Is Taxing Estates Under Income Tax a Good Idea – Center for Retirement Research
But it might be better to pay additional payroll taxes on the estate
In a great new book, British Columbia law professor Ray Madoff describes how federal tax laws have created two separate societies: working-class Americans who earn wages and pay taxes to support government programs, and the super-rich, who are almost completely divorced from the tax system. The wealthy often avoid earning income, which means they completely escape the payroll tax and ordinary income tax rates under income tax. Additionally, they can avoid capital gains taxes by not selling appreciated assets but instead borrowing money to support their lifestyle. Best of all, the money they inherit is tax-free. To correct the situation, Madoff proposed: 1) Repeal the estate tax, which no longer generates meaningful revenue; 2) Tax estates above the $1 million exemption under income tax; 3) Tax capital gains not only upon sale, but also when assets are transferred as gifts or upon death.
How feasible are these recommendations? How much money will they produce? Proposals to tax transfer gains have been around for decades and have actually been enacted in Canada. Other scholars have also proposed taxing inheritances received by heirs rather than those left by the deceased. The most recent representation comes from Lily Batchelder of NYU School of Law, who will serve as assistant Treasury secretary for tax policy from 2021 to 2024. Batchelder's proposal is more ambitious than Madoff's and is particularly interesting to anyone interested in Social Security because it would tax estates based on payroll taxes and income taxes. The Urban-Brookings Tax Policy Center provides income estimates for three levels of lifetime exemptions: $500,000, $1 million and $2.5 million. To be consistent with the Madoff proposal, the following discussion assumes the exemption amount is $1 million.
Batchelder's proposal has four features. First, any taxpayer who receives gifts or inheritances in excess of $1 million is subject to income and payroll taxes on gifts and bequests. Therefore, the excess amount will appear as ordinary income on their income tax form 1040. Additionally, excess inheritances will be subject to Social Security and Medicare taxes (currently 15.3%) on their Form 1040. The proposal envisions no Social Security maximum income threshold for this new type of taxable income. Proceeds collected will be donated to the Social Security and Medicare Trust Funds. A taxable estate can be spread over the current year and the first four years to cushion the impact of a surge in income. All exemptions and previously inherited amounts will be adjusted for inflation.
The second feature of the proposal is to apply constructive realization for income tax purposes to large accruals on gifts and bequests, abolishing the carryover basis and step-up basis. The proposal would maintain current law for the first $100,000 of accrued income ($200,000 per couple) plus $250,000 of individual residence income ($500,000 per couple). This part of the proposal also applies to charitable transfers, with the tax liability paid by the recipient.
The third feature of the proposal would address politically sensitive issues such as family businesses, farms and main residences through special provisions, and the fourth feature would limit tax avoidance through a series of reforms to the timing and valuation rules for transfers by trust and other means.
The revenue forecast shows three changes—1) elimination of the estate tax; 2) taxation of gifts and estates above the $1 million lifetime threshold at ordinary income rates and a 15.3% payroll tax rate; and 3) elimination of the base increase—which would increase revenue by $917 billion (see Table 1). The comparable figure for the $2.5 million threshold is $337 billion and the comparable figure for the $500,000 threshold is $1,393 billion.
These estimates are rough due to data limitations and the reliance on 1992 data for the distribution of estates among heirs. These estimates also likely underestimate the effect of the entire proposal because they do not include revenue from applying constructive realizations to charitable transfers and other revenue-generating proposals. Additionally, prices have increased by about 30% since 2020, so these estimates are $1,811, $1,192, and $438 billion in current prices, respectively, and will grow with wealth over time. By comparison, current estate tax revenue is expected to be $37 billion and is likely to decline as a share of wealth in the future.
For anyone interested in Social Security, a proposal to provide extra income to the wealthy needs serious consideration. Taxing death gains could dissuade older Americans from retaining oversized family homes to save on taxes. Even if you disagree, it's good to consider some options to ensure we're not a two-tiered society.
