Estate Taxation Issues In the 2016 Election

In Finance
Government Tax Sources

The election is now less than 6 weeks away, the first of three debates will air tonight and we might finally get to talk about and think thru some issues.  One broad issue that always plays into electoral politics are taxes.  In 2016, both candidates have put forward proposals for how they view one specific tax, which is the estate tax.  The estate tax is the tax paid on an individuals’ assets after they die.

We all know the rhetoric that comes from each party regarding taxation.  One party indicates that everyone needs to ‘pay their fair share’ and the other party thinks that we are ‘taxed enough already’.  The estate tax is an interesting issue.  The Republicans have always said that the value of the estate should not be taxed since all of the income has already been taxed.  The Democrats continue with their statement about paying their fair share.

Let’s first take a look at what the candidates are saying.  First, Mr. Trump.  According to his website, his position is that the death tax will be eliminated (repealed) but that the Capital Gains on the assets held until death will be taxed.  The first 10 million dollars will be excluded from the estate calculations in order to allow for a family farm or family business to be passed through the estate.

Next, Hillary Clinton’s proposal.  According to her website, her position is to restore estate taxes to the way that they were in 2009, with the exclusion amount increasing to $11 million, well above the $3.5 million exclusion back in 2009.  What this means is that the first $11 million would be exempt from estate taxes.  The estate tax rate was and is a progressive tax with the highest rate currently at 40%.  Her proposal would increase this maximum rate up to 45%.  She would also propose additional rates on extremely large estates, up to 65% for estates that exceed $1 Billion.  There are 1 or two additional brackets, but her site did not provide specifics.

Note – the current amount excluded from estate taxation is $5.43 million.

Is this even an issue that should be discussed?  According to the Tax Foundation, Estate taxes provide a little over 1/2% of Federal tax revenues.  As you can see from the chart below, this is not a huge portion of the current federal tax receipts.  In 2014, of the $3 Trillion in federal tax receipts, the estate tax represented $19.3 Billion.

Government Tax Sources
Estate and Gift taxes amount to less than 1% of Federal Government taxes.

While this tax might not be significant today, we can all concede that the US demographic profile is aging much in the way that Japan started to age a decade ago.  Last year, CNBC did a piece on the coming ‘Biggest Wealth Transfer in History‘, which speaks directly about how much money is currently held by high net worth individuals and how much it could mean to government receipts.  The article talks about $16 Trillion in assets that could get transferred to the next generation of individuals — so we are talking about a lot of money in the future.

Let’s take a look at how this works in reality.  Let’s assume (right now) that an individual passes away with $3 million in assets.  Today as well as with both candidates proposals these assets will transfer to the recipients tax free.  Let’s assume that the estate included invested assets, accumulated over their lifetime, worth $2.5 million and a home worth $500,000 that Mom & Dad paid $50,000 for back in 1975.  There’s an important term when talking about taxes that needs to be understood and that is ‘basis’.  Before I continue, just a word about this term ‘basis’.  The term basis refers to the cost of something that you will have to pay taxes on at some point in the future.  In the example above, the amount paid for the house ($50,000) is the ‘Tax Basis’ of the house.

When the estate described above gets passed to the next generation, the tax basis becomes the value of the asset upon death.  This is referred to as ‘stepped up basis’ according to IRC 1014(a).  [IRC is an Internal Revenue Code.]  So in the example above, the new tax basis for the recipients of the estate becomes the $2.5 million in investments and the $500,000 in the home.  In this example, it’s important that I described the invested assets as ‘accumulated over their lifetime’ as this indicates that the actual amount invested is likely to be far less than this amount due to the very nature of investing.  Let’s presume that for the purposes of the discussion that follows, the tax basis of these investments in $1 million.

Both candidates would exclude the value of all of these assets from the Estate Tax.  But now let’s look at the party statements about taxes in general and the estate tax specifically.  Were the estate taxes in fact already taxed?  Not really.  Did this estate pay its fair share – according to the provisions in the estate tax rules, yes, they paid nothing.  Was the income that the estate generated taxed?  No it wasn’t.

In this instance, the estate had a tax basis of $1,050,000 in assets that are worth $3,000,000, which means that there’s real income of $1,950,000 that was never taxed and can pass to the next generation completely void of taxes.  An alternate proposal would be to treat the death of the individual described above as a sale of these assets, with the proceeds passing to the next generation.  The house described above would be allowed to pass to the next generation tax free if both parents passed away in the same year, this is because $250,000 of profit, per person is excluded from taxes, $500,000 per couple.  If the house was originally owned by a couple this proposal would allow the full $500K to pass to the next generation tax free — in this case $450,000.

This leaves the question of the remaining $1,500,000 in appreciated invested assets that the estate would need to deal with.  Looking at the party positions, this amount should really be subject to some tax.  The increased value of the assets have not been previously taxed and never will be due to the aforementioned ‘stepped up basis’.  If you are looking for this estate to ‘pay its fair share’ then there should really be some kind of tax on this asset transfer.  If the transfer were to be viewed as a sale of the invested assets, then the $1.5 million should be subject to a capital gains tax of some kind.  Today, the maximum long-term capital gains tax sits at 20% with the majority of tax brackets subject to a 15% tax (if your income exceeds $37,000).

Would I be happy if I were the sole recipient of this $1.5 million and had to give the government $225,000, no.  Would I be happy that i was the recipient of $1,275,000 – you bet I would.  Thankfully I’m not a politician and I really don’t have to come out with a proposal, but if everyone was really being honest in this whole tax debate, this is a scenario that would, should or could get proposed.  The reality is that something far less than this would be the only thing that would be palatable to the populace by the time the news media fed into the political statements and we all got confused over what was being said.


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