Volume 13 Issue 1
The Basis of Death?
© by Tax & Business Professionals
If the death tax (a misnomer) dies, what will happen to the step-up in basis
at death? For income tax purposes, basis is, broadly speaking, what was paid for
an asset plus and minus a variety of adjustments such as, improvements,
depreciation, etc. When property is sold, basis is subtracted from the gain
(sale proceeds usually) in order to compute taxable gain. One of the major
adjustments to basis is for the "Basis of Property Acquired from a
Decedent." Section 1014 of the Internal Revenue Code (IRC) provides for a
step-up in basis in property received from a decedent to the property's Fair
Market Value (FMV) as of the date of death.
Letís use "X-pired" as an example. If X-pired purchased a
painting for $50,000, and he owns it at the time of his death when it has a FMV
of $1,000,000, the painting will be included in the taxable estate of X-pired
and be subject to estate tax at the paintingís FMV. When the heirs of X-pired
sell the painting, its basis for income tax purposes will be the FMV as of the
date of death. This means if the picture is sold for $1,000,000, its income tax
basis will be the same as the sale amount; hence, no income tax.
To date, there has been almost no attention paid to what happens to the
step-up in basis if the so-called death tax dies. Some proposed legislation
(proposed new IRC ß 1022, H.R. 8, 2000) allows a step-up in basis for a limited
amount of assets, $1,300,000, while other legislative proposals ignore the issue
of the step-up in basis altogether. Since the step-up in basis is not part of
the estate tax, repealing the estate and gift tax would not by itself affect the
provisions of the IRC that create the step-up to FMV.
In fact, the legislation proposed by the Senate on January 21, 2001 (S.
35) does not address the present step-up in basis provisions of the Code -- it
simply repeals the estate tax, gradually, by 2009. If this approach prevails
ultimately -- an unlikely assumption -- then the benefits to taxpayers
would be substantial, no estate tax and a step-up in basis for income tax
In 1976, a much worse scenario was briefly created and fortunately repealed
in 1980. During the late 1970s, there was an estate tax AND a carryover
basis system. Carryover basis works like this. Letís go back to X-piredís
painting. When the heirs sold it, there would be capital gains tax on $950,000 (FMV
less $50,000 carryover basis).
Here, we know what X-pired paid for the painting, but the heirs of X-pired
may not know and they could be forced to reconstruct the basis. Heirs of
decedents dying in the mid and late 1970s often found the basis reconstruction
task extremely difficult, if not impossible, and this was one of the principal
factors that led to the repeal of carryover basis.
Having taught carryover basis courses and experienced first-hand the
difficulty of reconstructing the basis of assets purchased by decedents many
years before death, I can verify that the task is daunting. With banks and
institutions disappearing at an alarming rate through mergers, the chance of
finding documents concerning basis is even less likely now than it was in the
1970s. Since many owners of real estate and businesses have questionable or
limited records about the amounts paid for assets and related improvements, any
return to some form of carryover basis should be a reason to explore all
alternatives well. Even while the elderly are alive, reconstructing basis is
difficult. After death, it sometimes becomes impossible.
At a minimum, it would seem prudent for Congress and the tax community to
revisit the late 1970s and re-examine the literature and complaints about
carryover basis. Assuming some form of carryover basis is enacted with the
repeal of the estate tax, there will be some interesting choices. Assuming the
step-up is limited to $1,300,000 (as in one proposal), it is likely everyone
with assets in excess of that amount will make death-bed gifts of the excess.
Such gifts would not be subject to any estate or gift (transfer) tax, therefore
why not make such gifts (of everything but $1,300,000) to avoid income tax and
probate and get the step-up in basis on the $1,300,000?
Even if Congress eliminates the federal estate tax, there would be no
restrictions on the 50 states that would prevent them from creating state estate
tax systems. Some states already have estate or inheritance tax systems that
operate independently of the federal estate tax. Assuming a state maintains or
creates a state estate tax system and has a state income tax, would the heirs of
X-pired have two potential income tax bases -- one basis for state income
tax purposes and another federal basis for federal income tax purposes?
The not-too-ancient saga of ß 89 may still be fresh in the minds of some tax
professionals. Section 89, created by the 1986 Tax Reform Act, forged a complex
set of non-discrimination rules for employee health insurance benefits. The
section was so difficult to understand and implement that it was, accordingly,
retroactively repealed in 1989. While ß 89 was well intentioned, as was
carryover basis in 1976, the facts got in the way.
Probably, if some form of carryover basis arises, history will repeat itself
and there will be the usual cries from the wounded and then the lame assertions
from Congressional members that they really did not understand the full
import of the legislation they approved.
Assuming there was a legislative basis for the original estate tax, has it
disappeared? While no one likes the estate and gift tax, with its mind-numbing
complexities like the generation skipping tax, there are alternatives other than
a complete repeal that have possibilities. Today less than 2% of estates incur
the estate tax. A practical middle-of-the-road choice may be to raise the
life-time estate tax exemption to, say, $5,000,000. Using standard estate
planning approaches, a married couple could protect $10,000,000 from estate tax;
then probably less than .5% of estates would incur the estate tax.
An added benefit to this moderate approach is that only the rich would be
affected by the estate tax system. This would mean that the estate planning
industry, composed largely of the rich, large law firms, the insurance industry,
and trust departments, could continue to "carry on" much as they do
today. Below the radar screen of the estate tax, the remaining 99.5 % of the
populace could continue to use the step-up in basis for income tax purposes.
Isnít the lesson learned in the 1970s worth remembering? Carryover basis
did not work then and there is no reason to believe it would be any different
Updated Note (February 21, 2001): As this article was going to
press, Congress appears to be considering replacing the estate tax with a
capital gains-based system that, apparently, would require use of a carry-over
basis for some or all assets.
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