Taxing Unrealized Appreciation On Lifetime Transfers And At Dying – Tax

A. Background

The Biden administration will propose a change in the tax-free

basis step-up at death which has been a part of the tax law for a

long period of time. Carter Ledyard’s first relationship with

this subject occurred in 1970 when Richard B. Covey was contacted

by the Trust Division of the American Bankers Association. In the

Tax Reform Act of 1969, changes were made in the trust income tax

laws relating to accumulation distributions and an unlimited

throwback rule was enacted. The ABA determined that it needed

outside help for modifying the newly passed throwback rules. In

addition, the ABA felt it needed help concerning changes in the

transfer tax laws which, because of a lack of time, were not

included in the 1969 Tax Act and would be dealt with later. One of

those changes was in the tax-free step-up in basis at death (the

“Basis Increase”). Covey was retained as special tax

counsel for the Trust Division, a status which continued until

around 2000. In the 1976 Tax Reform Act, the Basis Increase was

changed to carryover basis but before its effective date, Congress

repealed this change and continued the Basis Increase.

On April 28, 2021, the Biden administration released a fact

sheet describing the American Families Plan. It states:

End capital income tax breaks and other loopholes for

the very top. The President’s tax reform will end one

of the most unfair aspects of our tax system: that the tax rate the

wealthy pay on capital gains and dividends is less than the tax

rate that many middle-class families pay on their wages. Households

making over $1 million – the top 0.3 percent of all households –

will pay the same 39.6 percent rate on all their income, equalizing

the rate paid on investment returns and wages. Moreover, the

President would eliminate the loophole that allows the wealthiest

Americans to entirely escape tax on their wealth by passing it down

to heirs. Today, our tax laws allow these accumulated gains to be

passed down across generations untaxed, exacerbating inequality.

The President’s plan will close this loophole, ending the

practice of “stepping-up” the basis for gains in excess

of $1 million ($2.5 million per couple when combined with existing

real estate exemptions) and making sure the gains are taxed if the

property is not donated to charity. The reform will be designed

with protections so that family-owned businesses and farms will not

have to pay taxes when given to heirs who continue to run the

business. Without these changes, billions in capital income would

continue to escape taxation entirely.

The fact sheet does not mention other transfer tax changes such

as reducing the exemptions and curtailing the use of zeroed-out

GRATs.

B. Gutman Article – Introduction

An article by Harry L. Gutman captioned “Taxing Gains

at Death” was published in the January 11, 2021 issue of

Tax Notes Federal (the “Gutman Article”). On May 12,

2021, at a meeting of the Select Revenue Measures Subcommittee of

the House Ways and Means Committee on Funding Our Nation’s

Priorities: Reforming the Tax Code’s Advantageous Treatment of

the Wealthy, Gutman was one of several witnesses. His testimony was

based upon his prior article referred to. He is a former Deputy Tax

Legislative Counsel in the Treasury Office of Tax Policy from 1977

to 1980 and was later Chief of Staff of the Joint Committee on

Taxation from 1991 to 1993. The Article contends that the basis

step-up at death should be repealed and replaced by a policy in

which death and lifetime transfers are income tax realization

and/or recognition events (the “Appreciation Tax”). The

Article is comprehensive, well-written and covers many, but not

all, of the issues which would arise under the system he proposes

(the “Gutman Proposal”). Knowledgeable people thought

that the Gutman Proposal was a forecast of what the Biden

administration would recommend.

When we decided the main subject of this issue, the results of

the Georgia Senate races were in and the Senate was in a 50/50

division with the Democratic Vice President to resolve any tie

votes. President Biden had indicated his decision to repeal the

step-up in basis for a decedent’s assets and his desire to make

changes in the treatment of capital gains. Therefore, a discussion

of the Gutman Proposal seemed an appropriate subject.

Subsequent events confirmed that decision but “muddied the

waters” because of Democratic proposals for changes in the tax

laws. First, President Biden’s position on infrastructure

included social programs supported by progressives in significant

amounts. Second, proposals in both the Senate and House included a

change which broadened the elimination of the step-up in basis to

include a periodic taxation of appreciation in trust assets but not

in entities which could achieve purposes similar to those by

trusts. Also, Chairman Wyden of the Senate Finance Committee

announced that he was going to file a bill later this year which

would accomplish the purpose of marking-to-market assets held by

individuals and entities.

Several major concessions are made in the Gutman Article. First,

a deduction would be allowed against the estate tax for the

Appreciation Tax paid. This is not really a concession, but rather

a “fairness” point. Without it, the total taxes at death,

federal and state, could exceed 80 percent of some estates. Second,

assets currently owned would be exempt from the tax. Stated another

way, only assets acquired after the effective date would be subject

to tax. The second item contrasts with another approach which would

subject to tax assets currently owned but only appreciation

accruing after the effective date (a “fresh start”

approach). The Article states that a liberal transition rule is

necessary to gain adequate political support for the Proposal and,

in a section captioned “Inadequate transition relief,”

states:

Transition has proven to be a particularly difficult issue.

There is no agreement on whether the regime should apply to all

realizations occurring after the effective date, only appreciation

occurring after the effective date, or assets acquired after the

effective date. As detailed later, each option has a different

effect. Ideally, transition should not create winners and losers.

But sometimes the search for equitable transition rules produces

perceived inadequate relief or political impracticality and, as a

consequence, a desirable law change is not enacted. In my view, we

should not let the perfect be the enemy of the good. The most

important objective is the enactment of the general rule;

transition relief is, by definition, temporary.

Gutman makes a “political” judgment that without the

exemption, passage of an appreciation tax would be unlikely.

Whether that judgment is correct in the current fiscal and

political climate is unclear. The opposite concern is that the rule

would not be accepted by progressives, who are the strongest

supporters of taxing appreciation upon death and may oppose even a

fresh start.

Another concession relates to proof of basis problems. The

Gutman Proposal says:

2. Lack of basis records. Whether one finds

credible the claim that basis records somehow disappear at death

(recall that they were necessary to establish gain or loss on a

lifetime sale), the proposed system would put taxpayers on notice

prospectively of the need for basis records, and it would provide

relief for problematic asset areas – namely, personal residences

and noncollectible tangible personal property. Also, a lookback

rule would be provided to determine unknown basis. Under that rule,

the basis of an asset could be determined by discounting its value

at the relevant tax date back to its acquisition date.

Of course, if the acquisition date was also unknown, the relief

would be ineffective. The problem of proof is particularly

significant with respect to elderly persons who are now in their

80s and 90s.

C. Objectives of Gutman Proposal and Our

Conclusion

The Gutman Proposal states:

The challenge is to design a system that is comprehensive in

coverage, administrable, perceived as fair, and not subject to

abuse. The task involves not only identifying the assets that would

be subject to the regime but also the exclusions and exemptions

deemed necessary to promote administrability and perceptions of

fairness. One must resolve the fundamental question of what

constitutes the taxable unit to which the new regime would apply.

The need for and design of antiabuse protections must be examined.

Further, provisions to assist in valuation problems and the

determination of unknown basis must be devised. And finally, one

must select an effective date provision that will be viewed as

acceptable by the affected community of taxpayers and advisers. The

proposal reflects my judgment on the appropriate balance of

conceptual purity, administrability, and political reality.

In summary, we believe the Gutman Proposal needs changes in

respects discussed below.

D. Discussion of Details of Gutman

Proposal

A fundamental departure from past proposals would exempt

nonmarketable property held at death from immediate taxation. The

gain on a nonmarketable asset would be “realized” but not

“recognized” at death. The tax due would be calculated,

but payment deferred until the asset was disposed of by the

decedent’s estate or by the owner who inherits it during the

owner’s life. Interest would be charged on the tax for the

deferral period. This deferral would not apply to lifetime

transfers.

Life insurance would be exempt from the Appreciation Tax but

Gutman notes that internal interest buildup on permanent life

insurance should be taxed to the policyholder. A $250,000 exclusion

would apply to gain on a principal residence. See IRC Sec. 121. The

exclusion would be portable for transfers to a surviving spouse.

Thus, for spouses, the exclusion would be $500,000. All nonbusiness

tangible personal property (other than collectibles as defined in

IRC Sec. 408(m)(2)), would be exempt from tax. Transfers to charity

would also be exempt. An alternate valuation date similar to IRC

Sec. 2032 would apply. On another subject, the present gift tax

interest exclusion in IRC Sec. 2503(b) would be repealed, thus

ending the exemption for property subject to powers of

withdrawal.

