COMMENTARY ON PROPOSED TAX REFORM AFFECTING ESTATES AND TRUSTS PREPARED BY THE AMERICAN BANKERS ASSOCIATION FOREWORD During recent years certain criticism have been voiced of the laws governing the income tax cost basis of a decedent's assets and various provisions of the estate and gift tax laws, all of which have been essentially unchanged for many years. Two comprehensive proposals for changes have been the 1968 Treasury Studies during the Johnson Administration and the American Law Institute Project published in 1968. The most recent criticism has been directed at what is regarded as the modest $60,000 estate tax exemptions high estate tax rates which, may force the sale by the decedent's family of a farm or closely held business. The so-called liquidity problem was accentuated by the elimination in 1975 of the 4% interest rate applicable to estate tax on farms and closely held business. Since early 1970 the ABA has been studying changes. This is a Commentary reviewing current law, some major proposals for changes, evaluations of these proposals, and alternatives suggested by the ABA. A previous Commentary on these issues was published by the ABA in 1972. This Commentary modifies in some respects and expands the 1972 publication. Exemptions; Level of Taxation; Farms and Closely Current Law Since 1942 the estate and gift tax exemptions of $60,000 and $30,000, respectively, and estate and gift tax rates have remained the same. These rates progress rapidly in the lower brackets, reaching 30% at a taxable estate of $100,000. The result has been that over this 34 year period with continuing inflation the estate tax has ceased to be a rich man's tax and now has a significant impact on estates of the middle class. The tax causes particular hardship for estates with farms and closely held businesses and in a significant percentage of cases requires their sale even though family members would like to continue their operation. This result has been criticized with increasing frequency in recent years. Major Proposals for Change Estate tax relief has been proposed in either of two ways, or a combination of both: 1. Increase the estate tax exemption to a figure in the range of $100,000 to $200,000; 2. Limit relief to estates with farms and closely held businesses which under current law are eligible to pay estate tax in ten annual installments. The Administration has recently proposed a five year moratorium on the payment of estate taxes on certain farms and closely held businesses. No interest would be paid during the five year period. The payment period would be extended from the current 10 year period to 20 years after the end of the moratorium. The special 4% interest rate on deferred estate tax which was eliminated last year would be reinstated. Eligibility would be limited to $300,000 of assets, with a dollar for dollar reduction from $300,000 to $600,000. ABA Evaluation of Proposals The An increase in the estate tax exemption to a figure in the range of $100,000 to $200,000 would substantially decrease estate tax revenues. revenue loss from giving relief only to estates with farms and closely held businesses would be much smaller. The Administration's proposal is questionable in a number of respects. A moratorium, which amounts to a five year interest free loan on the amount of the deferred estate tax, seems unnecessary and will encourage the continued operation of farms and closely held businesses which cannot survive economically. An additional 20 year payment period is not needed and would raise additional complications when one or more of the heirs receiving the property dies during this period. A dollar for dollar decrease in eligibility between $300,000 and $600,000 seems too rapid and will operate inequitably when compared with some cases where the asset has a value under $300,000. ABA Alternative An increase in the $60,000 exemption should not be considered in a vacuum, but rather as a part of the issue whether estate and gift tax revenues should be increased, decreased or held at approximately the same level. The ABA assumes that the current level of estate and gift tax is not going to be significantly Based upon this assumption, it believes that the $30,000′ gift tax decreased. exemption should be retained, but that the estate tax exemption should be increased to $70,000 plus that part of the gift tax exemption which is not used during life. The ABA favors changing the exemption from a deduction, which may be claimed against a decedent's highest estate tax rates, to a credit against the tax at the lowest estate tax rates. This change will minimize the revenue loss from the estate tax exemption increase. The ABA favors relief from farms and closely held businesses. In order to assure that relief is given only in deserving cases, three additional requirements to the ones that now exist to qualify for the ten year installment payment provisions would be imposed, namely, that the farm or closely held business be at least 65% of the decedent's adjusted gross estate, that it be owned by the decedent for at least two years prior to his death and that the heirs continue in the business as "operators" rather than as "investors". If these requirements are met, the interest rate on the estate tax installment payments would be reduced to 4% and a part of the installment payments of tax and interest would be forgiven. The forgiveness would be 10% of the first installment and would increase by 5% for each succeeding installment until it is 55% for the tenth installment. If the value of the farm or closely held business exceeds $400,000, the forgiveness percentages would be reduced and be the percentages previously mentioned (10%, 15%, etc.) times $400,000 over the total value of the farm or closely held business. The ABA recommends other changes which will increase the usefulness of the installment payment provisions. SUMMARY OF BASIS COMMENTARY Current Law Current law providing a step-up of income tax cost bases of a decedent's assets to their market values at death has been criticized for allowing a permanent escape from income tax on the appreciation which encourages investment retention or "lock-in." Major Proposals for Change 1. Retain step-up in basis but levy a Capital Gains tax on appreciation at death, assess as part of the decedent's final income tax return, and allow as a deduction in computing the Federal estate tax. Usually only appreciation beyond a current Valuation Date would be taxed under this type of proposal. 2. End step-up and Carryover the decedent's bases for estate assets, but increase these bases by the Federal estate tax attributable to the asset's appreciation element. ABA Evaluation The Capital Gains tax proposal is regressive because its estate tax deductibility would result in a proportionately lower combined tax on appreciation in larger estates than in smaller estates. The Carryover basis proposal is objectionable because of its administrative complexity in allocating basis increases; its unfairness in giving basis increases to assets which occasioned no Federal estate tax because they qualified for the marital or charitable deduction; and the lesser hope it offers for reduced estate tax rates. Both proposals would further complicate the administration of estates and increase the "cost of dying" which |