As you likely heard, the White House yesterday released an outline of proposals for federal tax reform. One of the proposals is a repeal of the federal estate tax, which likely will be music to the ears of many clients and friends. Obviously, these are only proposals and the challenging process of crafting legislation that can pass both houses of Congress is only beginning, so it remains to be seen whether there will be an actual repeal of the federal estate tax.
Even if the federal estate tax is repealed, any celebrations by California entrepreneurs may be short-lived, as California State Senator Scott Wiener (D-San Francisco) has proposed California legislation that would undermine the efforts of the Republican-controlled U.S. Congress and President Trump to eliminate the estate tax by seeking to impose a replacement California estate tax (at 40%) if Congress repeals the federal estate tax:“If Donald Trump and Congressional Republicans are hell-bent on cutting taxes for our wealthiest residents, we should counter-balance those tax cuts by recapturing the lost funds . . .”1
Senate Bill 726 was introduced by Senator Wiener on February 21, 2017.2 Under the bill, a ballot measure would be introduced asking California voters to incorporate the current estate tax provisions of the federal tax code into California’s tax laws (the Revenue & Taxation Code), so that a California-level estate tax could be imposed on estates larger than $5.49 million. It also incorporates the gift tax and the so-called generation skipping transfer tax (think: taxing transfers
from grandparents to their grandchildren, which “skips” the grandchildren’s parent’s generation).
If the bill were to become California law, it could have some surprising results. But first some background. In exchange for repealing the federal estate tax, it is widely rumored that Congress would eliminate the unlimited “tax basis step-up” to fair market value of assets held at death, which means that the asset would have a “carryover” basis instead (this was not specifically addressed in the White House’s outline of proposals). The loss of this tax basis step-up can have significant income tax consequences for beneficiaries who sell inherited assets. This is because capital gains tax applies on the difference (i.e., the “gain” portion) between one’s “tax basis” and
Take, for example, a situation in which your daughter inherits stock worth $10.00 a share from your estate, but you only paid $1.00 a share for it. Absent a tax basis step-up to fair market value at the time of your death (such as currently applies), your daughter will have a “carryover” basis of $1.00 per share. If she sells the stock when it appreciates to $15.00 a share, then her gain is: $14.00 (i.e., $15.00 less $1.00), and, using current rates, she pays capital gains on that (at a rate as high as 37.1% (20% federal, plus 3.8% federal net investment income tax, plus 13.3% California)).
In addition to replacing the federal estate tax, if the voters were to approve the California estate tax, the likely outcome would be a mismatch between the tax basis of assets for purposes of calculating federal capital gains tax and California income tax. Presumably, for California income tax purposes, your heirs would continue to get a “tax basis step-up” due to the California estate tax having been paid, but for federal capital gains tax purposes your heirs would have to calculate tax using the “carryover” basis. This could create real administrative headaches as your heirs would have to track the separate bases for future tax reporting. If California did not provide for a “tax basis step-up” after payment of a California estate tax, the imposition of a California estate would be even more onerous.
If Congress repeals the federal estate tax but replaces it, as some have suggested, with a capital gains tax due at death (which is basically an estate tax by a different name and which is not discussed in the outline of proposals), it is unclear what effect this would have on Senator
Wiener’s proposed legislation.
Obviously, there are still many unanswered questions, particularly given that we only have an outline of some proposals regarding revisions to the federal tax code; no actual proposed legislation and no Congressional votes. We are still a long way from knowing what the revised federal tax code will look like, which also means that we do not yet know if an estate tax is on the
horizon for the Golden State.
Therefore, for those residents who already have accepted the rest of California’s current regulatory and tax regime, it would be premature to schedule the moving van based on this proposed legislation. However, if the people of California vote to impose a state-level estate tax after repeal of the federal estate tax (if that ever happens) and if other states do not impose such a tax, this could become one additional reason cited by successful families who decide to relocate to more
friendly regulatory and tax environments.
As this situation further develops, we will provide additional updates. In the meantime, there remain significant tax and non-tax (such as business continuity, charitable planning, and asset protection planning) reasons for moving forward with additional estate planning and asset transfers now. If you have questions regarding these planning opportunities, please contact John Peiffer
from our estate planning practice group at 707.400.6243 or firstname.lastname@example.org.
1 “Senator Wiener Announces Ballot Measure to Create California Estate Tax to Replace Federal Estate Tax Threatened with Elimination by Trump and Congress.” http://sd11.senate.ca.gov/news/20170221-senator-wiener- announces-ballot-measure-create-california-estate-tax-replace-federal
2 Accessible at: https://legiscan.com/CA/bill/SB726/2017