We’ve had a federal estate tax since 1916.  For many years, there’s been a fierce push to put this tax out of its misery.  Only a handful of votes have prevented its complete demise on a few occasions.  It actually disappeared for 12 months in 2010, but it’s back now and, absent Congressional action by end of this year (2012), it will be as mean as ever starting in 2013.

Is it time to finally kill the federal estate tax?  Most on the right and some on the left say the time has arrived.  Others passionately argue that we should not trash a 95-year old tax that’s targeted squarely at the top players in the top one percent.

Those who advocate death to the tax argue that it’s just plain wrong to strip a family of a major portion of its wealth when death occurs – to send the taxman in with the undertaker.  Plus, they point to the huge generational transition risks to successful, illiquid businesses and family farms, the gross inefficiencies of a tax based on property values that can easily be disputed, and the fact that the tax, relatively speaking, contributes peanuts to the federal coffers.

Proponents of the tax argue that death is a great time for the government to strike, that massive intergenerational wealth transfers should not be encouraged, and that the tax will start paying off once the right people start dying.  In the prologue to their book Wealth and Our Commonwealth (Beacon Press 2003), Bill Gates, Sr. and Chuck Collins, two of the leading proponents of the tax, write, “Americans who possess great wealth have a special obligation to pay back a debt to society…Preserving the estate tax will ensure that our society values the inherent  worth of the individual – rather than the inherited worth.” (Pages xi-xii).

Of course, the estate tax poses no direct threat to the masses that aren’t rich.  This is because the estate tax does not kick in until a person’s estate exceeds a certain amount – known as the unified credit exemption equivalent or, as some say, the “free amount.”

Most remember the heated battle in Congress over the extension of the Bush tax cuts that occurred during the final days of 2010.  A compromise was finally reached, amidst a whole slew of political theatrics.  As part of this compromise deal, the Republicans got their dream deal for estate taxes (short of complete repeal) for two years – 2011 and 2012.  For these two years, the estate tax free amount was set at an all-time high – $5 million in 2011 and $5.12 million in 2012.  And for a married couple, there is a provision that automatically doubles these amounts – again something brand new.  But these rules work only for those who die in 2011 or 2012.

If Congress does not reach an agreement on the extension of these breaks by the end of 2012, this estate tax free amount will plummet back to only $1 million starting in 2013, with no automatic doubling between spouses.  And the tax rate will jump to as high as 55 percent.  So the ultimate fate of this tax, like nearly every other important tax provision, was just kicked over to 2013 as our country struggles to crawl out of a debilitating recession and our elected representatives wrestle with unprecedented deficits that threaten to bring down everything.

Many reasonably ask: Given the high threshold of this tax, why should we even give a hoot about the tax?  If you’re like most, it’s not about the direct impact of this tax on you; it’s about the potential harm you many suffer if the tax is imposed on others.  There are two potentials – one rare, one not-so-rare.

The first potential, the rare one, is if your parents have an estate tax exposure.  If they do, sooner or later it will end up in your lap – and directly impact (in a big, negative way) your financial future.  Smart planning over time can seriously reduce or completely eliminate the pain.  So you may have a real vested interest in the quality of your parents’ planning.

The second not-so-rare scenario is the person who works for a company that has an owner who faces a serious estate tax exposure.  Fearful of not having enough liquidity (cash) to cover the estate tax hit and transition the business to a second generation, the owner elects to convert his illiquid business into a pot of cash or liquid securities by selling out to a big corporate enterprise.  The corporate buyer gets a new revenue source, and the former owner of the business walks with millions.  The big losers in this scenario are the employees, half of whom lose their jobs as the company’s operations are consolidated into the corporate buyer, and the local community that loses a solid employer that used to support local vendors and community efforts.   Business consolidations often are bad for employees and communities, and few things encourage such destructive consolidations more than an ugly estate tax exposure.