As to marital transfers, the Article states:

Unless recognition was elected, all transfers to a surviving

spouse in any form that would qualify for the estate tax marital

deduction would be treated as realization-but-nonrecognition events

in accordance with the rules governing outright transfers of

nonmarketable property. The effect would be to determine the tax

due for all property held by the decedent but defer the tax on

appreciated property transferred to a surviving spouse until the

earlier of the sale of the property, the inter vivos

transfer of the property (whether marketable or not), the death of

the surviving spouse in the case of marketable property, or the

taxable disposition of nonmarketable property in the hands of a

testamentary distributee of the surviving spouse. Immediate

recognition could be elected for loss property.

Payment of the tax and interest would be deferred until the last

of the events referred to in the quotation. This result contrasts

with what occurs with transfers in trust where deferral could be

extended through several transfers. See the discussion below under

the heading “Transfers in trust.” A simpler and fairer

alternative would be to apply the Appreciation Tax upon the

surviving spouse’s death or earlier disposition and providing

for carryover basis on the first death for spousal assets.

The Article summarizes the overall approach as follows:

Subject to specified exclusions and exemptions, all deathtime

and lifetime transfers would be income tax realization events. All

non-spousal deathtime transfers of marketable assets20

would be recognition events. All non-spousal lifetime transfers

would be recognition events. Recognition could be elected by the

taxpayer-transferor for any realized gain on an asset-by-asset

basis. The tax on realized but unrecognized gain, together with a

deferral charge to equate the total payment to what would have been

due upon realization, would be payable when the subject property is

later disposed of in a recognition event.

_________________

20Marketable securities are defined in Section 731(c).

Actively traded personal property, as defined in reg. section

1.1092(d)-2, would also be subject to recognition.

The use of the cross-reference to IRC Sec. 731(c), part of the

income tax partnership provisions, to define “marketable

assets” and to distinguish them from non-marketable assets

without further explanation is unfortunate. Many members of the

Trusts and Estates bar, an important constituency in winning

approval for the Proposal, will not be conversant with these

provisions. We will provide further explanation later in this

article.

In dealing with the administrative problems of the Appreciation

Tax discussed later, they will be simplified by having assets

either “in” or “out” of the system instead of

having each asset partly in and partly out.

President Biden has suggested that for taxpayers with more than

$400,000 of income, ordinary income tax rates would apply to

capital gains. His Press Secretary has clarified that the $400,000

figure covers families and not individuals. He has not gotten into

the details of “closing the loophole” step-up basis at

death. One of those details is providing a period of time for

updating estate plans to address the change in the law.

The Gutman Article discusses the treatment of nonmarketable

property and comments upon the transfer of such an asset, including

multiple nonrecognition transfers such as where A dies and

transfers property to B which is followed by the death of B and the

distribution of the property to C. The tax computed at A’s

death would not be changed by B’s death (even if assets had

declined in value). Any additional tax at B’s death would be

imposed on the difference between the value of the property at

B’s death and B’s basis of the property determined by

reference to the value of the property upon A’s death. If C

disposes of the property during life, he would be responsible for

the payment of deferred taxes and interest on both the transfer

from A to B and the transfer from B to C. This may be illustrated

by the transfer of a farm (presumably a nonmarketable asset) with A

dying and transferring the farm to B, his son, and B then dying and

transferring the property to C, a son of B. C sells the farm. At

A’s death, the transfer of the property to B would not be

taxable. At B’s death, the transfer of the property to C would

also be nontaxable and would include both the increase in value at

A’s death and any further increase in value at B’s death.

Upon C’s sale, the taxes deferred at A’s death and B’s

death, plus interest, would be payable, as would the

“regular” tax on C’s sale, with C’s basis based

on the value of the farm at B’s death.

Interest would be payable commencing with the transfer from A to

B and from B to C. The Article does not discuss whether interest

payable is deductible by any person owing the interest.

In a letter To the Editor of Tax Notes Federal posted on June 1,

2021 captioned “Farmers: The ‘Gains at Death’

Liquidity Issue is a Straw Man,” Gutman said:

Members of Congress from both sides of the aisle as well as

numerous commentators have expressed concern about the impact on

family farms and closely held businesses of treating death as an

income tax recognition event. They are correct.

Treating death as an income tax recognition event requires the

valuation of the affected asset, identification of its basis, and

calculation and payment of the tax due. While these requirements do

not generally pose significant issues for marketable property, they

raise legitimate concerns for nonmarketable property. And in the

case of business property, including both farms and closely held

businesses, the most acute problem is finding the funds to pay the

tax. Forcing a sale of some portion of the business interest,

borrowing to secure the funds to pay the tax, or providing for

payment of the tax in installments is not an acceptable solution.

The following addresses the problem directly.

We first divide the world into marketable and nonmarketable

assets. The latter category includes ALL nonmarketable assets – not

just farms and closely held businesses. The liquidity problem is

not restricted to them, and a broader category eliminates messy

design questions in determining the characteristics of the entity

entitled to relief. In all cases, there will be exclusions for

noncollectible tangible personal property and some level of net

gain.

For marketable property, the tax is due and payable at death.

For nonmarketable property, the first (and my preferred) option

would be to calculate the tax due at death but defer its payment

until the subject property is sold. The taxable event would not

turn upon material participation in the enterprise by a family

member, but rather would occur upon the identifiable event of sale.

In an ideal world, that deferred tax payment would bear interest at

a rate designed to make the present value of the deferred payment

equal to the tax that would have been paid at death. Thus, from the

perspective of horizontal equity, these interests would not receive

favorable treatment when compared with marketable assets for which

the tax is payable immediately. A second-best solution would be to

omit the interest charge and simply defer the tax. One must

recognize, however, that this solution would treat this class of

assets more favorably than marketable assets (and would provide

significant incentives to transform marketable assets into

nonmarketable assets). In addition, if this recognition route is

chosen, it would be possible to provide that the value of the

affected property could be determined under the special use

valuation provisions of the estate tax, thus establishing the value

of property at its actual rather than “highest and best”

use. This would be of particular importance to farms.

A distinctly less favorable alternative would be to simply

provide a carryover basis for nonmarketable property, thus

deferring the calculation and payment of the tax until the property

is sold.

Here is the takeaway: Any of the forgoing eliminates tax

liability at death. The tax payment is deferred until funds are

available from a sale of the affected property. The liquidity straw

man is eliminated.

E. Level of Taxation

The attached table in Appendix A compares the total estate tax

and Appreciation Tax on three New York estates. Each estate has a

value of $50 million. One estate has no appreciation, a second

consists entirely of appreciation and the third consists of 50

percent appreciation. The assumptions on rates are beneath the

table. As noted, the computation of the Appreciation Tax assumes

the stated Biden proposal for ordinary income rates on part of the

capital gain. If the estate is in the top brackets, a dollar of

appreciation results in about 20 cents of additional total tax as

compared to a dollar that is not appreciation.

The comment is often made that “people should pay their

‘fair share'”. Is such an increase “fair”?

The Proposal does not discuss the appropriate rate of combined

taxation on transfers of property. An Appreciation Tax would be a

new level of taxation in addition to the current levels which

consist of gift tax, estate tax, generation-skipping tax and

corresponding state taxes. We do not believe an appreciation tax

would be fair unless the basis of capital assets is indexed for

inflation.

Any tax payable upon death and paid would be deductible from a

decedent’s gross estate. Deferred tax paid upon a sale by the

executor should be made deductible for estate tax purposes as an

administration expense by an amendment to IRC Sec. 2053. Deferred

tax not paid during estate administration is not a liability of the

estate and is payable by the owner of the property when it is

disposed of in a taxable transaction. Since the value of property

that passes to a recipient is reduced by the deferred tax

liability, the deferred tax should reduce the value of the asset in

the recipient’s estate. However, this does not reduce estate

tax in the first estate.

F. Offsetting Gains and Losses

1. Transfers at Death

a. General Rules

A decedent’s marketable assets may have an overall net gain,

which is “recognized” and subject to the Appreciation

Tax, and nonmarketable assets which have an overall

“realized” net loss. Does the net loss on nonmarketable

assets offset the net gain on marketable assets, reducing the net

gain that is subject to the Appreciation Tax? In the converse case,

where marketable assets have a net loss and nonmarketable assets a

net gain, does the net loss offset the net gain, reducing the

realized gain that determines the deferred tax on nonmarketable

assets? The answer is yes, which it should be if the goal is to

produce the same result as if all the assets had been sold

immediately prior to death.

