Estate Tax Whiplash

By :: December 18th, 2009

Thanks to Senate gridlock, taxpayers engaged in estate planning will suffer whiplash over coming months as the federal estate tax disappears and reappears, possibly unexpectedly and retroactively.

When the Senate refused to act Wednesday, it opened the door for the estate tax to disappear in two weeks--although no one knows for how long. Not only will the tax end, but the gift tax rate will fall to 35 percent. And, hardly noticed by most, only some assets inherited in 2010 will get “step-up” in basis. (With step-up, your taxable capital gain when you sell the asset equals the increase in value since the donor died; under the alternative—“carry-over basis”—you measure your gain against the donor’s initial cost, which is often well below the current value.) All this happens because the 2001 tax act phased out the estate tax over a decade, repealing it entirely in 2010. But the estate tax returns in 2011 under 2001 rules—a $1 million exemption and a 55-percent top tax rate.

Republicans had hoped to make repeal permanent but the winds of political fortune shifted, Democrats took control of Congress, and repeal remained temporary. For their part, House Democrats earlier this month passed a one-year extension of the 2009 law—a $3.5 million exemption and a 45-percent tax rate. But lacking party unity, Democrats failed even to get the Senate to vote on the issue.

So, come the New Year, rich folks will have a twelve-month window in which to die tax-free. As Representative Richard E. Neal (D-MA) put it, “If you are at the checkout counter, you might want to expedite things.” He might have added, “But don’t go too fast.” You’ll still need to hang on for two more weeks to avoid being one of the 5,500—an estimated 0.23 percent of people dying in 2009—whose estates will pay the tax.

And you might want to wait a while in 2010. Before you (or your greedy heirs) hasten your departure from this “mortal coil,” note that Senate Finance Committee Chair Max Baucus (D-MT) has promised to revive the issue next month and to reimpose the tax retroactive to January 1. I have no idea whether such legislation could survive expected cries of “Foul!” and the accompanying lawsuits, but you might want to linger at least partway through the year to see what Congress does. Dying is pretty much an irreversible decision, and you’d really hate yourself if you timed your death to save taxes and the IRS still came after your riches.

The same story could apply to the gift tax. You might make a huge New Year’s gift to a favorite nephew to take advantage of the temporary 35-percent rate. But Congress could undo that tax break too. Can you make an irrevocable gift that’s contingent on the tax rate not changing?

But this is no joke. The 2001 tax act and the Senate’s unwillingness to address the uncertainty around the estate and gift tax have made estate planning impossible. What convolutions must your will include to account for all possible legislative outcomes?

There is only one certainty in this whole affair: Estate planners will not soon join the ranks of the unemployed.