Tulane Economics Working Paper Series

Re-assessing the Costs of the Stepped-up Tax Basis Rule

Jay A. Soled Richard L. Schmalbeck James Alm Rutgers Business School Duke Law School Tulane University [email protected] [email protected] [email protected]

Working Paper 1904 April 2019

Abstract The stepped-up basis rule applicable at death (IRC section 1014) has always been a major source of revenue loss. Now, in the absence of a meaningful estate tax regime, taxpayers and their estate executors and administrators are likely to report inated date-of-death asset values. As a result, the revenue loss associated with this tax expenditure, called the stepped-up tax basis rule, will surely increase markedly. The Internal Revenue Service will no doubt attempt to police excessive tax basis adjustments, but the agency lacks the resources to do so adequately. Congress should therefore institute reforms to ensure proper tax basis identication.

Keywords: Estate tax, capital gains, stepped-up basis tax rule. JEL codes: H2, H3. RE-ASSESSING THE COSTS OF THE STEPPED-UP TAX BASIS RULE

Jay A. Soled, Richard L. Schmalbeck, & James Alm*

The stepped-up basis rule applicable at death (IRC section 1014) has always been a major source of revenue loss. Now, in the absence of a meaningful estate tax regime, taxpayers and their estate executors and administrators are likely to report inflated date- of-death asset values. As a result, the revenue loss associated with this tax expenditure, called the “stepped-up tax basis rule”, will surely increase markedly. The Internal Revenue Service will no doubt attempt to police excessive tax basis adjustments, but the agency lacks the resources to do so adequately. Congress should therefore institute reforms to ensure proper tax basis identification.

TABLE OF CONTENTS

I. INTRODUCTION ...... II. THE UNFORTUNATE STATE OF THE TRANSFER TAX REGIME ...... III. THE TAX BASIS OPPORTUNITY ...... IV. ESTIMATING THE REVENUE LOSS OF THE TRANSFER TAX REGIME ...... V. CONCLUSION ......

I. INTRODUCTION

The “stepped-up basis rule” of IRC section 1014 has, unfortunately, been with us for nearly 100 years.1 This rule declares that the tax basis of a decedent’s asset is equal to its fair market value at the date of death.2 Most in the tax community and public, however, add “stepped-up” as a descriptive adjective because over time the vast majority of assets either appreciate in value or, due to expensing and generous depreciation allowances allowed under the Code, have a tax basis that is far less than fair market value.3 Taxpayers also have strong incentives to realize tax losses during their lives, so that only appreciated assets are likely to remain in their estates.

Permitting an asset’s tax basis to equal fair market value at the date of death comes with a significant revenue cost. Every year, the Treasury publishes a report detailing the nation’s tax expenditures – statutory provisions in the Code that reduce tax collections by departing from the

* Jay A. Soled is a professor at Rutgers Business School and directs its Masters of Taxation Program, Richard L. Schmalbeck is the Simpson Thacher & Barlett Professor of Law at Duke Law School, and James Alm is Professor and Chair of the Department of Economics at Tulane University. 1 For an excellent historical overview of this rule, see Lawrence Zelenak, FIGURING OUT THE TAX: CONGRESS, TREASURY, AND THE DESIGN OF THE EARLY MODERN INCOME TAX (2018), Ch. 4 (explaining Code section 1014’s obscure origins). 2 I.R.C. § 1014(a). 3 See, e.g., I.R.C. § 168(k), which now permits taxpayers to expense most new and used assets they purchase. 1

Haig-Simons broad definition of income.4 In recent years, the tax expenditure associated with the stepped-up tax basis rule has varied, with it currently estimated at about $50 billion.5 This revenue loss places the stepped-up basis rule among the nation’s largest tax expenditures.6

However, the revenue losses associated with the stepped-up basis rule are about to go from bad to worse. Until now, the presence of the federal estate tax kept the stepped-up basis rule in check: executors of estates that faced estate-tax liabilities would not generally seek to secure a higher asset tax basis to eventually save income taxes, knowing that the estate would first face a significantly higher estate tax. That being the case, executors secured asset appraisals that were at the moderate-to-low end of the value spectrum, and took other measures (e.g., strategic gifting) to minimize the overall value of the estates.7 However, now that the federal estate tax has largely disappeared for all but the uber-wealthy,8 this check on the exploitation of the stepped-up basis rule has largely disappeared along with it. Seeking to secure as high as possible basis in the estate’s assets in order to minimize any taxes on realized capital gains, executors now are at liberty to pursue inflated date-of-death asset valuations and to undertake other aggressive measures (see Section III below) with little or no downside financial consequences.

