Jamie's Corner: No Estate Tax, More Taxes?

In this year without estate tax, much of the commentary celebrating the tax's absence has also come with a stiff warning: some 2010 decedents would have been better off, from a tax perspective, had they died in 2009.  And although there's some variation, the tone of these warnings tends to be one of incredulity[1] - as though the author is revealing some scandal buried deep in the Internal Revenue Code. 

But while there is some truth to the claim - some would have fared better last year - the shock and awe seem misplaced. First, though, a brief explanation of the enigma: indeed, how could dying have been less expensive in 2009, when there was an estate tax, than this year, while the tax is on hiatus? The answer lies in another part of the Internal Revenue Code lying dormant this year - Section 1014. When active, that section does a remarkable thing to tax basis of inherited assets: it creates it out of thin air.

Section 1014 works by treating inherited assets as though the heir had purchased them at full fair market value on the date of the decedent's death.  So, let's say Mother died in 2009 holding only one asset: stock worth $1 Million for which she had paid $100,000 in 1999.  When Son, Mother's sole heir, takes ownership of the stock, the IRS will treat Son as if he had purchased the stock for $1 Million.  Thus, the $900,000 of appreciation that occurred while Mother held the stock will never be taxed.  Meanwhile, had Mother gifted the stock to Son before her death, the appreciation would have been preserved and taxed upon sale at (presumably) 15 percent - for a tax due of $135,000. 

Thus, Section 1014 provides a profound tax benefit.  Put another way, for the vast majority of people who died in 2009 (those with less than 3.5 million dollars in assets), death was not a tax-neutral event; indeed, it was tax beneficial. A report from the Joint Committee on Taxation estimates that without Section 1014 in place in 2009, the government would have collected an additional $28.3 Billion in taxes.  As a comparison, for tax year 2008, the government collected only $24.9 Billion in estate taxes (the most recent year for which statistics are available).  That's right: by these estimates, it's at least possible that a permanent repeal of Section 1014 could pay for a permanent repeal of the estate tax.   

However, all of this does not mean that 2010 will be a wash from the Fisc's point of view: not by a long-shot.  While Section 1014 is inactive this year, another section has emerged in its stead, Section 1022.  And per that section, large amounts of tax basis can still be created from nothing, like manna from Treasury.  Under the rules, the executor can use a statute-given "basis increase" ($1.3 Million for gifts to non-spousal heirs and $3 Million to surviving spouses) to wipe out appreciation that occurred while the decedent held the assets.  In addition, this "basis increase" would be increased even further to the extent of decedent's capital loss carryovers and built-in losses.  And while it's easy to get lost in the jargon, the upshot is clear: large amounts of appreciation are still protected from taxation even in the absence of Section 1014.

But even considering the protections of 1022, some people are arguably worse off this year.  For instance, imagine Unmarried Decedent died this year holding only $4 Million in stock for which he had paid $500,000.  Applying the basis increase of $1.3 Million, Decedent's sole heir, Son, would take a $1.8 Million basis in the stock.  Thus, if Son sold the stock at its current value he would have to pay capital gains tax of $330,000.  Had Decedent died in 2009, only $225,000 in estate tax would have been due and all appreciation in the stock would have been wiped away.

So yes, death can, for a limited group of people holding highly appreciated assets, be more expensive in 2010 than it would have been last year. But this doesn't strike me as a scandal.  There is no statutory or constitutional guarantee that decedents should better off this year than last.  And unless congress does something astounding in the next couple of months, decedents across the board will be better off, from a tax perspective, this year than next.  Section 1014 notwithstanding, 2010 is still a remarkable year for wealth transfer.