Estate Taxes: Past, Present & Future

An Overview of Estate Taxes in the U.S.

Matlin & Associates, P.C. — Northbrook, Illinois

Movie preview announcer's voice: "In a world of uncertainty..."

Currently:

The estate tax is something to think about if your net worth exceeds the "applicable exclusion amount", which is the amount that is taken off the top of a person's estate at death before federal estate taxes kick in. At this time, no one knows what the exclusion will be after 2009, but this is the current schedule:

Saying it another way, the exclusion from federal estate taxes is scheduled to go up for people dying in 2009 and disappear for people dying in 2010. Then, for people dying in 2011, the controversial "Sunset Provision" kicks in and the exclusion for estate taxes is reduced to only $1 million per person.

There is no limit to gifts between spouses who are citizens, during lifetime or upon the death of the first to go. Gifts to charities can also be unlimited without an estate tax.

What Does President Obama Say?

$3.5 million exemption, 45% top rate

"The estate tax would be effectively repealed for 99.7 percent of estates. For the remaining 0.3% of estates over $7 million per couple, (President) Obama will retain a rate of 45%. This policy would cut the number of estates covered by the tax by 84 percent relative to 2000." 2008 campaign website

"First of all, let's call this trillion-dollar giveaway what it is - the Paris Hilton Tax Break. It's about giving billions of dollars to billionaire heirs and heiresses at a time when American taxpayers just can't afford it." June 2006

"We have to stop pretending that all cuts are equivalent or that all tax increases are the same. Ending corporate subsidies is one thing; reducing health-care benefits to poor children is something else. At a time when ordinary families are feeling hit from all sides, the impulse to keep their taxes as low as possible is honorable. What is less honorable is the willingness of the rich to ride this anti-tax sentiment for their own purposes."

"Nowhere has this confusion been more evident than in the debate surrounding the proposed repeal of the estate tax. As currently structured, a husband and wife can pass on $4 million without paying any estate tax. In 2009, this figure goes up to $7 million. The tax thus affects only the wealthiest one-third of 1% in 2009. Repealing the estate tax would cost $1 trillion, and it would be hard to find a tax cut that was less responsive to the needs of ordinary Americans or the long-term interests of the country." 2006.

Back to the Future:

In 1906, when Theodore Roosevelt first proposed a federal tax on inheritances, he said that a "man of great wealth owes a particular obligation to the State because he derives special advantages from the mere existence of government."

Ten years later, in 1916, an estate tax was first implemented to help pay for the financial burden of the Great War. After an exclusion of $50,000 (equal to about $1 million in today's dollars), the top rate was 10%. The tax became permanent in 1926 with a top rate of 20%. The top rate and exclusion amounts grew and contracted over the years, hitting a high of 77% in the 1970s, until it was rolled back to 55%, coupled with a $600,000 exclusion (plus another 5% surtax on estates between $10 million and $17.184 million).

The Tax Reform Act of 1997 scheduled the $600,000 exclusion to rise in 2006 to $1 million. This is the law that will re-establish itself automatically if no superseding law is passed prior to 2011.

In 2001, back when there was actually a federal budget surplus, the Bush administration was in full tax-cutting mode. President Bush sought federal estate tax repeal and managed to accomplish it, but only for one year, 2010. Embedded in the Economic and Tax Relief Reconciliation Act of 2001 ("2001 Act") is the Sunset Provision whereby estate tax laws after 2010 automatically revert to what they would have been as if there had never been a 2001 Act, namely: an exclusion of $1 million for federal estate taxes and 55% top rate (plus the 5% surtax).

For a few years after 2001, a big push was made by the Bush administration and some Republican members of Congress, who sought permanent repeal of the estate tax. Changing the terminology of the discussion, they relabeled the estate tax as the "death tax" in an attempt to evoke a visceral disgust with the tax. Retired Sen. William Frist (R-Tennessee), was the Majority Leader in 2006 when he wrote in favor of ending the "death tax" forever:

"America is a nation taxed from the moment it awakes until the moment it sleeps...We are an overtaxed nation, and hardworking Americans deserve a break. There's a lot of senseless taxes out there. But no tax seems to make less sense to me than taxing you after you're dead...it is immoral: the amounts subject to the death tax have already been taxed once. More to the point, death should not be a taxable event."