This analysis explores the unintended income tax revenue losses stemming from Congress having gutted the nation’s transfer tax regime and subsequent taxpayer exploitation of the stepped-up basis rule. Section II provides a summary of the plight of the nation’s transfer tax regime. Section III next details how taxpayers are capitalizing upon the stepped-up basis rule, together with the IRS’s inability to police taxpayers’ actions. In light of the behavioral impacts that the absence of a meaningful estate tax has generated, Section IV offers a revenue loss estimate. Section V concludes.

4 For a recent and critical discussion of the Haig-Simons definition, see James Alm, Is the Haig-Simons Standard Dead? The Uneasy Case for a Comprehensive Income Tax, 56 NAT'L TAX J., 277-297 (2018). 5 Office of Mgmt. and Budget, Fiscal Year 2018: Analytical Perspectives of the U.S. Government 131 tbl. 13-1, item 72 (2016), available at https://www.whitehouse.gov/sites/whitehouse.gov/files/omb/budget/fy2018/spec.pdf. 6 Tax Policy Center, What Are the Largest Tax Expenditures? (2018), available at https://www.taxpolicycenter.org/briefing-book/what-are-largest-tax-expenditures. 7 See, e.g., Philip R. Fink, A Gift in Time Can Save an Estate Tax Gold Mine, PRACTICAL TAX STRATEGIES (Feb. 2000) (“Not only is it generally better to make gifts rather than testamentary transfers, but also to make gifts sooner (rather than later).”). 8 The inflation-adjusted exclusion amount for the estate tax in 2019 is $11,400,000, which is routinely doubled for married couples. Rev. Proc. 2018-57, 2018-49 I.R.B. 827, section 3.41. 2

II. THE UNFORTUNATE STATE OF TRANSFER TAX REGIME

The U.S. estate tax was first enacted in 1916.9 Congress had dual reasons for its initial imposition in 1916: to raise much needed revenue10 and to curtail wealth concentrations.11 In 1924, Congress augmented the estate tax with a gift tax, in an attempt to eliminate circumvention of the estate tax by a inter vivos gifts.12 In 1976, Congress introduced the generation-skipping transfer (“GST”) tax, in order to limit a taxpayer’s ability to avoid tax at least once at every generational level.13 Together, these three taxes – the estate tax, the gift tax, and the GST tax – constitute the nation’s transfer tax regime. In combination, these three taxes have sought to fulfill the historical missions of raising revenue and diminishing dynastic wealth, with minimal effects on economic behavior.

Whether the nation’s transfer tax regime has successfully fulfilled its dual mission is subject to much debate. Measured by the revenue-raising metric, the transfer tax regime has produced lackluster results. While it does annually raise approximately two to three percent of the federal government’s tax collections,14 it does not constitute a major source of federal revenues. Insofar as wealth concentrations are concerned, it is hard to know the exact role that the transfer tax regime has played in leveling the playing field. In theory, the higher are federal transfer tax collections, the less is the wealth concentration and vice versa. However, wealth concentration in the United States does not appear to correlate in any meaningful way to federal transfer tax collections.15

Regardless, the transfer tax regime has been the subject of severe criticism from

9 Revenue Act of 1916, Pub. L. No. 64-271, 39 Stat. 756 (1916). 10 See, e.g., Joel C. Dobris, A Brief for the Abolition of All Transfer Taxes, 35 SYRACUSE L. REV. 1215, 1216-17 (1985) (stating that the first federal estate tax was enacted in 1916 as a war tax); Louis Eisenstein, The Rise and Decline of the Estate Tax, 11 TAX L. REV. 223, 230 (1956) (reciting the House Ways and Means Committee's view that estate taxation would be a source of large revenue). 11 See, e.g., Paul L. Caron & James R. Repetti, Occupy the Tax Code: Using the Estate Tax to Reduce Inequality and Spur Economic Growth, 40 PEPP. L. REV. 1255 (2013) (explaining how Congress has used and can continue to use the estate tax as a means to mitigate wealth disparities). 12 Revenue Act of 1924, Pub. L. No. 68-176, §§ 319-324, 43 Stat. 253, 313-16. 13 Tax Reform Act of 1976, Pub. L. No. 94-455, § 2006(a), 90 Stat. 1520 (1976). The Tax Reform Act of 1986 retroactively repealed the 1976 generation-skipping transfer tax and replaced it with Chapter 13 of the Code. Tax Reform Act of 1986, §§ 1431-1433, Pub. L. No. 99- 514, 100 Stat. 2712, 2717. 14 See, e.g., Darien B. Jacobson, Brian G. Raub, & Barry W. Johnson, The Estate Tax: Ninety Years and Counting, Internal Revenue Service Statistics of Income Bulletin (Summer 2007), at 125 Fig. G, available at https://www.irs.gov/pub/irs-soi/ninetyestate.pdf. 15 There are obviously many other factors/dynamics at issue that dictate wealth dispersions in the nation’s economy. See, e.g., Caron & Repetti, supra note 11 and Jacobson, Raub, & Johnson, supra note 14. 3 politicians, who have repeatedly sought its repeal.16 Among the many lines of attack, transfer tax opponents contend that the estate tax reduces jobs, costs more to administer than it collects in revenue, and decimates family farms and small businesses.17 Despite the weakness of the evidence on all of these claims, many political leaders have launched a broad range of legislative initiatives designed to hobble or even to eliminate the transfer tax regime.

