ADVOCATING A CARRYOVER TAX BASIS REGIME.

Author:Schmalbeck, Richard
 
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INTRODUCTION

The U.S. income tax system generally adheres to the basic precept that all wealth accretions are subject to tax, (1) tempered by a realization principle that provides that income recognition is deferred until a point at which there is a sale or exchange. (2) When a sale or exchange occurs, the difference between the amount realized and the asset's adjusted basis gives rise to either a gain that must be recognized and taxed (barring an applicable exception) or a loss that must be allowed as a deduction (subject to certain limitations). (3) Since the inception of the federal income tax, the centrality of the wealth accretion concept combined with the realization principle have been part of its fundamental fabric.

But the Internal Revenue Code ("Code") also contains a rule in [section] 1014 that constitutes a significant departure from the concept of taxing wealth accretions and, more specifically, to the realization principle. When a taxpayer dies, the tax bases of assets in the hands of those who inherit them are deemed to be equal to fair market value at the date of the decedent's death, (4) eliminating any gains or losses accumulated during the decedent's life from the tax base. This basis rule, despite its fundamental deviation from the norm, has achieved a grudging acceptance. Historically, it was defended by the tacit acknowledgement that, upon a taxpayer's demise, accurate asset tax basis identification would be extraordinarily challenging, (5) often marred by a lifetime of poor record keeping. (6)

Notwithstanding the administrative convenience associated with the step-up in basis rule, (7) the rule violates fundamental tax principles and, accordingly, there have been repeated calls for its repeal. (8) In its place, the academic community has spoken with an unusually uniform voice, urging Congress to adopt a deemed realization at death rule. (9) If a deemed realization rule were enacted, then upon a taxpayer's death all unrealized gains and losses would be recognized and reported on the decedent's final income tax return or, alternatively, on a separate stand-alone return. (10) Academics advocating such a rule argue that it has the twin virtues of fostering economic equality and facilitating tax system administrability. (11)

Yet, despite the putative virtues associated with a deemed realization rule, Congress has never passed legislation incorporating its principles. (12) The reasons for congressional hesitancy are essentially threefold. First, a deemed realization rule violates the Code's deeply seated realization principle insofar as death does not--and, at least in many taxpayers' minds, should not--constitute a "sale or exchange." (13) Second, valuation concerns, particularly those with respect to closely held businesses, farms, and tangible personal property, diminish its attractiveness. (14) Finally, its implementation suffers from enormous issues of complexity. (15)

In lieu of a deemed realization rule, Congress has twice chosen an entirely different reform path; namely, the institution of a carryover tax basis regime. Under such a regime, the tax basis of an inherited asset is deemed to be the same as it was in the hands of the decedent. (16) Congress instituted the first carryover tax basis regime in 1976; (17) however, due to its unpopularity with banks, trust departments, and other institutional executors, Congress initially deferred its effective date (18) and then retroactively repealed it in 1980. (19) In 2001, Congress instituted a second carryover tax basis regime, effective in 2010, when the estate tax was to be suspended for one year; this second attempt to institute a carryover tax regime was largely successful, albeit perhaps in large part because this regime was temporary and of limited application. (20)

Since the time that Congress experimented with these two carryover tax basis regime initiatives, several fundamental changes have transpired that enhance the viability of a permanent carryover tax basis regime and underscore the need for reform. First, technological advancements have grown at a rapid pace, (21) and these advancements greatly facilitate tax basis record keeping and retention. Second, during the course of the last decade, Congress has come to appreciate the need for accurate tax basis reporting and, to this end, has instituted third-party safeguard measures to ensure proper tax basis identification. (22) The combination of enhanced record-keeping capabilities and third-party basis reporting now make a carryover basis regime eminently more feasible than it was in years past.

Additionally, the current economic climate requires nimble investing which is unimpeded by the so-called "lock-in" effect. (23) Code [section] 1014 exacerbates this lock-in effect by offering taxpayers an opportunity not merely to defer taxation of gains but to avoid it altogether. (24) A carryover basis regime, on the other hand, would mitigate distortions caused by [section] 1014.

