The United States Estate Tax: Demonized by the Public on Behalf of the Few
Sadie R. McCorkle, KLJ Articles Editor[1]
The United States estate tax[2] is arguably a hated tax convention. Pejoratively referred to as a “death tax,” its detractors characterize it as the ultimate in government greed: capitalizing on death by harming mourning heirs by depriving them of property.[3] In reality, the estate tax is a “tax on your right to transfer property at your death.”[4] Donald Trump used the estate tax as a scapegoat during his presidential campaign, promising to repeal it upon his election.[5] “Double taxation,” he called it.[6] “[A] lot of families go through hell over the death tax.”[7] Supporters—both in the government[8] and among ordinary voters[9]—praised the possibility. “For too long, this tax has threated family owned businesses—including women and minority-owned business—from being passed down to their children and grandchildren,” wrote one.[10] But an analysis of the policies behind the estate tax, as well as the realities of its impact on taxpayers, suggest that much of the outrage over a ‘death tax’ is due to public misconception about who is even impacted, as well as the alternative being proposed by President Trump.
The estate tax is by no means a recent phenomenon.[11] The modern version of the tax was created in order to help fund World War I in 1916.[12] Since then, the tax’s form has fluctuated, experiencing both tax rate cuts and spikes, changes to the portion of the estate ultimately taxable, and even repeal and reinstatement.[13] Today, it supplies relatively little income to the government—less than one percent of federal revenue in 2014.[14] Though this percentage was small, however, the revenue raised by the estate tax in 2014 was $19.3 billion—certainly a significant amount of money.[15]
Two forces work against the estate tax in the public’s mind: belief that it impacts hard-won small businesses, and belief that a possibility exists it will apply to the average American when he or she becomes a one-percenter. Efforts to demonize the tax gained momentum in the 1990s, when advocates realized that “the working rich, not the idle rich, had to become the poster children of the movement.”[16] Carefully, those advocates garnered public support for “ordinary people who had worked hard all their lives to build a nest egg about to be smashed at their death . . . . [Advocates] worked hard to ensure that the public would see the estate tax as a small- and medium-sized business issue”[17] Negative public perception persists today, and repeal is a popular Republican political platform.[18]Interestingly, despite widespread misconception about the amount and character of the populace affected—“the wealthiest 0.2%” of Americans who die every year[19]—some Americans also see the estate tax as a tax threatening who they could be.[20] The American dream has been, and continues to be, to become extremely wealthy. Americans “have underestimated the levels of inequality, overestimated their own wealth compared to others, and exaggerated their likelihood of moving up significantly and getting rich.”[21] Therefore, part of the American public resents the possibility of what they do not yet have being possibly taken away.In 2017, the tax applies only to individual estates worth more than $5.49 million because of a lifetime exclusion (the Unified Credit Against Estate Tax).[22] When a taxpayer is married, that number is $10.98 million, reflecting both spouses’ lifetime exclusion put together.[23] This number represents an exemption, not a cliff: none of the estate under that number will ever be taxed by the estate tax.[24] When estates are worth more than the exempted amount, only the excess worth—above $5.49 million for individuals—will be taxed, not the entire estate.[25] Numerous other exemptions exist, testament to the complicated nature of the tax code in general.[26]Estate assets over the threshold are taxed at 40%.[27] This percentage is ostensibly a high one, representing forty cents per every dollar over $5.49 million. However, the rate that is ultimately experienced differs from estate to estate, because of the amount of the estate initially exempted from any taxation whatsoever.