LEGAL GUIDE
Written by attorney Eric B. Dick | Oct 10, 2010

Modern Estate Tax and Its Development in Reagan Era

Brief History of Estate Tax

At the recommendation of Congress, in the United States the estate tax began in 1797 with the Death Stamp Act 1. This act was later repealed in 1802 2. In 1862, an estate tax was created by the Tax Act to help finance the Civil War 3. In Scholey v. Rew, the United States Supreme Court held that an estate tax is constitutional 4. In 1894, we find the limits of such constitutionality with the Income Tax on Gifts and Inheritance (which actually treated inheritance as income) as Pollock v. Farmers’ Loan and Trust Company ruled the statute as unconstitutional as it is a direct tax and unduly burdened taxpayers 5. As the Sixteenth Amendment repealed direct apportionment, Pollock may have been decided differently today.

Development of Modern Estate Tax

In 1916 the Revenue Act was created. In the Revenue Act of 1916, the estate tax was created. The Revenue Act is often though of as being the backbone of our current estate tax scheme. Creating a unified estate and gift tax credit, Tax Reform Act of 1976 also fathered the generation-skipping transfer tax. Currently, there are three types of generation skipping transfers.

Economic Recovery Tax Act (ERTA)

There are many different strategies on implementing taxes. One thought is that during economic recessions and depressions, if federal taxes are decreased then taxpayers will have more money to spend on goods and services. Henceforth, during hard economic times presidents often push for some type of tax reform to held financial hardships. Ronald Reagan, the fortieth president of the United States, believed and followed such philosophy.

Reagan’s Economic Recovery Tax Act (ERTA) stands timeless in the world of tax stimulating the economy during hard times. For example, Bill Brown, a visiting professor of the practice of law at Duke University, explains that President Obama should take guidance of Reagan in using ERTA to stimulate the economy. Specifically he says, "During the early days of the Reagan Administration, a time plagued by slow econonic growth, high interest rates, and runaway inflation, ERTA not only reduced tax rates, but established a powerful set of incentives to promote investment in income-producing ‘capital assets’ - plant, property, and equipment… 6" Further, Brown explains that, "ERTA] resuscitated the Kennedy-era investment tax credit, which gave businesses partial reimbursement for the purchase of every new - producing asset they acquired, and it added to this subsidy by allowing all those assets to be depreciated extremely rapidly under the new Accelerated Cost Recovery System. [7"

During the summer of 1981 a large focus of policy debate was on ERTA – commonly known as the Reagan tax cuts. At heart was a bill providing a twenty-five percent cut in tax rates. By reducing marginal tax rates and improving economic incentives, ERTA would increase the flow of resources into production, hence creating economic growth. Opponents said that ERTA would be a giveaway to the rich because their tax payments would fall.

Critics of Reagan often deceptively pout that the ‘rich got richer and the poor got poorer.’ To the contrary, Reagan was not an advocate for the wealthy to gain wealth. To prevent of benefits to the rich, Reagan raised their tax burden. For example, for individuals earning more than $200,000 annually, their burden rose to fourteen percent in 1986 from just seven percent in 1981. Lower income earners saw a one percent decrease in their tax payments within the same period.

ERTA’s major components were:

  1. A phase-in 23% reduction in individual tax rates with the top rate falling from 70% to 50%;

  2. Accelerated depreciation deductions replaced by the accelerated cost recovery system (ACRS);

  3. Indexing of individual income tax parameters starting in 1985;

  4. Creation of a 10% exclusion on income for two-earner married couples (subject to a $3,000 cap),

  5. Phased-in increase in the real estate tax exemption from $175,625 to $600,000 starting in 1987;

  6. Reduced windfall profits taxes;

  7. Permitting all working taxpayers to establish Individual Retirement Accounts (IRAs);

  8. Expanded provisions for employee stock ownership plans (ESOPs); and

  9. Replacement of the $200 interest exclusion with a 15% net interest exclusion (subject to a $900 cap) starting in 1985 8.

The end result of ERTA was fixing the economy in a time of crisis – something that many other presidents have aspired to do. Around twenty-five years after ERTA took effect, the public still praises it. On its annerversy Knight Ridder praises ERTA in an article by saying, "It took awhile, but the economy responded. Since enacting ERTA] about 45 million jobs have been created … and the economy has averaged 3.5 percent in real growth annually. Just as important was the policy transformation - from higher taxes and public spending to curbed spending and unleashing the power of lower taxes on private enterprise, savings and investment. [9"

ERTA, Estate Tax, and Marital Deduction

ERTA clearly made many changes in the estate tax realm. Such changes were designed to lower the number of taxable estates. ERTA increased the unified transfer tax credit from $47,000 to $192,800. It also made big changes in the marital deduction by eliminating quantitative limits between interspousal transfers. Prior, there was a dollar and percentage limitation for marital gifts.

