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.