the Proposal because the higher marginal rate at which the appreciation is taxed in the large estate results in a proportionately larger step-up in basis in such an estate than in a medium estate in a lower marginal tax bracket.

At the cost of logic, regression can be

eliminated by making no provision for an adjustment to basis, thus freeing the computation of the AET from the basic transfer tax rates in Section 1. Such an approach does, however, introduce an element of double taxation into the transfer tax structure. This double tax has the effect of making the AET progressive in the sense that given the same amount of net appreciation the AET is more significant in the case of the large estate because the double tax element is proportionately larger in that estate.

Under present section 1015 (d) the basis of property transferred by gift may be increased by the gift tax paid. The step-up is not limited to the gift tax on the net appreciation but rather is based upon the gift tax on the full value of the transferred property. This result is difficult to justify logically because it is only the net appreciation that is subject to both income tax and gift tax. As mentioned above, the AET would apply to lifetime transfers made within two years of death unless the transferred property were sold before death. Thus, if current section 1015 (d) were continued, the double tax element both a basic transfer tax and an AET on net unrealized appreciation - would not be present in the case of a gift within two years of death as a result of the basis step-up. In order to prevent an income tax incentive for transfers "in contemplation of death", section 1015(d) should be revised to eliminate the step-up basis for such a transfer. This section should also be revised to limit the basis step-up in other cases to the transfer tax on the net appreciation.

b. Rate of Tax

The double tax element previously referred to justifies a rate substantially below the applicable capital gains tax rate or rates. The AET rate reflects the complement of the highest transfer tax rate and the highest capital gains tax rate.* In this way a decedent whose net unrealized appreciation is subjected to the highest transfer tax rate would pay approximately the same total tax as he

*The complement of x is 100-x.

would pay if a capital gains tax on this appreciation at death were imposed and a deduction for this tax were allowed in computing the transfer tax. Other decedents except those with small taxable incomes in the year of death would pay a smaller AET than they would pay under a capital gains tax at death. The highest transfer tax rate under the Draft is 60%. Using this rate and a current capital gains tax rate of 35%, the AET would be set at 14% 35% x 40% (100-60).

C.

Treatment of Appreciation Qualifying for

Marital and Charitable Deductions

Section 2 grants no dispensation from the AET for transfers that qualify for the marital or charitable deduction. As a matter of theory, imposition of a tax on appreciation should not turn upon the destination or use of the appreciation. Further, if exemptions from the AET based upon the recipients of the property subjected to the tax or adjustments to it are introduced, simplicity is lost, and administration becomes complex. It is time that simplicity and ease of administration, whether it works "for" or "against" the taxpayer, be considered as priority objectives in the enactment of tax laws.

(1) The Marital Deduction

The marital deduction provides a postponement of estate tax in the estate of the first spouse to die; the deferred tax becomes payable upon the death of the surviving spouse. An AET exemption for property which qualifies for the marital deduction would similarly delay AET liability in the first spouse's estate. This would, however, be a mixed blessing for the surviving spouse. While more funds might be available for her use during her lifetime, she would hold the assets qualifying for the marital deduction with a basis equal to that of the decedent. Thus, the "lock-in" effect would be accentuated and if the spouse sold the appreciated assets the entire appreciation would be taxed under the income tax at rates which might be substantially higher than the AET rate.

The failure to grant an exemption from the AET for marital deduction property obviously produces a higher tax upon the death of the first spouse to die than if an exemption were granted. This "additional" tax will be particularly significant in the case of the medium estate, say between $100,000 and $500,000. The impact of the additional tax on such estates will, however, be mitigated by the basic estate tax rate reduction contained in Section Further relief is made available by increasing the maximum marital deduction to the greater of $250,000 or

1.

one-half of the adjusted transfers.

Still further relief is made available by not considering the AET as a debt of the estate for marital deduction purposes under Section 32, with the result that the maximum marital deduction available on the death of the first of two spouses to die is not affected by the AET.

(2) The Charitable Deduction

Under Section 2(a) (1) the AET will apply to any transfer, including one that is entirely or partially charitable, made at death or within two years of the grantor's death. On the other hand, the AET will not apply to any transfer made more than two years prior to the grantor's death where the transfer is partially charitable and no non-charitable beneficiary has an interest in the property transferred after the grantor's death. The exclusionary rule for transfers made outside of the two year period will apply to those made to pooled income funds or to charitable remainder trusts even though the grantor retains an interest in or a power over the transferred property or to entirely charitable transfers where the grantor retains a right to designate the charitable beneficiaries. This result is accomplished by changing current estate tax law and excluding under Section 21 of the Draft such transfers from the individual's transfers at death, which (except for property transferred within two years of death) constitute the property upon which the AET is imposed.