[28] The closer the estate’s value to the threshold of the exemption, the lower the effective tax rate paid by the taxpayer.[29] The effective tax rate is the amount of tax paid compared to the amount of property potentially taxable. For example, an estate whose included assets total $6 million would be taxed at 40% on $0.51 million, paying a total of $204,000 in taxes. That estate’s effective tax rate is actually only 3.4%, despite the statutory tax rate of 40%. The average effective rate of the estate tax was 16.6% in 2013.[30] The greater the assets of the estate—up and away from the lifetime exclusion—the nearer the effective tax rate is to the statutory 40% rate. In the end, those who are extremely wealthy have a greater reason to worry about the tax than most average Americans.[31]There are three final benefits related to the estate tax. First is the fact that a taxpayer can leave his or her entire estate to a spouse, tax free.[32] There is no cap to this benefit, ensuring that the surviving spouse is not impacted by the tax until his or her own death.[33] Second, the surviving spouse can elect to use the unused portion of his or her deceased spouse’s lifetime exclusion, tacking it on to the surviving spouse’s eventual lifetime exclusion.[34] For example, if A died and left an estate worth $1 million to her spouse, B, B could elect to use the entire $5.49 million of A’s lifetime exclusion when B dies, giving B a $10.98 million exclusion upon death.[35] Finally, those who inherit the estate are eligible for stepped-up basis in any property received.[36] Basis represents the tax system’s method of keeping track of net versus gross profits: it typically represents the amount someone has invested in a piece of property, and only the amount of income that he or she realizes and recognizes over that basis amount is taxed.[37] If, by contrast, that person were to die without selling the property, inheritors receive the property with a new basis: the fair market value at the time of the person’s death.[38] For example, if A had purchased a piece of property for $5 and died when that property was worth $10, B would receive the property with a new basis of $10. If B chose to sell the property immediately, he would do so without having to pay any tax—a tremendous benefit to the heir.Finally, many laws have foundational policy elements, in that those who enact them want the laws to have some effect on society beyond mere compliance.[39] Tax law is no exception. As stated above, the estate tax is actually a tax levied on the power each person possesses to say where his or her property will (or will not) go after his or her death.[40] This power is a formidable one. Before death, people can influence the behavior of those around them who hope to inherit. After death, the power to dictate where property goes can be similarly influential: within limits, people can even transfer property subject to conditions placed upon the still living.[41] So few estates are even taxed, however, that most Americans enjoy the privilege of saying where their property goes upon death without any tax consequence except the huge benefit of stepped-up basis.Additionally, the estate tax encourages wealth redistribution, because people naturally try to divest themselves of assets when faced with paying the government anything, even after their death. Despite popular thought, wealth redistribution usually describes “the flow of assets up from the poor to the rich.”[42] “[The] United States enjoys both growing poverty and a shrinking middle class.”[43] A common theme to upward wealth distribution is the idea of being wealthy itself: “the affluence of the few supposes the indigence of the many.”[44] This can also be seen in the idea of social trust: that contributing to a common pool (taxes) will contribute to social aid.[45] The United States has low social trust, and part of the reason is “the polarization in wealth and decline in social mobility.”[46] Lower social trust is reflected in the public’s general unwillingness to contribute to a common pool, based upon beliefs that their money is being taken to support the unworthy.