nation’s wealthiest families.

7Comments

  1. Anonymous  ::  9:10 pm on May 19th, 2010:

    I'd say let the cuts die unless the GOP behaves, although I would rather tax hiers instead as part of general tax reform – with all income, including liquidated inheritance subject to tax in the year it is received. Illiquid assets are not taxed unless they are consumed as in-kind goods (living in a mansion and being fed from a trust fund should be considered income unless the mansion is gifted to the hiers before the person dies. If a trust holds the mansion, living there should still be a taxable event. The tax should kick in at $75K individual and $150K family, although gifts to qualified, non-familial charities and sales of assets to qualified broad based employee ownership plans should be tax exempt.

  2. Anonymous  ::  5:54 pm on May 21st, 2010:

    A prepaid tax sounds complicated and gimmicky- more work for tax lawyers and accountants. If Congress really wants to help the economy, make the estate tax fair, and simplify estate planning, they should replace the current estate tax with one that only taxes the step-up in basis on assets held at death. With a reasonable exemption so that executors would not have to chase down the basis of every little asset to calculate the tax, this would make estate planning much simpler. It would be a fairer tax by eliminating the tax on wealth that has been already taxed and taxing capital gains that sometimes escape taxation through the step-up in basis. I could be indexed for inflation. Further, by taxing the step-up in basis, taxpayers would have no tax incentive to hold on to assets- capital would be allocated much more efficiently.

  3. Anonymous  ::  5:36 pm on May 24th, 2010:

    Whether taxes were paid by the original purchases is irrelevant to the question of whether they should be paid by the recipient. I am all for not taxing productive assets if they remain unsold or if they are sold to the enterprise's employees in a qualified ESOP plan. Simply granting stock to employees should also be a tax free enterprise if the grant is broad based and is in reward for past labor – although it should be taxable if sold to other than the company's other employees as part of a retirement distribution.
    I would think a $150,000 annual family (or $75K individual) exemption for spending liquidated assets is generous enough for most of the idle or working rich, since it buys quite a life style. This is especially the case with a 3% tax rate up to $171,550 for individuals and $208,850 for families, with a tax of 8% for individuals up to $200,000 and families up to $250,000.
    (Why these additional brackets were chosen by Obama is beyond me – he should have promised not to raise taxes at the tax rate boundary, not this arbitary figure. Of course, both the boundaries Graetz and I propose for tax floors are equally arbitrary. Perhaps the best boundary for reintroducing income tax over a VAT is the 28% rate boundary ($82.25K/$137.05K), which resides between the rate Graetz proposes ($50K/$100K) and the one I propose ($75K/$150K). Of course, by the time a VAT is enacted, bracket indexation should be near my proposal.)
    Income/Inheritance surtax rates for individuals over $200K and families over $250K would be 11%. Over $372,950 the rate would be 15% and 20% over $500K for both individuals and families.

  4. Anonymous  ::  12:28 am on May 25th, 2010:

    The gift tax already accomplishes these objectives, except for tax paid within 3 years of death.
    The politicians need to be educated about how the system really works.
    Steve Gorin

  5. Anonymous  ::  5:51 am on July 31st, 2010:

    I agree, we need to make the estate tax fair across the board, not just for the very wealthy.

  6. Anonymous  ::  6:53 am on August 29th, 2010:

    A couple of things. As my colleague Joe Rosenberg points out, the prepayment option would benefit people with liquid assets who could pay the capital gains tax on assets put into the trust.

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