Carryover Basis And Charitable Giving
By Jerry J. McCoy
Repeal of the estate tax, which some say reduces incentives for giving to charity, simultaneously creates several new ones by encouraging various types of charitable bequests.
Much has been written, in these pages and elsewhere, about the possible repeal of the federal estate tax and its potential effect upon charitable gift planning. This is understandable, for estate tax savings are viewed as a powerful incentive for some types of charitable transfers, and the repeal of the tax would necessarily bring about the end of this incentive. However, another important aspect of the estate tax repeal legislation has received comparatively little attention among charitable gift planners. The new basis rules that would have eventually replaced the estate tax under the versions of the repeal legislation that passed Congress (and were vetoed by President Clinton) in 1999 and 2000 would also affect charitable planning. Many observers believe that this replacement is likely to survive as the Bush Administration and the new, closely divided Congress approach this subject again in 2001.
History And Background
While the current estate tax dates from 1916, the basic concept is much older. Reports vary as to when the first United States "death" tax appeared. As early as 1815 the Secretary of the Treasury proposed such a tax to help defray the costs of the War of 1812, although that war ended before Congress could enact it. The first such tax actually passed by Congress appeared in the Revenue Act of 1862, as a means of financing the Civil War, and this was repealed in 1870. War costs (this time for the Spanish-American War) again led to enactment of a death tax in 1898, and this one was repealed in 1902. Finally, the modern estate tax was enacted in 1916, partly to meet governmental revenue needs and partly to discourage concentrations of great wealth, which were widely regarded as detrimental to national interests. The gift tax was added a few years later, in 1924, and has been around continuously in its present form since 1932. The purpose of the gift tax, as described by Congress in 1932, was to supplement both the estate tax and the income tax.1
A deduction for charitable transfers was added to the estate tax in 1918, a year after the income tax charitable deduction was enacted. Despite minor refinements and added restrictions, especially under the Tax Reform Act of 1969, the estate tax charitable deduction has continued without basic change through the current statute.
Repeal Legislation – The Approach and the Rationale
By the end of the Twentieth Century, the estate tax had accumulated a formidable collection of enemies. Its current critics speak most often in terms of the detrimental effect this tax is said to have on small businesses and farms, those sentimental sweethearts of United States tax policy. This group vilifies it as the "death tax," and portrays it as a sinister governmental confiscation of the fruits of a long life of toil, preventing the older generation that built these assets up through hard and honest work from passing them to their surviving family members. In fact, even estate tax opponents seem to acknowledge the undeniable fact that farms and businesses represent only a very small portion of the assets caught up in the estate tax.
In addition, the battle over the estate tax raises deeper social issues of class and the role of inherited wealth in our society. Only a small and shrinking number of estates is actually required to pay the estate tax, as a result of the steady increase in available exemptions from $60,000 in 1976 to $675,000 today and $1 million in 2006 and thereafter. As a result, only large estates are affected at all. Viewed in light of the average decedent’s estate, these are gigantic estates. Inevitably, then, repeal of the estate would benefit primarily individuals and families that are considerably wealthier than the average American and his/her family. This is historically relevant to one of the early policy justifications for the federal estate tax – limiting concentrations of great wealth and the economic and political power such concentrations could produce.
Despite these policy incongruities, the repeal of the estate tax seems more likely today than at any time in its 84-year history. The last Congress passed repeal measures twice, but both were vetoed by President Clinton. It is thought by repeal supporters that, with President Bush in office, a repeal measure is likely to be enacted later this year. Opponents suggest, a bit wistfully, that relief in the form of expanded exemptions and lower rates is more likely to emerge from the narrowly divided 107th Congress. Both of the repeal measures passed by the last Congress involved a ten-year phaseout of the estate tax and the gift tax, replacing them with a carryover basis rule that would take effect when the estate tax finally disappeared. The carryover basis rule has implications for gift planners above and beyond the direct effect of the estate tax repeal itself. While it is far from certain what estate tax changes are likely to emerge from the new Congress, and whether they will be accompanied by a carryover basis system, it is worth considering what impact the latter system might have on charitable planning principles.
The New Carryover Basis Rules
Under a long-standing tax principle, property passing from a decedent receives a new basis for tax purposes in the hands of the recipient. For example, let’s assume Mrs. X owns an investment she bought many years ago for $12,000 that is now worth $100,000. If she were to sell this investment, she would realize a taxable capital gain of $88,000. At a 20 percent capital gains tax rate, she would incur a tax of $17,600, leaving her with after-tax proceeds of $82,400. If instead she should die and leave this to her daughter, the property takes a basis for tax purposes in the daughter’s hands equal to the value of the property as of the mother’s date of death, or $100,000 here. [This is generally referred to as a stepped-up basis, although the basis would actually be stepped down if the date-of-death value is less than the decedent’s cost basis.] If the daughter sells the property immediately for $100,000, she has no capital gain and hence no capital gains tax.
