Tax & Business Insights

The Basis of Death?

Volume 13 Issue 1 --  January/February 2001

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.

Let’s 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 painting’s 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 § 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 purposes.

In 1976, a much worse scenario was briefly created and fortunately repealed in 1980.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. Let’s go back to X-pired’s 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 § 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 § 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.

Isn’t 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 now.

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.

Copyright 2001
By Tax and Business Professionals, Inc.
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