The Article states:

Net recognized gain, determined after accounting for any net

realized loss from nonmarketable property, would be taxed

separately from all other income realized during the decedent’s

final tax year, at the rate then applicable to capital gain. The

gain would be spread over five years, so the effect of progressive

rates would be moderated. A net recognized loss would first be

used, on a pro rata basis, to offset net realized gain from

nonmarketable property held at death. Any remaining loss may be

used to offset net capital gain on the decedent’s final income

tax return, and to the extent necessary, may be carried back to the

three preceding tax years. Losses in excess of net capital gain for

the preceding three years may be used to offset ordinary income

commencing in the year immediately preceding death. (footnote

omitted)

Does the five-year “spread” refer to payment in five

annual installments or to an income averaging computation? Based on

language elsewhere in the Article, it means averaging.

A net recognized loss on marketable property that exceeds net

realized gain on nonmarketable property can be used on the

decedent’s income tax returns as described in the quotation. Is

the converse true? The paragraph quoted above could be read to say

that a net loss on nonmarketable property that exceeds the net gain

on marketable property cannot be used on an income tax return.

However, the issue is clarified in a subsequent paragraph which

states:

Realized losses in excess of realized gains on nonmarketable

property (net realized losses) could be used to offset net

recognized gain, with any excess treated in the same manner as net

losses on marketable property.

This is the correct result. The ability to use an overall excess

loss on the decedent’s income tax returns should not turn on

whether the excess is attributable to marketable or nonmarketable

assets. If both marketable and nonmarketable assets have a net

loss, the combined excess loss should be usable in the same manner

as an excess loss attributable to one group of assets.

To the extent an excess loss is unusable on the decedent’s

income tax returns in the way described above, the unused amount

could be used to increase the basis of some, or perhaps all, loss

assets, pro rata, by the amount of the unused loss. The calculation

of an adjusted basis for the affected assets would be complex,

disrupting one of the simple aspects of the Proposal, that an

asset’s post-death basis is its value for estate tax

purposes.

The application of these rules to spousal transfers raises an

issue. If a spousal transfer includes marketable property, a third

category of property is introduced: marketable assets that are

treated on the decedent’s death in the same manner as

nonmarketable assets, but will be treated as marketable assets upon

the surviving spouse’s death. A simple and seemingly correct

approach is to treat these marketable assets as nonmarketable

assets on the first spouse’s death in applying the rules

discussed above in this section.

b. Election to Recognize Gain or

Loss

At several points, the Proposal refers to an election to treat a

realized gain as a recognized gain, and (less clearly) to treat a

realized loss as a recognized loss:

. . . unless immediate recognition is elected, the tax due for

illiquid nonmarketable property would be deferred until that

property is sold. Part I(C)(1).

Recognition could be elected by the taxpayer-transferor for any

realized gain on an asset-by-asset basis. Part I(E).

The transferor of any nonmarketable asset may elect recognition

treatment on an asset-by-asset basis. Part II(A)(3).

. . . I propose that the immediate recognition of gain be

limited to marketable assets other than those transferred to a

surviving spouse (and for which recognition is not elected) . . .

Part II(A)(2)

Unless recognition was elected, all transfers to a surviving

spouse in any form that would qualify for the estate tax marital

deduction would be treated as realization-but-nonrecognition events

in accordance with the rules governing outright transfers of

nonmarketable property . . . Immediate recognition could be elected

for loss property. Part II(A)(5).

As noted, the recognition rules are referred to piecemeal in the

Article, and no examples are given. A consolidated statement of the

recognition rules with examples is needed. Apparently, however, for

transfers at death it is possible, on an asset-by-asset basis, to

elect to recognize a gain or a loss that would otherwise only be

realized. In some cases, the rules permitting a net loss in one

category of assets to be offset against a net gain in the other

will eliminate the incentive for an election to recognize gain or

loss, but this will not always be the case.

For example, suppose the estate has two marketable assets, each

with a built-in $100 gain, and two nonmarketable assets, each with

a built-in $100 loss. The net recognized gain of $200 is offset by

the net realized loss of $200. The Appreciation Tax payable at

death is zero and there is no deferred tax. No election is needed.

However, if one of the nonmarketable assets instead has a $100

built in gain, the net realized loss is zero, and no portion of the

$200 recognized gain is offset. If an election can be made to

recognize the loss on the $100 loss asset, recognized gain is

reduced to $100. Of course, this must be reflected in the

calculation of the deferred taxable amount, which after the

election should be based solely on the nonmarketable asset with a

$100 gain. As a result of the election, the Appreciation Tax

immediately due will be reduced, but deferred tax will be

correspondingly increased.

2. Transfers During Life

The Article states:

The guiding principle of this proposal is that, to the extent

practicable and consistent with other applicable income tax rules,

all transfers of property should be accounted for in the tax return

of the transferor at the time of the transfer. Consequently, apart

from interspousal transfers, charitable transfers, and transfers of

nonbusiness tangible personal property (other than collectibles),

all gratuitous lifetime transfers would be recognition events.

Recognition (rather than realization) is appropriate because the

lifetime transfer is a voluntary event, and liquidity issues can be

anticipated and resolved. An election to treat interspousal

transfers as recognition events is provided in the proposal.

A threshold question is what is meant by “all transfers of

property should be accounted for in the tax return of the

transferor at the time of the transfer?” Apparently it means

that gains and losses on lifetime transfers are not, as with

transfers at death, the subject of a separate calculation of the

Appreciation Tax, but are reported on the transferor’s income

tax return and enter into the overall taxation of the

transferor’s net gains and losses for the year of the

transfer.

Gain is recognized on a lifetime transfer of property, whether

marketable or nonmarketable. Recognition of losses, however, is

limited:

Except as provided below, an outright transfer of property other

than to a spouse or charity would be a recognition event. Gain

would be recognized to the extent of the difference between the FMV

of the property and its basis. Losses would not be recognized for

transfers of nonmarketable property or property transferred to

related parties within the meaning of section 267. The recipients

of such property would receive a carryover basis.

Under these rules, the ability to offset gains and losses upon a

transfer at death is largely eliminated. Although losses on gifted

marketable assets are recognized under the general rule, in

practice most gifts will be to a “related party” within

the meaning of IRC Sec. 267 and any loss will be denied.

Lifetime transfers to a spouse are treated differently:

Consistent with the general principle of the proposal and the

suggested deathtime transfer rule, outright transfers to a spouse

(as well as transfers that qualify for the gift tax marital

deduction) would be treated as realization events. Recognition

would occur upon the disposition of the property by the transferee

spouse, with the tax determined in accordance with the rules set

forth earlier. However, immediate recognition of gain property

could be elected. (footnote omitted)

Clarification of this rule is needed, in particular of the words

“(c)onsistent with . . . the suggested deathtime transfer

rule.” Would both gains and losses be realized upon a lifetime

transfer to a spouse, and would nonmarketable property be eligible

for loss treatment? Or would the spouse’s status as a

“related party” under IRC Sec. 267 mean that no loss is

realized? If the gift is to a trust for a spouse covered by IRC

Sec. 677, the trust will be a grantor trust and the transferor will

remain the owner of the property for income tax purposes.

Therefore, the gift will not be a transfer for purposes of the

Appreciation Tax (see below). An inter vivos QTIP trust is

also a grantor trust, but under the quoted language is perhaps

treated the same as an outright transfer because it will

“qualify for the gift tax marital deduction.”

Given the limits on loss recognition for gifts, when would it

make sense to elect to recognize gain on property transferred to a

spouse? If the transferor will have losses from non-donative

transactions on his income tax return, gain recognized by the

election may be offset by those losses. This reduces the deferred

Appreciation Tax, and would be beneficial only if there were no

“real” gains on the return subject to immediate tax that

could be offset.

These, and probably more, complexities will arise from

application of the “realization” rule to inter-spousal

transfers. As discussed below, we favor the simpler carryover basis

approach for spousal lifetime transfers.

G. Problems With Proposal

1. Marital Transfers

The Article does not adequately discuss whether interest is

payable when the Appreciation Tax is deferred upon a predeceased

spouse’s death and later paid upon a transfer by or the death

of the surviving spouse. Under the general approach, the

predeceased spouse’s death would be a “realization

event” but not a “recognition event,” even for

marketable securities; this suggests that interest would be payable

from the predeceased spouse’s death. Appendix B compares the

results in several examples with what would occur under carryover

basis. The differences are significant.

The Article says:

Prior proposals have treated the marital unit as a single

taxpayer for realization purposes. Thus, transfers to a surviving

spouse would not be treated as realization events, and the

decedent’s basis in the transferred property would carry over

to the recipient spouse. However, the decision to treat the marital

unit as a single taxpayer is a policy choice that introduces

several issues that must be addressed.

