Tenative Estate Tax Deal Reached

President Obama and Congressional Republicans have reached a deal to extend the Bush tax cuts and all tax cuts passed since then, for all, even those making more than $1,000,000 a year, for two years, and to extend unemployment benefits for thirteen months. Congressional Democrats have not yet consented to the deal, and some will almost certainly vote against it, but it is likely that support from Blue Dogs and from other Democrats who don't want to oppose the President will lead to passage of the proposal.

As a tax lawyer who deals most often with estate taxes, the implications for me are practical.

The deal on estate taxes is to set the estate tax exclusion at death, per person, to $5,000,000 (from which are subtracted significant life time gifts) and to set the estate tax rate at 35%. This change is not permanent. Like the other parts of this deal, it will be in force for two years (2011 and 2012).

If no deal had been reached, the exclusion would have fallen to $1,000,000 and the estate tax rate would have been a progressive one, starting at 37%, with a top normal rate of 55%, and with a bubble rate of 60% to recapture the benefits of lower rates in large estates. There was no estate tax (although there was a gift tax) in 2010, and in 2009 the estate tax exclusion at death was $3,500,000 and the estate tax rate was 45%. It appears that efforts to retroactively apply the estate tax to decedents who died in 2010 has been abandoned. Before this deal was reached, the President and Congressional Democrats had pushed to freeze the estate tax at 2009 exemptions and tax rates.

The tax is roughly equivalent to an income tax equal to the top personal income tax rate for heirs of large estates.

New releases haven't clearly stated the fact, but it appears that the step up in basis of capital gains at death will be reinstated after lapsing in 2010, so heirs will not have to pay the 15% capital gains tax on unappreciated capital gains that would be due if the appreciated assets had been sold at some point.

Some important aspects of the deal on estate taxes remain unclear.

First, it isn't clear if the gift tax exclusion, which had been capped at $1,000,000 as the estate tax exclusion grew, will be again unified with the gift tax. The gift tax was kept low because it was temporary and would create an incentive to make lifetime gifts larger than those that could be made at death if the estate tax exclusion was reduced as a hedge against future legislative changes in the gift and estate taxes.

Second, it isn't clear if an election to allow decedents to get a step up in basis for 2010 while being subject to estate taxes, either as they were in 2009 or as they are proposed to be in 2011, which has been discussed, will become law. Currently, while there is no estate tax in 2010, heirs of large estates (the step up in basis still applies to small estates), take appreciated assets subject to the condition that accrued capital gains on those assets will be taxed when the assets are ultimately sold (the same rule that applies to gifts of appreciated assets.

Third, there was serious discussion of a proposal to allow a surviving spouse to inherit any unused part of a decedent's estate tax exemption so that it could be used at the second death.

This would make unnecessary the trusts, sometimes called "credit shelter" or "family trusts" set up at the first death in a marriage couple, and related estate equalization planning, necessary under current law since the estate tax was overhauled in the 1970s in order to make full use of the estate tax exemptions. While these trusts do have some non-tax benefits, most are included in wills or revocable trust terms primary as a result of estate tax considerations.

For most families today that need to do estate tax planning, putting these trusts in place and equalizing the estates are the main elements of planning that are required. Other estate tax planning approaches are largely limited to large estates.

In practical terms, the proposal would mean that, for tax purposes, simple wills and powers of attorney would be adequate for any individual with an anticipated date of death fair market value of his estate (including the face value of life insurance and the fair market value of trust in which he or she has a retained interest) of less than $5,000,000, and for any married copule with an anticipated date off death fair market value of their combined estate (again including the face value of life insuracne and the fair market value of trusts with retained interests) of less than $10,000,000.

The caveat to this, however, is that the proposal is not permanent, and anyone who has a reasonable possibility of living through 2011 and 2012 still needs to plan for the possiblity that the estate tax exclusion will revert to $1,000,000 with higher rates as it is a little more than three weeks away from doing today with the proposed deal still not yet made law. So, until this change is made permanent, a "Plan A and Plan B" formula in a will or trust will still be the prudent approach, and families with net worths of more than $1,000,000 and less than $10,000,000 will still need to plan to control their exposure to estate taxes.