The year 2009 ended, but the status quo on estate taxation remained in place. Conventional wisdom had assumed that this wouldn't happen. The authors of "Superfreakonomics" even wrote that as of press time it looked like this wouldn't happen. But, the partisans on each side of this issue played chicken, and we are left with what Congress has wrought.
The Status Quo
* Under the 2009 status quo, the first $3,500,000 of assets owned at death (including the fact value of life insurance payable at death) pass estate tax free (reduced by lifetime gifts subject to gift taxation where or not tax can be avoided due to the lifetime gift exemption of $1,000,000). The balance of the assets owned at death, and not left to a charity or a citizen spouse were subject to a 45% estate tax on that excess amount. Small gifts during life were excluded from the calculation, and various special rules applied.
For capital gains tax purposes, heirs were deemed to have purchased inherited property at fair market value on the date of death. Capital gains on appreciated assets owned at death were not taxed.
* Under the 2010 law, there is no estate tax, although the tax on major gifts of more than $1,000,000 prior to death during a lifetime, remains subject to gift taxation.
For capital gains tax purposes, heirs who sell inherited property receive the same tax treatment that they would have received had the decedent still owned it, subject to an exception that treats death as a sale that benefits from the exclusion of capital gains on the sale of a personal residence, and subject to an adjustment of the deemed purchase price for capital gains tax purposes to fair market value for the first $1,300,000 of assets left by a decedent. This is called a modified carryover basis.
The carryover basis is the system used for capital gains taxation of assets received as gifts from someone during life. A previous attempt to use a carryover basis at death for capital gains tax purposes was swiftly abandoned because it was an administrative nightmare.
Generally speaking, capital gains taxes are 15% of the gain when gains are substantial or the property owner has a middle class or high income from other sources. Many large estates consist primarily of highly appreciated real estate or business investments that is almost entirely subject to capital gains taxation. But, a 15% capital gains tax is almost always preferable to a 45% estate tax, particularly when the carryover basis rules are modified for small estates as they are under current law.
The 2010 temporary repeal of the estate tax has no impact in cases where a decedent does not die in 2010.
* In 2011, under current law, the estate tax return in the basic form it was prior to 2010, with a $1,000,000 exclusion at death (instead of the $3,500,000 exclusion in place in 2009) and higher tax rates up to 55% (plus a bubble rate where the top rate reaches 60% as it recaptures the benefits of prior lower marginal rates).
Opponents of the estate tax insisted on taking a hard line through the end of 2009 against to freeze the estate tax at 2009 levels. They hoped that Democrats other than Blue Dog Democrats would be willing to accept large increases in the estate tax exemption, and large reductions in the estate tax rate, in order to avoid the temporary abolition of the estate tax in effect now.
They had little incentive to get a deal done by 2009, because waiting allowed them to achieve the symbolic goal of abolishing the estate tax, if only for a year. But, they now have a strong incentive to reach a deal that can win over enough liberal Democrats to avoid a filibuster, in order to prevent the estate tax from coming back with a vengeance in 2011. Many Democrats would not be deeply troubled if the estate tax impacted decedents with just $1,000,000 of assets in 2011.
President Obama and most Democrats would like to freeze the estate tax at its 2009 levels, perhaps with an inflation adjustment. Democrats have also proposed some uncontroversial slight tweaks to reduce compliance costs associated with the tax like a change in the way that the exemption amount is calculated that would eliminate the need for spouses with unequal assets to retitle property and create trusts to make full use of estate tax exemptions in most cases.
There is room for compromise, of course. Increasing the exemption, for example, from $3,500,000 to $5,000,000, makes only a small dent in tax revenues, while excluding significant numbers of estates from paying an estate tax at all. Lowering the estate tax rate, from 45% to 35%, for example, has a large revenue impact, because the bulk of estate tax revenues come from very large estates.
I suspect that a permanent estate tax compromise somewhat more generous than 2009 levels will be reached in 2010, but that the compromise will not be a generous as what Republicans and conservative Democrats held out for in 2009.
Forced to guess, I would predict a final deal with a $5,000,000 exemption (unified for gift and estate taxation and perhaps the generation skipping transfer tax as well) that is indexed for inflation, a 40% tax rate (possibly with a new calculation method that no longer treats gifts more favorably than inheritances), and a return to pre-2010 capital gains tax basis adjustment rules. A few other bells and whistles may be changes as well to obscure the identity of the winners and losers in the deal.
Will An Estate Tax Deal Be Retroactive?
Members of Congress have talked about reaching a deal on estate taxation in early 2010 that would be retroactive to the start of the year. Congress routinely makes changes in the law beneficial to taxpayers that are retroactive, and not infrequently, will set an effective date for a tax increase or loophole closing measure at a pre-enactment committee hearing date, on the theory that this gives people fair warning that a soon to be adopted tax change may impact them. The U.S. Supreme Court frequently upholds retroactive tax changes as constitutional.
But, my instinct is that either politics, or a legal ruling, will allow the heirs of decedents who die before a new deal is reached to take their inheritances estate tax free with a modified carryover basis. Death is hard to identify as culpable tax planning tool, unlike other tax planning transactions, and generally, retroactively tax increases are limited to individuals who could have chosen not to engage in the transaction giving rise to the tax if they wished. Absent that moral dimension, a retroactive law of any kind looks very unfair.
So, a few heirs are likely to get very lucky, and the U.S. Treasury will take a bit of a hit on a tax that isn't one of its biggest revenue generators anyway. Moreover, the prospect of lost revenue as more and more wealthy individuals die before a deal is reached gives Democrats an incentive to cut a deal sooner rather than later.