Estate Tax Change Threatens Obama’s Tax Compromise
Life + Money

Estate Tax Change Threatens Obama’s Tax Compromise

Among the most contentious issues in the tax compromise package that comes before the House of Representatives today is likely to be an unexpectedly generous change in the nation’s estate tax that could deliver significantly greater wealth to heirs of America’s greatest fortunes.

Under a plan approved Wednesday by the Senate after months of gridlock, the top tax rate typically would be 35 percent on estates larger than $5 million, which can include stocks, bonds and other assets, such as cash and the family home. The Senate version also includes a major change that could save many heirs large amounts of capital-gains taxes if they eventually sell the assets they inherit. (Transfers from one spouse to the other typically would remain tax-free.)

That’s a far better deal than the top tax rate of 45 percent on amounts over $3.5 million in 2009, before the estate tax expired in 2010. The $5 million exemption amount would be indexed for inflation, with the first adjustment coming in 2012.

If Congress does nothing, the top tax rate on the largest estates next year would revert to 55 percent on amounts over $1 million, the rate before the estate tax began to be phased out by President George W. Bush.

The staff of Congress's Joint Committee on Taxation estimates that including provisions that ripple through multiple years, the cost of the compromise plan, if approved, would be about $68 billion over a decade — a much larger revenue drain on the Treasury than many tax specialists had expected.

Earlier this year, many lawyers predicted Congress would bring back the 2009 rules. But that was before the November elections, in which Republicans scored major gains. Under the Senate-approved plan, the estate-tax provisions would "sunset," or disappear, after 2012, which means this issue is likely to resurface during the presidential campaign in 2012. If Congress takes no action then, in 2013 the top rate on the largest estates would jump to 55 percent, and the exemption would drop to $1 million.

The compromise plan still might come unglued in the House, where critics are expected to argue that the estate-tax provisions represent an unjustified bonanza for a tiny group of high net-worth people who don't need help at a time of exceptionally high unemployment — and when Congress should be searching for ways to slash the federal budget deficit. Some Democrats were planning a move to amend the estate-tax provision, including Rep. Chris Van Hollen, D-Md., who said the “hole” it would create in the deficit would benefit “the wealthiest three-tenths of one percent of estates in America.”

Others, reeling from heavy losses in the November elections, may be unwilling to buck President Obama's decision to accept the  compromise package. Raul Grijalva, D-Ariz., one of the deal’s most outspoken opponents, told The Washington Post after the Senate vote that while his opposition hadn’t diminished, the bill was likely to pass because of White House lobbying and the way the House Democratic leadership had structured the process. If an amendment passes, the revised bill would have to go back to the Senate for approval.

In the Senate earlier this week, leading Democrats blasted the estate-tax changes but still came out in support of the overall tax compromise package, which also includes an extension of unemployment benefits. Among them was Senate Budget Committee Kent Conrad, D-N.Dak., "The one provision in this package that I particularly am unhappy with is the estate-tax provision," he said. "But I understand that the president did what he had to do to get an agreement. This economy clearly remains in a fragile state and we can't afford to wait until we get everything we want. We cannot let the perfect be the enemy of the good."

Parts of the new plan can be very confusing. For example, consider the effective date and a tricky decision many executors will face.

"Someone who has well more than $5 million … still has a Congressional incentive to consider lacing the Dom Perignon with arsenic on New Year's Eve."

The new $5 million exclusion and top estate-tax rate would be effective as of the start of this year (yes, 2010). But if someone dies this year, the estate could choose to use the law as it now stands (with a zero estate-tax rate) or the new law (which could save heirs capital-gains taxes when they sell what they inherit).

In some cases, the choice will be relatively simple. If someone who died this year had a very large estate, the estate typically would benefit from the law as it now exists since that would mean no estate tax. But many smaller taxable estates would be better off choosing the new law, and benefiting from more favorable capital-gains tax rules: The value of inherited assets typically would be based on their market value on the date of death. It wouldn’t matter what the person who died originally paid for those assets, which could be much less. Whatever the case, the clear winners here will be tax lawyers, accountants and other professional advisers.

Strangely, the new plan — in what might be called the deathly prose provision — would leave in a place a ghoulish tax incentive: It would give some extremely wealthy people who truly care about their heirs a powerful incentive to die before New Year's Day because the tax savings could be enormous, especially for the super-wealthy.

"Someone who has well more than $5 million and no surviving spouse to leave it to, if he or she truly loves his or her family, still has a Congressional incentive to consider lacing the Dom Pérignon with arsenic on New Year's Eve," says Josh Rubenstein, a lawyer at Katten Muchin Rosenman LLP in New York and head of the law firm's trusts and estates department.

There are more details on the website of the Joint Tax Committee. The staff has written a lengthy document with important information about such areas as the gift tax and generation-skipping tax. Look for "JCX-55-10," dated Dec. 10, 2010.