Estate Tax Confusion

It is not surprising that that a debate like the one over estate taxes that attracts so many class warfare fanatics should miss the point on a lot of issues.  However, the estate tax debate has been handled in the media perhaps worse than even other tax debates, which is a pretty low bar to try to crawl under.  The reason I say this is that the most serious "end the estate tax" type proposals out there have two parts, only one of which I have ever seen mentioned in the press:

  1. End the federal tax on estates (this, of course, is the part that gets the press)
  2. End the stepping-up of the cost basis of financial assets at death (this part never gets mentioned)

This 2nd piece of the proposal may seem arcane to some -- let me explain.  Most large estates (ie, the ones that estate tax supporters are concerned about) are dominated by financial assets (e.g. stocks, bonds).  These financial assets, typically held for years, tend to have a cost basis far below their current market value.  An example might be shares of Microsoft held for 10 years that were purchased for only a small fraction of the current price.  The cost basis of a financial asset is generally its purchase price plus commissions and other transaction charges.

Lets take a gentleman who dies and whose estate is made up entirely of $10 million worth of Coca-Cola stock bought years ago for just $5 million.  The estate all goes to his one daughter.  Under estate law, two things would happen.  The estate pays a large tax on the $10 million, and the remainder flows through to his daughter.  Lets say taxes take half, and his daughter now has $5 million of stock with an original price of $2.5 million.  The other thing that happens is the basis of assets is stepped up to current market value.  That means that as far as the IRS is concerned, his daughter owns stock worth $5 million with a basis of $5 million.  If she immediately sold the stock, she would have no capital gains tax.

There are a couple of good arguments against the estate tax.  From an efficiency standpoint, it diverts large pools of capital from private investments into the hands of the Federal Government, where only the most ardent statist would argue that it is better spent.  Also, billions and billions of dollars are spent every year with lawyers, accountants and financial planners to find ways to dampen the impact of the estate tax.  This is all wasted, unproductive effort that would immediately be redirected to more productive uses if the estate tax were eliminated.

From a fairness standpoint, the estate tax acts as a second tax on income that has already been taxed before.  In our example, though the $5 million capital gain is getting taxed for the first time in the estate, the $5 million original costs, which must have come from taxed income at one time, is getting taxed for at least a second time.  The other fairness problem becomes visible if we change the name of the stock from Coca-Cola to "Dad's private company."  For family businesses, ownership is not as easily divisible - you can't sell half or two-thirds that easily in part because there is not much market for minority shares of small family businesses.  What therefore happens in practice is that the daughter must sell the family business to pay the taxes.

The estate tax reform plan outlined above eliminates both these latter problems.  Under these rules, the daughter would inherit the full $10 million of stock, but, unlike today, her basis would remain the same as her dad's -- in this case, $5 million.  She would not pay any tax until she sold any of the assets.  And then she would pay capital gains taxes using the lower basis of her father's.

This results in two beneficial outcomes:  a)  taxes are only charged on the part of estates that have not already faced income taxes and b)  taxes are only paid when the individuals who inherit choose to make an asset sale and convert assets to cash.  The timing of assets sales drive taxes, whereas today, in all too many cases, taxes drive the timing of asset sales.  (By the way, supporters of the estate tax also argue that it is good because the estate tax incentivizes charitable giving.  The argument is that the tax is so confiscatory, and that the government so well-known as a black hole for money, that rich people decide it is better to give it away than to let the government take it all.  This is an odd argument for statists to make, but they do.  Note that in this estate tax proposal, the daughter would inherit a lot of low-basis stocks.  The same charitable giving incentives exist for low-basis stocks, since the IRS will give you credit for the market value as a deductible gift but you don't have to pay the capital gains).

Asymmetrical Information has been on this case for a while:

There is no case for saying, as the New York Times inexplicably does, that "Repeal would shield
the estates of the very wealthiest Americans from the tax." It does not. It
does, however, defer taxation. Because basis will no longer be 'stepped-up'
after death (except for a $1.3 million exemption) they will simply be taxed like
all other capital gains - at the time those gains are realized.

Stepped-up basis is one of the four legs of the estate-planning stool along
with the life insurance tax exemption, minority discount valuations and the division of income and
principal interests (such as the "estate
"). It is not entirely clear that beneficiaries of large estates are
better off after repeal when the full toolkit of estate planning techniques is
taken into account - unless capital gains tax is done away with altogether and
the states stop taxing estates. Neither is likely to happen.