In the meantime, taxpayers have routinely taken matters into their own hands to reduce their transfer tax obligations. Among the many the devices in their transfer-tax-savings toolkit, one tried-and-true method is a strategy premised on minimizing asset values. Some of these strategies are simple in nature (e.g., executors report date of death values that are as low as possible along the permissible valuation spectrum). Many other strategies are far more complex in nature (e.g., taxpayers arrange their business affairs to secure minority and marketability discounts).18 Whatever valuation technique taxpayers have employed, the goal has always been the same: to keep date of death fair market values of a decedent’s assets as low as possible.19 Minimizing asset values have yielded significant and immediate transfer tax savings.

As taxpayers turned to valuation minimization techniques to reduce their transfer tax obligations, the IRS did not stand idly by. More specifically, on a routine basis, the IRS would challenge taxpayer valuation minimization strategies. However, the agency would often meet with judicial defeat.20 In many other instances, there’s a strong likelihood that the taxpayers’

16 See, e.g., Grayson M.P. McCouch, THE EMPTY PROMISE OF ESTATE TAX REPEAL, 28 VA. TAX REV. 369, 373 (2008) (“Estate tax repeal figured as a prominent issue in the 2000 presidential campaign, especially after candidate George W. Bush endorsed repeal as part of his tax-cutting agenda, along with income tax rate cuts, an expanded child credit, and reduction of the marriage tax penalty.”). 17 See, generally, Michael J. Graetz & Ian Shapiro, DEATH BY A THOUSAND CUTS: THE FIGHT OVER TAXING INHERITED WEALTH (2005). 18 See, e.g., James R. Repetti, Minority Discounts: The Alchemy in Estate and Gift Taxation, 50 TAX L. REV. 415, 416 (1995) (“A common tool of estate planning involves the purposeful diminution in value of family property in order to reduce estate and gift taxes.”); William S. Blatt, Minority Discounts, Fair Market Value, and the Culture of Estate Taxation, 52 TAX L. REV. 225, 226 (1997) (“The allowance of minority discounts encourages transactions designed to reduce transfer taxes.”). 19 See, e.g., Joseph M. Dodge, Redoing the Estate and Gift Taxes Along Easy-to-Value Lines, 43 TAX L. REV. 241, 244 (1988) (“[V]irtually all of the transfer tax loopholes involve undervaluation of gratuitous transfers with the blessing of existing law.”); Mary Louise Fellows & William H. Painter, Valuing Close Corporations for Federal Wealth Transfer Taxes: A Statutory Solution to the Disappearing Wealth Syndrome, 30 STAN. L. REV. 895 (1978)(“Disappearing wealth occurs in two situations. First, if a controlling shareholder makes one or more inter vivos gifts of minority blocks so that he divests himself of control…. Second, the value incident to de facto control over a corporation is not subject to the transfer taxes….”). 20 See, e.g., Keller, et al v. U.S., 104 AFTR 2d 2009-6015 (decedent’s estate entitled to apply discounts in valuing interests in a limited partnership); Church v. U.S., 85 AFTR 2d 2000- 804 (partnership formation by a cancer patient who died two days before the certificate of limited partnership was filed was held valid, resulting in permissible valuation discounting); 4 valuation minimization strategies went undetected.21

Congress also entered into the valuation foray. Approximately, two decades ago it added Chapter 14 to the Code; entitled “Special Valuation Rules”,22 it was specifically designed to curtail taxpayers’ aggressive valuation ploys.23 Notwithstanding the good intentions of these legislative measures, they were largely ineffective, as taxpayers simply designed new valuation minimization techniques (e.g., zeroed-out GRATs) that readily navigated around these intended defenses.24

