6. Gain on property qualifying for the marital or charitable deduction or for the orphan's exemption and on personal and household effects having a value of not more than $1,000 per item would not be taxed. Losses on all personal and household effects would be disallowed. 7. When property passes to a spouse or charity or qualifies for the orphan's exemption and the gain is exempt from tax, the basis of all property in the estate would be reallocated to each asset based upon fair market value before the taxable gain, if any, is computed. 8. A minimum basis of $60,000 would be allowed so that no tax would be due if the value of the estate was not more than $60,000. 9. Items giving rise to ordinary income (now classified as income in respect to a decedent) would be "accrued" and reported on the decedent's final return but would be eligible for income averaging. 2. A Critique We believe the Proposal is, for the reasons discussed below, unfair and overly complex and therefore is an unacceptable approach to taxing appreciation at death. Fairness must be a central feature of any tax. The impact of the Proposal imposed in connection with an estate tax is uneven and favors the large estate. Put another way, the effect of the new tax would be regressive when considered with the estate tax. This is caused by the removal, through an estate tax deduction for the capital gains tax, from the estate tax base of a portion of the estate assets which would otherwise be taxed at the highest estate tax rate or rates. Thus, the true rate of new tax on the gain is a function of the complement of the highest estate tax rate or rates at which the deducted capital gains tax would otherwise be taxed in the estate (i.e. the complement of x is 100-x). To illustrate using current rates, an estate taxed at the highest rate of 77% would be subject to an effective net additional tax commencing at only 23% of the actual capital gains tax paid but an estate whose highest estate tax rate was 30% would be subject to an effective net additional tax of at least 70% of the actual capital gains tax paid. Lower estate tax rates alone cannot remedy the inequitable and unfair impact of the capital gains tax proposal on the medium estate. The regressive nature of a capital gains tax on net unrealized appreciation at death is clearly demonstrated by the following illustration, employing the lower transfer tax rate schedule of the Studies. Assume a taxable estate, before tax but after expenses and claims have been deducted and with no marital or charitable deduction, of $4,500,000, with assets having a total basis of $1,500,000. Under current law, the estate tax is $2,115,400, or 47% of the total estate. Using the maximum 25% rate of tax in effect when the Proposal was made, the capital gains tax is imposed on the appreciation in the estate, $3,000,000, and the amount of this tax, $750,000, is deducted from the assumed estate of $4,500,000 to result in a taxable estate after allowance for the specific exemption of $3,690,000. The transfer tax, using the lower rates proposed in the Studies, will then be $1,373,100. The total tax "cost of dying" will be $2,123,100, a negligible increase of $7,700 in tax revenue over current law. If, however, the taxable estate were $450,000, with assets having a total basis of $150,000, the current estate tax is $110,500, or 24.5%. Again using a 25% rate of tax, the capital gains tax would be $75,000, and the taxable estate before the exemption would be $375,000. The Studies transfer tax is $66,150, and the "cost of dying" will be $141,150 an increase in tax over current law of $30,650 or 28%. When the percentage increase in tax in the smaller estate is compared with that of the estate ten times larger having the same proportion of net appreciation, the regressiveness is apparent. Using current capital gains rates, rather than the 25% rate, and the transfer tax rates in the Studies, the disparity in result between the medium and large estate becomes even more pronounced. The increase in tax for the large estate would be 7.6%, while the increase in tax for the medium estate would be 44.7%. The disastrous effect that such an overall increase in tax would have on a medium estate consisting largely of a closely held business is apparent. b. Technical Objections to the Proposal. The regressive operation of a capital gains tax on net unrealized appreciation included in a decedent's gross estate is, standing alone, sufficient reason to justify its rejection. In addition, there are technical reasons to reject the Proposal or parts thereof. The Proposal is needlessly complex. Complicated adjustments and computations will be required in all but the simplest estates. Exclusions and exemptions are included which are either inappropriate or inadequate. Administration is complicated by payment of the tax through two returns, an income tax return and a transfer tax return. The discussion which follows points up the aspects of this unnecessary complexity. (a) Reallocation of Basis-Marital, Charitable and Orphan's Exclusions. The reallocation of basis concept is one of the most objectionable features of the Proposal in that when applicable it would introduce substantial complexity into the administration of estates. The reason for its use is explained as follows: "The exemption on property passing to a sur- Reallocation of basis would be unnecessary if there were no exemptions for transfers to certain classes of beneficiaries. The Proposal takes the position that it is inappropriate to impose a capital gains tax