So what is Congress going to do with this tax in the future?  No one has a crystal ball nearly powerful enough to predict this one with any certainty.  Many members of Congress complained bitterly in the 2010 tax extension debates, claiming that they were being held hostage – being forced to make a sweetheart deal on the estate tax to secure an extension of unemployment insurance benefits that many Americans desperately needed.  They vowed to fight any extension of these tax breaks for the rich.

Looking ahead, there are four potential scenarios.  First, Congress could be deadlocked and end up doing nothing, in which case the old, low $1 million free amount would return in 2013, along with the maximum 55 percent rate.  Second, some believe that the stage has been set for a negotiation that will result in a complete repeal of the estate tax (the ultimate dream of many rich) as a quid pro quo for something much bigger that those on the left badly want.  Third, there is the possibility that such a negotiated deal could result in the big breaks for 2011 and 2012 being made permanent or being extended for an additional term.  And finally, the negotiation could result is the current breaks being watered down a bit.  Many (including Obama in his newest budget) suggest that the free amount be set at $3.5 million and the maximum rate at 45 percent.

What should happen to this tax?  For me, that’s an easier question. I don’t think it should be eliminated.  It’s time to fix, not kill, the federal estate and gift tax.   We need a smart fix that will keep the tax targeted squarely at the rich, contribute to a balanced approach of fiscal discipline and economic growth, protect family-owned businesses and farms, and eliminate screwy loopholes.

When viewed in the context of our present massive spending and deficit challenges, the revenues generated by this tax are peanuts by almost any standard.  Total revenues in 2011 funded just about 24 hours of federal spending.  Even in 2009, before the huge breaks for 2011 and 2012 kicked in, the total take from the estate and gift tax funded only about two days of the federal government’s current spending level.  And if the unthinkable happens in 2013 and the estate tax free amount (the unified credit exemption equivalent) dives to only $1 million and the maximum tax rate escalates back up to 55 percent, the yield to the government in 2013 is projected to still fund only about seven days of federal spending.

Some argue that this peanut numbers reality cuts in favor of killing the tax.  They’re missing the point.  With this tax, it’s not about the size of the numbers.  It’s about perceptions, priorities and opportunity costs.

The exclusive beneficiaries of killing the tax would be the ultra rich, and the strongest supporters of the tax are those who resist any attempts to tackle our out-of-control spending and daunting financial mess.  So any serious efforts to kill the tax must be advanced by those who, out of the other side of their mouths, advocate for strong measures to restore financial discipline and hope – senior entitlement reforms, spending caps, fewer entitlements, a plan for a balanced budget, and more.

And that’s the rub.  Why should any fiscal discipline advocate consider wasting even a smidgen of precious political capital trying to kill a 95-year old tax that impacts only the rich?  Any such effort will create a huge (irrefutable?) target that can be easily leveraged to create a powerful obstacle to any real change – a slam dunk  perception that, when it comes to fiscal discipline, priority one is always protecting the rich.  Given the unprecedented fiscal challenges we now face, we just can’t afford a knock-down fight over a tax break for the rich that will trigger serious perceptions problems, evidence messed up priorities, and ultimately result in huge opportunity costs.

But everyone agrees that something must happen before 2013.  The prospect of a do-nothing approach that expands the tax to those who aren’t “really rich” with a measly $1 million unified credit exemption equivalent (free amount) appeals to no one.  So there’s a need for a smart fix.  Here’s my take on the key elements of such a fix – my wish list.

1.  New Break for Family Businesses and Farms. An elective exemption would be available to exclude from the estate tax any interest in a family-owned active business or farm that is left to other family members so long as the recipient family members agree to continue to operate the business or farm for at least five years and personally commit to retroactively pay any avoided estate taxes (plus interest) if the active business or farm is sold within the five-year window.  If the election is made, the recipient family members would permanently forgo any income tax basis step-up in the inherited interest, thereby assuring that they will pay a higher income tax down the road if and when the interest is sold.  To qualify for the elective exemption, over 50 percent of the equity interests in the active business or farm would have to be owned by family members (narrowly defined to include only parents, descendants, and select trusts for descendants).   An elective exemption of this type would tremendously help those families that want or need to transition an active business or farm to the next generation.  The tax pressure to sale would be gone. And it would moot the strongest argument for killing the tax.