In cases where the AET is imposed, a differentiation is made in the amount subject to tax depending upon whether Section 21 is applicable. If that section is not applicable, as would be the case with a wholly charitable transfer made within the two year period or with a transfer made within the two year period to a pooled income fund or a charitable remainder trust where as of the date of transfer it is certain that there will be no non-charitable beneficiary of the property after the grantor's death, the value of the property transferred, determined as of the time of transfer, will be the figure against which the basis is applied in determining the AET.

If as a result of a non-charitable beneficiary having an interest succeeding the grantor's interest in a pooled income fund or charitable remainder trust created during the grantor's life there is a taxable interest in the fund or trust, the value of the transferred property as of the date of death or the alternate valuation date (rather than its value on the date of the creation of the trust) will be subject to the AET as a result of the transfer being included in the grantor's transfers at death under Section 21.

When Section 21 is applicable, the problem arises as to what the income tax basis of the property should be in computing the AET. A charitable remainder trust is exempt from income tax and a pooled income fund is also exempt from tax on long term (but not short term) capital gains. A "loophole" would exist if the basis for computing the AET was the basis of the assets held at death because the tax could be avoided at no cost in capital gains tax by selling appreciated property transferred by the grantor immediately after receipt. This result is avoided by providing in Section 2 (b) (3) that the basis to be used in computing the AET is the donee's basis for the assets originally transferred immediately after the transfer plus, in the case of a transfer to a charitable remainder trust, an "upward" basis adjustment equal to the aggregate capital gains taxed to a recipient through the grantor's death. This adjustment will prevent an AET being imposed on amounts subjected to income tax after the transfer and prior to the grantor's death.

It will no doubt be contended by some persons that granting an exemption from the AET for charitable transfers which "take effect" at death is inappropriate. On the other hand, other persons will contend that an AET should not be imposed on any charitable transfer. The position taken in the Draft is a compromise of these conflicting positions. The AET may be avoided for charitable transfers, but only if the transfer is made outside of the normal two year "contemplation of death" period and the grantor creates an irrevocable interest in property to charity during his life.

Although Section 2 does not grant an AET exemption for transfers of appreciated property to charity, indirect relief is provided under Section 31 by permitting calculation of the charitable deduction for the purpose of the Section 1 transfer tax without reduction for the AET, thus maintaining for the estate the full benefit of the charitable deduction available under current law. For example, if the estate of $4,500,000 previously used for illustrative purposes were bequeathed in its entirety to charity, an AET of $420,000 would be payable on the entire appreciation in the estate, $3,000,000. Although the charity would actually receive no more than $4,080,000, the estate may claim a charitable deduction of $4,500,000 under Section 31. As the appreciation in an estate increases, the benefit to charity for this provision becomes proportionately greater because of the higher marginal rates at which the transfer tax would be imposed on the AET amount.

2.

Technical Explanation

a. Imposition of Tax

Section 2(a) (1).

Subsection (a) imposes the AET at a 14% rate on the net appreciation in the transfers of an individual at death or within two years immediately preceding death. The two year provision excepts from its application any property that is disposed of prior to death in a transaction resulting in the recognition in full of gain or loss. This provision prevents avoidance of the AET by a transfer "in contemplation of death". As used in Section 2(a)(1), "the recognition in full of gain or loss" upon a disposition by a recipient of transferred property means that the full gain or loss realized by reason of such disposition is included in the calculation of his income tax liability. Thus, the sale prior to the grantor's death of property transferred by him within two years of his death to a charitable trust described in section 4947 (a) (1), to a charitable remainder trust described in section 664 or to a pooled income fund described in section 612 (c) (5) will not avoid the application of the AET.

Net appreciation is the difference between the fair market value of the property (the "estate tax value" concept of current law) and the basis of such property. The appropriate basis for different assets is determined through the application of subsections (b), (c) and (d).

b. Special Election for Community Property

Section 2(a) (2)

Current law (section 1014 (b) (6) and (7)) provides a change in basis for a surviving spouse's share of community property upon the death of the other spouse to its value on the applicable valuation date for the deceased spouse's share of this property. This result is inappropriate in the context of an AET since it would permit the complete avoidance of a tax on one-half of the unrealized appreciation in community property that occurs prior to the death of one of the spouses. A distinction in treatment of separate property and community property for AET purposes is justified by the differences in these two types of property.

Two approaches to community property and the AET were considered. First, the surviving spouse's share of community property could be subject to the AET along with the deceased spouse's share. Although permissible (see Fernandez v. Wiener, 326 U.S. 340 (1945)), this approach seems unfair in that the differences between separate and community property would not be recognized. Second, carryover basis could be applied to the surviving spouse's share,