2. Repeal of the "Stepped-up Basis" Rule

Present Law

The cost or basis of property acquired from or passing from a decedent is its fair market value at the date of death (or alternate valuation date if that date is elected for estate tax purposes). The basis of property acquired from or passing from the decedent is often referred to as a "stepped-up basis." Under the stepped-up basis rule, appreciation after the decedent acquired the property is not subject to income tax.

On the other hand, in the case of property acquired by gift, the donee's basis generally is the same as the donor's. The basis of property acquired by gift is often referred to as a "carryover basis." The Tax Reform Act of 1986 repealed the tax favored treatment of capital gains.

Possible Proposals

1. An income tax could be imposed on the net appreciation in property passing from a decedent at his death. In order to exempt relatively small estates from such an appreciation tax, that tax could be offset by an exemption or any unused portion of the decedent's unified credit. Property passing to a surviving spouse or to charity would not be subject to the appreciation tax, but would receive a carryover basis similar to that provided for transfers by gift. As under present law, the basis of all other property would be its fair market value at the date of death. A similar proposal was described in the report of the Task Force on Transfer Tax Restructuring of the Section of Taxation of the American Bar Association.

2. Alternatively, it would be possible to achieve a similar result by permitting a partial credit against the estate tax for the decedent's basis in the property includible in the gross estate. In order to raise revenue, the enactment of the credit would be coupled with increased estate tax rates.

3. The basis of an asset acquired from a decedent could be made equal to the decedent's basis in the asset (i.e., a carryover basis). Pros and Cons

Argument for the proposals

1. Adoption of any of the proposals would end the "lock-in" effect of present law under which taxpayers retain assets during their lifetimes in order to obtain forgiveness of the tax on the gain at death through the "stepped-up" basis rule. This "lock-in" effect has been exacerbated by the 1986 Act changes. The "lock-in" effect impedes the efficient operation of the capital markets.

2. Under these proposals, the overall taxes imposed on property would be roughly the same regardless of whether the property is

sold before death by the decedent, sold after death by his estate or heir, or sold by a donee to whom the property had been given prior to death.

3. Under the Canadian income tax, both death and gift are treated as realization events-a system which generally is viewed as workable.

Arguments against the proposals

1. In order to comply with the rule taxing appreciation at death (or carryover basis), individuals would be required to retain written records for all their assets. Many taxpayers do not keep such records. The Congress should not impose such an extensive recordkeeping burden on the public.

2. Even where individuals keep adequate records of the bases of their assets, the executor or spouse must locate those records. Moreover, where decedent does not keep such records and the are not otherwise available, executors and heirs will have difficulty complying with an appreciation tax.

3. Any tax on appreciation of assets held at death (or a carryover basis for such assets) would increase the overall taxes on assets passing from one generation to another.

3. Taxation of Life Insurance

Present Law

The proceeds of a life insurance policy on the decedent's life are includible in the gross estate of the decedent if either (1) the proceeds are receivable by the executor or administrator or payable to the estate or (2) the decedent at his death (or any time within three years of his death) possessed any "incidents of ownership" in the policy. Incidents of ownership include the power to change the beneficiary of the policy, to assign the policy, to borrow against its cash surrender value, and to surrender or cancel it.

Possible Proposal

Include in the gross estate the proceeds of any insurance policy payable, directly or indirectly, to a relative of the decedent. A similar proposal was described in the report of the Task Force on Transfer Tax Restructuring of the Section of Taxation of the American Bar Association.

Arguments for the proposal

Pros and Cons

1. Under present law, an individual may take out a life insurance policy, irrevocably designate beneficiaries of the policy, and transfer all incidents of ownership to another person. In that situation, the proceeds of the life insurance policy are not includible in the decedent's gross estate even if the decedent pays all policy premiums. Such an arrangement effectively transfers property at death while avoiding estate tax.

2. Life insurance is inherently a death-time transfer. Adoption of the proposal would ensure that all transfers at death are subject to estate tax. The requirement that the proceeds be paid directly or indirectly to a relative of the decedent ensures that the proposal would not result in estate taxes being imposed upon "key man" insurance purchased by the individual's employer or partners.

Arguments against the proposal

1. Life insurance often has a significant investment element which should be taxed like other investments. Consequently, life insurance should be includible in the gross estate only where the decedent retained interest in, or control over, the investment at his death.

2. The transfer of the incidents of ownership and the payment of insurance premiums are subject to the gift tax and, consequently, the present tax treatment of life insurance does not permit improper avoidance of transfer taxes.

4. Valuation of Property: Estate Freezes and Minority Discounts

In general

Present Law

The value of property includible in a gross estate is its fair market value at the date of the decedent's death (or on the alternate valuation date if the executor so elects). The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

Where actual sales prices and bona fide bid and asked prices are lacking, the fair market value of stock is determined by looking to various factors, including the company's net worth, prospective earning power and dividend-paying capacity, the goodwill of the business, the economic outlook in the particular industry, the company's position in the industry and its management, the degree of control of the business represented by the block of stock to be valued, and the values of securities of corporations engaged in the same or similar lines of businesses.

Valuation freezing techniques

Where an individual transfers a remainder interest in property but retains the income from that property for his life, his gross estate includes the full value of the property. An individual may, however, exclude from his gross estate the value of common stock transferred to others, even though he retains preferred stock in that corporation with the right to most dividends. See Estate of John G. Boykin, 53 T.C.M. (CCH) 345 (1987). A person also may exclude from her estate the value of an option to purchase property owned by her, despite her enjoyment of the property prior to the exercise of the option. See Dorn v. United States, 59 A.F.T.R. 2d 1148,875 (W.D. Pa. 1986).

Estate planners use the above rules to "freeze" the value of property so that appreciation in the estate's assets accrues to the owners' children and is thereby excluded from the gift and estate tax base. One method is to recapitalize a closely-held corporation to have both voting preferred and common stock outstanding. The par value of the preferred stock is set at the estimated value of the corporation at that time. The owners give the common stock to their children and retain the preferred stock themselves. The owners claim that since the par value of the preferred stock is set at the estimated value of the corporation, the common stock has little value and, consequently, there is little or no gift tax owed. At the owners' death the executor values the preferred stock at its par value (i.e., the value of the preferred stock is "frozen" at the time