First, a marital exemption gives an executor the incentive to

transfer low-basis property to a surviving spouse and transfer

high-basis property to other beneficiaries . . . Second, the assets

used to fund a marital bequest would have to be identified before

the income tax liability of the decedent was calculated. Thus, an

executor would be required to claim tentative exemptions on the

decedent’s income tax return that reflected the property to be

transferred after death. Amended returns would be required if the

distribution differed from that originally claimed on the

return.

An alternative, which would be consistent with the objective of

determining all gain and loss at the decedent’s death, would

recognize the special status of the marital unit but remove the

gaming opportunities and administrative difficulties presented by

treating the marital unit as a single taxpayer.

The Proposal does not eliminate the incentive to transfer low

basis property to the spouse and high basis property to others

because doing so still reduces the gain recognized upon the first

spouse’s death. Nor does it eliminate the possible need for an

amended return based on the final determination of the property

received by the spouse and other beneficiaries. The final

dispositions will determine the amount realized, which must be

reported along with the resulting deferred tax on an information

return. These arguments do not make a persuasive case against

treating the spouses as a unit.

Also, current IRC Sec. 2014 creates an incentive to rely on

portability of the estate tax unified credit rather than a bypass

trust. Property in a bypass trust will not receive a second step-up

upon the surviving spouse’s death. The Article’s approach

would eliminate this particular incentive to avoid use of a bypass

trust but would replace it with a stronger incentive, because

appreciated property passing to the trust may be subject to the

Appreciation Tax on the first death. The size of the basic

exclusion from the Appreciation Tax and how it compares in scope to

the estate tax AEA are relevant in measuring this incentive.

The Article’s concern is overridden by the opposition that

will arise against any imposition of a tax on a transfer from

spouse to spouse, even a deferred tax (which may eventually be paid

by the recipient spouse). The forty years since introduction of the

unlimited marital deduction have confirmed the belief that the

taxable moment for a married couple is the surviving spouse’s

death, not the predeceased spouse’s death.

The correct approach to marital transfers, both during life and

at death, is a carryover basis approach, under which no interest

would be payable for any period prior to the death of, or the

disposition of an asset by, the surviving spouse. If the asset is

sold, it will be replaced by another asset of the same value. If

the asset is distributed to the surviving spouse and is retained by

her until her death, no interest is payable because she is

receiving the income from the asset whether or not it is held in

the trust. However, if she makes a gift of the asset, interest

would be payable from the date of the gift in the same way the

interest would be payable if she received the asset outright

instead of through a QTIP trust.

For lifetime transfers, footnote 35 of the Article states:

An inter vivos spousal transfer does not raise the same

administrative issues as a deathtime transfer. See supra

Section II.A.5. Consequently, the decision could be made to exempt

those transfers from the general rule and account for the property

only upon disposition by the transferee spouse.

More fundamentally, under IRC Sec. 1041, no gain or loss is

recognized on a lifetime transfer of property from an individual to

(or in trust for the benefit of) the individual’s spouse. The

basis of the transferee spouse in the property is the adjusted

basis of the transferor. There is no sound reason for the

Appreciation Tax to seek to “override” IRC Sec. 1041. It

is wrong to treat a transfer that would not result in gain under

the applicable income tax rules, even if a sale, as a

“realization event” resulting in a deferred gain on which

a deferred tax will be paid, possibly with interest during the

period of deferral.

The Article concedes no reason exists to impose the

realization-deferred tax-interest regime on a lifetime marital

transfer. The administrative arguments for imposing it on marital

transfers at death are not persuasive. The correct approach, in

terms both of policy and of politics, is to exempt marital

transfers from the Appreciation Tax, and instead impose a carryover

basis.

If a carryover basis regime is not adopted for marital

transfers, clarification is needed with respect to the treatment of

QTIP marital trusts. A lifetime QTIP trust is a grantor trust and

in general a transfer to a grantor trust is not subject to

Appreciation Tax. However, because the transfer would be eligible

for the gift tax marital deduction, the Article appears to intend

that it would be treated in the same manner as an outright transfer

to a spouse, resulting in a realization event. Clarification is

also needed that upon the death of a spouse who is the beneficiary

of a QTIP trust, the trust is subject to Appreciation Tax even

though the trust property is neither owned by the spouse nor

subject to a general power of appointment, and that the trust

property should be aggregated with the spouse’s property in

calculating net gains and losses. These issues are discussed

further in Appendix B.

Inherited nonmarketable property generates a deferred tax

liability. The tax is not payable until the property is disposed of

in a recognition event. Death as such is not a recognition event,

and therefore the deferred tax generally will not be payable when

bequeathed by a recipient to a subsequent recipient. As discussed

above, although the deferred tax does not reduce the value of

property in determining the gross estate of the original owner, it

can be argued that the deferred tax liability reduces the value of

the property in the recipient’s estate, even though the tax is

not payable upon the recipient’s death. That would be a

favorable result, but in the context of a transfer between spouses

there may be a catch. If the deferred tax reduces the value of

property received by a spouse, it may reduce the value of the

property for marital deduction purposes in calculating the original

owner’s taxable estate, creating a gap between the gross estate

value and the marital deduction value. Perhaps the best rule is

that deferred tax does not reduce valuation for estate tax purposes

in any estate, reducing the taxable estate only when it becomes

payable, and therefore deductible. An executor should have the

power to elect to pay a prior decedent’s deferred tax, similar

to the election to recognize the decedent’s current realized

gain on nonmarketable property.

2. Nonmarital Lifetime Transfers

Additional lifetime transfers that should not result in an

Appreciation Tax are:

(i) A transfer for full and adequate consideration, taking into

account Treas. Reg. §25.2512-8. Transfers for full

consideration should not be taxable even if the transfer does not

result in the realization or recognition of gain for income tax

purposes and even if the transfer changes the ownership of the

transferred property for income tax purposes. An example would be

the transfer of appreciated securities for a partnership

interest.

(ii) A transfer that does not change the ownership of the

transferred property for federal income tax purposes, provided that

property owned by an individual that ceases to be owned by the

individual during life or upon death shall be subject to the

Appreciation Tax whether or not the cessation is a taxable gift or

is included in the individual’s gross estate. An example would

be a sale of property to a grantor trust for full and adequate

consideration, including a sale for a note. The sale would not be

subject to the Appreciation Tax, because the grantor continues to

be the owner of the trust property. The gain in the trust at the

grantor’s death or earlier if the trust ceases to be a grantor

trust, would be taxed, even if the trust is not includible in the

transferor’s gross estate.

3. Marketable Securities

“Marketable securities” are defined in IRC Sec.

731(c), a partnership income tax provision which, in general,

treats marketable securities as equivalent to money in determining

whether a partner receives a distribution of money in excess of the

basis of the partner in the partnership interest.

Marketable securities include “actively traded”

stocks, other equity interests, debt instruments, options, forward

or futures contracts, notional principal contracts, derivatives,

and foreign currency as well as interests in common trust funds,

mutual funds, instruments which are readily convertible into

marketable securities, instruments whose value is determined

substantially with reference to the value of a marketable security,

and most interests in actively traded metals. Interests in entities

substantially all of whose assets (90% or more by value) consist of

marketable securities and interests in other entities, to the

extent the value of their marketable securities is between 20% and

90% of the entity’s total value (“look-through

entities”), are also treated as marketable securities. Whether

bitcoin or other cryptocurrencies qualify will need to be

clarified. Property is actively traded if it is property for which

there is an established U.S. or foreign financial market.

Although the emphasis in the definition of marketable security

is on liquidity, some illiquid assets qualify. Thus, a share of

stock that is part of a class that is actively traded is a

marketable security even if its transfer is restricted by an

investment letter or if it is subject to an IRC Sec. 83 substantial

risk of forfeiture after an IRC Sec 83(b) election has been made.

No policy reason exists for treating property of this sort as

marketable securities while there are restrictions on sale.

4. Entities Owning Marketable

Securities

How to treat a nonmarketable asset that owns marketable

securities is a difficult issue. Despite the breath of the

definition of look-through entities, it can be expected that much

attention will be directed to converting marketable securities to

nonmarketable property (as long as that can be done in a way that

will avoid gain recognition under current law) to avoid the full

impact of the Appreciation Tax.

Transfers of property to a wholly-owned corporation can be

accomplished without current gain recognition and as long as less

than 20% of the corporation’s assets are marketable securities,

the interest in the corporation would not qualify as a marketable

security. The disregarded entity status of wholly owned limited

liability companies would presumably apply for Appreciation Tax

purposes whether or not less than 20% of the LLC’s assets were

marketable.

