The 2017 tax law not only delivers large, direct tax cuts to wealthy Americans but also creates myriad opportunities for them to push the boundaries of the tax code to reduce their tax bills further, which would make the law even costlier and more tilted to the top than current projections indicate. A prime example is its cut in the estate tax.
The 2017 law doubled the amount that a wealthy couple can pass tax-free to their heirs, from $11 million to $22 million. This eliminated the tax for many estates (less than one-tenth of 1 percent of estates now owe it, down from two-tenths of 1 percent previously) and gave the few estates large enough to still owe the tax a direct tax cut of $4.4 million apiece. The larger exemption has also increased interest in existing “upstream planning” techniques designed to help wealthy individuals avoid paying capital gains taxes on certain assets.
Here’s the background. Under “stepped-up basis”— a tax break that the 2017 law retained — if someone holds an asset without selling it until death, neither she nor her heirs owes capital gains tax on the growth in its value during her lifetime. This enables parents with assets (such as stock or real estate) that have appreciated over time to pass them to their children free of the accumulated capital gains tax. But stepped-up basis is available only for an asset that is transferred after a parent’s death, which can be many years away. Upstream planning enables parents to accelerate the transfer of assets to a child by funneling appreciated assets to the child’s grandparents, who then pass those assets on to the child upon their death. On the assumption that the grandparents pass away before the parents, the child receives the asset — and the benefit of step-up basis — sooner.
The estate tax has generally been a barrier against upstream planning, underlying its role as a critical backstop to the income tax. Upstream planning isn’t worthwhile if transferring assets to the grandparents pushes the value of their estate above the estate tax exemption limit, since a 40 percent tax would then be owed on the amount above the limit upon their death. But the 2017 tax law, by doubling the exemption, made upstream planning attractive for more wealthy families. As one tax lawyer quoted in Tax Notes put it: “Now that you’ve got $11 million [per individual, or $22 million per couple] to work with, there are a lot of things that all of a sudden start to be worth the trouble.” It creates an “enormous opportunity” for upstream planning, another tax lawyer was quoted as saying.
Some of these upstream planning techniques are legally questionable. But some tax professionals expect the under-resourced IRS to be too busy to focus on the likely rush to use upstream techniques. The IRS isn’t “likely to enact new regs or new laws to put the kibosh on it,” tax lawyers discussing the tax reduction opportunity said, since its “hands are full right now,” because “the IRS is already busy with the mammoth task” of implementing the new tax law.
Moreover, policymakers haven’t given the IRS adequate resources; enforcement funding is 23 percent below the 2010 level in inflation-adjusted terms. As we’ve warned, the combination of an underfunded IRS and the 2017 tax law’s new avoidance opportunities invites the wealthy and profitable corporations to push the law’s boundaries to extract benefits that go even beyond the large, explicit tax cuts they receive from it.
Upstream planning will likely be just one of many examples of how the loopholes and gaming opportunities in the hastily drafted, poorly conceived tax law will deliver even larger tax cuts to the wealthiest Americans than its authors intended.