However, over the last two decades, Congress – particularly Congressional Republicans – has succeeded in greatly increasing the transfer-tax exemption threshold. At the beginning of the century, the threshold at which wealth transmission became potentially taxable was only $675,000. It increased in several steps to $3,500,000 by 2009, pursuant to temporary provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001.25 The following decade saw further increases in the filing threshold (e.g., the American Taxpayer Relief Act of 2012 raised the estate tax exemption amount to $5 million in 2012),26 culminating in the Tax Cuts and Jobs Act of 2017, which doubled the estate tax exemption amount to $10 million.27 (Because the inflation adjustment relates back to 2011, the 2019 exemption amount is $11,400,000, which represents nearly a 17-fold increase over its level at the beginning of the century.28) Among the many effects of raising the exemption amount is that the number of taxpayers subject to the

Knight v. Commissioner, 115 T.C. 506 (2000) (gifts of interests in family limited partnership qualified for valuation discounts); J.C. Shepherd v. Commissioner, 115 T.C. 376 (1991) (taxpayer’s contributions of leased land and bank stock to family partnership qualified for valuation discounting). 21 See, e.g., David Barstow, Susanne Craig, & Russ Buettner, Trump Engaged in Suspect Tax Schemes as He Reaped Riches from His Father, NY TIMES (Oct. 2, 2018) (“Much of [Fred Trump’s] giving was structured to sidestep gift and inheritance taxes using methods tax experts described to The Times as improper or possibly illegal.”). 22 Chapter 14 of the Internal Revenue Code, entitled “Special Valuation Rules,” was enacted under the Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-508, § 11602, 104 Stat. 1388, 1388-1491 (1990). 23 See generally, Louis S. Harrison, The Real Implications of the New Transfer Tax Valuation Rules--Success Or Failure?, 47 TAX LAW. 885 (1994). 24 See, e.g., Daniel L. Daniels & Michael N. Delgass, Design GRATs to Reap Court- Approved Extra Tax Savings, PRACTICAL TAX STRATEGIES 324 (2003). 25 Pub. L. No. 107-16, 115 Stat. 38 (2001). 26 Pub. L. No. 112-240, 126 Stat. 2313 (2012). 27 I.R.C. § 2010, as amended by §11061, Pub. L. 115-97, 131 Stat. 2054 (2017). 28 There has been approximately a 45% increase in price levels since the year 2000. Thus, if expressed in constant dollars, the current exemption level could be said to represent roughly an 11- to 12-fold increase in the exemption amount. See www.minneapolisfed.org for historical tables on the consumer price index. Note also that the 2017 increase in the exemption level will expire at the end of 2025, unless extended by Congress. At that point, the exemption will revert to an inflation-adjusted $5,000,000 level. 5 transfer tax has dwindled to the point of being virtually nonexistent.29 In addition, in those rare cases when transfer taxes are actually imposed (i.e., the gift, estate, and generation-skipping transfer taxes all impose a flat 40% tax rate),30 their imposition leaves the bulk of a decedent’s estate largely intact.

Due to the fundamental shift in the transfer tax regime, the previous strategy of claiming moderate asset valuations at death has largely ceased to exist. Instead, for the reasons enumerated below, the vast majority of executors will now seek to inflate date of death asset valuations.

III. TAX BASIS OPPORTUNITY

In the past, the presence of the transfer tax regime functioned as a check on taxpayers exploiting the stepped-up tax basis rule. Rational taxpayers and executors did not generally overstate asset values to save on their future income taxes, because the cost of doing so was an immediate and more onerous transfer tax. With the transfer regime now relegated to near irrelevance, a new taxpayer strategy has emerged: many informed taxpayers are doing everything in their power to exploit the stepped-up tax basis rule.

To capitalize upon the stepped-up basis rule, taxpayers are essentially employing four broad strategies.

The first strategy is the simplest to employ. Upon a taxpayer’s demise, estate executors are securing high asset appraisals. For example, consider the situation of a widow who owns title to a family farm whose “true” value is somewhere between $9 to $11 million. In today’s transfer tax regime climate, barring extenuating circumstances,31 the widow’s executor would opt to use the $11 million appraisal. The reasons are obvious: using a higher basis will reduce any subsequent income taxes on realized capital gains by the widow’s heirs.

