Which Tax to Cut?

Posted: May 17, 2001 12:00 AM
George W. Bush talks a great deal about the importance of lowering the top income-tax rate as a boost to small businesses. But if you ask small businessmen what provision of the tax bill is most important to them, they will unanimously say abolition of the estate tax. They might be less enthusiastic, however, if they better understood carryover basis, which will replace the estate tax. Under current law, capital gains that arise during one's life and are held until death are forever untaxed. The tax basis for assets passing through an estate is stepped-up, so that an heir selling the asset subsequently will only be taxed on the appreciation that occurs after death of the decedent. Step-up basis has long been criticized by tax reformers, who view it as an unjustified tax benefit for those who hold assets until death, as compared to those who sell the same asset during their lives. It also encourages a "lock-in" effect that discourages the elderly from selling assets and paying taxes that can be avoided if included in their estates. While these are legitimate concerns, step-up basis has two great virtues. First, it prevents double taxation of assets at death -- first by the capital gains tax and again by the estate tax. Second, it enormously simplifies the settling of estates by executors. Under step-up, they need only calculate the value of assets at death, and don't need to know their original purchase price or any adjustments to it, such as depreciation. Eventually, the reformers were able to sneak abolition of step-up into the Tax Reform Act of 1976. Although there was no such provision in either the House or Senate versions of this legislation, the conferees invented a provision providing for carryover basis. Under carryover basis, the value of assets was no longer stepped-up at death. Instead, heirs inherited the original basis. Thus, they would henceforth have to pay capital gains taxes on inherited assets from the time the asset was originally acquired by the decedent. To see how this works, suppose someone buys some stock for $10 a share and holds it until death, at which time the stock is worth $100. His heir later sells the stock for $120. Under current law, he pays taxes only on the $20 increase since death of the original purchaser. Under carryover basis, he would pay taxes on the entire $110 increase since the stock was originally bought. While simple in theory, in practice carryover basis proved to be a nightmare. The biggest problem was in finding records indicating the original basis for assets in estates. Knowing that such assets would be held until death and that the basis would be stepped up afterward, many people had not bothered keeping such records. Even when the records existed, it was often impossible to accurately calculate basis. For example, on mutual funds where dividends were reinvested over a long period of time, exact basis was extremely difficult to determine. And in the case of small businesses or investment properties, historical basis needed to be adjusted for depreciation, renovations and other difficult-to-determine factors. Almost immediately, there was an outcry from lawyers and accountants, who found it impossible to comply with carryover basis. At a hearing before the Senate Finance Committee on July 25, 1977, just six months after the law took effect, there was universal condemnation for carryover basis. So loud was the outcry that Congress basically told people not to bother with the law. In 1978, it delayed implementation of carryover basis retroactive to its effective date. In the meantime, legal theorists went after carryover basis, as well. Writing in the Texas Law Review in January 1979, one said that, in operation, "carryover basis is extraordinarily complex, and administration by the estate and the Internal Revenue Service is virtually impossible." Congress was urged to repeal carryover basis as soon as possible. In 1980, it did so, retroactive to December 31, 1976. Thus it was as if carryover basis had never existed. Lawrence Zelenak of the University of North Carolina Law School later said that the "short unhappy life" of carryover basis was "one of the greatest legislative fiascoes in the history of the income tax." But alas, memories are short, and even the worst legislative ideas often come back again and again. So it is with carryover basis, which has been included in H.R. 8, the House-passed tax bill. It will likely be in the Senate bill, as well. It is thought by supporters of estate tax repeal that this is a necessary political price to pay. It recoups some of the revenue lost to estate tax repeal and counters the argument that great wealth would be entirely untaxed without it. Unfortunately, it appears that the new carryover basis regime suffers from the same problem of complexity that led to repeal of the earlier effort. Writing in the May 7 issue of Tax Notes, Joseph M. Dodge of the University of Texas Law School subjects the House version of carryover basis to withering criticism. Among the provisions Dodge is most concerned with is the proposal to allow limited step-up basis. This is politically necessary to keep estates too small to be subject to the estate tax from being worse off after repeal of the estate tax than they are now. Unless they are allowed to step-up their basis to the estate tax exemption level, they will have to pay capital gains taxes on assets that are now tax-free. Implementing this limited step-up basis will be extraordinarily complicated and subject to abuse, Dodge believes. "The so-called carryover basis regime contained in H.R. 8 is mostly an illusion," he concludes, "and is so seriously flawed as to be unworthy of serious consideration." Abolition of the estate tax is a good idea, and so long as there is a capital gains tax there is a case for taxing such gains at death. But the carryover basis provision Congress appears ready to endorse may not be the best way to go. If it is enacted into law, I predict a repeat of the 1976 experience, with almost immediate pressure for its repeal all over again.