Death is a bonanza
By: David A. Smith
Step up your basis!
Have you died so far in 2010? If you have, you’re in luck!
I’m from eternity and I’m here to help you solve your tax problem
If you’re still alive in 2010, but wonder how much longer you’ll make it, then you have a decision to make.
“Now, you have a decision to make: do I feel lucky?”
Rich Cling to Life to Beat Tax Man
You mean you’re not glad to see me?
[Article published in the The Wall Street Journal on December 31, 2009.]
Nothing’s certain except death and taxes – but a temporary lapse in the estate tax is causing a few wealthy Americans to try to bend those rules.
[As of January 1, 2010], the estate tax – which can erase nearly half of a wealthy person’s estate – goes away for a year. For families facing end-of-life decisions in the immediate future, the change is making one of life’s most trying episodes only more complex.
“I have two clients on life support, and the families are struggling with whether to continue heroic measures for a few more days,” says Joshua Rubenstein, a lawyer with Katten Muchin Rosenman LLP in
Though we always claim human life is priceless, markets and tort lawyers endlessly demonstrate to us that it is not. For every person, for every family, there is a price, the more so when the soon-to-be-decedent is suffering, no longer cognitive, or terminally ill.
Currently, the tax applies to about 5,500 taxpayers a year.
While that may sound like a small number, recognize that to qualify, you must (a) die during the year, and (b) have a marital estate greater than $7,000,000. The money involved is large – say $40 billion a year of asset transfers. Every year – at least until we get the bugs out of this immortality thing.
Helluva deal on the estate tax, dude
So, on average, at least 15 people die every day whose estates [will] benefit from the tax’s lapse.
Except, and this is a major exception, the estates will gain no benefit from what is called the step-up in basis under Section 754 of the Internal Revenue Code.
The theory of estate taxation. As estate taxation is encrusted with political cant on both sides, few people spare the time to go back to first principles and exposit, much less analyze, the theory of estate taxation. (If you already know it, skip to the next boldfaced title.)
An ‘estate’ is a newly created legal entity that acquires all of the decedent’s assets and liabilities. The estate concept thus embraces both positive estates (testamentary and trust) and negative estates (insolvency, bankruptcy, and dissolution). Death is therefore a ’sale’ of the financial corpus – yes, even the terms resonate – to this newborn taxpayer.
I am your father’s estate, newly born
Now, if I bought all your assets at fair market value, you’d have capital gains from that sale. If I get t hem as a gift, I am instantaneously that much richer, so in the absence of a special provision, I’d have to take that increase in my wealth into income (whether ordinary or capital is unimportant at this juncture). To transfer assets into a new entity, with no tax payable on either side, thus seems like too good a deal.
More significantly from a public-policy perspective, if we create entities with infinite life, they can own assets indefinitely, benefiting from the appreciation thereon, with never a taxable event. Such entities do not exist without government to validate them, so if taxes are a ‘user fee’ for all the things government does that enable society to function efficiently, there needs to be some moment in time when the wealth accumulation is taxed. Estates, being tied to personal mortality, represent a convenient stopping point. And, since it’s presumed that you do not kindly stop for death, your estate is relieved of the capital gains tax – in exchange for an estate tax.
“He’s gone to the great step-up in basis in the sky”
However, since most people have small estates, and everybody resents the estate tax – there is something necrophiliac in the IRS arriving at the gravesite, palm outstretched – Congress has long exempted from such taxes all estates below a certain aggregate asset threshold, which was $7,000,000 per couple in 2009. But then, something funny has happened in 2010:
The macabre situation stems from 2001, when Congress raised estate-tax exemptions, culminating with the tax’s disappearance [in 2010].
It’s not macabre to be exempt from estate tax; the macabre part is taxing death. Like I wanted to die, or needed the government’s permission to die?
However, due to budget constraints, lawmakers didn’t make the change permanent.
At the time, the Bush Administration was confident the political environment would preclude restoring what Republicans call the ‘death tax.’ So it adopted a budget-scoring fiddle:
The estate tax is due to come back to life in 2011 – at a higher rate and lower exemption.
That 2011 restoration of estate taxes created ‘tax revenues’ for the CBO projections to offset the ‘tax expenditures’ of the previous years’ estate tax cuts.
Need those revenue offsets to pay for the goodies we want to hand out now
The result is that death is an incredible bonanza – if you arrange it for 2010, not 2011.
To make it easier on their heirs, some clients are putting provisions into their health-care proxies allowing whoever makes end-of-life medical decisions to consider changes in estate-tax law. “We have done this at least a dozen times, and have gotten more calls recently,” says Andrew Katzenstein, a lawyer with Proskauer Rose LLP in
Of course, plenty of taxpayers themselves are eager to live to see the new year. One wealthy, terminally ill real-estate entrepreneur has told his doctors he is determined to live until the law changes.
“Whenever he wakes up,” says his lawyer, “He says: ‘What day is it? Is it Jan. 1 yet?’”
In affordable housing, death is actually a tremendously positive financial event, because investors who have a negative capital account (implied contingent tax liability on death) can step it up to the post-death fair market value, without paying capital gains on the stepup.
