Candidate Donald Trump’s campaign platform contained a cryptic line regarding the tax treatment of assets transferred at death: “The Trump Plan will repeal the death tax, but capital gains held until death and valued over $10 million will be subject to tax to exempt small businesses and family farms.” Some read that to mean Trump would treat death as a realization event; others interpreted it to mean that Trump would allow inheritors to defer capital gains tax until they sold the inherited asset, but with carryover rather than stepped-up basis. No one was quite sure how the $10 million exemption would work. Would it apply to the first $10 million in transferred assets or the first $10 million in capital gains? (Unless the decedent’s basis is zero, those two things aren’t the same.)
To help us sort through these alternatives, Richard Schmalbeck, Jay Soled, and Kathleen DeLaney Thomas have produced an excellent article arguing for a carryover basis regime and against any exemption. Soled, Thomas, and James Alm of Tulane have published two shorter pieces in Tax Notes advocating a carryover basis regime limited to marketable securities. (See Soled, Alm & Thomas, A New Carryover Tax Basis Regime for Marketable Securities, 154 Tax Notes 835 (Feb. 13, 2017); Soled, Alm & Thomas, Trump and a Populist Agenda?, 154 Tax Notes 1131 (Feb. 27, 2017).) Soled, Thomas, and Alm also have condensed their argument into an op-ed for The Hill, distilling a complicated issue of tax law into clear language comprehensible to nonlawyers.
With their longer law review article and their shorter contributions, these authors show how academics can play an important role in policy debates as tax reform efforts heat up. They also make a compelling case for switching from stepped-up basis to carryover basis. In the law review version, Schmalbeck, Soled, and Thomas emphasize three virtues associated with a carryover regime. First, it would raise revenue. Second, it would make the tax system more progressive. Third, it would help alleviate the “lock-in effect” (i.e., the incentive for individuals to hold onto suboptimal investments until death so their heirs can take advantage of stepped-up basis). Meanwhile, technological advancements make it much easier to track basis in most assets, mitigating the administrative challenges of a carryover system.
Schmalbeck, Soled, and Thomas do not claim that a carryover basis regime is superior to a deemed realization rule on all counts. They do argue, though, that carryover basis beats deemed realization on dimensions of administrability and political feasibility. As for administrability, carryover basis would do away with the need to value assets at death while deemed realization would not. And as for the politics, deemed realization looks a lot like a “death tax,” even though it is very different from the estate tax to which that epithet is usually attached.
As between stepped-up basis without an estate tax and carryover basis without an estate tax, I — like the authors — favor the latter. But I’ll conclude with three caveats about carryover basis that might curb our enthusiasm for the idea at least slightly.
(1) Switching from stepped-up basis to carryover basis won’t raise as much revenue as one might think. The Joint Committee on Taxation estimates that stepped-up basis will cost the federal government $179.4 billion over the next five years, but that $179.4 billion number is comparing stepped-up basis to deemed realization, not to carryover basis. As Schmalbeck, Soled, and Thomas acknowledge, carryover basis will raise less revenue than deemed realization. JCT pegs the five-year revenue haul from carryover basis at $22.8 billion. Some heirs will donate inherited assets to charity, avoiding capital gains tax altogether and claiming a deduction equal to fair market value at the time of contribution. Others will hold onto the assets as long as they can, taking advantage of deferral. Those who do sell will part with their highest-basis assets first; they will time their sales for years in which they fall in a lower bracket; and in some cases they will be able to offset capital gains with losses.
(2) As between the status quo (stepped-up basis plus an estate tax) and the alternative of carryover basis with no estate tax, there are strong reasons to prefer the status quo. First, the estate tax raises much more revenue. The Congressional Budget Office projects that wealth transfer taxes will generate $121 billion over the next five years, almost all of which is attributable to the estate tax. (This assumes, of course, that the estate tax is not repealed.) Second, the estate tax is more progressive than stepped-up basis: the burden of the former falls only on estates over the $5.49 million exemption amount (double that for a couple), while stepped-up basis affects all families that transfer appreciated assets from generation to generation. Third, the lock-in effect is arguably less severe under the status quo, because basis resets every generation (or more frequently than that when assets are transferred at death between spouses). With carryover basis, individuals and families might hold onto assets indefinitely—hoping that a future Congress ultimately lowers the capital gains rate or restores stepped-up basis. In this respect, lock-in under a carryover basis regime might look a lot like lock-out under the existing U.S. international tax regime: corporations stash cash in offshore subsidiaries indefinitely because they think that Congress will ultimately lower the rate on repatriation.
(3) If the estate tax survives (as it’s starting to look like it might), the case for carryover basis becomes considerably more complicated. Schmalbeck, Soled, and Thomas rightly note that carryover basis and the estate tax could exist simultaneously: the former would ensure that capital gains do not escape income tax; the latter would serve the separate purpose of breaking up dynastic wealth. However, the coexistence of carryover basis and the estate tax would give rise to inefficiencies of its own. Wealthy individuals would have an incentive to sell appreciated assets later in life and transfer cash to the next generation so that they can extinguish capital gains tax liabilities with pre-estate tax dollars while taking advantage of the tax exclusivity of the gift tax base. Instead of wealthy individuals inefficiently holding onto suboptimal investments, we’d see wealthy individuals inefficiently disposing of optimal investments.
Much to their credit, Schamlbeck, Soled, and Thomas are transparent about the fact that carryover basis has drawbacks. Indeed, one of the most admirable aspects of their effort is that they play an advocacy role without papering over the problems with their own preferred alternative. If and when lawmakers take up estate tax reform, we can only hope that they will turn to these authors’ nuanced analysis of policy options for the treatment of death-time transfers.