The State of the Estate Tax: What We Know and What We Don’t Know*

An integral aspect of the estate planning process involves planning to minimize estate taxes payable at death and gift taxes payable during life in connection with transfers of assets. In 2001, Congress enacted a schedule for increasing the estate tax exemption, and modestly diminishing the maximum estate tax bracket, with repeal of the federal estate tax in its entirety in the year 2010. To pay for the anticipated decrease in estate tax revenues, the tradeoff was to phase out the credit for state death taxes at the end of 2004, and to limit the step-up in income tax basis enjoyed by all estates, regardless of whether the estate is subject to estate tax. Finally, and most importantly, the tax schedule contains a sunset provision, with the exemption reverting back to $1,000,000 in 2011 as though the increased exemptions and repeal had never occurred. Moreover, the lifetime exemption from the federal gift tax remained fixed at $1,000,000. It was clear to the estate planning community that the only certainty inherent in the legislation was that Congress would need to revisit the entire estate tax question sometime before 2011.

 

In the last several years, many states that formerly had an estate tax equal to the amount of the federal credit for state death taxes realized that, beginning in 2005, there would be no state estate tax revenue as a result of the elimination of the state death tax credit. Some, but not all, states quickly enacted separate state estate tax systems independent from the federal estate tax. What had become over a period of years a fairly uniform system across the states is now once again a patchwork of very different state estate tax rules, and a number of states now have no state estate tax at all.

In the meantime, there has been an ongoing public discussion about the wisdom and value of having a federal estate tax, against a backdrop of an economy that has not been as vigorous as it was when the estate tax was last revised, and substantially increased federal budgets. President Bush formed a committee to study the estate tax and make recommendations. Congress has focused now on the matter in earnest. The House of Representatives has passed one bill repealing the estate tax in its entirety, beginning in 2010. There are proposals for compromise which include increased exemptions of $3,500,000 to $5,000,000, and perhaps lower marginal tax rates than the current 46 percent. As in the past, there will likely be a number of bills introduced and voted upon before a final decision on the federal estate tax is reached. One encouraging sign is the statement by Rep. William Thomas (R-Calif.), the chairman of the House Ways and Means Committee, that certainty in the area of the estate tax was needed, if repeal was not possible.

Those favoring estate tax repeal believe that it is an unfair and unnecessary tax that impacts family businesses and farms disproportionately, and subjects assets to “double tax” since the assets were likely subject to income tax during the taxpayer’s life. Those who favor retention of an estate tax believe that the estate tax affects only two percent of the population, and is therefore not unfair; that elimination of the tax will have a cost of $290 billion dollars over the next 10 years, and that compromises will be made that may affect many more taxpayers than does the estate tax. For example, if carryover basis were eliminated, the beneficiaries of an estate would pay capital gains tax when inherited real estate or stock is sold based on the deceased’s basis, rather than based on the value at the deceased’s death. And, so far there has been no discussion about whether the current $1,000,0000 lifetime exemption from the gift tax would be affected by any legislation. While it is premature to speculate what will ultimately be decided, it is clear that many taxpayers are likely to be affected.

With that said, we are planning as usual for clients. Many estate planning professionals assume that there will be some sort of tax, if not now, at some point in the future. As a result, flexible planning is often recommended to accommodate changes not only in the tax structure but in families and their financial situations as well.

*As of the date of this publication