A Second Act for Estate Tax?

The gift that ultra-high-net-worth investors want most this holiday season is one step closer to reality: imminent congressional action on new estate tax rules.

The gift that ultra-high-net-worth investors want most this holiday season is one step closer to reality: imminent congressional action on new estate tax rules. On Monday, President Obama announced a deal with congressional Republicans that calls for a $5 million estate tax exemption and a 35 percent rate—part of a broader package that would extend the Bush-era income tax cuts another two years for taxpayers of all income levels.

Details are in the works, and the deal still has to be sold to skeptical Democrats in Congress. If the proposal does not make it through Congress, the estate tax is scheduled to return with a vengeance on Jan. 1 with a $1 million exemption and a 55 percent rate, plus a 5 percent surcharge on estates between $10 million and $17.2 million. Either way, the halcyon days of 2010, which saw the historic lapse of the tax, are almost over.

Some industry observers last week were reluctant to handicap what will happen with the estate tax—particularly since few ever expected that legislators would allow it to lapse this year. There was some optimism today, tempered by the lack of full details or certainty concerning what’s ahead.

“We were pleased the president came forward last night and agreed to accept something that maybe he didn’t like,” said Chris Walters, manager of legislative affairs for the National Federation of Independent Business. Walters said he believes that Congress will act on the deal. The $1 million exemption that would go into effect Jan. 1 if new legislation is not passed, will affect more constituents than 20 or 30 years ago, because real estate values have risen over their lifetimes, he said; those constituents have been pressing their members of Congress in recent weeks to act, he added. Small business owners are finding it difficult to plan without more visibility into their future tax liabilities, Walters said, so they’re reluctant to spend and expand at a time when the economy could use it.

As part of the Economic Growth and Tax Relief Reconciliation Act of 2001, estate tax exemptions gradually rose and rates gradually declined over the nine years that followed. The Tax Policy Center says that 99.8 percent of deaths trigger no estate tax liability. In short, it is virtually a voluntary tax, since most wealthy people plan ahead and legally avoid it. Those who pay are generally younger rich people who die unexpectedly, says a spokesman for the The Tax Foundation. And the liability is lopsided; nearly two-thirds of the tax is paid by the richest 1 percent of taxpayers. Net estate tax proceeds generated $20.6 billion in 2009, the IRS reported. In 2009, the first $3.5 million of an estate was exempt from tax, and the rate on the amount exceeding that was 45 percent.

This year’s estate tax lapse wasn’t a complete victory for the wealthy; rules that affect the cost basis, or taxable value, of estate property were less favorable in 2010. Normally, the cost basis of property that passes to heirs is stepped up to the market rate at the time of death, which means heirs do not need to pay capital gains on the appreciation in value. But this year a modified cost basis regime was in place that required heirs to accept the lesser of either the fair market value of property at the date of death or the decedent’s cost basis plus improvements (the regime also allows adjustments that increase the basis by $3 million for surviving spouses and $1.3 million for beneficiaries other than surviving spouses.)

It wasn’t clear today whether the former step-up in basis would be part of any legislation. Walters said the NFIB hoped it would be.

A number of rule proposals were bandied about in Congress this year, including letting taxpayers pay their estate taxes in advance so they wouldn’t need to do so after they died. The consequence of allowing the tax to lapse left many investors and their financial advisors in a kind of limbo, said David J. McCabe, senior partner at Willkie Farr & Gallagher. Speaking to the Foundation for Accounting Education’s tax/plenary conference in New York City last month, McCabe said in the past, many estates that needed to raise cash simply sold assets that had been stepped up in value; the uncertainty this year over whether and how Congress would change the law, and whether it would do so retroactively, created more uncertainty over the best way to raise cash, he said. Congress’ inaction “is tantamount to malpractice,” McCabe said.

It’s the tax rate and not the exemption that’s of greater concern to UHNW investors, McCabe says, and he believes that changes in the rate are where most of the wrangling in Congress will focus. If negotiations drag into 2011, any change in the estate tax could be retroactive to Jan. 1, 2011. A retroactive tax would probably be held up as constitutional by the courts, provided the retroactive period is not excessively long, he added.

In his comments last month, McCabe was more pessimistic about a deal getting done before the end of the year. “I really believe that on the agenda of items for Congress to deal with, the estate tax is probably one of the lowest. I think in reality they know it doesn’t affect 98.8 percent of Americans, and they really don’t care how it affects the estate planning attorneys and accountants.”

“Political chemistry is very volatile right now. It’s really a complete unknown as to how this could come out,” Dan Prebish, senior wealth planning strategist at Wells Fargo Advisors, said last week. “It could be much more a result of good old-fashioned political horse trading than of reasoned policy making.”

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