Ironically, although death and taxes are the only two certainties in life, the “death tax” is largely voluntary. (Forgive the controversial term—its purpose is rhetorical, not ideological.) With the estate and gift tax exemption up to $11.18 million per person, the tax’s voluntary nature is truer now than ever before. In their recent article, Jay Soled and Richard Schmalbeck argue that the transfer tax’s diminution will not only reduce estate and gift tax revenue, but will enable taxpayers to game the income tax as well.
The crux of the authors' argument rests on IRC § 1014(f), which requires that the stepped-up basis of property acquired from a decedent not exceed the property’s value that is reported for estate tax purposes. This rule creates two counterbalancing incentives for taxpayers appraising an estate’s assets. First, taxpayers will want to undervalue property to reduce estate tax burdens. Second, taxpayers will want to overvalue property to obtain a higher basis under § 1014. When weighing both, the estate tax’s pressures have typically dominated, largely because the tax cannot be deferred until later. Thus, a robust estate tax mitigates incentives for taxpayers to abuse the already generous § 1014 step-up in basis.
Of course, the United States has not had a robust estate tax for quite some time. As the authors note, the Economic Growth and Tax Relief Reconciliation Act of 2001 took the first meaningful steps toward excusing wealthy estates from taxation by increasing the exemption from $675,000 to $3.5 million, as well as reducing the tax rate for estates subject to the tax. Eighteen years and $7.68 million in exempted value later, hardly any estates now face the ameliorating downward valuation pressure of the estate tax. According to estimates from the Tax Policy Center, TCJA cut the number of estates subject to taxation from about 5,500 in 2017 to fewer than 2,000 in 2018. Put another way, 99.8% of all decedents’ estates will now be transferred free of tax.
Soled and Schmalbeck argue that the fisc will feel the cost of these reforms beyond just lost estate tax revenue. Now, nearly all taxpayers valuing decedents’ property at death face only one incentive: Increase property values to reduce later capital gains. An already difficult-to-fight tax avoidance tactic will grow yet more intractable, undermining the integrity of the capital gains tax.
Adding technical texture to the discussion, Soled and Schmalbeck describe several gaming strategies by which taxpayers can inflate property values at death—although only one directly targets valuation. Quite simply, taxpayers can instruct appraisers to overvalue assets, and even hire appraisers more likely to do so. Most of the other strategies the authors describe ensure that assets will be allowed stepped-up basis at death, generally by including the assets in decedents’ estates. Such strategies include, for example, favoring bequests over inter-vivos gifts and transferring assets to older taxpayers (outside the 1-year transfer limit in § 1014(e)), to be returned upon death. A functional estate tax would serve as a backstop to such strategies. Now, for most taxpayers, there is nothing.
Even worse, they argue, the IRS faces special challenges when it comes to policing valuation. For one, basis inaccuracies are difficult to detect. Many years may have passed since purchase, basis amounts can reasonably vary significantly, and such gaming is likely impossible to catch via computer algorithm. Additionally, valuation inaccuracies are difficult to punish, largely because appraising property is as much art as science. Under current law, taxpayers need only hire a reputable appraiser and not act recklessly or negligently in order to avoid penalties.
The authors’ most interesting proposed reform to correct this problem is a procedural one, specifically: Stiffen penalties for inflated property valuations. They suggest penalizing third-party appraisers, as well as disallowing taxpayers’ reasonable cause defense, when appraisals exceed 120% of the actual value. Such penalties would encourage taxpayers to better monitor appraisers and ensure accurate valuations.
Although I am intrigued by this proposal, I fear that its efficacy would be limited. For one, it might simply drive taxpayers to inflate values to 119% of a supportable actual value. What if, alongside stiffer penalties, the IRS offered their own valuation experts for private hire to taxpayers? Taxpayers could pay the IRS a fee for appraisal services, and in exchange the Service would not challenge the property valuation upon audit. Service valuation would offer taxpayers greater certainty, reduce gaming, and generate fee revenue for the IRS. Based on my own experience practicing before the IRS, I trust Service employees to value property as accurately as possible. They seem like quite good folks, if a bit beleaguered by weakening laws and an ever-shrinking budget.