The transfer by multiple transferors of appreciated property to

a partnership, LLC or corporation controlled after the transfer by

the transferors is, in general terms, not an income tax recognition

event under current law. However, the general rule does not apply

to transfers to an “investment company” where the

transfer results in a diversification of the transferor’s

interests and the transferee entity is a regulated investment

company (mutual fund), real estate investment trust or an entity

more than 80% of whose assets are held for investment and are

readily marketable stocks or securities (with the term “stock

or securities” being defined in a manner similar to the IRC

Sec. 732(c) list). “Diversification” is present where the

transferors transfer non-identical assets unless each transferor

transfers a diversified (as defined) portfolio of stocks and

securities.

Accordingly, there are possible avenues for a transferor, with

or without family members, to form an entity that will fail the

test for marketability.

A difficult issue for look-through entities is the time at which

the marketability test is applied. Could carefully balanced

deathbed transfers to a newly formed corporation convert marketable

securities into nonmarketable assets? Is the test applied at

formation or, given the possibility of asset value fluctuation and

asset re-deployments, only when there is a transfer subject to the

Appreciation Tax? Consistent with their purpose the IRC Sec. 731

regulations test for marketability at the time of a partnership

distribution, but this is a concept that would need to be modified

for purposes of an Appreciation Tax.

The Article’s proposed reliance on IRC Sec. 731(c) without

adjustments to define marketable securities seems misplaced.

Arguably this is the most significant unresolved issue in the

Article, and casts doubt on its fundamental proposal to treat

marketable and non-marketable assets differently. It should be

addressed in the statute, and not left solely to regulations.

5. Dynasty Trusts

The transfer of property during life or at death to an

irrevocable long-term “dynasty” trust may incur

Appreciation Tax, but subsequent appreciation within the trust

could remain free of Appreciation Tax indefinitely as long as the

trust is not included in any beneficiary’s gross estate. A

solution would be to provide that the Appreciation Tax applies to

any GST taxable distribution or taxable termination, with an

appropriate deduction to avoid double taxation. A strict version of

the rule would disregard the GST exemption and the trust’s

inclusion ratio in applying the Appreciation Tax.

A more difficult question is the treatment of a distribution of

appreciated property from a trust that is not a GST taxable

distribution, e.g., a distribution to a child from a trust for the

child. Should the distribution be subject to Appreciation Tax if it

does not otherwise result in recognition of gain? If so, how is the

basic exclusion from Appreciation Tax determined?

H. Other Developments

1. Van Hollen Proposal – the Sensible Taxation

and Equity Promotion (STEP) Act of 2021

On March 29, 2021, Senator Chris Van Hollen released a

discussion draft captioned “Sensible Taxation and Equity

Promotion Act 2021” which would provide for the realization of

property gains at the time of death and when transferred during

life. He said:

The stepped-up basis loophole is one of the biggest tax breaks

on the books, providing an unfair advantage to the wealthiest heirs

every year. This proposal will eliminate that loophole once and for

all.

Other sponsors of the draft legislation are Senators Booker,

Sanders, Warren and Whitehouse. A similar proposal was also

introduced in the House of Representatives by Representative Bill

Pascrell, a senior member of the House Ways and Means Committee.

H.R. 2286.

The major points in the STEP Act are:

(i) Any transfer of property by gift or upon death would be

treated as sold. Thus, a tax on the unrealized appreciation would

be payable. A $1 million exclusion would be available. An exclusion

of $500,000 would be available for personal residences. An

exemption would be provided for (1) transfers to charitable

organizations and assets held in retirement accounts and (2)

transfers qualifying for the gift or estate tax marital

deduction.

(ii) The proposal would be effective for transfers made on or

after January 1, 2021 and would contain no exception for

appreciation occurring before that date. A retroactive effective

date is unwarranted given the need to make changes in many estate

plans because of a new tax on appreciation.

The proposal contains no special rules for valuating farms and

other closely held businesses but does contain deferred payment

rules similar to IRC Sec. 6166 which defer tax for five years and

provide for payment over a ten-year period with interest at a

reduced rate.

(iii) A new section 1261 captioned “Gains from Certain

Property Transferred by Gift or at Death” would read:

(a) IN GENERAL. – Any property which is transferred by gift, in

trust, or upon death shall be treated as sold for its fair market

value to the transferee on the date of such gift, death, or

transfer.

(b) SPECIAL RULES FOR TRUSTS. –

(1) GRANTOR TRUSTS. –

(A) IN GENERAL. – In the case of a trust for which the

transferor is considered the owner under subpart E of part I of

subchapter J –

(i) except as provided in subparagraph (C), subsection (a) shall

not apply to property transferred to such trust, and

(ii) subparagraph (B) shall apply.

(B) DEEMED TRANSFERS. – Property held by a trust described in

subparagraph (A) –

(i) shall be treated as transferred by the owner in a transfer

to which subsection (a) applies on any date that –

(I) the owner ceases to be treated as the owner under this

chapter,

(II) such property is distributed to any person other than the

owner, or

(III) the property would no longer be included in the

owner’s gross estate under chapter 11, or and

(ii) shall be treated as transferred by the owner upon the death

of the owner.

(C) EXCEPTION. – Subparagraph (A)(i) shall not apply to property

if such property would not be included in the gross estate of the

transferor immediately after the transfer.

(2) NONGRANTOR TRUSTS. – In the case of any trust not described

in paragraph (1) –

(A) all property held by such trust shall be treated as sold for

fair market value on the last day of the taxable year ending 21

years after latest of –

(i) December 31, 2005,

(ii) the date such trust was established, or

(iii) the last date on which such property was treated as sold

by reason of this subsection (emphasis added), and

(B) proper adjustment shall be made in the amount of any gain or

loss subsequently realized for gain or loss taken into account

under subparagraph (A).

(c) EXCEPTIONS AND OTHER SPECIAL RULES. –

(1) TANGIBLE PROPERTY. – This section shall not apply to any

tangible personal property other than a collectible (as defined in

section 408(m) without regard to paragraph (3) thereof) which is

not held-

(A) in connection with a trade or business, or

(B) for any purpose described section 212.

The effect of the quoted language above in (2)(A) is that a

constructive transfer resulting in the realization of gain and loss

is considered made every 21 years. A constitutional issue may be

raised concerning the constructive transfer because there is

nothing that changes in the trust on which to base the imposition

of a tax. Arguably, some change is needed.

(iv) Section 1014 is amended to provide that for marital

deduction property the “transferee” takes the

“transferor’s” basis.

(v) A new section 6048A would require that certain trusts having

a value of $1 million or gross income of $20,000 supply information

concerning the trust to the Secretary of the Treasury.

(vi) A new section 199B would provide a deduction for costs

incurred in making a valuation appraisal.

(vii) A new section 6168 would provide an extension of time for

the payment of gains on certain assets for up to ten years and

would be available for an “eligible asset.” This term is

defined as:

any property other than personal property of a type which is

actively treated (within the meaning of section 1092(d)(1)).

Interest would be charged on any deferral of payment.

(viii) A special lien for taxes deferred under section 6168

would be created in section 6324C.

(ix) A severability clause stating that if part of the Act is

deemed unconstitutional, the remaining provisions continue in

effect.

An article discussing the STEP Act is Curry, STEP Act

Highlights Difficulty of Tackling Stepped-Up Basis, Tax Notes

Federal, April 22, 2021.

2. H.R. 2286

H.R. 2286 is a “condensed” version of the Van Hollen

proposal with some changes. Its version of the constructive

transfer provision quoted and underscored above states:

DYNASTY TRUSTS. –

(A) IN GENERAL. – Any property that is continuously held in

trust and is not subject to subsection(a) for a period of 30 years

shall be treated as transferred pursuant to subsection (a) at the

end of such 30 year period.

(B) PROPERTY HELD IN TRUST ON THE EFFECTIVE DATE. – Any property

held in trust on January 1, 2022, that has been continuously held

in trust for more than 30 years as of such date shall be treated as

transferred pursuant to subsection (a) on such date.

The reason for the differences in periods in the two bills is

uncertain. The constructive transfer provision in 1 and 2 would

attack dynasty trust.

I. General Explanations of the

Administration’s Fiscal Year 2022 Revenue Proposals (the

“Green Book”)

On May 28, 2021 General Explanations of the Administration’s

Fiscal Year 2022 Revenue Proposals (the “Green Book”) was

released. It refers to a tax on unrealized appreciation as

follows:

Proposal

Treat transfers of appreciated property by gift or on death as

realization events.

