By Olen M. "Mac" Bailey, Jr.

Does the repeal of the federal estate tax in 2010 mean that the "death" tax is "dead"? To play the devil's advocate, let's say NO and examine why the answer may be "not yet."

Loss of Stepped-Up Basis

The statistics are clear and the media is quoting them without hesitation: The federal estate tax affects ONLY two percent (2%) of people who die each year. The affect is only 2% due to the facts that the first $2,000,000 (2007) (increasing to $3.5 million by year 2009) of a decedent's assets are 100% exempt from estate taxes and that the estates of the majority of people who die each year do not exceed the exemption amount. Therefore, if logic prevails, after the estate tax is repealed, 0% of people who die each year will be affected by a "death" tax. YES, but probably NOT.

Under the current estate tax law, when a person dies (a decedent), the decedent's assets are appraised as of the date of death to determine their fair market value (FMV). Beneficiaries or heirs who inherit these assets receive a "stepped-up" tax basis equal to that FMV. If the beneficiary sells the assets for an amount equal to or less than that FMV, then the beneficiary owes NO capital gains tax on the sale. For example, grandparents paid $100,000 for a tract of land many years ago. Grandparent's basis for capital gains purposes is $100,000. The FMV of the land is $2,000,000. If grandparents sold the land while they were alive, then they would owe $285,000 in capital gains tax [($2,000,000 minus $100,000) x .15]. However, if the second to die of the grandparents dies in 2010 and leaves the land to the grandchildren and the FMV of the land at the grandparent's death is $2,000,000, then the grandchildren's tax basis is "stepped-up" to the FMV, i.e. from $100,000 to $2,000,000. If the grandchildren sell the land for $2,000,000, then the grandchildren owe NO capital gains tax.

The repeal of the estate tax in 2010 is coupled with the repeal of the "stepped-up" basis at death. Therefore, the grandchildren's basis in the land for capital gains tax purposes will be $100,000. If the grandchildren sell the land for $2,000,000, then the grandchildren will owe NO estate taxes but will owe $285,000 in capital gains tax.

To recap, if grandparents die in 2007, then the grandchildren pay NO estate tax (assuming a $2,000,000 estate tax exemption) and NO capital gains tax (100% "stepped-up tax basis). Therefore, in 2007 when the estate tax is still effective, the grandchildren's net inheritance would be $2,000,000.

If grandparents die in 2010, then the grandchildren ALSO pay NO estate tax (estate tax completely repealed). However, the grandchildren will owe a capital gains tax of $285,000 when they sell the land.

Based on this scenario, the percentage of persons affected by a "death" tax may be more than 2% after the estate tax is "repealed."

10 Years Is A Long Time

The repeal of the federal estate tax is being phased in over a ten (10) year period with the full repeal not effective until January 1, 2010. For certain elder Americans, waiting 10 years may be the same as no repeal. For younger Americans, there is no guarantee that anyone will survive until 2010.

Furthermore, ten (10) years is a long time in political years. During that 10 years, there will be two (2) new Presidential Elections, a majority of the Senate seats challenged and a hundred plus House districts subject to change. What is the possibility that the new estate tax repeal may be extended, amended, modified or, yes, even repealed?

History may provide part of the answer. The current estate tax would be the fourth (4th) estate or death tax enacted, and then repealed by Congress.

The first was established in 1797 and abolished in 1802.

The second was enacted in 1862 and repealed in 1870.

The third was enacted in 1898 and abolished in 1902.

The fourth (our current estate tax) was introduced in 1916 (and repealed in 2010). Furthermore, since 1986, a plethora of amendments to the tax code (and regulations) have been the hallmark of most congressional legislative sessions.

The future may provide the rest of the answer. The repeal of the estate tax will result in a reduction in federal revenues. The economical justification for this reduction is the projected federal budget surpluses and decreased or stabilized Congressional spending. However, if the U.S. experiences a downturn in the economy (which some economists argue is occurring as you read this article), then the projected federal budget surpluses may be reduced, or even eliminated entirely. Furthermore, dependent upon the party make-up of Congress and inflation, government spending may increase, not decrease. If the surpluses are reduced or eliminated and/or if governmental spending increases, then new (or revived, yet previously repealed, old) taxes may be required to offset the reduced surpluses and/or increased spending. A new estate tax may be one of those taxes.

The Rate Game

Under the current estate tax law, estate tax rates range from 18 to 45 percent (2007) with the actual, initial effective rate being 37% on amounts in excess of the $2,000,000 exemption. The current "repeal" is an estate tax phase-out, NOT a repeal, which means the estate tax will remain in effect until January 1, 2010, with modest decreases in the rates each year for the next 10 years. For example, from 2001 to 2006, the top tax rate was reduced from 55% to 46%. From 2006 to 2007, tax rates are reduced another percentage point to 45%. In other words, from 2001 to 2009, the top rate of 55% is reduced by ONLY 10 percentage points, resulting in a still significantly high, top tax rate in 2009 of 45%. Finally, in 2010, the rate is reduced to 0% and the estate tax is eliminated completely.

This "rate game" raises the question: Why didn't Congress completely repeal the estate tax effective July 1, 2001? The uniform congressional response is that the U.S. government could not afford an immediate repeal. If we could not afford a repeal in 2001, then how and why can we afford a complete repeal in 2010? Once again, the congressional response is that current and future federal budget surpluses and decreased or stabilized federal spending over the next 10 years will permit the affordability of the estate tax repeal. This response, by its own admission, assumes that the federal budget surpluses will offset the loss of revenue from the repealed estate tax and that federal spending will be flat or decrease. This response may or may not have considered the factors of probable inflation, possible decreased economic growth and the passage of President's Bush plan to reduce federal income taxes. If one or more of these factors occurs, then we may not be able to afford the estate tax repeal in 2010, no more than we could have afforded the repeal in 2001.

Impact on the States

Internal Revenue Code Section 2011 provides for a CREDIT against the federal estate tax for any estate or inheritance taxes paid to any state or to the District of Columbia. The amount of the credit is determined by the State Death Tax Credit Table and ranges from a minimum of .8% to a maximum of 16% of a decedent's Adjusted Taxable Estate. This credit is called the State Death Tax Credit or "Pick-Up" Tax.

All states impose some form of estate or inheritance tax. Thirty-five (35) states (including Tennessee) specifically impose a "Pick-Up" estate tax to take advantage of the maximum allowable state death tax credit. In such states, the revenue from the credit is paid directly to the state but the payment does not increase the estate taxes paid to the federal government. Therefore, the repeal of the federal estate tax would eliminate this form of revenue sharing between the federal and state governments and thereby result in a loss of state revenues, unless the states take affirmative actions, i.e. new legislation, to impose and collect the "credit" themselves.

The State of Tennessee collected $7,601,729 in estate and inheritance taxes for the single month of January 2001. Do we really expect the states to simply "give-up" this revenue source?

If the federal estate tax is repealed, one of two scenarios will result: (1) the states will enact new estate tax laws and collect the revenues themselves; or (2) the states will NOT enact new estate tax laws and collect the revenues from another existing or new tax source.

If the states enact new estate tax laws, then the new state estate tax rates may be the same as the state death tax credit, or the new rates may be higher and more similar to the repealed federal estate tax rates.

If the states do NOT enact new estate tax laws, then other taxes will more than likely be imposed or increased to cover the loss of revenues.

Either way, there will probably be more taxes at the state level to make-up for the loss of the "pick-up" estate tax.

* Internal Revenue Service, Federal Estate Tax Returns, 1995-1997 & 1998.