On the Money Trail
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Anatomy of a Tax Cut
by Al Jacobs, author of Nobody's Fool
April 2008

With the 2008 election season in full bloom, and the candidates hurling charges at one another, we are witness to the usual quadrennial antics.  As is traditional, the participants are dubbing this “the most important election of all time.”  Actually, this time there’s an element of truth in that claim.  Following inauguration of a new president and seating of the 111th congress in January 2009, these officials must resolve a matter that currently festers in limbo: an unprecedented tax increase scheduled to take place on the first day of January, 2011.  Despite the standard mantra that Republicans support tax cuts while Democrats oppose them, this simplistic generalization does not begin to address the problem.  Perhaps the following will give you an understanding of what the tax cut business is really all about 

On May 26, 2001, a Republican-dominated U. S. Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001.  Twelve days later, newly elected President George W. Bush—also a Republican—signed it into law.  Judging by the orchestrated pronouncements at the time, Americans finally obtained tax relief.  The most immediate consequence of the new law, and on which attention focused, seemed to be one-time refund checks mailed out the following summer¾up to $300 to individual taxpayers and $600 to married couples.  As expected, politicians seized on what many citizens perceived as a windfall to take credit for this munificence.  The opening paragraph from the IRS letter accompanying the payments read: “We are pleased to inform you that the United States Congress passed and President George W. Bush signed into law the tax bill which provides long-term tax relief for all Americans who pay income taxes.”  Incidentally, and perhaps not by coincidence, the IRS letter recently announcing the Economic Stimulus Act of 2008 starts off much the same, but with twice the one-time benefits—$600 and $1,200—although this time, as Democrats now control congress, taxpayers with higher incomes are not included as recipients.  Despite the variations, some things never change.

Time has passed since the 2001 tax relief act, with few persons ever understanding the actual details of this very complex legislation.  Select portions of the law, almost gossamer in quality, occasionally float by: rate brackets dropping a few percentage points over a number of years . . . slowly increasing estate tax exemptions . . . allowance for higher 401-k contributions . . . other bits and pieces of this and that.  Also within the text, but not widely publicized, included a stipulation designed to override everything: all the modifications enacted by the tax act expire on January 1, 2011.  Known commonly as a “sunset provision,” the result will be a reversion to the 2001 rules on that date.  Whatever the mixed blessings, by and large the substance remains buried in accolades.

At the risk of sounding contrary, let me give a divergent analysis of the bill.  It’s necessary, as with so many other aspects of life, to separate illusion from reality.  There is a time-honored adage: The devil is in the details.  In this case Satan in all his horror is firmly imbedded in one specific element of the estate tax portion of that act.  I am convinced that this provision, if not rescinded beforehand, will prove to be the most massive tax increase in the history of our nation.  I’ll explain—but first, a little background.

The estate tax law exists mostly unchanged over the years.  Upon death, the deceased’s assets are valued.  A portion of the estate known as the unified credit is subtracted from the total.  The remainder is then subject to tax at rates that in 2001 started at 18% on the first $10,000, rapidly increased through 16 separate brackets until it reached 55% on sums exceeding $3,000,000. The changes purported to address this by gradually increasing the credit while reducing the rates.  And on January 1, 2010, the estate tax will cease to exist.  However under the sunset provision, Nirvana will be short lived¾exactly one year later the credit and brackets revert to the status in 2001.  Instead of waking up from a nightmare, it will be more like waking up to a nightmare.

If that concluded the story, I might concede that some tax relief resulted—albeit temporary—particularly for those with the good judgment to die in 2010.  However, there is a matter known as “stepped-up basis” that inserted an entirely new element into the mix.  I’ll illustrate this with the following example.  Aunt Emma, having eaten four too many cannolis at her 74th birthday in 2003, passed on to her great reward, leaving behind the home she lived in for forty years.  Back in what may seem like antiquity she purchased the property for the then formidable sum of $20,000.  Upon her demise its market value hovered at $400,000.  Please don’t scoff at these numbers; they are more typical than unusual.  In any event, her nephew Rollo¾probably an undeserving lout—became sole heir to her estate and acquired title to the house, with his first thought to cash it in.  Let’s see how he fared.  The sales price, $400,000, less his cost basis determined taxable income.  As to his cost basis, understand that it became $400,000, because in the hands of an inheritor, cost basis of property equals the market value at the time of decedent’s death.  This is known as stepped-up basis.  So Rollo’s tax consequences on the sale were simple to calculate: sales price $400,000; cost basis $400,000; taxes owed on the difference: zero . . . zip . . . nada.

Let us now fast-forward to January 1, 2011.  Presume that Aunt Emma displayed the good sense to avoid those cannolis eight years earlier, thereby percolating on happily for a time.  However nothing is forever, and the new year’s eve dinner consisting of gnocchi di patate, pappardelle with stuffed tomatoes, and a double serving of tiramisù proves more than her 82-year-old digestive tract can handle.  This time there is no escaping the inevitable—Aunt Emma’s chips are irrevocably cashed.  It’s time to do Rollo’s math once again, but under the rules that will exist in 2011.  Sales price: $600,000 (credit the increase to an annually compounding inflation rate of 5% over eight years).  Cost basis: What do you guess this time?  If you expect it to be market value at the time of death, you are wrong . . . wrong . . . wrong!  The 2001 “tax cut” did away with the stepped-up basis after 2010.  In its place will be the decedent’s adjusted cost basis.  In short, Rollo’s basis will be that of Aunt Emma’s: $20,000.  This time the tax consequences on the sale work out a little differently: sales price $600,000; cost basis $20,000; Rollo incurs a $580,000 taxable capital gain.

This single illustration gives you a glimpse of what the future offers.  Now multiply it by the tens of millions of estates to be affected and you get an idea of what transpired.  Whatever its description, one thing is certain¾tax relief it was not.

One last thought: How did we come to this?  I suspect that few members of congress—Republican or Democrat—possessed any inkling as to what they voted into law.  They merely engaged in the time-honored practice of enacting feel-good legislation, with the real culprits probably long-tenured staff members of the House Ways and Means Committee who plotted for decades to accomplish this goal.  But for a last minute reprieve, they almost managed it in the 1970s.  Whether they’ve pulled it off this time, we shall see.

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Al Jacobs has been an entrepreneur for forty years. His business experience ranges from property management and securities investment to appraisal, civil engineering, and the operation of a private trust company. In his book, Nobody's Fool - A Skeptic's Guide to Prosperity, Al presents his Ten Ground Rules for Success for achieving wealth and a prosperous life by outlining a philosophy for spending, borrowing, making sound investments, and how to avoid being victimized by America's many intimidating institutions.