[47] “When people don’t trust their governments and their fellow citizens, who would be excited to contribute to the financial commons—taxes?”[48] Therefore, part of the policy behind the estate tax is to encourage downward wealth distribution, by encouraging reallocation, before or after death, of potentially huge estates.[49]A final note should be made about President Trump’s plan to repeal the estate tax: he plans on making a second change to the end-of-life tax system by eliminating stepped-up basis.[50] “[W]ith no estate tax, beneficiaries would instead pay capital gains taxes based on the original cost—the share price grandma and grandpa paid for their AT&T stock when they bought it decades ago . . . .”[51] An initial problem with this idea is the difficulty taxpayers and the IRS will have in ascertaining what the initial basis even was for many properties, especially ones held for generations.During his campaign, President Trump also said that “the first $10 million” would be “tax-free,” although it is unclear what exactly this means.[52] “Without providing details, the Trump plan calls for retaining a step-up on assets roughly [equal to] the amount of the current [estate] tax exemption . . . .”[53] It is unknown whether this capital gain tax on estate assets would be owed at time of death, or later, when heirs sell the estate property. Practically speaking, the latter should be the case, or the tax would “force survivors to liquidate family businesses, farms and homesteads in haste”[54]—the same concerns many express about the consequences of the estate tax. However, if this were the case, taxpayers would have little incentive to divest themselves of any of their property. They could simply hold it forever, and very well might. Therefore, though the potential changes to the system are by no means clear or set in stone, President Trump’s plan might look a lot like the current system, simply with a better tax rate for the wealthy taxpayers impacted.In conclusion, the estate tax is not quite the ravager of small- and medium-sized businesses its critics make it out to be. Public opinion of the tax has been manipulated repeatedly by preying on natural, American indignation at property being taxed upon death, but much of that public anger seems to be on behalf of the extremely wealthy—because nearly all Americans are not currently impacted by the tax. Policies behind the tax echo in property and economic interests, with strong encouragement to spend rather than pay the government—for example, by giving to charity, or giving gifts. Repeal has been a popular promise, but President Trump’s plan is not so far from the current system—just a different name for what ultimately may impact many people in the same way. Nevertheless, it is important to understand who exactly has a reason to really hate the estate tax right now: “mainly . . . the very wealthy who are passing on stock portfolios that have never been subject to capital gains taxes.”[55][1] J.D. expected May 2018.[2] See generally I.R.C. ch. 11 (2012).[3] See Glenn Kessler, Is the Estate Tax Killing Small Farms and Businesses?, Wash. Post (April 14, 2015), https://www.washingtonpost.com/news/fact-checker/wp/2015/04/14/the-facts-about-the-estate-tax-and-farmers/?utm_term=.cd1f17e7712e.[4] Estate Tax, IRS (last updated Oct. 28, 2016), https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.[5] Jessica Dickler, Who Wins if Trump Repeals the Estate Tax?, CNBC (Nov. 21, 2016, 8:30 AM), http://www.cnbc.com/2016/11/21/who-wins-if-trump-repeals-the-estate-tax.html.[6] Id.[7] Id.[8] See id.[9] See, e.g., Scott Adams, Why I Switched My Endorsement from Clinton to Trump, Scott Adams’ Blog (Sept. 25, 2016 12:41 PM), http://blog.dilbert.com/post/150919416661/why-i-switched-my-endorsement-from-clinton-to.[10] Dickler, supra note 5.[11] Michael J. Graetz, “Death Tax” Politics, 57 B.C. L. Rev. 801, 801 (2016).[12] Id.[13] Id. at 801-11.[14] Andrew Lundeen, The Estate Tax Provides Less than One Percent of Federal Revenue, Tax Found. (April 7, 2015), https://taxfoundation.org/estate-tax-provides-less-one-percent-federal-revenue/. Compare this to the individual income tax, providing 46.2% of federal revenue in 2014. Id.[15] Id.[16] Graetz, supra note 11, at 805.[17] Id.