The second strategy is to retain assets, rather than gift them. When the transfer tax regime was potent, many estate planners recommended that taxpayers engage in so-called estate freezes (i.e., for transfer tax purposes, taxpayers were instructed to divest themselves of appreciating assets in order to “freeze” their values, letting them appreciate outside of a taxpayer’s taxable estate).32 The downside of the estate freeze strategy was that the Code accorded the asset

29 See Joint Committee on Taxation, History, Present Law, and Analysis of the Federal Wealth Transfer Tax System, Table 2, at p. 25 (2015), available at https://www.jct.gov/publications.html?func=startdown&id=4744. 30 I.R.C. §§ 2001(c), 2502(a), & 2641(a). 31 For example, suppose that, independent of the family farm, the widow had other assets that exceeded $400,000 so that her overall estate was in excess of $11,400,000 (i.e., the current threshold for estate tax application). In that case, the widow’s executor might consider securing a lower valuation appraisal for the family farm. 32 See generally, Henry J. Aaron & Alicia H. Munnell, Reassessing the Role for Wealth Transfer Taxes, 45 NAT'L TAX J. 119, 134-37 (1992) (describing how taxpayers would avail 6 transferred a carryover tax basis, which was often far less than its fair market value.33 In a complete strategic reversal, taxpayers are now seeking to retain their highly appreciating assets in order to enable their heirs to avail themselves of the stepped-up basis rule.

The third strategy is more complicated and even a bit shady, despite its legality. Some estate planners are currently recommending that younger generation taxpayers make significant gifts of highly appreciated assets to an elderly parent or loved one who, upon the latter’s demise, will bequeath such assets back to the original owner. This strategy works as long as the elderly parent or loved one survives the receipt of the gift by more than one year.34

A final strategy involves the taxpayer moving to a community property state.35 In the past, states have been known to enact various and generous tax incentives to attract taxpayers.36 The stepped-up tax basis rule will now be an added attraction to community property states (where all property owned by a married couple is stepped up at the death of one spouse37) than in non- community property states, in which only the property in the decedent taxpayer’s name is stepped up.38

The IRS is largely powerless to curtail these four ploys: all are legal strategies under the Code. Furthermore, even for those taxpayers who take negligent or reckless valuation positions, their actions are apt to be met with impunity. For example, at the time of death, suppose a taxpayer’s family farm and only estate asset is worth between $6 to $8 million. (Note that at this level, there would be no obligation to file an estate tax return.) Suppose further that the taxpayer’s son and sole heir sells the family farm a decade later and overstates its tax basis to be $9 million (rather than using a value within the permissible date of death fair market value range). The IRS in such a case will have a difficult time knowing that the reported tax basis is flawed, due to the substantial time lag between the date of death and the subsequent realization event.

A final noteworthy point is that the exploitation of the stepped-up tax basis rule benefits

themselves of this technique); Edward J. McCaffery, The Iceman Cometh Again: Return of the Estate Freeze?, 46 TAX NOTES 1327 (1990) (same). 33 I.R.C. § 1015(a). 34 I.R.C. § 1014(e). However, this strategy carries some risk. For example, the elderly parent or loved one may forget to bequeath the gifted asset back to the taxpayer, she may consciously change her mind about the bequest if the relationship deteriorates, or she may dispose of the gifted assets during her lifetime. For these practical reasons, this strategy seems likely to be unappealing. 35 See generally, Paul Caron & Jay A. Soled, Tax Basis and Estate Planning, 150 TAX NOTES 1569 (2016). 36 For an excellent overview of various state tax incentives, see Kirk J. Stark & Daniel J. Wilson, What Do We Know about the Interstate Economic Effects of State Tax Incentives?, 4 GEO. J.L. & PUB. POL’Y 133 (2006). 37 I.R.C. § 1014(b)(6). 38 I.R.C. § 1014(a). 7 primarily those taxpayers who have the greatest amount of wealth.39 Any given percentage overstatement in value will be larger in absolute dollars for high-value assets than for low-value assets. In the absence of any safeguards – namely, a meaningful transfer tax regime – Congress should anticipate that the dollar amounts of this tax expenditure will thus accrue predominately to the wealthy.

IV. ESTIMATING THE REVENUE LOSS OF THE TRANSFER TAX REGIME

Making revenue estimates is never easy, and estimating the revenue effects associated with the near elimination of the estate tax on the stepped-up basis rule is no exception. The revenue loss will arise because the inflated date-of-death asset valuations stemming from the interaction of the estate tax with the stepped-up basis rule will reduce income tax collections on capital gains. To estimate this revenue loss, we must make three main determinations.

