As part of his new tax plan, the president has proposed ending the “step-up” in tax basis for inherited assets, and, furthermore, requiring the capital gains tax to be paid at death rather than when an heir later sells the assets. There would be an exception for surviving spouses, with no taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. due until the death of the second spouse, and an exemption for the first $200,000 of gains for a couple.
The step-up in basis has been libeled as some form of tax “loophole” for trust fund babies or the undeserving rich. These criticisms have generally been based on a misunderstanding of how estates are taxed, how the step-up works, why it exists, and how it affects the economy.
Eliminating Stepped-up Basis Would Create an Additional Tax on Estates
The step-up in basisThe step-up in basis provision adjusts the value, or “cost basis,” of an inherited asset (stocks, bonds, real estate, etc.) when it is passed on, after death. This often reduces the capital gains tax owed by the recipient. The cost basis receives a “step-up” to its fair market value, or the price at which the good would be sold or purchased in a fair market. This eliminates the capital gain that occurred between the original purchase of the asset and the heir’s acquisition, reducing the heir’s tax liability. is no loophole. The step-up is needed to prevent double or triple taxation of the same assets. Without it, the president’s plan could result in a 68 percent tax rate on capital gains upon death (the inheritance would be taxed at the 40 percent estate tax rate plus the proposed 28 percent tax rate on capital gains).
Ending step-up would be bad tax policy. It would surely harm capital formation and reduce wages and employment, and would ultimately lose revenue for the government.
Under current law, when assets are inherited, any gains built up during the decedent’s life are “forgiven,” and the heir’s cost basis in the asset is “stepped up” to the value of the asset as of the date the decedent died (or, alternatively, the date when the property was received by the heir). If the heirs sell the asset immediately, there would be no capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. . If the heirs defer the sale of the asset, a capital gains tax would be paid when the asset is sold, but only the gain above the stepped-up basis since the inheritance.
Eliminating the “step-up in basis” for heirs when assets are inherited could trigger two taxes on the same assets: the estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. on the total value of the assets, and the capital gains tax on any gains embedded in the value of the assets. The purpose of the current-law step-up is to prevent the assets in the estate from being subjected to both the estate tax and the capital gains tax. The estate tax rate (40 percent) is generally the higher rate. Estates subject to tax (those with assets over the $5,430,000 amount exempted by the unified estate and gift tax credit) pay the 40 percent tax on the excess over the exempt amount. If the step-up is eliminated, that portion of the estate would be hit twice. If the President’s proposal to raise the top capital gains tax rate to 28 percent were adopted, the top combined federal tax rate on the gains would be 68 percent.
To avoid the double tax, the taxed capital gain portion of the estate would have to be exempt from the estate tax, or a double tax would apply. The President’s plan does not appear to afford that protection. It excludes up to $200,000 in gains in the estate from the capital gains tax, but subjects all the gains to the estate tax. It seems to assume that people should have taken their gains while living and then paid the estate tax in full, as if deferring capital gains were a loophole in itself. [1]
Eliminating Stepped-Up Basis Would Create a New Estate Tax
Ending the step-up would also impose the capital gains tax on heirs of smaller estates that are currently exempt from tax. In effect, assets up to $5,430,000 that are now protected from the estate tax by the credit, and currently owing neither the estate tax nor the capital gains tax, would become subject to the capital gains tax or, a new estate tax. To avoid hitting these smaller estates, there would need to be a much larger exempt amount for the gains. If a $5 million estate contains $3 million in capital gains, the proposed $200,000 exemption is hardly giving the same protection as current law.
The president’s fact sheet dismisses this problem by saying that gains are a small share of most estates, and most would be protected by a $200,000 exclusion. But for estates with large gains, this would be a large problem. One could imagine two estates of the same size, one with small gains and one with large gains, paying two very different tax bills.
Eliminating step-up can lead to serious administrative and compliance issues if the heirs do not know the decedent’s cost basis of their portion of the estate. These concerns are a big reason why an earlier plan to end stepped-up basis, during the Carter Administration never went into effect.
Capital gains taxes depress capital formation by discouraging saving and raising the cost of plant and equipment. This new tax on inherited capital gains would raise money in the first few years by taxing existing assets, but over time, people would respond by saving less and creating less capital. That would eventually reduce GDP and total federal revenue from all sources due to the adverse effect on capital formation, wages, and employment. Long term, the provision would therefore provide no new revenue to pay for the middle income tax breaks the President is offering.
The Estate Tax Already Taxes a Dollar Multiple Times
There is a more fundamental issue that should be noted. The estate tax is always multiple taxation, even when capital gains are not present. Every penny in an estate has been, or will be, subject to the income tax. To tax the assets again with the estate tax is multiple taxation.
Ordinary Assets
Most assets in a typical estate were purchased with after-tax money, and are not in a tax–deferred retirement plan. The subsequent earnings of these ordinary savings were also subject to the income tax, as interest, dividends, or realized capital gains. In the case of corporate stock, the income was also taxed at the corporate level. These added layers of personal and corporate income taxes are double, or even triple taxation that applies to income that is saved (but not to income that is used for consumption).
Pensions and retirement arrangements were established to offset some of this tax bias against saving in favor of consumption under the ordinary income tax. The estate tax is yet another layer of tax applied to the savings, and can be a third or fourth hit on the same income.
Tax-Deferred Savings
Some assets in the estate may be in regular tax-deferred IRAs, 401(k)s, or other tax-deferred retirement plans, and have not yet been hit with the personal income tax. When an heir inherits these tax-deferred plans, he or she must begin withdrawing the funds and paying income taxes on them the next year. The heirs cannot continue the deferral of the tax.[2] Even tax-deferred retirement plans do not escape tax in the end.
The old saying is that nothing is more certain than death and taxes. In the case of the estate tax, this is literally true, regardless of what types of assets and accounts the decedent acquired. Step-up in basis is only a partial offset to several layers of tax that the savings in an estate have had to pay. Step-up should be retained as good tax policy and good policy for growth and job creation.
[1] Taxing capital gains as they accrue, instead of deferring them until the assets are sold, has long been the desire of the advocates of a “pure” Haig-Simons income tax. It would have a devastating effect on capital formation and wages.
[2] In a Roth IRA, the savings are built on contributions of after-tax money, and are therefore not subject to further taxation, including on any capital gains earned in the account. (However, the heir to an inherited Roth IRA must begin to make distributions from the account. These distributions are not taxed, but any future earnings on distributions kept as ordinary savings will be taxable.) The step-up in basis for small estates not otherwise subject to the estate tax provides a Roth-type exemption of the tax on the gain. It could be considered as giving additional Roth protection to people who never cashed out their savings, but instead left them at work creating jobs and higher wages for the rest of the country.