Raising the Top Estate Tax Rate to Infinity?
Hillary Clinton says she wants to reduce the estate tax exclusion amount from $5.45 million to $3.5 million. She also says that she will restore the 2009 estate tax rate schedule and impose even higher rates on very large estates: 50% starting at $10 million, 55% starting at $50 million, and 65% starting at $500 million. If Clinton wins the presidency (as she most likely will), and if she gets her estate tax plan through Congress (a much bigger “if”), and if she makes no further adjustments to the way that estate taxes are calculated, what would be the maximum effective tax rate on estates?:
(A) Something less than 65%
One might think the answer is (A), because even a multibillion dollar estate pays tax at less than a 65% rate on the first $500 million (given the progressive rate structure). Yet the answer is potentially (D), infinity (or, perhaps more precisely, undefined). The details are somewhat complicated, but if you’re interested in the estate tax for personal, professional, or policy reasons, bear with me.
For starters, while the estate tax is often described in the popular press as applying at a 40% rate above the $5.45 million per-person exclusion, this is not actually how the estate tax is calculated under subtitle B of the Internal Revenue Code. Subtitle B sets out a different method: First, figure out the sum of (a) the value of the estate and (b) the value of taxable gifts that the decedent made during her lifetime. (Gifts under the annual exclusion — currently $14,000 — don’t count as taxable gifts for this purpose.) Second, calculate the tentative tax on that sum using the section 2001(c) rate schedule. If the sum is over $1 million, this calculation is straightforward: $345,800 plus 40% of the amount over $1 million. Third, figure out the amount of tax on the decedent’s lifetime gifts that would have been payable given the exclusion amount at the time of the gift and the rate schedule at the time of death. Then subtract the third figure from the second. And finally, apply any credits, the most important of which is the unified credit ($2,125,800 in 2016). The unified credit is, not coincidentally, equal to the tax that would be imposed under section 2001(c) on the $5.45 million exclusion amount: $345,800 + 40% x ($5.45 million — $1 million).
Why do these details matter? Normally, they don’t: your estate tax is usually 40% times the value of your taxable estate above the exclusion amount — or, if you have made taxable gifts during your lifetime, 40% times the value of your taxable estate above your unused exclusion amount. (I say “usually” with the caveat that 99.8% of estates owe no tax at all; only the wealthiest 0.2% owe any estate tax.) But soon, the mechanics of the subtitle B calculation may become very relevant to the very rich. To see why, imagine that D, who has made no previous taxable gifts, decides to take advantage of this year’s $5.45 exclusion amount before President Clinton reduces it. D’s tentative tax under the section 2001(c) rate schedule is $2,125,800; she can subtract her unified credit of $2,125,800; and voilà — no gift tax due. D might be forgiven for thinking she has dodged a bullet: she has transferred $5.45 million to her children just in the nick of time, before President Clinton reduces the exclusion amount to $3.5 million and raises rates. But such a conclusion would be premature.
Imagine that by 2020, the Clinton reforms are passed. The exclusion amount is $3.5 million, and the rate schedule looks like it did in 2009 — i.e., the same as current law for the first $1 million, with a 41% rate starting at $1 million, a 43% rate starting at $1.25 million, and a 45% rate starting at $1.5 million. (The new 50%, 55%, and 65% brackets won’t matter for purposes of this example.) The credit corresponding to a $3.5 million exclusion amount under the new rate schedule (i.e., the tax that would be imposed on a $3.5 million transfer) is $1,455,800.
Now say that D dies in 2020 and leaves a taxable estate of $2 million. The tax on D’s estate would be computed as follows: First, add the value of the estate ($2 million) to the value of D’s lifetime gifts ($5.45 million). Next, calculate the tax on that sum under the new rate schedule: $555,800 + 45% x ($7.45 million — $1.5 million) = $3,233,300. Next, figure out the tax that would have been payable if the 2016 exclusion amount and 2020 rates had applied at the time of D’s 2016 gift. Here, that turns out to be zero, because the 2016 gift was equal to the exclusion amount. Finally, subtract the new unified credit ($1,455,800). If I’m doing my math right (and I’m pretty sure I am), that leaves D’s estate with a tax bill of $1,777,500.
Not coincidentally, $1,777,500 is equal to 45% times the sum of D’s taxable estate ($2 million) and the difference between the 2016 and 2020 exclusion amounts ($1.95 million). That is, section 2001 is set up so that if D uses her full exclusion amount now and President Clinton raises rates and reduces the exclusion amount subsequently, D’s estate will pay tax at the increased rate on the difference between the old exclusion amount and the new one. D doesn’t dodge a bullet by using up her exclusion amount today, because she (or more accurately, her estate) will have to make up the difference down the road.
