Resurrection of the Estate Tax
Life + Money

Resurrection of the Estate Tax

The recently expired tax will probably be restored, but its ultimate form remains to be seen

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On New Year's Day, the federal estate tax, dubbed the "death tax" by critics, died unexpectedly. But don't even think about writing its obituary.

Many lawyers and accountants predict that Congress probably will restore the tax retroactively to Jan. 1 this year. However, nobody knows when lawmakers will act or precisely what the resurrected tax will look like. Nothing may be certain except death and taxes. But this year, there is no certainty about taxes after death.

All the questions swirling around this grisly topic have created thorny issues for many wealthy people and their tax advisers. "It's a real mess," says Herbert Nass, a New York City trusts and estates lawyer and author of two books on wills and estate tax-related topics. He is handling a case involving a very wealthy person who died earlier this year. Will that person's estate have to pay a federal estate tax this year or not? Also, he wonders, "Will we need to liquidate assets in the estate in order to pay the federal estate taxes, if any?" And how can wealthy clients plan their affairs in view of all the uncertainty?

Last year, tax advisers and political analysts assumed that Congress would surely take action before 2010 and not leave the issue in limbo. "It certainly seemed to me that the dynamics of a deal were there" before this year, says Douglas Holtz-Eakin, a former director of the Congressional Budget Office and the director of economic policy for Sen. John McCain when the Arizona senator ran for president in 2008. The House did approve legislation restoring the tax, but the Senate didn't act.

Now, with important midyear elections coming up later this year, the estate tax outlook is growing increasingly cloudy, and tax specialists see a wide range of possible outcomes. (See below for an updated list of options, including President Obama's new budget proposals, released Feb. 1.)

For 2009, the top federal estate tax rate was 45 percent, and the basic exemption was $3.5 million. (Transfers from one spouse to the other typically are tax free.) If Congress takes no action, the tax will remain zero this year but then will come roaring back next year with a top rate of 55 percent for the largest estates and an exemption of $1 million.

Comedians have been quick to point out the implications of having no federal estate tax at all in 2010 followed by a tax of as much as 55 percent on Jan. 1 next year. As Stephen Colbert recently quipped: "So wouldn't this be a great year to visit your lonely, frail, unhealthy uncle and just be by his side to make sure no one coats his banister with Teflon? ... And if you yourself are a wealthy senior, please protect yourself from greedy grandchildren. Go to Colbert Nation dot com and transfer all your money into my Platinum Inheritance Lock Fund. I promise: No relative of yours will ever see that money." 

Despite all the uproar about the issue, very few estates wind up paying the federal estate tax. The Internal Revenue Service says 38,373 estate tax returns were filed in 2008. Of those, only 17,172 were taxable.

By contrast, the IRS said a total of about 108,000 estate tax returns were filed in the year 2000. Of those, 52,000 returns were taxable. The sharp drop in the number of returns reflects major estate tax cuts enacted during the Bush Administration. At stake, however, are billions of dollars. According to Obama budget documents, estate and gift taxes raised about $23.5 billion last year.

Here are some of the major options that have been discussed and an assessment of their prospects based on interviews with lawyers and accountants:
1. Gridlock and Inaction: Even though this seems highly unlikely, it can't be ruled out completely in view of the intensity of political bickering in Washington and the looming midterm elections. One analyst speculates, for example, that the Senate might reach a compromise agreement this year that would cut the top tax rate and increase the basic exemption amount — only to see it torn apart in the House, leading to no action. The longer Congress waits to act this year, the tougher it could be to reach a compromise agreement.

 2. Back to the Future: Many analysts think the most likely outcome is Congress will restore the tax this year in its 2009 form. That would mean a $3.5 million exemption, or $7 million per couple, assuming they did the proper estate-planning maneuvers. It would also mean a 45 percent top rate.

President Obama recently proposed this approach as part of his new budget. As a budget document put it: "Estate and gift taxes are assumed to be extended at parameters in effect for calendar year 2009 (a top rate of 45 percent and an exemption amount of $3.5 million)."

"Congress has put this approach on the front burner," says Mr. Nass, the New York City trusts and estates lawyer. "But it’s hard to predict what will happen because of the unpredictability of politics. Last year, every trusts and estates lawyer expected that Congress would continue the then-current law. But we were all wrong."

Congress probably also will restore the 2009 system for valuing inherited assets for tax purposes. This is exceptionally important to many heirs. Under that law, you typically value what you inherit based on the value of those assets on the date of your benefactor's death. (To be sure, there is also the option of picking an alternate valuation date six months later.)

For example, if you inherit Pop's stamp collection, you don't have to figure out what he originally paid for it decades ago. You typically use the value of the collection on the date he died. This "step up in basis" system (so named because the cost basis of assets that have gone up in value over the years gets "stepped up" to the date-of-death value) expired at the end of 2009 and was replaced by a complex system that essentially would require calculating the tax basis on the original cost of the assets above a certain amount. Critics say eliminating the step-up approach would lead to burdensome record keeping. Under that system, it would be "cumbersome for many estates to be able to ascertain the original cost basis of assets in the estate," says Mr. Nass.

President Obama also is calling for "certain reforms" in order to "close loopholes in estate and gift taxation." This would include modifying estate and gift tax "valuation discounts" in certain circumstances, such as lack of marketability and control in determining the value.

3. Compromise One: Last year, some senators were talking about a compromise that would increase the exemption amount to about $5 million per person and slash the top rate to somewhere around 35 percent. But it didn't materialize, and it's unclear whether that would survive in the House.

4. Compromise Two: This would involve restoring the 2009 law but with a few tweaks. It would index the exemption amount for inflation in future years, rather than leaving it at $3.5 million permanently. It would also make the exemption "portable" between spouses. Portability essentially means that when one spouse dies, the other spouse would get the unused exemption amount of the deceased spouse without first having set up complex trusts or take other steps. During the 2008 presidential campaign, Obama and McCain agreed on the basic concept of portability as an important simplification move. It’s hard to gauge how much support there is for these ideas today.

Whatever the case, many states have their own taxes. For example, New York has an exemption of $1 million, $2.5 million less than the federal level in 2009. But Florida doesn't have a state income or estate tax, creating a powerful incentive for wealthy New Yorkers to pack up and head south — especially if they are in poor health and care about their heirs.

Tom Herman is a former reporter for The Wall Street Journal.