Under the proposal, the donor or deceased owner of an

appreciated asset would realize a capital gain at the time of the

transfer. For a donor, the amount of the gain realized would be the

excess of the asset’s fair market value on the date of the gift

over the donor’s basis in that asset. For a decedent, the

amount of gain would be the excess of the asset’s fair market

value on the decedent’s date of death over the decedent’s

basis in that asset. That gain would be taxable income to the

decedent on the Federal gift or estate tax return or on a separate

capital gains return. The use of capital losses and carry-forwards

from transfers at death would be allowed against capital gains

income and up to $3,000 of ordinary income on the decedent’s

final income tax return, and the tax imposed on gains deemed

realized at death would be deductible on the estate tax return of

the decedent’s estate (if any).

Gain on unrealized appreciation also would be recognized by a

trust, partnership, or other non-corporate entity that is the owner

of property if that property has not been the subject of a

recognition event within the prior 90 years, with such testing

period beginning on January 1, 1940. The first possible recognition

event for any taxpayer under this provision would thus be December

31, 2030.

A transfer would be defined under the gift and estate tax

provisions and would be valued using the methodologies used for

gift or estate tax purposes. However, for purposes of the

imposition of this tax on appreciated assets, the following would

apply. First, a transferred partial interest would be its

proportional share of the fair market value of the entire property.

Second, transfers of property into, and distributions in kind from,

a trust, partnership, or other non-corporate entity, other than a

grantor trust that is deemed to be wholly owned and revocable by

the donor, would be recognition events. The deemed owner of such a

revocable grantor trust would recognize gain on the unrealized

appreciation in any asset distributed from the trust to any person

other than the deemed owner or the U.S. spouse of the deemed owner,

other than a distribution made in discharge of an obligation of the

deemed owner. All of the unrealized appreciation on assets of such

a revocable grantor trust would be realized at the deemed

owner’s death or at any other time when the trust becomes

irrevocable.

Certain exclusions would apply. Transfers by a decedent to a

U.S. spouse or to charity would carry over the basis of the

decedent. Capital gain would not be recognized until the surviving

spouse disposes of the asset or dies, and appreciated property

transferred to charity would not generate a taxable capital gain.

The transfer of appreciated assets to a split-interest trust would

generate a taxable capital gain, with an exclusion allowed for the

charity’s share of the gain based on the charity’s share of

the value transferred as determined for gift or estate tax

purposes.

The proposal would exclude from recognition any gain on tangible

personal property such as household furnishings and personal

effects (excluding collectibles). The $250,000 per-person exclusion

under current law for capital gain on a principal residence would

apply to all residences and would be portable to the decedent’s

surviving spouse, making the exclusion effectively $500,000 per

couple. Finally, the exclusion under current law for capital gain

on certain small business stock would also apply. (See IRC Sec.

1202.)

In addition to the above exclusions, the proposal would allow a

$1 million per-person exclusion from recognition of other

unrealized capital gains on property transferred by gift or held at

death. The per-person exclusion would be indexed for inflation

after 2022 and would be portable to the decedent’s surviving

spouse under the same rules that apply to portability for estate

and gift tax purposes (making the exclusion effectively $2 million

per married couple). The recipient’s basis in property received

by reason of the decedent’s death would be the property’s

fair market value at the decedent’s death. The same basis rule

would apply to the donee of gifted property to the extent the

unrealized gain on that property at the time of the gift was not

shielded from being a recognition event by the donor’s $1

million exclusion. However, the donee’s basis in property

received by gift during the donor’s life would be the

donor’s basis in that property at the time of the gift to the

extent that the unrealized gain on that property counted against

the donor’s $1 million exclusion from recognition.

Payment of tax on the appreciation of certain family-owned and

-operated businesses would not be due until the interest in the

business is sold or the business ceases to be family-owned and

operated. Furthermore, the proposal would allow a 15-year

fixed-rate payment plan for the tax on appreciated assets

transferred at death, other than liquid assets such as publicly

traded financial assets and other than businesses for which the

deferral election is made. The Internal Revenue Service (IRS) would

be authorized to require security at any time when there is a

reasonable need for security to continue this deferral. That

security may be provided from any person, and in any form, deemed

acceptable by the IRS.

Additionally, the proposal would include other legislative

changes designed to facilitate and implement this proposal,

including: the allowance of a deduction for the full cost of

appraisals of appreciated assets; the imposition of liens; the

waiver of penalty for underpayment of estimated tax to the extent

that underpayment is attributable to unrealized gains at death; the

grant of a right of recovery of the tax on unrealized gains; rules

to determine who has the right to select the return filed; the

achievement of consistency in valuation for transfer and income tax

purposes; coordinating changes to reflect that the recipient would

have a basis in the property equal to the value on which the

capital gains tax is computed; and a broad grant of regulatory

authority to provide implementing rules.

To facilitate the transition to taxing gains at gift, death and

periodically under this proposal, the Secretary would be granted

authority to issue any regulations necessary or appropriate to

implement the proposal, including rules and safe harbors for

determining the basis of assets in cases where complete records are

unavailable, reporting requirements for all transfers of

appreciated property including value and basis information, and

rules where reporting could be permitted on the decedent’s

final income tax return.

The proposal would be effective for gains on property

transferred by gift, and on property owned at death by decedents

dying, after December 31, 2021, and on certain property owned by

trusts, partnerships, and other non-corporate entities on January

1, 2022.

The Green Book also states:

Tax capital income for high-income earners at ordinary

rates.

Long-term capital gains and qualified dividends of taxpayers

with adjusted gross income of more than $1 million would be taxed

at ordinary income tax rates, with 37 percent generally being the

highest rate (40.8 percent including the net investment income

tax),1 but only to the extent that the taxpayer’s

income exceeds $1 million ($500,000 for married filing separately),

indexed for inflation after 2022.2

This proposal would be effective for gains required to be

recognized after the date of announcement.

__________________

1 A separate proposal would first increase the top ordinary

individual income tax rate to 39.6 percent (43.4 percent including

the net investment income tax).

2 For example, a taxpayer with $900,000 in labor income and

$200,000 in preferential capital income would have $100,000 of

capital income taxed at the current preferential tax rate and

$100,000 taxed at ordinary income tax rates.

The date referred to is April 28, 2021. The Green Book does not

mention some items as to which changes had been mentioned as

possibilities, namely, (i) a cap on the income tax charitable

distribution deduction, (ii) reducing the applicable exclusion

amount, (iii) a change dealing with GRATs, (iv) other transfer tax

changes.

The discussion of the appreciation tax does not refer to the use

of the alternate valuation date in IRC Sec. 2032, which the Gutman

Proposal uses. Also, because carryover basis will be applied to

marital deduction property, a section formerly in the Code should

be reinstated, namely, IRC Sec. 2040 which was repealed when

carryover basis was repealed many years ago. It dealt with limiting

gain on the funding of a pecuniary legacy to post-death gain and

reducing the recipient’s basis by the unrecognized gain.

The effective date provision makes clear that trusts created

before January 1, 2022 are not subject to tax. Passage occurring

before Labor Day seems unlikely and would leave at most four months

for clients to make changes in existing estate plans. This is not

sufficient time for the process to work in a reasonable way. Also,

the use of the word “certain” needs to be explained in

detail.

It is useful to set forth a rule concerning the appreciation tax

as background for specific comments. The rule is that, leaving

aside the allocation of the $1 million exemption to a trust, every

distribution in kind of appreciated property by a trust is subject

to tax except for marital deduction dispositions and charitable

dispositions. Another point is that the Green Book refers to

outright marital dispositions but not to trust dispositions, which

should be covered.

No reference is made to state taxes on unrealized appreciation.

A deduction or credit should be allowed for some part of a state

tax.

We criticized the Gutman Proposal for making a distinction as to

carryover basis property between a recognizable and a realization

event with the result that upon a disposition of the property by a

spouse, interest was payable for the period from a decedent’s

death to the disposition. It appears that this distinction will not

be part of the Administration proposal and marital deduction

property will have a carryover basis with no interest until the

date of disposition.

The treatment of loss assets needs more explanation.

Will interest paid on deferred tax be deductible for estate tax

purposes?

The Green Book says nothing about community property.

Decanting statutes apply in some states which permit the

amendment of certain trusts. What effect does such a statute have

on the application of the appreciation tax?

Are outright distributions of appreciated property from a

non-marital trust to a surviving spouse subject to tax?