Sen. Charles E. Grassley (R-Iowa) ranking Republican on the Senate Finance Committee agreed during hearings in late 2007, saying that the estate tax repeal should be made permanent because "death should not be a taxable event", but at the same time he indicated that he might be willing to compromise his position as long as lawmakers "are looking out for small-business owners and family farmers."

At those hearings, Warren Buffet commented (quoted and paraphrased):

• Of the more than 2.4 million Americans who die this year, only about 12,000 will leave an estate that will be taxed if the exemption goes to $3 million. That would leave 99 ½ % estates tax-free. You would have to attend 200 funerals to be at one at which the decedent's estate owed a tax. He pointed out the disingenuousness of using the term "death" tax, because, in fact, far greater numbers of people who die receive a large tax benefit, namely the stepped-up basis on assets that have grown in value. [The stepped-up basis sets basis at date of death value, which eliminate huge amounts of capital gains taxes on appreciated assets sold after someone's death, and is itself scheduled for one-year elimination in 2010.]
• Citing various wage statistics, Mr. Buffet said that "in a country that prides itself on equality of opportunity, it is becoming anything but that, as the gap between the super rich and the middle class widens in dramatic fashion...Dynastic wealth, the enemy of a meritocracy, is on the rise. Equality of opportunity has been on the decline. A progressive and meaningful estate tax is needed to curb the movement of a democracy toward a plutocracy."
• The exemption should remain at $2 million.
• Money raised by a tax on the wealthiest 12,000 Americans can help 50 million Americans in a "material" way.

The Center on Budget and Policy Priorities has lobbied for continuation of a federal estate tax. In an October 2007 statement, it called the loss of family farms a myth and cited the American Farm Bureau Federation's acknowledgement to the NY Times that it possessed no evidence of a single "family farm" being sold to pay a federal estate tax debt. Beyond the hundreds of billions in lost tax revenue posed by an elimination of estate taxes, it pointed to the potentially disastrous decline in tax-advantaged gifts to charity as a major public policy reason to keep the tax.

In 2005 the Congressional Budget Office wrote a study entitled Effects of Federal Estate Tax on Farms and Small Businesses. It projected that in the year 2000, 65 farms nationally would have paid estate tax if the 2009 exclusion of $3.5 million had been in effect. Of those 65 farms, less than 15 would have faced any liquidity issues caused by the tax. Numbers for "Qualified Family Owned Businesses" were not too different: Of 94 such businesses that would have paid estate taxes, a projected 41 would have had liquidity issues.

Next?

The law that existed before the 2001 Act will be modified with a new one in place before 2010. The 2001 Act was signed into law on June 7, 2001, just over 3 months before the World Trade Center was destroyed. Pre-Iraq war. From budget surplus to trillions in debt and a near-shattered economy.

All signs point to the one year tax hiatus never taking place. Beyond the need to increase revenue, the combination of a one-year elimination of estate taxes combined with a one-year elimination of basis step-up is already wreaking havoc on financial and estate planning. It's not only a bean-counter nightmare (or dream of a lifetime, depending on your point of view), but It may also cast a suspicion on heirs of super rich people who die in 2010. Complete political gridlock is possible, but I would bet either on a new law in place before 2010 or simply a continuation of the law as existing in 2009.

Some possible scenarios:

