A Taxing Change

By Daniel Kadlec

Any school kid knows to be wary of a bully offering candy in one hand while the other arm is folded behind his back. Take the bait and you're bound to get soaked, smudged, smeared or socked. The ploy is an old one, and Uncle Sam is gaming taxpayers with a version right now. Eliminating the estate tax, which the Senate will consider this week, is the sweet stuff. Levying additional tax on capital gains, a form of wealth the stock-owning masses have come into big time, is the punch.

While just about every taxable estate stands to benefit if the so-called death tax gets buried, the rub of additional capital- gains tax is no trifle. Don't worry. No one's messing with the cap-gains rate: 20% for long-held assets. What's getting deep-sixed is the "step-up" in value of some inherited assets. The step-up may sound arcane, but it's a bedrock of estate planning.

Say your parents own $300,000 of Microsoft stock for which they paid just $25,000 some years ago. If they sell while they're alive, they'll get hit with a cap-gains tax totaling $55,000 on their profit of $275,000. If they hold until death, though, their heirs will get the stock at the stepped-up basis of $300,000. They could turn around and sell, and owe no cap-gains tax. This money saver is an overriding motivator for many parents who choose not to sell, possibly forgoing a better end of their life. Under the bill, in some cases, that sacrifice would be for naught.

The bigger issues surrounding the bill, and which have gotten all the ink since the House passed it a couple of weeks ago, have to do with saving family farms and businesses. Sometimes heirs must sell out to pay inheritance tax. Repealing the estate tax would fix that. But President Clinton--and Al Gore, if elected--would never sign the bill, viewing it as favoring the rich. There may be enough momentum, though, to override a veto, and if things fall to George W. Bush, the Republican presidential hopeful, the bill would become law in a nanosecond.

So it's worth considering how you'd fare. Under the bill, you could leave your spouse $3 million at the stepped-up value, and an additional $1.3 million at stepped-up value to others. The surviving spouse in a marriage could leave yet another $1.3 million at the stepped-up basis. That's a lot of tax protection. Yet a single person could shield only $1.3 million in all, and by 2010, when the bill would be fully phased in, single estates will be common.

One thorny issue will be choosing which assets get the benefit of the step up. Presumably, you'd choose those with the most appreciation. But if your best stocks sag and the laggards charge ahead after you've died, you'd have chosen wrong. And how can you be fair to several heirs? If one gets a Renoir, another gets the house and another gets your stocks, whose bounty gets the critically important stepped-up value?

The proposed system puts tremendous strain on your record keeping. Thirty years of home improvements and stock splits are tough to track. Before, everything got stepped up to market value when heirs took over. Now you'll need an army of accountants. Finally, this bill shifts the tax burden from the estate to heirs, who must remember not to spend everything. The estate never settled with Uncle Sam, so it's up to the heirs to make good. Owing tax on a windfall is what you call a good problem. But if you're not careful, the bully is going to clock you.

See time.com/personal for more on estate taxes. E-mail Dan at kadlec@time.com See him Tuesday on CNNfn at 12:20 p.m. E.T.