First, we must estimate the number of taxpayers affected by the changes made to the nation’s estate tax law. Here we rely upon historical data that indicate roughly 3% of the nation’s decedent estates annually endure some estate tax exposure since the inception of the federal estate tax in 1916.40 In 2017 (the last year for which mortality figures are available), there were 2,744,248 deaths reported in the United States.41 Using the 3% historical standard, this means that 82,327 estate tax returns would have been required to file (i.e., 0.03 x 2,744,248). However, under the current estate tax regime, the percentage of taxable estates has dwindled from 3% to 0.1%.42 Accordingly, under current practice only 2,744 estate tax returns would now need to be filed (i.e., 0.001 x 2,744,248). The difference between these two estimates, or 79,583 (i.e., 82,327 – 2,744) represents the number of taxpayers who are now essentially at liberty to take aggressive measures to increase the tax basis of their assets.

Second, we must examine the asset composition of the average decedent taxpayer in the top 3% wealth category. Studies indicate that the asset composition of estates varies depending upon a decedent’s net worth at the time of death.43 Not surprisingly, wealthier taxpayers’ estates

39 See Congressional Budget Office, The Distribution of Major Tax Expenditures in the Individual Income Tax System, Figure F at page 35 (2013), available at https://www.cbo.gov/sites/default/files/113th-congress-2013-2014/reports/taxexpendituresone- column.pdf (depicting how the lion-share of this tax expenditure inures to the nation’s wealthiest taxpayers). 40 See Jacobson, Raub, & Johnson, supra note 14, at 125 Fig. F, available at https://www.irs.gov/pub/irs-soi/ninetyestate.pdf. 41 Kenneth D. Kochanek, Sherry L. Murphy, Jiaquan Xu, & Elizabeth Arias, Mortality in the United States, 2016, NCHS DATA BRIEF (#293) (2017), available at https://www.cdc.gov/nchs/data/databriefs/db293.pdf. 42 See Jeanne Sahadi, New Estate Tax Law Gives an Enormous Gift to Rich Families, CNN MONEY (2018), available at https://money.cnn.com/2018/01/09/pf/taxes/estate- tax/index.html (“Less than 4,000 estates will have to file every year, and 1,800 or fewer will end up owing any money, the [Tax Policy Center] estimates.”). 43 See, e.g., IRS, Statistics of Income, Estate Tax Returns Filed for Wealthy Decedents, 2007-2016 (Undated), available at https://www.irs.gov/pub/irs-soi/2016estatetaxonesheet.pdf; 8 usually contain assets such as stock, bonds, real estate, and closely-held business interests44 that can readily capitalize upon the stepped-up tax basis rule. In contrast, those taxpayers at lower ends of the economic spectrum whose wealth is comprised largely of pension plans, IRAs, and 401(k)s45 (which generate income with respect to decedent, or “IRD”), are not able to make much use of the stepped-up basis rule.46 In 2017, the average decedent taxpayer owning wealth that qualified for the 3% net worth category had assets of approximately $4 million.47

Third, we must estimate the amount by which executors and personal representatives will inflate date-of-death asset values. In light of the valuation techniques previously described, it is unclear exactly how much executors and personal representatives would inflate date-of-death asset values. However, we believe that it is reasonable to assume a range, from 5% to 25%, in order to examine the implications of a low rate of inflation of asset values (e.g., 5%) and a high rate (25%), with intermediate rates included for sensitivity analysis. It is of course possible to make many alternative assumptions.

Given all of these assumptions, the projected revenue losses associated with taxpayers inflating the tax basis of their assets would be substantial, as reflected in the chart below: 48

PROJECTED ANNUAL REVENUE LOSSES Percentage Basis Adjustment Per Estate Projected Revenue Loss (%) ($ billions) 5% $3.2 billion 10% $6.4 billion 15% $9.6 billion 20% $12.7 billion 25% $15.9 billion

These projected annual revenue losses are of course only estimates, dependent upon the specific assumptions that we made. Even so, they reveal a financial problem lurking on the