The discussion of property transfers into and distributions in

kind from a trust, partnership or other non-corporate entity other

than a revocable trust is confusing and is inconsistent with the

general rule referred to above. No exception for a distribution to

the settlor’s spouse or a marital trust for the settlor’s

spouse is referred to.

IRC Sec. 2514(e) deals with a lapse of a power of appointment

and provides that a lapse is not treated as a release if it is

restricted to an amount that does not exceed the greater of $5,000

or five percent of the property subject to the power. Such a power

is often used to provide flexibility regarding the distribution of

trust property. If the power is granted to a descendant and is

exercised, the question becomes whether a tax would be incurred on

any appreciated property distributed to the descendant upon the

exercise of the power. If the answer is yes, a further question is

whether the powerholder has control over what property is deemed to

be exercised.

In some cases, a single family trust is created and the trustees

are given authority to divide the trust into separate trusts for

each child and his or her descendants. Does the exercise of such a

power cause a distribution of appreciated property to result from

the division?

The $1 million exclusion from recognition, which is indexed for

inflation, is too low even under the President’s test of not

increasing the tax for middle-income taxpayers and should be

increased.

J. Senator Wyden Proposal

In 2019, Senator Wyden, the current Chairman of the Senate

Finance Committee released a white paper captioned “Treat

Wealth Like Wages” which contains a basic framework for a

mark-to-market proposal to which would apply a lookback charge to

capital assets owned by individuals, estates or trusts with more

than $1 million in annual income or more than $10 million in

assets. Tradable assets would be marked-to-market and non-tradable

assets would have a lookback charge. See Tax Notes Federal,

February 8, 2021, p. 995. An article in Tax Notes Federal, Sapirie,

“A Time of Renewal for Mark-to-Market?” updates

developments concerning Wyden’s proposal. Tax Notes Federal,

April 12, 2021, p. 174. Also, Senator Wyden intends to introduce a

“mark-to-market” bill later this year. See Cadwalader

Cabinet, April 7, 2021. Wilhelm, Top Senate Democrat Pushing

Forward With Capital Gains Overhaul, Daily Tax Report, June 28,

2021. This bill would apply the proposal to living individuals as

well as to trusts.

K. Congressional Activity

After the brief description by the Biden administration of its

proposal for taxing unrealized gains (see page 2), reaction from

Congressional sources was quick.

Speaking for Senate Republicans, the Minority Leader said it was

“a second estate tax” and “This is a devastating

blow to family farms and small businesses all across America.”

This statement did not recognize the exception quoted on page 2

concerning family farms and small businesses.

On the other hand, 13 Democratic House members sent a letter

dated May 6, 2021 to three Democratic House leaders, Nancy Pelosi,

Speaker, Steny Hoyer, Majority Leader and Richard Neal, Chairman of

the Ways and Means Committee, which states:

As you work to develop a comprehensive infrastructure package

that prepares the American economy to grow and thrive over the

coming years and decades, and expands support for American

families, we write to express concern over the impact that certain

tax changes enacted to pay for this package could have on our

family farms and local economies. The repeal of stepped-up basis

for capital gains and immediate taxation could especially hurt

family farms, some of which have been in families for generations;

therefore, we strongly urge you to provide full exemptions for

these family farms and small businesses that are critical to our

communities.

We support many of the concepts outlined in recent weeks in the

American Jobs Plan and American Family Plan, including ensuring

that the wealthiest Americans pay their fair share. And while the

clear intention of making changes to stepped-up basis is to ensure

vast fortunes worth tens or even hundreds of billions are not

passed on without any income taxes paid at any point, we are

concerned about the unintended burden this could place on farms and

family businesses. We appreciate the President’s reference to

this burden and the need to address it in the outline of the

American Family Plan; and as representatives for districts that

would be directly impacted by that change, we hope you will see us

as a resource as we work to make that exemption a reality.

The requirement to recognize capital gains at death runs the

risk of forcing farms and ranches to sell part, or all, of a farm

that may have been passed down for several generations in order to

pay the tax burden. While the ability to simply sell a small part

of an asset may work for those with shares of stocks, it would

force farmers to break up land that may have been in their family

for decades and seriously impact their ability to remain

economically viable. Additionally, eliminating stepped-up basis

without an exemption for our farmers presents administrative

difficulties. For example, shares of stock or many other assets are

relatively simple to value, and taxing other assets when

they’re sold gives a clear reference price for valuation, so

capital gains taxes have thus far been relatively simple to

administer. However, since farms, machinery, and some small

businesses may be illiquid or difficult to value, the

administrative difficulty is increased.

We look forward to working with you as we develop a full

infrastructure package, and we again urge you to take additional

care in considering changes to stepped-up basis for capital gains

taxes. Farms, ranches, and some family businesses require strong

protections from this tax change to ensure they are not forced to

be liquidated or sold off for parts, and that need is even stronger

for those farms that have been held for generations. We would ask

that you work closely with representatives of rural districts like

us to ensure those protections are well executed. Many of our

constituents started working on their family’s farm when they

were children, or built their farm with the intention of passing it

on to their relatives, and we must ensure that their kids or

grandkids are able to continue working that land for future

generations. Thank you for your attention to this important

matter.

Also, more than 30 House Democrats have taken a similar position

on another issue saying they would not support an infrastructure

bill that did not include repealing the SALT deduction

limitation.

Without the support of the representatives referred to, the

House would have problems in passing a bill dealing with the

taxation of unrealized appreciation of property included in a

decedent’s gross estate.

On May 13, 2021, Senators Cotton and Boozman, both from Arkansas

and Ernst from Iowa introduced the Estate Tax Reduction Act which

would reduce the estate tax to 20 percent. The same bill was

introduced in the House by Representatives Arrington, a Republican

from Texas and Cueallar, a Democrat from Texas. Tax Notes Document

Service, Doc. 2021-19747.

During her hearing before the Senate Finance Committee

concerning her appointment as Undersecretary for Tax Policy, Ms.

Batchelder answered a question from Senator Grassley of Iowa and

indicated that the Administration’s proposal to impose a tax on

unrealized gains would include an exemption for family farms. See

Bloomberg Law News, May 25, 2021, Condon and Davison,

Treasury’s Batchelder Aims to Bolster IRS, Opposes Digital

Tax.

The House Ways and Means Committee is considering allowing

beneficiaries of estates to defer tax on unrealized appreciation

while the beneficiaries continue to hold the assets. See Cook and

Davison, Democrats Mull Weakening Biden Tax on Capital Gains

for Estates, Bloomberg Law News, May 24, 2021.

A Wall Street Journal article on June 8, 2021 contains an

article by Eliza Collins on page 4 of an interview with Senator Jon

Tester, a Democratic senator, which states:

Mr. Tester has raised objections to Mr. Biden’s proposal to

impose capital-gains taxes on unrealized asset appreciation upon a

person’s death, with the new revenue used to fund Mr.

Biden’s antipoverty or infrastructure plans. The tax has a $1

million per-person exemption, plus the existing exemption for

principal residences and special rules that would let farms and

other businesses defer payments so long as they are family-owned

and operated. Mr. Tester, like other rural Democrats, said the

proposal would hurt farmers and called it a nonstarter.

L. Increased Reporting for Trusts

The bills referred to in H.1. and 2. above contain a proposed

new Section 6048A which requires reporting of information

concerning trusts to the Secretary of the Treasury. The purpose of

this requirement is unclear. Perhaps it resulted from a recent

article in the November 30, 2020 issue of Tax Notes Federal, by

Rossotti, Sarin and Summers, Shrinking the Tax Gap: A

Comprehensive Approach. The article asserts that more

resources should be devoted to attacking the tax gap of

underpayment of owed tax liabilities and includes not only income

tax underpayments but estate and gift tax as well. The article

blames insufficient information reporting and inadequate technology

and lists specific areas where the Treasury “in consultation

with the IRS” can take immediate steps. One such area is

“an IRS notice can add gift and estate tax avoidance

strategies to the set of transactions that must be reported by tax

advisors”;30

__________________

30 For example, grantor retained annuity trust, family

limited partnerships, and dynasty trusts. Cross-party reporting in

those cases could help the IRS target attention on the most

suspicious transactions.

However, the problem is not primarily “transactions”

but rather the law itself, as illustrated by Audrey Walton v.

Comm’r, 115 T.C. 589 (2000). The enactment of IRC Sec.

2701 created a loophole for GRATs that was not recognized. Also, as

to dynasty trusts, statutory change is necessary.