Further, aside from the foregoing technological, political, and economic changes, the relaxation of the estate, gift, and generation-skipping taxes (collectively, transfer taxes) that began in 1976 and continues today (25) makes the institution of a carryover tax basis regime imperative. Due to the gradually increasing size of the applicable exclusion amount (26) (currently, in 2017, equal to $5,490,000) (27) and the generation-skipping exemption amount (28) (also currendy equal to $5,490,000), (29) transfer taxes apply only to the tiniest sliver of the taxpayer population--the lowest percentage of decedents in the history of our transfer tax. (30) In years past, wealth transfer taxes were promoted as a backstop of sorts that served to mitigate the revenue loss and unfairness created by the step-up in basis rule. (31) Because transfer tax application is now extremely limited, that backstop is no longer reliably effective, and the step-up in basis rule enables vast amounts of income to escape taxation completely.

As the transfer tax system continues to ebb in importance, Congress should institute a permanent carryover tax basis regime. Part I of this Article provides a short historical overview of the two prior carryover tax basis regimes and the catalysts that led to their adoption. Part II explains why the tax system is now ready for a permanent carryover tax basis regime--one that overcomes the mistakes of its predecessors and places a premium on simplicity and administrability. Part III details the strengths and shortcomings of a deemed realization regime and reasons why, at least for now, Congress should not adopt it.

  1. HISTORICAL OVERVIEW OF PRIOR CARRYOVER TAX BASIS REGIMES

    Surprisingly, the step-up in basis rule may have come into being by way of a misunderstanding. With the passage of the nation's first constitutionally sanctioned income tax in 1913, (32) the Treasury Department was charged with promulgating regulations; however, the enabling legislation was silent as to the issue of death and its effect upon the tax bases heirs held in their assets. (33 )Lacking clear guidance one way or the other, the Treasury Department crafted the step-up in basis rule, (34) probably basing its position on either the laws of the United Kingdom (which, at the time, did not tax capital gains) or trust law, in which capital gains are assigned to principal rather than income. (35)

    Whatever the case, the Treasury Department's decision came at a substantial price. As a general matter, inflation and growth in economic productivity cause most investments to increase in nominal value. (36) Combine this observation with two other propositions--that selective realizations allow taxpayers to claim their losses while deferring their gains, and that wealthy taxpayers own more valuable assets than do less wealthy taxpayers (37)--and it is no surprise that the step-up in basis rule will predictably produce two deleterious effects. First, the vast majority of decedent-owned assets receive a "stepped-up" (rather than a "stepped-down") tax basis, resulting in enormous revenue losses to the government. (38) Second, rather than applying equitably to all taxpayers, the financial benefits of [section] 1014's application inure disproportionately to taxpayers of wealthy families. (39)

    An example illustrates [section] 1014's application, and its defects. Suppose Taxpayer X purchased a farm in 2010 for $1 million and that the farm is worth $10 million in 2017. If Taxpayer X sells the farm, he will incur a tax on the $9 million gain (i.e., $10 million amount realized less $1 million cost basis). (40) Instead, suppose that Taxpayer X dies in 2017 and he bequeaths the farm to Taxpayer Y. If Taxpayer Y subsequently sells the farm, say for $10 million, she will incur no tax on the disposition (i.e., $10 million amount realized less $10 million adjusted basis) (41) due to [section] 1014's application. (42)

    Consider, too, that one of the primary justifications for retention of [section] 1014 has long rested on the commonly held belief that income should not be taxed twice--once under the income tax regime and another time under the transfer tax regime. (43) There are deep flaws in this belief, as the income tax pertains to wealth accretions over an annual period, while the transfer tax pertains to the act of transmitting wealth to people other than surviving spouses and charitable entities. (44) Nonetheless, this single-tax sense has provided theoretical cover for [section] 1014's existence. If assets are subject to transfer tax, the argument goes, then the step-up in basis rule functions much as any other "tax basis" rule does; that is, as a safeguard against a redundant application of tax. But as Congress has gradually emasculated the transfer tax system, (45) it has correspondingly subverted one of [section] 1014's pivotal (albeit faulty) justifications.

    Identifying the shortcomings of Code [section] 1014 is easy; addressing...

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