Barry Johnson, Brian Raub, & Joseph Newcomb, The Income and Wealth of 2007 Estate Tax Decedents, STATISTICS OF INCOME BULLETIN (2012), available at https://www.irs.gov/pub/irs- soi/13rpwealthdedents.pdf, Figure 2. 44 Jenny Bourne, Eugene Steuerle, Brian Raub, Joseph Newcomb, & Ellen Steele, More than They Realize: the Income of the Wealthy, 71 NAT’L TAX J. 335 (2018), Table 1. 45 See Edward Wolff, The Asset Price Meltdown and Wealth of the Middle Class, NBER Working Paper 18559 (2012), available at http://www.nber.org/papers/w18559.pdf, Table 6. 46 I.R.C. § 1014(c). 47 See Don’t Quit Your Day Job, United States Net Worth Brackets, Percentiles, and Top One Percent in 2017 (2018), available at https://dqydj.com/net-worth-brackets-wealth-brackets- one-percent/. 48 To illustrate the calculations, consider the first row for the 5% percentage basis adjustment rate. We multiply the percentage basis adjustment per estate (5%) times the estimated size of the estate ($4 million) times the number of affected estates (79,583) times the average capital gains tax rate (20%), to get the projected revenue loss ($3.2 billion). We follow the same procedure for the other rows. 9 horizon. In the absence of the nation having a meaningful transfer tax regime, the tax expenditure associated with the stepped-up basis rule will be propelled to new heights. This development does not bode well for the nation’s fiscal, distributional, or allocative health. Consider the possibility that those taxpayers no longer subject to transfer tax exposure decide to capitalize upon the tax basis augmentation techniques previously described.49 Under these circumstances, even if we use the low-range estimate of only a 5% increase in the tax basis of the assets that decedents’ own, the annual revenue cost to the country would be $3 billion and over a ten-year scoring period over $30 billion.50 If taxpayers more aggressively inflate the value of a decedent’s assets, the numbers increase accordingly and significantly. Clearly, the potential impact on asset inequality via wealth accumulation and even on behavioral incentives would also dramatically change.

Congress should not sit by idly. Left unmonitored, the stepped-up basis rule will further enable the wealthy to drain the nation of potential income tax revenue, exacerbating the ever- rising tide of inequality. Congress has several options to consider.

First and most obviously, Congress should consider eliminating the stepped-up tax basis rule. Elimination was tried in 1976 with the introduction of a carryover tax basis rule,51 but this reform was met with such stiff resistance52 that it was retroactively repealed.53 However, this occurred over four decades ago when the so-called “Information Age”, with its emphasis on data availability, was in its infancy and tax basis identification was problematic. Now that the Information Age is reaching new heights, tax basis identification has never been easier. Given these developments, Congress should either reinstitute a carryover tax basis rule54 or, alternatively, make death a deemed realization event.55

49 See supra, Section III. 50 The vast majority of states impose an income tax that utilize the federal tax base to compute tax (see Ben Casselman, Federal Tax Cuts Leave States in a Bind, N.Y. TIMES, p. 1 (2018), available at https://www.nytimes.com/2018/05/12/business/economy/state- tax.html?rref=collection%2Fissuecollection%2Ftodays-new-york- times&action=click&contentCollection=todayspaper®ion=rank&module=package&version= highlights&contentPlacement=1&pgtype=collection). That being the case, tax basis augmentation vis-à-vis the stepped up basis rule comes at a steep price to state coffers as well as state legislatures watch their income tax coffers dwindle. 51 Tax Reform Act of 1976, Pub. L. No. 94-455, § 2005, 90 Stat. 1520, 1872. 52 See, e.g., Howard J. Hoffman, Drive to Repeal Carryover Basis Goes into High Gear, 9 TAX NOTES 211 (1979); Practitioner Community Writes Congress on Carryover, 6 TAX NOTES 502 (1978); see also Stefan F. Tucker, Thoughts on Radical Estate and Gift Tax Reform, 91 TAX NOTES 163, 165 (2001) (“It can be extraordinarily difficult to trace the historic basis of many assets, such as personal property held for generations within families for reasons of family history or affection, rather than because the property was not marketable.”). 53 Crude Oil Windfall Profit Tax Act of 1980, Pub. L. No. 96-223, § 401(a), 94 Stat. 229, 299. 54 See, e.g., Richard Schmalbeck, Jay A. Soled, & Kathleen DeLaney Thomas, Advocating A Carryover Tax Basis Regime, 93 NOTRE DAME L. REV. 109 (2017). 55 See, e.g., Lawrence Zelenak, Taxing Gains At Death, 46 VAND. L. REV. 361 (1993). 10

Second, Congress should reinvigorate the nation’s transfer tax regime. For over a century, the transfer tax regime has been one of the nation’s fiscal staples.56 Over the course of time, the transfer tax regime has gone through many permutations. However, its scope has never been so narrow, as reflected in its application to a miniscule percentage of taxpayers.57 In the presence of mounting economic inequality58 and falling tax revenues,59 Congress should reduce both the lifetime exemption amount and the GST tax exemption amount and raise transfer tax rates.60 Doing these things would also generate additional transfer tax revenues, even aside from any reform in the stepped-up tax basis rule.