2.  A $3.5 Million Free Amount.  The unified credit exemption equivalent (the free amount threshold) would be set at $3.5 million and be adjusted annually for inflation.  Plus, the automatic spousal doubling provision that was temporarily added in 2011 and 2012 would be retained.  No couple with an estate of less than $7 million would have to sweat the estate tax, and the automatic spousal doubling provision would help those couples who don’t properly structure their affairs before the death of the first spouse.  The $3.5 million level, advocated by many, is far greater than the $1 million level that will be triggered if nothing is done, and it represents a significant, fiscally-responsible step-back from the $5 million level that was temporarily negotiated for 2011 and 2012 in a power play for the rich that many detest.

3. Maximum Rate of 35 Percent.  The maximum rate would be set at 35 percent.  This would put the maximum hit far south of the 50 percent mark that freaks out so many who can’t fathom the notion of surrendering nearly half of their wealth to the federal government at death.  It should help with the sale of any compromise package.

4. Eliminate the Family Valuation Discount Loophole.   This loophole enables a family to generate minority interest and lack of marketability valuation discounts (often as high as 40 percent) by shifting to family members minority interests in family partnerships and other entities that own investment assets.  This loophole should be closed with a provision that aggregates interests held by members of the same immediate family for valuation discount purposes.  It would put an end to many aggressive, tax-driven family partnerships and LLCs.

5. Terminate the “Crummey Withdrawal Right” Loophole. This loophole enables a taxpayer to secure a gift tax benefit by granting family members specific rights to withdrawn property from a trust, even though the there is no intention of exercising the withdrawal rights, and, in fact, the rights are never exercised. The loophole should be closed with a simple provision that eliminates the gift tax benefit if the withdrawal rights are not exercised.  The use of such artificial withdrawal rights to create gift tax benefits would instantly disappear.

6.  Wipe-Out the “Zero-Out GRAT” Loophole.  This loophole creates a “heads I win, tails I break-even” tax bet for a taxpayer who creates an aggressive grantor retained annuity trust (GRAT) that runs for a designated number of years and pays a substantial annuity to the taxpayer for the term of the trust.  The annuity payments are structured to eliminate any gift tax burdens on the front end.  If the taxpayer outlives the term of the trust (the mortality risk) and the yield on the trust’s investment assets exceeds the rate used to value the annuity payments (the yield risk), property ends up passing to the taxpayer’s heirs free of all gift and estate taxes. The key to eliminating this loophole is a provision that requires an upfront taxable gift equal to at least 10 percent of property passing to the trust.  A GRAT would still be allowed, but it would no longer be a freebie – a “no-lose” deal.  The taxpayer would have something to lose – some skin in the game – if either the mortality or yield risk didn’t work out.  Many fewer big hitters would jump on the GRAT bandwagon.

7.  End the IDGT Installment Sale Loophole. This loophole allows a taxpayer to freeze the value of property for estate tax purposes by selling the property to a family trust that has been carefully structured to be a nullity for income tax purposes (it’s an intentionally defective grantor trust) but to be effective for estate and gift tax purposes.  The goal is to have the sale set the stage for a big estate tax savings with no income tax consequences. The whole effort is based on a technical incongruity between the estate and income tax provisions of the tax code.  The loophole can be shut down by eliminating the incongruity or imposing a valuation rule that triggers a prohibitively expensive gift tax at the time of the sale to reflect the economic reality of the deal.

These seven changes would go a long way to fixing the federal estate and gift tax. They would soften the impact on family-owned businesses and farms, eliminate loopholes that create big tax advantages for those who have the know-how and means to exploit them, and buttress (not frustrate) a broader fiscal discipline agenda.

June 22, 2012