Estate Taxes: Where Are We Headed?
by Gerald Townsend, Financial Editor

No federal estate tax is currently imposed until a person’s “taxable estate” exceeds $2 million. This exemption increases to $3.5 million in 2009 and the federal estate tax disappears entirely in 2010, before reemerging in 2011 with an exemption of only $1 million. And we pay our representatives in Washington to come up with ideas like this?
The estate tax has gone through many births and deaths since the establishment, in 1797, of a death “stamp” tax to pay for a naval buildup in response to heightened tensions with France. The death stamp tax was abolished in 1802, resurrected in 1862 to raise money for the Civil War, repealed in 1870, reestablished in 1898 to finance the Spanish-American War, abolished again in 1902 and finally brought back once more, with the advent of World War I, in 1916.

The history of the estate demonstrates one of the objectives of having the tax – to raise revenue. However, the tax has never been an important revenue source, normally accounting for just 1 to 2% of federal collections. Another argument in favor of the estate tax is that it reduces income and wealth inequity, but empirical evidence supporting that view is lacking and the rationale for the inequity argument is itself on shaky grounds.

Behaviors that most people value, such as hard work, savings, and entrepreneurship are discouraged by the estate tax. Instead, the estate tax encourages large-scale consumption and causes many to spend significant dollars on attorneys and accountants trying to ensure they minimize the tax’s impact.

In many studies examining how the wealthy obtained their wealth, the same pattern has emerged: they earned it. A very small percent identified inheritance as their source of wealth, but 80-90%, depending on the study, earned their fortune. With four out of five millionaires being “first generation rich” it raises the question of how they did it. Other than the obvious necessity of earning a lot of money, they also expressed that they managed their money effectively and lead a frugal lifestyle.

The well-know phrase “shirtsleeves to shirtsleeves in three generation” aptly expresses the result of real life, even without the estate tax. The first generation, in shirtsleeves, works hard and earns a lot of money which is then enjoyed by their children, leaving the grandchildren back in shirtsleeves, working hard again.

In 1835, Alexis de Tocqueville observed that, in contrast to Europe with its old families and inherited wealth, American wealth naturally dispersed over time. In Democracy in America, he stated that “wealth circulates with inconceivable rapidity, and experience shows that it is rare to find two succeeding generations in the full enjoyment of it.”
No one knows if, when, or in what form estate tax changes might ultimately emerge from Congress. Many advocate a permanent repeal of the tax, while its supporters obviously want to retain it, while increasing the exemption level.

As you watch the political debate, keep a close eye on the fate of “stepped-up basis.” Under the current system, with most assets you inherit you get to use the value of the asset on the day the decedent died when figuring your gain or loss on a later sale, instead of having to use what the decedent paid for the asset. This “stepped-up basis” results in a much lower income tax on a future sale of the asset than would otherwise be the case.

Any repeal or substantial increase in the estate tax exemption might be coupled with losing this “stepped-up basis,” resulting in much higher capital gain taxes when the inherited asset is sold. Some studies indicate that the income tax revenue gained from this maneuver dwarfs the potential revenue lost from estate tax repeal.

Gerald A. Townsend, CPA/PFS, CFP®, CFA® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com.