An Estate Tax Deal: Pay Now, Die Later

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.