Third, Congress should better fund the IRS to enable the agency to fulfill its oversight mission of ensuring taxpayer compliance. A number of recent reports indicate that Congress has not been adequately funding the IRS – even proposing that the agency’s resources be cut.61 The by-product of these congressional actions is a tax agency teetering on disaster – unable to monitor taxpayers; taxpayers may consequentially become more aggressive in their reporting practices, including how they report the tax bases they have in their assets. Because taxpayer compliance is crucial to the integrity of any tax system, Congress must supply adequate financial

56 Paul L. Caron & James Repetti, The One Hundredth Anniversary of the Federal Estate Tax: It’s Time to Renew Our Vows, 57 BOSTON COLLEGE L. REV. 823 (2016). 57 See supra note 36. 58 See, e.g., Carmen Reinicke, US Income Inequality Continues to Grow, CNBC (2018), available at https://www.cnbc.com/2018/07/19/income-inequality-continues-to-grow-in-the- united-states.html (“The top 1 percent of families took home an average of 26.3 times as much income as the bottom 99 percent in 2015, according to a new paper released by the Economic Policy Institute…. This has increased since 2013, showing that income inequality has risen in nearly every state.”). 59 See, e.g., Chuck Jones, Trump’s Federal Budget Deficit, FORBES (2018), available at https://www.forbes.com/sites/chuckjones/2018/02/09/trumps-federal-budget-deficit-1-trillion- and-beyond/#5e9131de544f (“[T]he U.S. Federal Deficit will probably increase this year (fiscal 2018), could come close to if not exceed $1 trillion in fiscal 2019 and will likely exceed $1 trillion in fiscal 2020 and beyond. And this is before the additional deficits created by the tax reform bill and the just passed two year budget.”); Michael Tanner, Budget Deficits Are Only Getting Bigger Under Trump, NATIONAL REVIEW (2018), available at https://www.nationalreview.com/2018/07/trump-budget-deficits-growing-big-spending-fiscal- irresponsibility/ (“According to OMB, the federal budget deficit will reach $1 trillion in 2019, roughly $101 billion more than previously projected. That also means deficits will top $1 trillion a year earlier than under previous projections from the Congressional Budget Office. And the tide of red ink is only expected to grow taller in the future.”). 60 See, e.g., Caron & Repetti, supra note 11 and Jacobson, Raub, & Johnson, supra note 14. 61 See, e.g., Wendy Connick, 4 Things the IRS Doesn’t Want You to Know, CNN MONEY (2017), available at http://money.cnn.com/2017/04/07/pf/taxes/irs-rules/index.html (“In recent years, the IRS's budget has been repeatedly slashed. As a result, it has been forced to reduce its personnel, including auditors. The inevitable result is a steep decline in audit rates: Fewer than 1% of taxpayers are audited these days, and as the budget cuts continue, this rate will likely drop further.”). 11 resources to the IRS to enable the agency to fulfill its mission of ensuring taxpayer compliance.

V. CONCLUSION

For as long as the nation has had an income tax, the stepped-up tax basis rule has been one of the Code’s central features.62 Its retention has largely been due to the administrative ease this rule offers. Put in practical terms, when taxpayers pass away, estate executors and administrators do not have to locate historic purchase-price information to make tax basis identifications. Instead, the Code accords the right to use an asset’s fair market value on the date of death as its tax basis. Application of this rule obviates the need for potentially nettlesome, time-consuming, and expensive tax basis identification exercises.

However, since the stepped-up basis rule came into effect, the world has dramatically changed. Due to technological advances and the advent third-party tax basis information reporting,63 tax basis identification has never been easier. Furthermore, with the estate tax nearly eliminated, the nation’s deficit hemorrhaging, and inequality surging, retention of the stepped-up basis rule no longer makes financial sense. Congress must therefore take immediate legislative action. Otherwise, the integrity of the nation’s income tax base will be further eroded.

62 There was no counterpart of section 1014 in the first several revenue acts constituting our modern income tax. The predecessor of section 1014 first appeared in 1921, as part of the Revenue Act of 1921, Pub. L. No. 98, §202(a)(3), 42 Stat. 227. However, this statutory provision simply codified the existing practice of the IRS. 63 I.R.C. § 6045(g). 12