Estate Planning and the Capital Gain Tax – Part I

It wasn’t so very long ago that when someone died owning a home, some life insurance, and perhaps a retirement account, that person would have an estate subject to federal estate tax. Back then, the choice between paying estate tax versus paying capital gain tax was an easy one to make, since the highest estate tax rate was 55% and the top long-term capital gain tax rate was only 15%. If you had the option of paying estate tax or paying capital gain tax, paying capital gain tax was the clear choice to make. This choice was really so clear-cut that most people had no idea there was even a choice to be made, especially since the estate tax and capital gain tax are entirely different taxes imposed at entirely different times. How could these taxes in any way be related, especially to the point where payment of one may affect payment of the other?

Whether you realized it or not, the attorney who helped you set up your estate plan probably made the choice for you. In all likelihood, he opted to minimize the estate tax your estate would be obligated to pay, even if doing so might at some point cause an increase in capital gain taxes payable by your heirs. With a rate differential between the two taxes being what it was, the attorney could hardly be faulted for making that choice. To understand how this tradeoff works, you need to understand how estate and capital gain taxes are related.

Within the Internal Revenue Code lies Section 1014. This Code section provides that when a person dies, any assets which are owned by that person at death receive a new basis for income tax purposes equal to the value of the assets on the person's date of death. So very simply, if at your death you owned one share of IBM stock valued on the day you died at $100.00 per share, and if you happened to have purchased that share for only $60.00, then the person lucky enough to survive you and inherit that one share is entitled to a new basis in the stock of $100.00, even though your basis on the day before you died was $60.00. Thus, the capital gain of $40.00 that accrued from the date you bought the stock until the day you died is, in effect, forgiven and when your heir sells the stock, he only pays gain on the amount by which the stock value exceeds his new $100.00 basis. (This rule does not apply to all assets. For example, an inherited IRA has no forgiveness of gain and the recipient of the IRA must recognize ordinary income for the value of any distributions received from an IRA.)

You may wonder, what does this have to do with the tradeoff between estate taxes and capital gain taxes? Let's say that back when the top estate tax rate was 55% and the top long-term capital gain tax rate was 15%, your estate planning attorney suggested to you that you take advantage of the gift tax annual exclusion which allows each of us, if we are so inclined and can afford to do so, to make gifts each year up to a certain amount (currently, $15,000.00) to as many people as we wish without incurring any tax on making the gift. If, following that advice, each year you made a gift of stock or other assets valued at $15,000.00 to five individuals, you would have removed $75,000.00 from your estate. You would not have been required to report the gifts, nor would you incur any gift tax for the gifts made. By utilizing such an annual gifting strategy, a person over time could remove hundreds of thousands of dollars from his or her estate, avoiding estate tax on the gifted assets.

But then something happened. The law was changed. The exemption for estate tax which was a meager $60,000.00 in 1976, grew substantially over time to $600,000.00 in 1987, then to $5,450,000.00 in 2016, and to a whopping $11,400,000.00 for people who die in 2019! Furthermore, the top estate tax rate, once 55%, dropped to 40%. The result of all these changes is that there are now very few of us who are even subject to estate tax. It is especially true if you are married. Now when a spouse dies, any part of his or her $11,400,000.00 estate tax exemption which is not used in the spouse’s estate can be transferred to the survivor. This means that, regardless of how ownership of the assets may be divided between the two of you, unless you and your spouse have combined estates exceeding $22,800,000.00, no estate tax will be payable on the transfer of the assets you own! As a consequence, much of the estate planning which attorneys helped their clients implement in years past has been rendered, for many, unnecessary because most estates, even without annual gifting programs, would still be less than the new exemption amount.

Is it possible, though, that these tremendous changes which have occurred in the gift and estate laws which have eliminated, for most people, any liability for gift or estate taxes have actually resulted in increased liability for other taxes, capital gain taxes in particular?

In other words, has the IRS given us a significant tax benefit with one hand and taken it away with the other? These questions will be addressed in Part II of this article.