As ERTA changed the marital deduction, the transition from pre-ERTA and post-ERTA was uncertain. As Gregory DiCenso of the American Law Institute explains, when referring to the "Moving Target Deduction," it was common both before and after ERTA to word a marital bequest by saying you devise your spouse "an amount which shall equal in value the maximum allowable marital deduction. 10" This common language presents a problem as those devising such marital bequest could normally not be expected to anticipate the substantial changes of IRC §2056(a).

IRC § 2056(a), gives the current federal estate tax marital deduction rule:

For purposes of the tax imposed by section 2001, the value of the taxable estate shall, except as limited by subsection (b), be determined by deducting from the value of the gross estate an amount equal to the value of any interest in property which passes or has passed from the decedent to his surviving spouse, but only to the extent that such interest is included in determining the value of the gross estate.

As discussed above, IRC § 2056 was changed to create an unlimited marital deduction. Before ERTA, IRC § 2056 limited the federal estate tax marital deduction to the greater of $250,000 or 50 per cent of the adjusted gross estate. Thus, a potential conflict arises.

DiCenso goes on to explain that "Congress was concerned that decedents with pre-ERTA wills and trusts providing merely for the ‘maximum’ marital deduction, executed when the limitation was 50 per cent of the adjusted gross estate, or possibly the greater of 50 per cent of the adjusted gross estate or $250,000, might not have been] anticipat[ing] the law being amended to allow a marital deduction for an unlimited amount of property, and thus [such individual] did not intend to pass along that ‘maximum’ of a marital devise [in their will or trust]. [11" Thereby, to prevent needless litigation over the intent of the devisee, Congress created the transition rule as follows:

3) If:

(a) the decedent dies after December 31, 1981,

(b) by reason of the death of the decedent property passes from the decedent or is acquired from the decedent under a will executed before the date which is 30 days after the date of the enactment of this Act, or a trust created be for such date, which contains a formula expressly providing that the spouse is to receive the maximum amount of property qualifying for the marital deduction allowable by federal law;

(c) the formula referred to in subparagraph was not amended to refer specifically to an unlimited marital deduction at any time after the date which is 30 days after the date of enactment of this Act, and before the death of the decedent, and

(d) the State does not enact a statute applicable to such estate which construes this type of formula as referring to the marital deduction allowable by Federal law as amended by subsection (a), then the amendment made by subsection (a) shall not apply to the estate of such decedent 12.

If a one meets all four of the above elements, then the transaction rule applies and limits the marital deduction. Furthermore, there are three situations in which will stop the transaction rule and allow the unlimited marital deduction to apply. These are:

  1. The state enacts a statute interpreting maximum marital as unlimited marital;

  2. The will or trust expressly provides that the law in effect at the date of death controls; or

  3. The will or trust formula is a reduce-to-zero formula maximum marital.

Conclusions

Taxes affect our everyday lives and have been the topic of many a discussion. They provide the federal and state government a revenue flow to give its residence services. Though some services may be controversial, many are much needed. Unfortunate for the taxpayer, the idea of taxes and implementation of taxes is a very old concept.

1 P.L. 107-16, 107th Cong., 1st Sess. (2001).

2 Act of April 6, 1802, 2 Stat. 148.

3 Act of July 1, 1862, 12 Stat. 432, 483.

4 23 Wall. (90 U.S.) 331 (1874).

5 158 U.S. 429 (1895).

6 USA Today (http://proquest.umi.com.ezproxy.apollolibrary.com/pqdweb?RQT=318&pmid=28602&TS=1259700899&clientId=2606&VInst=PROD&VName=PQD&VType=PQD). Farmingdale: Apr 2009 (http://proquest.umi.com.ezproxy.apollolibrary.com/pqdweb?RQT=572&VType=PQD&VName=PQD&VInst=PROD&pmid=28602&pcid=42466331&SrchMode=3). Vol. 137, Iss. 2767; pg. 14, 1 pgs

7 Id.

8 Anderson, John E., U.S. Tax Reforms and Their Effects on Average Tax Rates (November 19, 2007). Available at SSRN: http://ssrn.com/abstract=1031203

9 Knight Ridder Tribune Business News (http://proquest.umi.com.ezproxy.apollolibrary.com/pqdweb?RQT=318&pmid=42957&TS=1259702210&clientId=2606&VInst=PROD&VName=PQD&VType=PQD). Washington: Aug 31, 2006 (http://proquest.umi.com.ezproxy.apollolibrary.com/pqdweb?RQT=572&VType=PQD&VName=PQD&VInst=PROD&pmid=42957&pcid=33286721&SrchMode=3). pg. 1

10 DiCenso, Gregory V. The Practical Tax Lawyer. Philadelphia: Fall 1993. Vol. 8,

Iss. 1; pg. 63

11 Id.

12 ERTA § 403(e)(3)

Additional resources provided by the author

www.irs.gov

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