1. The repeal of the Sunset Provision. This would amount to the elimination of the federal estate tax permanently rather than for just one year. No chance any time soon. The "death" of the death tax is, for now, a dead issue.
2. The federal estate tax exclusion reverts to $1 million, as it is scheduled to do in 2011. If no new law is passed, this is what will be the automatic default. The top tax rate, currently about 45% will rise to 55% (plus the 5% surtax). If this happens, the basis step-up will also return automatically. Also unlikely.
3. A new estate tax with a new exclusion and top rate greater than zero (even for people with tens of billions) but less than half (even on relatively modest Americans whose estate exceeds $1 million). Best guess: a continuation of the $3.5 million exemption (plus possible inflation adjusters in the future). Second best guess: $2 million.
4. Continuation of the basis step-up. The bookkeeping difficulties of using a "carryover" basis (basically, the original cost plus) to measure capital gains after the sale of assets that follow a person's death constitute an argument that the basis step-up at death continue and that the U.S. look elsewhere for additional tax revenue.
5. Bringing back and increasing the QFOBI (qualified family-owned business-interest) deduction that existed prior to 2004 to alleviate the impact of estate taxes on family-owned businesses and farms whose vulnerability to the tax make the issue so politically sensitive. In addition to allowing for increased deductions, the QFOBI allowed a stretched payout over 15 years, allowing qualifying businesses the time to pay their taxes (instead of the usual 9 months from the date of death).
6. Automatically allocating the applicable exclusion amount of the first spouse to die, potentially eliminating the need for shelter trusts that are used by married couples solely for estate tax reasons. That proposal could allow a married couple to exclude $7 million from taxes (if indeed the exclusion is set at $3.5 million), without the need for trusts. The exemption would be "portable", so that the unused exclusion amount of the first spouse to die would automatically be added to the surviving spouse's exclusion. The complicating aspect of this becoming law is the reality of the multiple divorce/marriage cycle.
7. Taxing inheritances, rather than the estate itself. Typical planning tactics would then shift to spreading the wealth around more broadly by naming more beneficiaries, as multiple smaller gifts would be taxed less than larger concentrated ones.
8. Reunification of estate and gift taxes, as was the law prior to 2001.
9. Coupling estate tax reform with AMT (alternative minimum tax) relief on the middle class. Proposals have been made to permanently alleviate the burden of AMT on many middle-class Americans for whom neither tax was originally intended. If the two taxes are eventually packaged in one bill, this at least seems less cynical than tying the elimination of the estate tax to an increase in the minimum wage, which was part of a 2005 proposal.
10. Reduce potential abuse of Charitable Lead Trusts (CLTs) by revising valuation calculations and/or statutory rates to lessen taxpayer ability to overstate tax deductions and understate tax liabilities for beneficiaries. Instead of the donor's tax deduction being based upon an estimated future value at the time of transfer, it would taken when the charity actually receives its full benefit. The risk of assets underperforming would remain with the donor and would prevent larger than deserved deductions to be taken on underperforming assets based upon promises that don't materialize.

Nobody knows where we're headed on this issue. The confusion over estate taxes will continue until President Obama and the 111^th Congress get around to this. Based upon what I have seen, the most likely short-term forecast is a "Band-aid" solution that would see a continuation of the law as it exists in 2009 ($3.5 million exemption) until such time as an agreement is made, but skipping the changes scheduled for 2010 and 2011 until a new law is enacted.

For more in-depth understanding, I recommend History, Present Law, and Analysis of the Federal Transfer Tax System prepared for the November 14, 2007 hearings by the staff of the Joint Committee on Taxation.

Increased State Estate Taxes

The 2001 Act contained a hidden estate tax increase for many people that will probably continue into the future. Prior to 2001 many states, including Illinois, had their own "pick-up" estate taxes that were "coupled" with the federal estate tax in an arrangement that provided money for the state coffers, but did not result in any additional estate tax burden. The state estate taxpayer, received a dollar-for-dollar credit on the federal return. By "de-coupling" the federal estate tax from the state estate tax, the U.S. government grabbed a larger part of each estate tax dollar paid and the states' estate tax of as much as 16% has become an additional separate estate taxpayer burden.

If the laws don't change in the meantime, a typical shelter trust for a married couple, intended to reduce overall estate taxes upon the death of the surviving spouse, if fully funded in 2009 with $3.5 million upon the first death, may result in a state estate tax of more than $200,000 at that first death if your state, like Illinois, has retained a $2 million state estate tax exclusion.

When the dust settles, not only is a "re-coupling" of state and federal estate taxes unlikely, but the possibility exists that the state estate tax may not even get a deduction (as opposed to a dollar for dollar credit) on the federal estate tax return. Elimination of that deduction has been proposed. Besides the potential migration of Americans for climate and other reasons, this will be an additional reason for some very wealthy people to shop the proper state to die in.