Under the carryover basis rules that are expected to follow if the estate tax should be repealed, the decedent’s basis in property would carry over to the person receiving it at the decedent’s death, subject to some important exceptions that we will review in a moment. Thus, in the preceding example the daughter would take the property with the same $12,000 basis it had in her mother’s hands. If she sold it immediately upon receiving it, she would realize a taxable capital gain of $88,000 – the same amount her mother would have realized upon a sale of the property.
Now, this daughter might be less enthusiastic about the repeal of the estate tax if she finds that it simply replaces the old tax on the property she receives from her mother with this new capital gains tax. What is the appeal of this change? Wouldn’t it just shuffle the deck and make some people pay more tax? Perhaps, but the proponents of estate tax repeal contend that the carryover basis rule would eliminate the need to sell farms, businesses and other property received upon the death of the holder. A person who inherits a farm or business asset from a parent faces the prospect of an immediate estate tax liability under current law. With the carryover basis rules in place instead, that person would have a choice; if he or she continued to hold the property, there would be no tax, but if he or she sold the property, there would be a capital gains tax. The possibility of a liquidity problem would be minimized, since the sales proceeds could be used to pay any capital gains tax bill.
As pointed out before, farm and business properties represent a small portion of the assets affected by the estate tax. Moreover, the liquidity problems encountered by estates that hold such property are mitigated by a number of other provisions, including the right to pay estate taxes in installments over a 15-year period. Nevertheless, to replace the tax revenues lost by repeal of the estate tax, legislative customs suggest that some offsetting revenue measure is a necessary addition. Perhaps for the reasons described, the carryover basis rules have served that purpose in the 1999 and 2000 versions of estate tax repeal and it is widely thought that they will be included in the version that is thought to be so much more likely to be enacted in 2001.
President Bush made it clear in his campaign rhetoric that he supported repeal of the estate tax, and his party holds a majority, however slim, in Congress. For this reason, repeal legislation is certain to be introduced in Congress again this year, and one should not be surprised if that legislation, including the carryover basis rules, should become law this time. At the present time, a majority in Congress appears to support the repeal legislation and, if it should pass, the new president has indicated he would sign it. This is not a certainty, but it is likely enough to justify the farsighted gift planner’s giving some thought to just what effect the carryover basis rules might have on accepted charitable planning principles. The effect of repealing the estate tax will itself have an important impact on charitable planning, but that prospect has received substantial discussion already.
The discussion that follows will address the consequences of a carryover basis system of the sort seen last year and the year before. In this discussion, we will assume that 1) Congress does repeal the estate tax and the gift tax, 2) that repeal is accompanied by enactment of a carryover basis regime; and 3) that regime is substantially the same as the one passed by Congress and vetoed by the president in 2000. Of course, it goes without saying that any one of those assumptions could prove wrong, and a spirited debate will occur in any event.
Impact of Carryover Basis on Charitable Gift Vehicles
First, one should note that repeal of the estate tax and gift tax would leave in place all of the income tax incentives for charitable giving. The carryover basis provisions promise to usher in a whole new set of income tax planning considerations as well as considerable new complication. As a starting point, one should be aware of how those rules would work.
Under the 2000 version of this legislation, property acquired from a decedent dying after 2009 would have had a carryover basis in the hands of the recipient. Exceptions to this general rule would be made for three basic categories of property:
1. The first $1.3 million of a decedent’s property (as selected by the executor of the estate) would continue to receive a stepped-up basis;
2. Also excepted would be up to $3 million of property acquired from the decedent by a surviving spouse, provided that the property would qualify for the marital deduction under the current estate tax rules; and
3. The new rules would not apply to "income in respect of a decedent," such as IRAs and other retirement plan assets.
The $1.3 million and $3 million amounts above would be indexed for inflation. These exceptions are so large as to remove most estates from the operation of the new rules. Estates of $1.3 million or less would be completely unaffected, plus another $3 million could be left to a surviving spouse with a stepped-up basis (although the surviving spouse’s estate would have only the $1.3 million exemption, unless he/she remarried). Thus, most people would be unaffected by the carryover basis rule, just as most people are unaffected by the estate tax. Nevertheless, even this brief summary reveals a number of complications.
