Why Tax Estates Instead of Inheritances?

By Megan McArdle

A friend on facebook asks a reasonable question:  what is the justification for taxing estates, rather than inheritances?  After all, why should we care if Bill Gates wants to leave $300 apiece to millions of people?

It's a question I've asked myself, and on net, I still think it's probably a good idea.  But there are arguments on the other side, and here are the good ones that I've gleaned from years of debating this:


1.  Estate taxes don't just tax the value of the estate, but also step up the "basis"--aka "the price you paid"--for the purpose of calculating capital gains.  This is actually pretty valuable, because it simplifies the record-keeping.  Once you've inherited something, you probably have no idea what Mom paid for it in 1952.  If you don't tax the estate, you allow heirs to enjoy, for free, all the capital gains that the dearly departed would have paid taxes on if they had sold their asset while they lived.

2.  Taxing the inheritance instead of the estate adds a lot more paperwork.  Since the estate is already going through probate, it's relatively simple to stack tax compliance on top of this.  If you tax it at the inheritor level, you'll need a whole new tax apparatus for taxing it.

3.  Many estates consist of large illiquid assets.  Businesses have often been cited, but there are also houses, farms, art, etc.  If you tax at the estate level, you can use whatever cash is in the estate to pay the taxes.  But if you tax at the inheritor level, you may frequently end up with a situation in which someone is forced to liquidate an asset because they've inherited the asset, but no cash with which to pay the tax man.

I've also heard it argued that this helps break up large estates to keep power from accumulating, but taxing inheritance seems like it would actually work better; it gives people incentive to break up large fortunes rather than having it all taxed at some huge rate as a one-year windfall.

This article available online at:

http://www.theatlantic.com/business/archive/2010/07/why-tax-estates-instead-of-inheritances/60446/