You step up without paying tax
[Warning: technical exposition. In tax-motivated investments, investors receive paper deductions or tax credits that they use to offset taxes payable on other income. The result, from the perspective of the affordable housing investment, is that the remaining asset – net of deductions and credits – has a written-down book value well lower than its associated (non-recourse) liabilities like the mortgage. (This arises because the stipulated depreciation or tax credits operate independently from the economic obsolescence the property may or may not be experiencing.) When the interest passes to an estate, the estate records it at fair market value (which is often low, the interest having been depreciated on the books), and gets to reset its depreciable basis by increasing it for the difference between the fair market value and the decedent's negative capital account. The step-up adds economic value and yet costs no tax.]
Many years ago, I was discussing with a crotchety old limited partner whether a particular property could be kept out of foreclosure, and if so for how long. Foreclosure would have triggered tax, whereas dying – because of the Section 754 election – would have yielded exactly the same stepup but without the tax due. As I was explaining our property-life-prolongation measures, he cackled, “I just hope this project makes it longer’n I do.”
Estate-tax experts didn’t expect Congress to allow the tax to lapse, and are flabbergasted that it is actually happening. “All fall when I gave speeches, I said I was willing to bet anyone in the room $10 that we would have an estate-tax extension by the end of the year,” says Thomas Ochsenschlager, head of taxes for the American Institute of CPAs. “Thank goodness I didn’t have any takers,” he says.
Glad to have been dead wrong: Tom Ochsenschlager
Now, all bets are off. “If Congress couldn’t do it this year, why will they be able to do it next year?” says Prof. Michael Graetz of
Graetz is unhappy with Congress
He would, wouldn’t he J?
Under current laws in effect until the end of this year, the size of the exemption is $3.5 million per individual or up to $7 million per couple. The tax [disappeared] entirely on January 1.
But estate planning in 2010 will be complicated by a new twist: a complex tax on capital gains that will affect a broader swath of taxpayers.
As my earlier exposition suggested, there is a logical linkage between estate tax and capital gains tax. Capital gains are payable when an asset is sold from Owner A to Owner B. In an estate, the assets pass from Owner A to Owner B without benefit of an economic sale, but certainly within benefit of a sale for legal and tax purposes (the old owner is legally dissolved, a new one created with full protection of the law).
The idea is that you shouldn’t be able to put assets into a vehicle and pass them, generation after generation, without tax. Legal vehicles have their force because government protects property, and the capital gains and estate taxes can be seen as a user fee for protecting wealth when it passes from the hands of a capable person to potentially less capable beneficiaries.
The estate tax is scheduled to return in 2011 at a 55% rate with an exemption of slightly more than $1 million.
The lapse of the estate tax is presenting some families with unprecedented ethical quandaries.
“I’ve been practicing for more than 30 years, and never has the timing of death made such a financial difference,” says Dennis Belcher, president of the American College of Trust and Estate Counsel. “People have a hard enough time talking about death and addressing estate planning without this.”
Congress could pass an estate tax next year and make it retroactive to Jan. 1.
I can imagine some investors rising from the dead just to fight that retroactivity.
I’m here to dispute my tax assessment
Whether that would withstand a court challenge is a subject of debate in the estate-planning world.
Personally, I doubt a retroactive tax could possibly be upheld, particularly as there is now no legislation on the horizon.
In the past, when Congress has passed retroactive laws, congressional leaders often issued formal statements of intent in advance.
Or put effective dates into the proposed legislation that were as of the date of its introduction (say), so as to put taxpayers on notice of a possible change.
That hasn’t happened this time. The main statement has been a verbal one by Senator Max Baucus (D., Mont.) on the floor of the Senate, not a joint declaration by leaders from both parties.
And if we took as gospel everything any Senator said on the Senate floor, the nation would be crushed into immobility under the weight of syllabification.
In addition, the composition of the Supreme Court has changed, and some financial advisers believe the court might not again bless a retroactive law.
Roberts doesn’t believe in retroactivity
‘Again bless’? Retroactive laws are very seldom blessed – very seldom. It’s just a sound principle that people who act on the law as it stands have a right to rely on that law; if an ex post facto change in the law can unmake the status quo at the time an investor acted, then the investor will have detrimentally relied on Congress, and if the sovereign can confiscate property (through taxation) after the fact, then the sovereign is unreliable and investment will cease, with severe adverse economic consequences.
“People with the means to fight against a retroactive law will die” –
He means ‘people whose estates will have the means’ …
We demand refunds
– and someone will challenge it and we might not know the answer for years,” Mr. Belcher says.
Mr. Belcher and everyone else know the answer; the litigants would win. A retroactive tax would be outrageous (which doesn’t make it impossible, as I know, having sued the government before).
The estate-tax-relief window is now open. While it will be closed, the closing will not be retroactive.
All the uncertainties – Will the law be changed? Will it be retroactive? – are forcing family legal advisers to craft various provisional financial-planning strategies that can be undone later if the rules do change.
An excellent example of the financial entropy occasioned by uncertainty.
The situation is causing at least one person to add the prospect of euthanasia to his estate-planning mix, according to Mr. Katzenstein of Proskauer Rose. An elderly, infirm client of his recently asked whether undergoing euthanasia next year in Holland, where it’s legal, might allow his estate to dodge the tax.
His answer: Yes.
Heck, even suicide or murder – double indemnity – wouldn’t affect tax law.
“Now, remember – even if it’s your last supper, the stepup is Painless”
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