First, even if the current estate tax would be repealed, some of its provisions would survive for the limited purpose of determining which of a decedent’s properties would qualify for a stepped-up basis. Specifically, the marital deduction rules as they now exist would govern the step-up for property passing to a surviving spouse. [Maybe this will help stem the public outpouring of concern for the plight of estate planners if the estate tax should be repealed.]
Second, the fact remains that many people simply do not know the amount of their current basis in many (perhaps most) of their property holdings. This was considered a major problem under the more complicated carryover basis provision adopted by Congress in 1976, and it eventually led to the retroactive repeal of that provision in 1980 after spirited lobbying by bankers and professional groups. The new legislation would attempt to mitigate this by exempting smaller estates. Nevertheless, there is no doubt that many estates will be affected and that the executors and beneficiaries of those estates will be quite disappointed.
The rule allowing the executor to select which property in an estate will receive the benefit of the $1.3 million exemption and be stepped up in the hands of the beneficiary will certainly simplify the operation of the new rule, but this simplification will still create some problems. Consider for example an estate of $5 million that is divided among 10 family members. Will the executor simply decide that each beneficiary gets to use a pro rata share of the exemption, stepping up $130,000? If so, what about the beneficiary who receives only $50,000? Maybe that beneficiary will get his/her full bequest stepped up, and the other $80,000 referable to him/her will be divided among the others. Or will the executor allocate the exemption among direct descendants, leaving the carryover basis property to more distant relatives and non-family members. Also, consider what should happen if some beneficiaries receive property that has a fair market value on the date of the decedent’s death that is less that the decedent’s basis.
Obviously, these issues will have to be addressed in the decedent’s Will, and the likely result will be a new form of complication in Will drafting. Trust companies and other professional executors will be reluctant to accept the sort of broad authority the statute would appear to give them to allocate the exemption however they deem best. The planning necessary to facilitate the carryover basis rules will require some very basic retooling of accepted planning and drafting approaches. And that retooling itself will create some new charitable planning approaches. Here are some likely examples of how charitable planning may continue to be useful under the carryover basis regime:
4. New trust formats. One likely new approaches for dealing with the carryover basis rules is in the use of trusts. Standard practice today often results in a two-trust approach, with the unified credit amount in one trust and the balance in another trust (the marital trust in the case of a married testator). With carryover basis, there may be reason to utilize a three trust approach as a new standard – a marital trust for the $3 million of property qualifying for the spousal step-up, another trust for the $1.3 million of exempt property, and a third trust for carryover basis property. Likewise, it may be advisable to develop ordering rules for determining which types of property are assigned to each of these trust categories. Even with no estate tax to worry about, planners will have tax problems to anticipate and solve. And (as discussed in Item 7 below) it is likely that some of those new problems will have charitable solutions.
5. Funding Bequests to Charity with Low-Basis Property. Under the carryover basis rules, emphasis will have to be placed upon assigning low-basis property wherever possible to one of the categories that qualifies for a basis step-up. One useful allocation of low-basis property in this situation would be to fund bequests to tax-exempt charitable entities, which will not be adversely affected upon sale of such property. [This would correspond to the present day tendency to leave IRA and retirement plan assets and other items of income in respect of a decedent to charity.] The donor’s favorite charity, as a tax-exempt entity, would offer a ready recipient for property disadvantaged under the carryover basis regime. By allocating a decedent’s lowest-basis property to charity, the planner would thus optimize the overall tax position of family beneficiaries.
6. New emphasis on charitable remainder trusts. Repeal of the estate tax and the gift tax would not affect the income tax. As a result, the present income tax incentives for charitable giving would not merely survive, but would become more significant. One of those incentives that is likely to become more important in the post-estate-tax era is the charitable remainder trust ("CRT"). Many donors would find it attractive to create such trusts for the same reasons that donors today create them. But one of those reasons – the use of the charitable remainder trust to avoid or delay capital gains tax – would become even more attractive under a carryover basis regime. Estate beneficiaries receiving low-basis property would find the CRT an attractive means of selling such property without immediate tax. And estates themselves might be structured to utilize CRTs. Particularly in larger estates, where the $1.3 million and $3 million exemption amounts are insufficient to step up sufficient property to meet overall needs, it may prove useful to include a testamentary charitable remainder trust in the estate plan and allocate low-basis property to it for resale free of capital gains tax.
7. Long transition period. Charitable gift planners concerned about the loss of estate tax incentives should remember that this loss is likely to be phased in over a period of years, so that the impact on charitable plans would be mitigated. [Of course, the long phase-in is designed to alleviate the impact on federal tax revenues, not the effect on charities, but both are eased nevertheless.] This means that planners have to anticipate the new rules, educate their donors or clients, and be prepared to operate under both systems during the transition period.