Given the large estates I've seen avoid taxes, I am skeptical of analyses
that suggest an enormous impact to revenues from this repeal. I don't believe
they factor in the new potential revenues from carryover basis outside the
traditional estate tax shelter vehicles. Certainly, the capital gains rate is
lower than the estate rate, but when estate tax shelter vehicles dwindle away,
more assets will ultimately be subject to capital gains taxation. Based on what
estate planning professionals tell me, it will be a wash in many cases and more
expensive in some significant estates. In other words, with respect to the
Estate Tax, we may still be in the fat part of the Laffer curve, where a lower statutory rate may yield higher
revenues over time (due to avoidance behavior, not a lack of work

This post also cites a study that says that increased capital gains taxes on inherited assets could offset estate tax losses to the government.  That seems aggressive, assuming a lot of assets are getting passed in vehicles (trusts?) that avoid or limit estate taxes, but the offset is there never-the-less and is something you will never ever see in a newspaper article about the estate tax.

I haven't paid attention to the current Congressional proposals out there, but the post goes on to argue that Congress, as is its wont, has chosen the worst of both worlds while maximizing rent-seeking opportunities.

postscript: By the way, shame on all of those accountants, lawyers, and others in the estate planning profession.  They all tell their clients that the estate tax is confiscatory, and can go on for hours with a client about various things that are unfair in the system.  But at the same time they run to Congress begging them to keep the whole tottering complex system in place to protect the rent they extract from inefficiencies in the system


  1. unknown:

    India is a good example of how things will go wrong without estate taxes.

    DESPERATION 85% of people are working poor in an informal economy to earn $2 a day so that they can feed a meal for their family. Their lives oscillate between desperation and frustration. As of today, sex, movies and democracy aka 'voting in elections' is the only respite for them.

    COLLUSION The remaining 15% well to do people are even 'more' desperate. They 'prefer' not to pay taxes. The only 'professional' relation between any two individuals is collusion.

    Enforcing inheritance taxes will stimulate compassion instead of collusion among people.

  2. Glen Raphael:

    It seems to me stepping up" the cost basis when someone dies has a huuuge advantage over not doing so in that it removes the necessity of figuring out what the real cost basis was. The assets were accumulated over a lifetime. The person who bought the assets is dead so you can't ask him when he bought what at what price, nor can you ask him to explain his filing system or records. Unless he kept truly meticulous notes and told somebody where to find those notes, the inheritors are screwed. In many cases they'd have to guess what the capital gains might be and sign an under-penalty-of-perjury statement that they think their guess is objectively correct. No?

    It's hard enough figuring out what your own capital gains were - figuring out somebody else's in absentia is a bit much to ask.

  3. burt:

    The argument of "second tax" is catchy, but unreasonable. If I earn a dollar, and then pay my piano teacher that dollar, the dollar is taxed twice. It can't be helped. All money flows in a circle, and a various points a tax event occurs. When an asset is sold at a profit, the profit is taxed. That's a tax event. When someone dies, the estate tax says that that's a tax event.

    Perhaps they should only tax the difference between the value at death and the basis, as if the poor deceased "cashed out" on death, and reestablished the position immediately, in the name of the heir. New basis, taxes paid just up to that point. In this case, the fortunate daughter would pay 1.5 million to receive 10 million (10 million on a 5 million basis, less 2 exclusion, 50% on what's left). Or at 15% is this still too much?

    If you consider this a second tax, then you have to remove all taxes on capital. I guess you can do that, but then only people who work would pay taxes, and the receipts won't amount to much.

  4. Steve:

    If double taxation is the problem, I think it's the income tax that should be repealed, and not the estate tax. Eliminate capital gains tax entirely, and bad basis information won't be a problem.

  5. alj:

    Firstly, Unknown’s argument that our country would turn into chaos because of a lack of estate taxes is absurd. The differences between our two governments cannot be summed up in a paragraph and to assume that The United States could be compared to India in any respect is ridiculous.

    Second, Glen, I understand what you are saying when you talk about cost basis numbers being hard to keep track of, but any investors today that do any amount of trading has software that will keep track of these numbers. Also those investors that do less trading still go through brokers or banks when they wish to purchase securities, these banks would then update and log cost basis for these clients.

    Also the argument that Burt proposed is invalid in that the “piano lesson” tax is imposed on two different people. The person who earns the dollar is taxed on income as is the income earned by the “piano teacher.” In the case of estate tax the tax burden falls on the same person twice. The same way it falls on any investor today. The capital gains tax is the second tax on a single person’s money. The first tax is on income earned, while the second tax applied is on monetary gains earned by this person in the form of stocks, bonds or the like being converted to cash or sold off. The same applies for estate tax, when the person dies/is forced to sell the securities they own. The real reason I despise estate tax, is because it ruins small family owned businesses where a lack of cash available to pay the estate taxes could possibly and in most cases causes the heirs to sell the business to cover the tax burden of the deceased’s estate.

