PUBLISHED:January 29, 2020

Zelenak explains how a loophole that gives big tax breaks on inherited assets was created

Originally published on POLITICO Pro: Democrats want to bury 'Angel of Death'

By Brian Faler

01/29/2020 05:02 AM EST

Elizabeth Warren’s wealth tax has gotten all the attention, but there’s a sleeper issue in Democrats’ campaign to raise taxes on the rich.

A growing number of them, including presidential contenders Joe Biden and Michael Bennet, are proposing to scale back or dump altogether a break known as the “Angel of Death” loophole.

It forgives capital gains taxes when people die, which can allow the wealthy to pass fortunes to heirs tax free.

It’s been in the tax code for a century, thanks in part to an oversight by Congress, but it’s getting a closer look as Democrats search for ways to squeeze the rich, in order to pay for their spending planswhile also chipping away at income inequality. 

“It’s an enormous, glaring loophole in the law,” said Jonathan Blattmachr, a retired estate tax lawyer and director at Pioneer Wealth Partners, a wealth management firm.

Advocates say targeting the break is more viable than Warren’s better-known wealth tax. For one thing, it’s more technically feasible than her plan to annually tax everything from artwork to privately held businesses.

And unlike that and other Democratic plans to hike taxes, this one has a patina of bipartisanship. Sen.Mitt Romney (R-Utah) surprised many when he came out last month in favor of scaling back the provision, something President Donald Trump also did during his 2016 presidential campaign (though his 2017 tax overhaul left the break untouched). 

All the debate over Warren’s more draconian wealth tax may have also given the idea a boost by making it seem moderate by comparison. And Congress has made similar changes before, albeit temporarily, during the Carter administration and in 2010.

Not everyone is enamored with the idea though. 

Romney’s support notwithstanding, it’s a nonstarter for many Republicans worried about what it would mean for family farmers and other small businesses.

It also wouldn’t raise nearly as much money as Democrats want to fund their priorities. While Warren says a wealth tax would raise trillions, clamping down on what experts call “stepped-up basis at death” would raise a fraction of that, hardly enough to fund big-ticket spending plans. 

The issue is this: Normally, when people sell things like stocks, they are taxed on the growth in the asset’s value.

So if someone bought stock for $100,000 and later sold it for $500,000, she would pay a capital gains tax on the $400,000 difference.

But different rules apply when someone dies. 

If that person leaves the $500,000 in stock to her heirs, that $500,000 is considered the new starting price or “basis” for them — and no one ends up paying capital gains on the $400,000 increase in value. If the person receiving the stock then sells it for $510,000, he or she only pays tax on the $10,000 difference. 

That’s been part of the tax code for a century, thanks to a snafu by lawmakers, said Larry Zelenak, a law professor at Duke University.

When lawmakers created the estate tax, they didn’t explain what the basis for inherited assets ought to be.

“It was one of the big questions that Congress just overlooked — the statute simply didn’t address the question,” said Zelenak, author of "Figuring Out the Tax: Congress, Treasury, and the Design of the Early Modern Income Tax.”

That left it up to the Treasury Department to sort out, which decided that the basis would be the value when the person died.

Appearing before the Senate Finance Committee in 1921, Treasury economist Thomas Adams explained the government already had the estate tax as a backstop. Congress later codified that as part of the Revenue Act of 1921.

It's been the policy ever since, with two brief exceptions. In 1976, lawmakers rescinded the break, although they never allowed that change to take effect. Amid heavy lobbying, they first delayed it, and then repealed the repeal in 1980.

Later, for one year, in 2010, lawmakers gave the wealthy the option of either paying the estate tax or skipping that levy by losing much of their ability to “step up” assets.

Biden and Bennet, a senator from Colorado, are now reviving the issue, proposing that people inherit an asset's original basis along with the asset itself, at its current value. Sen. Cory Booker (D-N.J.), who recently dropped out of the Democratic presidential primary, also backed the idea.

Romney quietly endorsed reducing the break as part of a tax plan he introduced last month with Bennet. They would give individuals a $1.6 million exemption, and spouses would get an additional $3.7 million exemption. A Romney spokesperson did not respond to requests for comment.

Critics complain stepped-up basis allows the rich to pass along millions tax free even in cases where the estate tax does not apply.

People can get the benefit, for example, on assets they leave their spouses when they die, even though no estate tax is then due, said Blattmachr. He said he knew someone who used that provision to avoid taxes on $2 billion in stock left to his wife.

“It’s the biggest savings in estate planning,” he said. 

Many Republicans oppose touching the break in part because of concerns from farmers about what they could owe on land that’s been appreciating for decades, said George Callas, who was a top tax aide to former House Speaker Paul Ryan (R-Wis.).

Even if relatively few farmers would be affected, “the ag community has a tremendous amount of heartburn about meddling with step-up.”

It could also be administratively difficult because people may not have records of how much those who died originally paid for assets being passed down.

Said Callas: “That’s a lot of the reason why you’ve had Republicans say, ‘Forget it, we’re just going to stick with full step up because we don’t want to be responsible for those problems.'”

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