8. Foundations – good news and bad news. The standard wisdom would have to be that, since private foundations are often created or funded at death as a means of reducing estate taxes, they would become less useful if the estate tax is repealed. That would be the bad news for foundations. However, there would be lots of good news to offset that effect. First, to the extent that estates and beneficiaries turn to charitable transfers to minimize the capital gains taxes they would face under carryover basis, they are likely to find a private foundation an attractive form of charity to use for this purpose. Wealthy families have long made that choice, and they may be expected to continue in that vein.
Another, more subtle difference would be the possibility of a new use for foundations or, more precisely, a new type of foundation. We know that many foundations have been created (or have received their major funding) at death in order to gain the benefits of the estate tax charitable deduction. The price of that deduction has been the qualification of the private foundation as a charitable organization under Sec. 501(c)(3), which in turn has required the foundation to comply with all of the private foundation restrictions. The foundation must comply with the prohibitions on self-dealing, excess business holdings, etc., if it is to produce an estate tax charitable deduction for its creators. Without the estate tax, however, the foundation would be free to operate outside the private foundation limitations. Although this would make it a taxable entity, at least in theory, it could readily avoid or at least minimize its income tax liability in either of several ways. First, it might qualify as a social welfare organization exempt from tax under Sec. 501(c)(4). Its contributors would not qualify for income tax charitable deductions, but that would not be necessary if it were created by bequest, and it would be subject to a much less rigorous standard of supervision. Even better might be to operate as a testamentary trust, so that its charitable distributions would be deductible without limitation and it could avoid tax simply by distributing all of its income to charity. At least under current dividend conditions, this could enable it to distribute far less than the 5-percent minimum required of private foundations.
9. Some devices will be less useful. Remember, if we do end up in a carryover basis planning world, it will be because this is the price Congress exacted for the repeal of the estate tax and the gift tax. Thus, the new carryover basis planning considerations will have to take into account the absence of those taxes. This will mean that some familiar planning devices – those that are used to achieve estate and gift tax savings – will no longer be needed for that purpose and will thus be less useful. For example, charitable lead trusts have long been a classic planning device for minimizing transfer taxes on large estates and gifts, but without transfer taxes to minimize, they may lose some of their appeal. Of course, they will still be useful for other, more limited purposes, such as avoidance of the percentage limitations on charitable transfers or income tax deductions. Similarly, as discussed above, private foundations would not be needed to reduce estate tax burdens under a post-repeal system. However, foundations are proving increasingly popular among younger donors for whom the estate tax has never been an important planning factor, so this effect is hard to evaluate.
10. Other devices may be made possible. An indirect consequence of estate tax repeal would be to change estate plan patterns based upon such noncharitable considerations as the marital deduction. A typical plan under present law is to leave the bulk of the first spouse’s estate in some fashion that qualifies for the marital deduction, with the principal nonspousal distribution delayed until the second spouse’s subsequent death. This sort of arrangement would not be necessary in an estate-tax-free environment, so the estate planner would be free to utilize other arrangements that would be impossible under present law because they would violate marital and/or charitable deduction principles. Some of those are likely to include charitable transfers. For example, a trust could be created to run for the surviving spouse’s life with discretionary distributions sprinkled among a group consisting of the spouse, other family beneficiaries, and charity. This would be unthinkable under present law, but could be a useful model in the absence of the estate tax. The carryover basis rules are not directly involved in this area, but would have a secondary impact here as well.
Summary and Conclusion
Many charitable gift planners have focused their attention entirely upon the unhappy fact that the repeal of the estate tax would remove a traditional tax incentive for charitable giving in the form of estate tax savings. On closer examination, however, they may find that the legislation simultaneously creates several new ones by encouraging various types of charitable bequests. Some of those are described above, and as time goes on we will no doubt discover more. The glass may prove to be more than half full after all.u
Copyright 2001, Jerry J. McCoy. All rights reserved. This article is adapted from a discussion in Charitable Gift Planning News, PO Box 551606, Dallas, TX 75355-1606.
Jerry McCoy is an independent attorney in Washington, DC, specializing in charitable tax planning, tax-exempt organizations and estate planning. He is co-author (with Kathryn W. Miree) of The Family Foundation Handbook, recently published by Aspen Law & Business, and is also Co-Founder and Co-Editor of Charitable Gift Planning News, a monthly newsletter.
1. See H.R. Rep. No. 708, 72d Cong., 1st Sess. 27 (1932), reprinted in 19391 C.B. (Part 2) 476, 477.