    Lastly, I agree with Steve in that the taxation in the United States is virtually impossible to navigate for any average person. If income tax is repealed and a flat tax is implemented, this tax should be on goods purchased. If a higher sales tax is put in place, this would increase revenues in the short and long run and also be “fair,” to those who believe taxing is acceptable in the first place, since this tax would be harder to avoid. Therefore on all goods purchased and sales rendered we oppose a 15% or 20% sales tax and eliminate the income tax, more Americans would participate in taxation spreading out the burden and forcing those using goods and services to “pay the freight.” Eliminating the complicated IRS tax laws would allow the federal government to eliminate some IRS personnel, cutting back on federal employees is always a good thing, and could divert this money to paying back our foreign and domestic debts or give future tax refunds.

  6. burt:

    I appreciate that alj took the time to read and respond to my comment. I see the estate tax as falling upon the heirs. It is a transfer of wealth and, unless the relation is to a spouse, it is a transfer between distinct entites, just as the dollar earner and his/her piano teacher.

    Is it a tax on the deceased or a tax on the heirs? Is the difference just a matter of opinion? The deceased doesn't pay. The deceased is dead, in most cases (there might be loopholes here too ... I'm no lawyer). The natural enemy of this tax are those that pay it, the heirs.

    Alj goes on to say that the estate tax ruins family business, the idea being that in transfering the business, tax is due, and this distroys the business. Family business are exempt from the tax. First, you get to place your own value on a family business. It's maybe five times the salary you draw from it. That's all it's worth. Next you get to reduce that by some 70% as long as you hold it for 10 years. And then you do a deduction and then you take 40% or so percent. (we are down to 12%, which is less than the tax on the next dollar earned, and you are now entitled to the entire profit of the business, no longer a partner.) You then get to pay it over 14 years, at 2% per annum interest, which is less than inflation, so this is what you do.
    (See )

  7. unknown:

    i am not trying to compare two governments.
    my point is simple.
    "estate taxes will stimulate compassion".
    compassion might be "obvious" for people living in america, but it is not for people living in india.

  8. SamS:


    You are confusing the flat tax and a value added tax. The flat tax is an income tax in which all deductions such as charitable contributions and home mortgage interest and property taxes are eliminated and everyone, regardless of income, pays the same rate. A value added tax is a sales tax that is hidden in the price one pays for goods and services. Both benefit the wealthy.

    As a tax accountant who has done a lot of estate tax planning, I know many ways for family owned businesses to get around the inheritence tax. The problem is that the father generally refuses to face his own mortality and plan for his demise. In many cases, he doesn't want to turn control over to his children so the company is owned by an eighty or ninety year old and run by a sixty year old still waiting for dad (and mother) to die. I had one case where I kept bugging the dad to do some estate planning until he finally told me he would rather the government get the money than his sons. When dad finally died, the kids blamed the IRS rather than dad.

    It is true that brokerage houses now keep track of stock costs, but that is a recent practice. Few people know how much they paid for stock purchased before about 1995. A more difficult problem is the cost of real estate and the basis of property inherited form their parents or grandparents. The same holds true for paintings, antiques and collectibles.

    Under a VAT, the IRS would not be eliminated, only the name would change. Kind of like when Russia changed the name of the secret police from whatever it was called under the Czar to NKVD to KGB after Stalin died to whatever it is today. Ever person who sells at a garage sale, by the side of the road or on Ebay would have to pay the tax. Without agressive enforcement, none of these people (and there are millions of them and billions in sales) would pay any tax.

    My final objection to removing the estate tax is that too many beneficiaries turn into people like Ted and Patrick Kennedy, Steve Forbes, Paris Hilton or Jay Rockefeller, rather useless people who keep telling the rest of us how to run our lives.

    For social, not economic or tax reasons, I would rather see the inheritance tax increased and the income tax decreased. I like people who earn money but am annoyed by those who inherit it.

  9. T J Sawyer:

    And let's not forget that the step-up of basis currently applies to all estates, not just to large ones. This rather marvelous provision in the current law is a significant benefit to the children who might inherit mom and dad's vacation home. This second home, purchased 25 years ago for $30,000 is now worth $300,000. Lose the step-up and the kids will owe taxes on $270,000 of "income." Of course, this just illustrates the lie behind the Capital Gains tax. There is no gain. The value of $30,000 25 years ago was a small vacation home. The value of $300,000 today is a small vacation home. Just say no to losing the step-up in basis without indexing Capital Gains.

    Now let's see you explain this to the average voter so they can understand it make decisions based upon it. Good luck!