M. Conclusion

As previously noted, consideration and passage of the

Administration proposal in the year 2021 seems unlikely. The

proposal includes some elements of mark-to-market which involve

more than taxing unrealized appreciation at death of decedents. The

difficulties of developing an overall policy on the subject are

substantial. See Curry, Biden’s Vague Plan on Partnerships

Sparks Rampant Speculation, Tax Notes Document Service

2021-25020.

The Administration may be delaying moving forward with repealing

step-up in basis at death until it has resolved the question of how

to handle farms and small businesses. Whether a delay in the

payment of taxes on such assets will be sufficient to satisfy

Congressional concern is uncertain. Unless this problem is solved,

sufficient votes may not be available for passage.

A compromise solution would be to reduce the applicable

exclusion amount to $5 million plus an inflation adjustment and

provide that the repeal of step-up in basis applies only to

property acquired after the effective date. The latter change would

“protect” existing farms and small businesses from change

for about a generation. The acquisition date of property acquired

by gift or bequest from a spouse would “relate back” to

the original acquisition date of the spouse.

Addendum

Shortly after this article was completed another analysis

concerning the Administration’s taxing unrealized gains at

death was written. Jackel, No Escape: Proposals for Taxing Gains at

Death, Tax Notes Federal, July 5, 2021. This article confirms that

many issues are involved in doing a complete job.

APPENDIX A

Table Comparing Estates

Gross estate	50,000,000	50,000,000	50,000,000
Appreciation	zero	50,000,000	25,000,000
Appreciation Exclusion	n/a	1,000,000	1,000,000
Taxable appreciation	zero	49,000,000	24,000,000
Appreciation tax	zero	21,032,000	10,182,000
NY taxable estate (gross estate less appreciation tax)	50,000,000	28,968,000	39,818,000
NY estate tax	7,466,000	4,100,880	5,836,880
Appreciation tax plus NY estate tax	7,466,000	25,132,880	16,018,880
US taxable estate	42,534,000	24,867,210	33,981,120
US estate tax	17,565,300	9,615,245	13,716,504
Total tax: appreciation tax + NY estate tax + US estate tax	25,031,300	34,748,125	29,735,384
Effective tax rate	50.0626 percent	69.4962 percent	59.4708 percent

Assumptions:

US estate tax: 45% rate on US taxable estate over $3.5

million

NY estate tax: 16% rate on NY taxable estate (less 534,000 to

reflect lower brackets)

Assumes New York has not adopted its own appreciation tax and

that New York recognizes the federal deduction of appreciation tax

in calculating the New York taxable estate.

Capital gains tax: Biden proposal: 20% on first million of

taxable appreciation, and 43.4% (39.6% + 3.8%) on balance. Gutman

article suggests exclusion, and we have assumed $1 million

nontaxable exclusion.

Switching dollar to appreciation generates .434 of appreciation

tax, and reduces estate tax by .1953 (.434 * .45) + .06944 (.434 *

.16) but increases tax by .031248 (.45 * .434 * .16). Net result is

+.434 – .1953 -.06944 + .031248 = .200508.

CHECK: A. .200508 * 25,000,000 = 5,012,700 B. 34,748,125 –

29,735,384 = 5,012,741

APPENDIX B

Questions Raised by the Proposed Approach to

Spousal Transfers

1. When tax is deferred upon a predeceased spouse’s death,

and later paid upon a transfer by, or the death of, the surviving

spouse, will the deferred tax be increased by the interest charge

that applies to deferred tax generally? The Article does not

address this question specifically for marital transfers, but under

general scheme the predeceased spouse’s death would be a

“realization event” but not a “recognition

event,” even for marketable securities, and therefore interest

would apply. This creates a significant difference from a carryover

basis regime, where there would be no interest charge when tax is

paid upon the surviving spouse’s death.

Marketable property passing to descendants upon the surviving

spouse’s death would immediately be taxed, in two tiers: the

first spouse’s deferred tax and the survivor’s separate

tax. Nonmarketable property would not be taxed on the surviving

spouse’s death. A nonmarketable asset passing from a

predeceased spouse to the survivor, and then to a child, would have

two deferred taxes when eventually transferred by the child: a

deferred tax computed upon the predeceased spouse’s death and

carrying interest from that date, and a deferred tax computed upon

the surviving spouse’s death and carrying interest from that

date. The second tax would be computed using the surviving

spouse’s basis, i.e., the value of the asset at the predeceased

spouse’s death.

Example 1: H dies leaving stock with a basis of 50 and a value

of 100 to W. During W’s life, the stock increases in value to

150. Under the Article’s proposal, there would be two taxes

payable: (i) a tax on H’s gain of 50 computed upon H’s

death but payable upon W’s death, with an interest charge for

the period of deferral between the two deaths, and (ii) a tax on

W’s gain of 50 (W acquired a basis of 100 upon H’s death),

with no interest charge. The total gain subject to tax is the same

as under a carryover basis rule, but the interest charge increases

the tax paid.

Example 2: Same as Example 1, except that during W’s life

the stock falls in value to 50. In a carryover basis regime there

would be no tax at H’s death or W’s death. Under the

Article’s proposal, W has a loss of 50 upon her death, which

does not offset the tax owed by reason of H’s death, but can be

used to offset W’s recognized gain on her other marketable

assets, and if the loss exceeds all such gains, to offset her gain

on her nonmarketable assets.

Example 3: H bequeaths a stock with a basis of 50 and a value of

100 to a testamentary QTIP trust. This transfer qualifies for

marital treatment because it is made “in any form that would

qualify for the estate tax marital deduction.” A gain of 50 is

realized but not recognized upon H’s death. During W’s life

and upon W’s death, the intended result of the proposal appears

to be that if the trustee sells the stock, the deferred tax on

H’s sale would be payable, with interest. However, the trust is

a separate owner and taxpayer from W, so clarification is needed

that this is the case. With respect to the gain realized and/or

recognized on W’s death, the QTIP trust presents questions. The

first is whether the trust property is subject to appreciation tax

by reason of W’s death. Clearly the answer should be yes, but

the Article’s general rule does not accomplish this result. The

general rule is that “death would be treated as an income tax

realization event for all property owned by a decedent, as well as

any property subject to a general power of appointment in the hands

of the decedent.” And footnote 21 to this language states:

“This realization rule would not depend on estate tax

inclusion rules.” The QTIP property is not owned by W or

subject to a general power, and therefore does not fall within the

general rule. Assuming that the general rule is revised to make

W’s death a taxable event for the QTIP property, upon W’s

death are there two taxpayers or one? Is gain realized and/or

recognized computed by a single calculation treating W’s

property and the QTIP property as one fund, or is the QTIP property

treated separately? Can W’s losses be offset against the

trust’s gains, and vice versa? The answer should be to treat

all property as if owned by W in calculating realized and

recognized gain.

Example 4: H makes a lifetime gift to a QTIP trust of stock with

a basis of 50 and a value of 100. Under the general rule, an

outright transfer to W would cause a realization of 50 of gain,

with tax deferred until a subsequent taxable event. The outright

lifetime transfer to W would clearly be a transfer for purposes of

the appreciation tax. The transfer to the QTIP trust should be

treated like an outright transfer, but the Article’s general

rule does not clearly accomplish this result. The general rule for

lifetime transfers is that “noncharitable transfers to trusts

would be recognition events when and to the extent the transferor

is no longer treated as the owner of the property for income tax

purposes.” The QTIP trust is a grantor trust and H remains the

owner of its property for income tax purposes. Clarification is

needed that the transfer to the trust is a taxable event treated as

if a transfer to W. (As such, it would be a “realization”

but not a recognition event, because “outright transfers to a

spouse (as well as transfers that qualify for the gift tax marital

deduction) would be treated as realization events”.

Additionally, clarification is needed that subsequent sales by the

trust are recognition events for H even though they are not sales

by W. The alternative would be not to treat the initial transfer to

the QTIP trust as a taxable event because H remains the owner for

income tax purposes, with the appreciation tax applying only upon a

sale by the trustee or upon W’s death. This approach would

eliminate interest on the tax. The treatment of the trust assets

upon W’s death would raise issues discussed under Example

3.

Footnote 37 of the Article provides: “The proposal’s

application to lifetime transfers in trust, as well as to deathtime

transfers of property included in the decedent’s estate,

invites a reexamination of the differing rules regarding the income

and transfer tax treatment of transfers to trusts, with the goal of

establishing identical rules for the taxable event for both.”

Pending such a reexamination, the proposal needs to state specific

rules for QTIP trusts.

The content of this article is intended to provide a general

guide to the subject matter. Specialist advice should be sought

about your specific circumstances.