Spotlight: Impact of Estate Tax Repeal on Income Taxes

By Julie Malekhedayat, CPA, Principal
ASL Family Wealth & Individual Tax Group

Estate tax repeal is on the wish list of both the Republican party and the new President and is an idea that is generally popular with voters. However, a repeal of the existing transfer tax system would likely impact taxpayers in ways they are not aware of.  In 2015, only 4,918 estates paid estate taxes, but the beneficiaries of all estates benefited from the income tax savings of a higher tax basis for the assets they inherited.  Historically the repeal of an estate tax has been accompanied by changes in income tax rules that could reach far more taxpayers than the estate tax itself.

Currently, Sec. 1014 of the Internal Revenue Code provides that inherited assets receive a new tax basis in the hands of a beneficiary instead of retaining the decedent’s cost basis. The new basis is equal to the fair market value of the asset on the date of the decedent’s death. In other words, an asset that has appreciated in the hands of the decedent receives a stepped-up basis to fair market value at death instead of retaining a carryover basis.

For example, say John Taxpayer owned stock at his death for which he paid $100,000 to purchase, and the stock was worth $180,000 when he died. If John had sold the stock before he died, his taxable gain would have been the appreciation of $80,000. But if he held the stock at death and his daughter inherited it, her tax basis would equal the $180,000 value at his death, and she could then sell it for $180,000 with $0 taxable gain (a tax-free sale), keeping the full $180,000 in her pocket.

In 2010 when the estate tax was repealed and made optional for that one year, estates opting out of the estate tax were also opting into a carryover basis regime. Therefore, beneficiaries receiving those appreciated assets retained the decedent’s original tax basis, including the liability to pay capital gain taxes when those inherited assets were sold in the future. There was also a carryover basis regime under the Tax Reform Act of 1976, which was later repealed.

As part of the transfer tax system, gift rules currently provide for a carryover basis to the gift recipient, but that could change as well. The new Administration has not signaled its intent on the gift tax front.

Little is known at present as to what income tax changes may accompany a potential estate tax repeal, but some possibilities include:

  • Carryover tax basis for all estates (as in 1976 and 2010 laws)
  • Capital gain taxes paid on all assets at death (Canada law)
  • Capital gain taxes paid on all gifts of appreciated assets (Canada law)
  • Capital gain taxes paid at death on estates worth over $10 million (Trump proposal)
  • Repeal of estate tax, but not gift tax

As taxpayers watch and plan for possible changes in gift and estate tax laws, it will be equally important to consider the income tax changes that have historically accompanied such transfer tax revisions, which could impact the beneficiaries of all estates, large and small.