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With all of the talk about potential repeal of the federal estate tax1, many people have decided to postpone further estate planning, hoping that the repeal will occur. However, Californians should hold out no such hope. On February 21, 2017, California State Senator Scott Wiener announced a ballot measure, Senate Bill 726, that would create a California estate tax if the federal estate tax is repealed, equal to the federal estate tax that would have been paid by a California resident decedent. This “springing” estate tax is meant to recapture those funds for California’s schools, healthcare, roads and public transportation, according to Senator Wiener.2
California voters in 1982 voted to repeal any state inheritance or estate tax by approving Propositions 5 and 6 by votes of 61.8% and 64.4%, respectively. Senator Wiener’s proposed measure would repeal that ban. Unfortunately for wealthy Californians, history shows that the majority of voters favor increased tax on the perceived rich. In 2012, 55.4% of California voters approved Proposition 30, a “temporary” increase in the top marginal tax rate for the wealthiest Californians to as high as 13.3% to help fund education and vital services. In 2016, 63.3% of the voters extended those higher rates by passing Proposition 55. It appears, therefore, there is a realistic possibility that a ballot measure to merely “capture” the estate tax that California’s wealthiest residents would have paid to the federal government may pass.
A “double whammy” from a new California estate tax could occur if, as many believe, the cost of repeal of the federal estate tax will be that the income tax basis of a decedent’s assets will not be stepped up at death as currently provided. Thus, income taxes on the sale of appreciated assets could replace estate taxes on the value of those assets at death – except in California, and other states with a state level estate or inheritance tax, where both taxes could remain – a “double whammy.”3
Under current law, although a decedent’s estate may be subject to estate tax, in most cases the assets included in the decedent’s estate receive a step-up in basis equal to their date of death fair market value.4 This means that when you inherit Apple stock from your mother that she paid $1 per share for, valued at $140 per share as of your mother’s death, it is treated as though you acquired the Apple stock for $140 per share. If you later sell the stock for $145 per share, your taxable gain is only $5 per share. However, if the ability to obtain a step-up in basis on assets received from a decedent is eliminated, your taxable gain could instead be $144 per share – the same gain your mother would have had if she sold the stock during her lifetime.
Assume, for example, a single California decedent left an estate valued at $20 million which passes to his sole child. The decedent’s aggregate income tax basis in those assets at the time of his death was $10 million.
Under current law5, $5.49 million of the decedent’s estate is exempt from estate tax, and the remaining $14.51 million is taxed at 40%, resulting in a net inheritance to the child of $14,196,000 ($20,000,000 – $5,804,000). The child could sell the inherited assets the same day he received them and pay no federal or California income taxes. Senator Wiener’s proposal would result in the same estate tax (although it would be payable to California, not the Department of the Treasury), but if the ability to obtain a basis step-up is eliminated it would also cause the child to incur an income tax on the inherited assets upon disposition, if not earlier.6 If the child decided to liquidate his inheritance the same day he received it, he could be subject to a capital gains tax equal to 37.1% of the gain, or an additional $1,556,716 of tax.7 This combination of California estate tax and the loss of a step-up in basis could result in some Californians being subject to a total tax burden of up to 77.1%.
California residents should not postpone estate planning in the “false hope” that there will not be an estate tax in the future. Waiting could also result in losing the ability to make lifetime transfers of interests in family entities if the proposed regulations under Internal Revenue Code Section 2704(b) are finalized.8 Thus, “hope is not a strategy.”9 In the event the federal estate tax is repealed, it may end up costing Californians more to pass assets to their heirs than ever before.
1 The “Death Tax Repeal Act of 2017”, H.R. 631, and a similar bill in the Senate, S.205, are among the proposed legislation that could be enacted.
2 http://sd11.senate.ca.gov/news/20170221-senator-wiener-announces-ballot-measure-create-california-estate-tax-replace-federal
3 A number of states currently have a state level estate tax, including Washington which has the highest state estate tax rate at 20%.
4 IRC Section 1014.
5 IRC Section 2010.
6 Some commentators believe that income tax may be triggered automatically at the time of the decedent’s death, rather than at a later disposition of the assets.
7 The highest federal capital gains rate is currently 20%, the highest California income tax rate is currently 13.3%, and the Net Investment Income Tax is equal to 3.8%. Combined, this results in a 37.1% long term capital gains tax rate for Californians.
8 Prop. Treas. Reg. Sections 25.2704-1, 2, 3 and 4, 81 Fed. Reg. 150, 51413 (Aug. 4, 2016).
9 James Cameron; also often attributed to Vince Lombardi.
About the Authors
Gordon Schaller is a prominent tax and estate planning attorney in Southern California who has been in practice for over 30 years. Gordon focuses his practice on tax, estate planning, business succession, charitable and wealth management services and trust and estate litigation. He has represented individuals, family offices, and numerous public and private charitable organizations. Gordon provides creative solutions for tax, charitable, business succession and family issues. He is experienced in the use of captive insurance companies. He is well known throughout the country for developing comprehensive, integrated multi-generational wealth planning, preservation, insurance and management solutions. Gordon is a Fellow in the American College of Trust and Estate Counsel (ACTEC). Contact him at 949.623.7222 or GSchaller@jmbm.com.
Eric Bardwell is a tax and estate planning attorney in Orange County. His practice focuses on all aspects of wealth transfer planning, including estate planning, charitable planning, business succession planning and post-death administration. Eric routinely assists individuals and families in efficiently minimizing estate, gift and generation-skipping transfer taxes through the creation of wills, trusts, business entities and charitable organizations and the use of gifts, sales and other wealth-transfer strategies. He works closely with each client’s team of advisors, including accountants, investment advisors and insurance agents, to ensure the client’s personal planning and wealth preservation goals are accomplished in a coordinated manner. Eric is designated as a Certified Specialist in Estate Planning, Trust & Probate law by the State Bar of California, Board of Legal Specialization. Contact him at 949.623.7234 or EBardwell@jmbm.com.