[18] Id. at 811.[19] Id.[20] See id. at 807.[21] Id.[22] Rev. Proc. 2016-55, 2016-45 I.R.B. 707. The Unified Credit Against Estate Tax applies to the estate at death, but also encompasses gifts made during the lifetime of the deceased. Kay Bell, Estate and Gift Tax Exemption Amounts for 2016-17, Bankrate http://www.bankrate.com/finance/taxes/estate-tax-and-gift-tax-amounts.aspx (last updated Jan. 10, 2017). The credit can be used during life to offset gift taxes, but the amount available to reduce the estate tax upon death will be reduced. Id.[23] Ashlea Ebeling, IRS Announces 2017 Estate and Gift Tax Limits: The $11 Million Tax Break, Forbes (Oct. 25, 2016, 2:33 PM), http://www.forbes.com/sites/ashleaebeling/2016/10/25/irs-announces-2017-estate-and-gift-tax-limits-the-11-million-tax-break/#36ff156e43fa.[24] Chye-Ching Huang & Chloe Cho, Ten Facts You Should Know About the Federal Estate Tax, Ctr. on Budget & Pol’y Priorities, http://www.cbpp.org/research/federal-tax/ten-facts-you-should-know-about-the-federal-estate-tax (last updated Sept. 8, 2016).[25] Id.[26] See id. It is worth noting that a major issue exists regarding the valuation of estates: wealthy taxpayers have been limited partnerships as holding mechanisms for their property, and transferring their interests in the partnership itself upon death. Brant J. Hellwig, Estate Tax Exposure of FLPs Under Section 2036, 38 Real Prop. Prob. & Tr. J. 169, 172-77 (2003). Because of the closely held nature of the partnership, no real market exists to establish a fair market value for the interest being transferred, allowing taxpayers to essentially say what their interest is worth. Id. They then have a claim that their estate is worth significantly less than it would be if the property had not been transferred to the limited partnership to begin with. Id.[27] I.R.C. § 2001 (2012); see also Ebeling, supra note 23.[28] Huang & Cho, supra note 24.[29] Id.[30] Id.[31] See id.[32] I.R.C. § 2056 (2012); see also Frequently Asked Questions on Estate Taxes, IRS, https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-estate-taxes#5 (last updated Jan. 6, 2017).[33] See Frequently Asked Questions on Estate Taxes, supra note 32.[34] I.R.C. § 2010(c) (2012).[35] The exemption B can use can actually be higher than it was when A died, because the exemption goes up with inflation.[36] I.R.C. §1014 (2012).[37] Topic 703 – Basis of Assets, IRS, https://www.irs.gov/taxtopics/tc703.html (last updated Jan. 10, 2017).[38] Publication 551 – Main Content, IRS, https://www.irs.gov/publications/p551/ar02.html#en_US_201612_publink1000257012 (last visited Feb. 17, 2017).[39] See Public Policy, Black’s Law Dictionary (10th ed. 2014).[40] Estate Tax, supra note 4.[41] Mary Randolph, Conditional Gifts in Wills and Trusts, NOLO http://www.nolo.com/legal-encyclopedia/conditional-gifts-wills-trusts.html (last visited Feb. 17, 2017).[42] Beverly Moran, Wealth Redistribution and the Income Tax, Howard L.J. 319, 320 (2010) (“As tax from truck drivers and teachers went to bail out American International Group (A.I.G.) and Goldman Sachs, twenty-five hedge fund managers received more in combined annual salary than the gross domestic product of Costa Rica, Iceland, Jordan, or Uruguay.”).[43] Id. at 321.[44] Id.[45] Lixing Sun, How America Hates Socialism Without Knowing Why, Evonomics (June 16, 2016), http://evonomics.com/america-hates-socialism-without-knowing/.[46] Id.[47] Id. See also Tami Luhby, Why So Many People Hate Obamacare, CNN Money (Jan. 6, 2017 10:45 AM), http://money.cnn.com/2017/01/05/news/economy/why-people-hate-obamacare/ (“[Yet] another entitlement program that uses hard-working taxpayers’ money to help lazy, undeserving people.”).[48] Sun, supra note 45.[49] Moran, supra note 42 at 322.[50] Allyson Versprille, Trump Plan Repeals Estate Tax, Scraps Capital Gain Benefit, Bloomberg BNA (Sept. 20, 2016), https://www.bna.com/trump-plan-repeals-n57982077269/.[51] Dickler, supra note 5.[52] Versprille, supra note 50.[53] William Baldwin, Tax Strategies for the Trump/Ryan Plan, Forbes (Dec. 14, 2016, 9:57 AM), http://www.forbes.com/sites/baldwin/2016/12/14/tax-strategies-for-the-trumpryan-plan/#4fb8a4b03c84.[54] Id.[55] Kessler, supra note 3.