A tax bill of $1,777,500 on an estate of $2 million amounts to an effective rate of almost 89%. Under different circumstances, D’s effective estate tax rate might be even higher than that. Imagine all the same facts as above except that instead of dying in 2020 with a taxable estate of $2 million, D dies with a taxable estate of zero. (How might she manage that? Perhaps by investing all of her wealth in an annuity that has no survivor benefit.) The tax on D’s estate would then be computed as follows: First, add the value of the estate (zero) to the value of D’s lifetime gifts ($5.45 million). Next, calculate the tax on that sum under the new rate schedule: $555,800 + 45% x ($5.45 million — $1.5 million) = $2,333,300. Next, figure out the tax that would have been payable if the 2016 exclusion amount and 2020 rates had applied at the time of D’s 2016 gift. Again, that’s zero. Finally, subtract the new unified credit ($1,455,800). Now, the result is a tax of $877,500. That’s an $877,500 tax on an estate of zero (and hence, an effective rate approaching infinity).
[As one of my students pointed out, the infinity result obtains only if we think of the denominator as the taxable estate. If the denominator is the sum of D’s taxable estate and taxable gifts, then the effective rate is $877,500/$5.45 million = 16.1%. The fact remains, though, that the estate would owe $877,500 at a time that its value is zero.]
What does this mean for wealthy individuals (and their advisors) in the event that Clinton wins the election with enough political capital to put her estate tax plan in place?
First, you can’t avoid the higher rate or the lower exclusion amount by using your full exclusion now. Your estate still will have to pay tax at the higher rate on the difference between the pre-Clinton and Clinton exclusion amounts. (I’ll add a caveat to this claim at the end.) Practitioners are apparently preparing for a “mad rush” from clients seeking to use the $5.45 million exclusion before it drops, but note that making a tax-free inter vivos transfer today won’t necessarily immunize you from clawback at the time of death.
Second, you can avoid higher rates by making gifts above the full exclusion now. Such gifts are credited against future estate taxes as if you paid a tax of 45% or more, when in fact all you had to pay was 40%. (This is over and above the longstanding tax advantage of inter vivos transfers — namely, the fact that the gift tax is calculated on a tax-exclusive basis while the estate tax is calculated on a tax-inclusive basis.)
Third, even if it is theoretically possible for the estate tax due to exceed the value of a decedent’s estate under the Clinton plan, the IRS can’t collect more from an estate than the estate is worth. (And going after the decedent for the deficiency isn’t a viable strategy either.) Moreover, wherever one thinks the top of the Laffer curve for the estate tax is, it’s presumably to the left of 100% (and certainly not to the right). From a revenue-raising perspective, an estate tax of 100% or higher is counterproductive: it encourages individuals to annuitize so that they die with next to nothing in their estates.
How might President Clinton and Congress address the conceptual and practical difficulties of the estate tax exceeding 100%? One possibility would be to say “c’est la vie” (or “c’est la mort”) and accept the fact that in a relatively small set of cases, the estate tax due will exceed the estate’s value. Another possibility would be to incorporate a grandfather (or grandmother) provision for taxpayers who used the full $5.45 million exclusion before 2017. (Query whether Treasury would have the power under section 2010(c)6) to do this on its own even if Congress doesn’t include a legislative grandfather clause; the regulatory exception to the last deceased spouse rule in Treasury Decision 9725 arguably provides precedent.) A third possibility would be to stick with the existing rules for computing the estate tax but to cap the tax at 65% times the amount of the taxable estate (or some other percentage).
And this is where the above-mentioned caveat comes in. If estate tax reform comes with either of the last two fixes — a grandfather provision or a 65% cap — then it may indeed pay to use your $5.45 million exclusion now, assuming you have $5.45 million to spare. Moreover, it’s unlikely that any taxpayer will be worse off if she transfers wealth to her children (or the other objects of her generosity) now rather than waiting. (Well, she’ll be worse off in the sense that she will have parted with her money, but she won’t have increased her or her estate’s tax liability.) And while a taxpayer who transfers wealth inter vivos rather than at death ordinarily sacrifices the benefit of stepped-up basis, recall that Clinton wants to do away with stepped-up basis entirely. For all these reasons, the “mad rush” among wealthy individuals to use their $5.45 million exclusion now might not be so mad after all.