on property which qualifies for the marital deduction, for the charitable deduction or, subject to certain limitations, which passes to orphans (a child of the decedent under the age of 21 years, if the other parent of the child does not survive the decedent). When applicable, the exemptions would create a "hybrid" system of part capital gains tax at death and part carryover of basis that would raise administrative problems and add considerably to the time required to administer estates. that of The most serious administrative problem "unknown" basis will arise in any case where a reallocation is required and, as is usually the case, the "exempt" property is not segregated as of the decedent's death. To illustrate, assume that the decedent leaves one-half of his residuary estate to his wife and one-half to his children and the executor makes sales of assets shortly after death, in part to raise cash for expenses, claims and taxes and in part for investment reasons. How is the executor to determine the income tax cost basis for the assets sold? Logically, all sales for expenses, claims and taxes or for investment reasons and allocable to the children's share should be exempt from tax except to the extent the value of the property sold exceeds its estate tax value and all sales for investment reasons and allocable to the marital share should be taxed based upon reallocated basis. It is, however, impossible to make such differentiations until the administration of the estate is completed and the amounts needed for expenses, claims and taxes are finally determined and the respective shares are fully distributed. As a practical matter, the reallocation of basis provision is, because of the uncertainty it produces, unworkable in the type of "typical" case under discussion. Reallocation would apply to a large number of estates (apparently even to cases where charity is given a small cash bequest); when there are a number of different assets the reallocation process would be time-consuming. Further, a serious problem would be presented in connection with funding marital bequests. Even assuming that a complete inter-spousal exemption is enacted, there would still be many cases where the decedent would prefer to divide his property in such a manner that one-half would be taxed in his estate and one-half in his wife's estate in order to reduce the combined transfer taxes on both estates. Thus marital deduction formula clauses would continue to be used and the same problem discussed above concerning the realization of gain upon the funding of a bequest of a pecuniary amount qualifying for the deduction would be present. The orphan's exemption bears no relationship to need and seems unnecessary. An allowance for minor children was a part of the estate tax law until 1950 (1939 Code, section 812 (b) (5)). It was repealed. No reason has been given that justifies its reinsertion into the law, particularly if there is a reduction in the transfer tax imposed on transfers at death. Also, its amount $3,000 multiplied by the difference between 21 and the child's age at the decedent's death will in many cases be hopelessly inadequate and not even cover basic educational costs. The charitable exemption in the Proposal, seems -55 unduly broad in that it would appear to exempt from any tax gain on assets transferred to charity in satisfaction of a cash legacy where the benefit of the exemption would not increase the amount passing to charity. The Proposal may involve interdependent computations of the capital gains tax and the transfer tax when gain must be recognized to pay administration expenses and claims and the capital gains tax will reduce the value of property that will pass to the surviving spouse or charity and qualify for the marital or charitable deduction. The amount of the marital or charitable deduction is dependent upon the capital gains tax and the amount of this tax is dependent upon the amount of property that qualifies for the deduction. An unlimited marital deduction does not avoid this problem. The average practitioner will, at best, have difficulty with the interdependent computations and, at worst, be unable correctly to determine the taxes. (c) Income in Respect of a Decedent The Proposal would change the current method of taxing income in respect of a decedent, commonly referred to as 691 income. This change is not a necessary part of evolving a system for taxing net appreciation at death, which is fundamentally concerned with taxing capital rather than income. The Studies state (page 347) with respect to 691 income: "The rules presently contained in section 691 were developed to avoid the bunching of income in the decedent's final return. But the complexities of section 691 have created troublesome problems. Therefore, for decedents dying after December 31, 1969, section 691 would cease to have application. The basic rule would be that gain on an asset, the sale or exchange of which would produce ordinary income or capital gain, or a combination of both, will be taxed at death with ordinary income to the required extent and capital gain as to the remainder." (emphasis added) Under the Proposal a recipient of property now classified as 691 income and subject to taxation as ordinary income would receive a basis for such property equal to its value on the applicable valuation date and the amounts received by the recipient in excess of (or below) basis would result in ordinary income (or loss). In substance, the Proposal would recreate the problem - bunching of income at one point |