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Is This The Beginning Of The End?

Here are some odds you can’t find in Las Vegas: There is a better-than-even chance, in my opinion, that U.S. estate and gift taxes will be repealed by the year 2010. Not just eased, as under last year’s tax law, but completely wiped out.

The foundation for repeal has already been laid, partly by the 1997 legislation but more so by changes in the economy, by public attitudes toward wealth and entrepreneurship, and even by the financial perils of Social Security. The logistical problems of the Internal Revenue Service also point toward repeal.

The point of this column is not just to persuade you that the days of the wealth transfer tax are numbered. I want to convince you that the estate planning we do today already should reflect the possibility of repeal. We should ask ourselves whether the steps we are taking to reduce the bite of these taxes will still look good, or at least acceptable, if the taxes go away.

The Achilles heel of virtually all tax planning is that we assume today’s law will be the law in the future. This is often disastrous. Ask anyone who bought a tax shelter in the early 1980s that was gutted when the 1986 Tax Reform Act curtailed deductions and slashed income tax rates. Or ask someone who pulled money out of Individual Retirement Accounts in the early 1990s, sacrificing decades of tax deferral to avoid potential application of a 15% “success tax” that was repealed last year.

None of us has a crystal ball, but that ought not stop us from playing the percentages. Tax law does not change randomly. It changes only to the extent political and economic forces make it change. By studying these forces we can get an idea of the future direction of the tax system, and we can avoid wasting time on proposals, such as replacing the income tax system with a national sales tax, that are non-starters.

Writing On The Wall
The forces pointing toward repeal have been building for years, but it was the 1997 tax legislation that put the writing on the wall. By raising the lifetime tax-free exemption amount from $600,000 to $1 million (to be phased in by 2006), and by indexing most of the law’s provisions for inflation beginning next year, Congress rejected calls to expand the wealth transfer tax (as gift, estate and generation skipping transfer taxes are known) and ensured that it will never be a significant source of federal revenue. The tax presently accounts for barely more than 1% of all federal tax collections.

Congress also provided new, additional exemptions to family farms and closely held businesses, but only if the transferor’s family continues to operate the business for at least a decade. This will greatly complicate succession planning for many small enterprises whose owners want to provide for their heirs, but who realize that the heirs may lack the inclination or skill to maximize the long-term value of the business. Moreover, the value of these new tax breaks will automatically diminish through 2006 as the universal tax-free amount rises toward $1 million. This ensures that lawmakers will have to revisit the entire issue in the fairly near future.

Most importantly, however, Congress decided that there should be a universal income tax exemption of $250,000 ($500,000 for married couples) for homeowners who sell their dwellings. There is also, under current law, an unlimited income tax exemption for appreciated assets that are held by a decedent — the famous “basis step-up at death.”

These provisions have nothing directly to do with gift and estate taxes, but they provide a basis for a compromise that would make the wealth transfer tax extinct. To pay for eliminating the wealth transfer tax, Congress can end the basis step-up at death, or limit it to a fairly small amount of assets. That limit could be coordinated with the sale-of-residence tax exemption so that, for example, a couple who twice excluded the maximum $500,000 gain on home sales would get no step-up, while heirs of a couple who had never claimed the residence exemption might be allowed to avoid tax on $1 million of gains in securities.

This is where Social Security comes in. Any feasible approach that seeks to save Social Security, or any attempt to phase it out in the course of the 21st Century, will have to rely on individual Americans to save and invest more. This privatization will run into great resistance when people realize that if they succeed in accumulating substantial wealth but die before enjoying it, the government will reap an estate tax windfall. After all, the value of unreceived Social Security benefits does not count in the estate of someone who dies young and wealthy. How will Congress justify giving special breaks to the families of business owners and farmers while everyone else’s retirement investments are subject to estate tax?

Help For The IRS
Gift and estate taxes are an administrative nightmare for the IRS. Some studies, in fact, suggest that after considering enforcement costs and the disincentives for wealthy citizens to retain and generate still more taxable wealth, these taxes may not net the Treasury any revenue at all. Yet the Service must devote an increasing share of its resources to protecting the integrity of the transfer taxes.

At the most basic level, enforcement is difficult because gifts and bequests are, by nature, private and non-commercial transactions. The reporting and audit trail that helps keep the income tax system honest is not present. I am sometimes asked, “How will the IRS know?” I always reply, “Because we are honest citizens and we are going to tell them.” It is safe to assume that the people who will not accept that kind of answer are not asking this question of advisers like me.

Moreover, the wealth transfer tax demands that taxpayers and enforcers alike know the unknowable — namely, the “fair market value” of property, such as a stake in a closely held business, for which there is no ready market. This has generated a decades-long war between the IRS and planners over “estate freezes” and, more recently, over family limited partnerships and other structures that depress the taxable value of the property our clients transfer.

While nobody can accuse our income tax system of being simple, it does, in most cases, look at real transactions. We can know the amount somebody received and we can compute, under prescribed rules, the taxable profit element of those receipts. This is not true for wealth transfer taxes, which are based on hypothetical estimates of value in the absence of real buying and selling. I believe this is a fundamental flaw that will undermine gift and estate taxes no matter what new rules are layered on.

Who Loves You, Baby?
Repeal of the wealth transfer tax will hardly be an easy or one-sided debate. Historically, these taxes have been seen as a way to break up “unhealthy” concentrations of family wealth, and as a backstop to tax gains missed by the income tax system, such as unrealized capital gains at death. The class-struggle argument, however, had much more resonance in the days when stocks, bonds and other wealth were held by a tiny minority while the masses struggled to buy food and pay rent.

With the spread of 401(k) plans, mutual funds and stock options, most American families hold at least a bit of financial wealth and aspire to more. Do you suppose anybody mutters “capitalist pig” when Warren Buffet drops in on a McDonalds in Omaha?

The life insurance industry, which has latched onto the estate tax as an important sales tool, probably will not be happy to see it go, but this industry is struggling to keep its own income tax breaks and has bigger legislative fish to fry. Of course, certain lawyers and other estate planners (your correspondent among them) will also have to turn to more productive work when the law no longer makes it easy to propose a six-figure tax-saving strategy after just 15 minutes of conversation with a new client.

Perhaps the biggest losers in transfer tax repeal would be the community of charities, who derive an estimated $10 billion a year from charitable bequests alone. This is only one-fifteenth of all charitable giving, but it ain’t beanbag. While it may take some time, I suspect charities will ultimately resign themselves to the loss of this easy money and will concentrate on persuading donors to keep giving even in the absence of a tax subsidy.

The Planning Response
Does this mean that I no longer consider the gift and estate tax worth worrying about? Of course not. Under current law, 55 cents of every dollar in an estate greater than $3 million goes to Washington or a state capital. It remains vitally important to consider the impact of transfer taxes on a family’s accumulated wealth.

On the other hand, I am going to caution clients that some of our planning approaches will be difficult or impossible to unwind if the law changes a few years down the road. More often than not, I expect the key question will be: “If there were no estate or gift taxes to be saved, would you be willing to take this step anyway?” If the answer is no, the plan probably needs more work.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.