Stepped-Up Basis After Estate Tax Repeal: Is the House Creating a Monster?

Kevin Brady, Chairman of the House Ways & Means Committee has released the text of the GOP’s tax reform plan, and as of this writing, the Committee has passed the bill. The legislation passed by the Committee includes (an albeit delayed) full repeal of the estate and generation-skipping transfer taxes beginning in 2025.  But the interesting part about this isn’t the repeal; it isn’t even that the bill retains a stepped-up basis regime (the last two attempts to move to some form of carryover basis never really made it off the ground); it’s the mechanism by which the bill would achieve stepped-up basis.

The proposed legislation (which still has a ways to go in the House, to say nothing of the Senate), would effectively retain all of the rules of Chapter 11 that currently govern estate inclusion and use that regime to determine what assets will be eligible for a step up in basis, even though none of those assets will be subject to a transfer tax. While this is certainly easy, it seems to miss the point of many of the inclusion provisions in the Code. A section like §2035 wasn’t about stepped-up basis, it was about preventing taxpayers from avoiding the estate tax by giving away property shortly before death. But without the tax, a taxpayer can give away rapidly appreciating assets to younger family members and then see those donees get a stepped-up basis (without any tax cost) if the taxpayer-donor dies within three years of the gift.

So, what gives? Maybe the House authors weren’t thinking ahead to how this might all work and somewhere along the legislative path (or before the repeal kicks in) they will go back and clean things up. But assuming they don’t, the new rules could be incredibly beneficial to taxpayers seeking the best of both worlds. One very obvious example is the “deathbed transfer” under §2035, which would become an “all upside” provision. Taxpayers could gift property (at presumably lower value for gift tax purposes) and if they happened to die within three years of the gift, the donee would get to step up his or her basis to fair market value at death (as the property “would have been included” in the decedent’s estate under §2035) without any additional transfer tax consequences.

Another technique that may “explode” in popularity could be family limited partnerships (and LLCs). With the recent case of Estate of Powell v. Commissioner, in which the the Tax Court appears to have expanded the circumstances in which §2036 would apply to family limited partnerships to bring assets transferred to the partnership back into the estate, the post-repeal basis regime would make these arrangements potentially more valuable than they were as means to create valuation discounts.

As one of our Estates, Gifts & Trusts Advisory Board members put it to me, these entities could be used in conjunction with the valuation rules to actually increase the value of the underlying property through the use of control premiums and other enhancements to the value of the partnership interests that would result in beneficiaries taking partnership interests with fairly high basis in comparison to the underlying assets, resulting in little or no gain to them should they liquidate or sell the entity afterwards.

Of course, there are still significant legislative events to come that could make much of this moot. The Senate’s conceptual framework, released this afternoon, doesn’t include even a delayed estate tax repeal (though it does increase the exclusion amount to $10 million). Given recent comments by Sen. Susan Collins (R-ME) that she does not favor an estate tax repeal, it is uncertain that even the House’s delayed repeal could pass the Senate. In addition, scores for the House bill indicate that, as written, it would likely fail the “Byrd Rule” in the Senate and, therefore, would have to sunset in 10 years. So it may turn out that we just keep the whole current system in place.  We, of course, will be following the process closely to bring you the latest as it happens.