Retroactive Estate Tax?

CONGRESS MAY IMPOSE RETROACTIVE ESTATE TAX

There is currently no tax on the estates of those dying during 2010. Although Congress may reinstate the tax retroactively in 2010, perhaps as part of broader tax reform, this is by no means a certainty.

If Congress fails to act, a few thousand very wealthy families will have reason to celebrate, while tens of thousands of taxpayers of more modest means will pay capital gains on inherited assets – and executors will face additional and confusing administrative burdens. And if Congress does change the law retroactively, extensive litigation over inheritances is almost guaranteed.

Congress has had nine years to prevent this from happening but hasn’t been able to. Under the provisions of a Bush-era tax-cut bill enacted in 2001, the value of estates exempt from the tax has been gradually raised over the past eight years while the tax rate on estates has been reduced, so that in 2009 only an individual estate worth $3.5 million or more is taxed, at a rate of 45 percent. For the year 2010, according to the 2001 law, the estate tax disappears entirely, only to be restored in 2011 at a rate of 55 percent on estates of $1 million or more, which is where things stood before the 2001 change.

Loss of Step-Up Means Step Down for Many Taxpayers

The catch for taxpayers of more modest means, however, is that for 2010 the estate tax is replaced with a 15 percent capital gains tax on inherited assets that are later sold. Normally someone inheriting property at an individual’s death gets a “step-up in basis” in the property. That is, the value of the property for determining capital gains tax due is calculated at the time it is inherited, not when it was originally bought.

But the law eliminating the estate tax in 2010 also largely does away with the basis step-up rules. This means that those inheriting estates will have to pay capital gains taxes on any assets sold based on the original price paid for the asset, after an exemption for the first $1.3 million in capital gains (plus $3 million for assets transferred to a surviving spouse).

Let’s say your father dies and leaves you a home worth $1.5 million and a $500,000 portfolio of stocks purchased at various times over the past 40 years. If you decided to sell any of these assets, you’d normally pay little or no capital gains tax on the sales. The new provisions mean that you have to calculate capital gains based on the value of the home and the stocks when your father bought them, not when you inherited them. That could be very expensive, not to mention time-consuming in trying to ascertain the original price your father paid for everything.

“If we do not extend our estate tax law, all taxpayers, all heirs will be subject to massive, massive confusion in trying to determine the value of their underlying asset,” Senate Finance Committee Chairman Max Baucus (D-MT) said on the Senate floor.

The chief tax counsel for the House Ways and Means Committee estimates that while extending the 2009 estate tax law would affect about 6,000 estates, 71,400 estates could face new capital gains taxes if the estate tax disappears. According to the Center on Budget and Policy Priorities, “at least 62,500 of these are estates that would not owe any estate tax if the 2009 rules were continued and that thus would be adversely affected by estate tax repeal. Farm and business estates would constitute a disproportionately large share of this group.” Small farms and businesses are the groups whose interests opponents of the estate tax have claimed they are defending.

Couples With Credit Shelter Trusts at Risk

The new world of no estate tax places at particular risk couples who have so-called “credit shelter” or “bypass” trusts that are designed to allow both spouses to take advantage of their respective estate tax exemptions. These are common arrangements used in estate planning for married couples. With the estate tax gone, the wording of these trusts could be interpreted as completely bypassing the surviving spouse when the first spouse dies, meaning a surviving spouse would get nothing without the expensive process of claiming her “elective share.” For explanations of all this, click here and here. Married couples with such trusts should consult their attorney.

The House passed a bill in early December permanently extending the 2009 estate tax rules, which will bring in an estimated $25 billion for 2009 by imposing the 45 percent rate on estates over $3.5 million (or $7 million for a couple). The Senate’s Democratic leadership wanted to pass a similar bill and put it on President Obama’s desk before the estate tax expired at the end of 2009, but they were blocked by united Senate Republicans who prefer a lower tax rate of 35 percent and a higher exclusion amount of $5 million ($10 million for couples).

The Perils of Going Retroactive

Sen. Baucus has pledged to try to restore the estate tax retroactively in 2010. This would undo the capital gains increase, but it could also create fertile ground for lawsuits by those whose family members die between January 1, 2010, and the date when any retroactive law is enacted.

“I can guarantee this: if they succeed in getting retroactive in hiking the death tax from zero to 45 percent, there are going to be lawsuits,” said Dick Patten, president of the American Family Business Foundation, which opposes the estate tax. “Its going to be messy, its going to be noisy.” (For an excellent discussion by Forbes.com of the mess that a lapse in the estate tax could create, click here. “Beneficiaries will deal with uncertainty for years,” warns one tax expert.)

In a 1994 decision, the U.S. Supreme Court ruled that the Constitution’s ban on the enactment of ex-post facto laws doesn’t apply to tax legislation, provided the retroactive application is “supported by a legitimate legislative purpose furthered by rational means”. United States v. Carlton, 512 U.S. 26 (1994). Since most estates don’t file tax returns until about nine months after someone dies, if Congress can come to an agreement quickly in 2010 the problems caused by a retroactive law may be limited. But Bloomberg.com notesthat “The pressure to reach agreement may breathe new life into” the Republicans’ “compromise proposal” of a 35 percent tax on couples’ estates worth more than $10 million.

For more on the implications of the disappearance of the estate tax, see CBS MoneyWatch’s “Estate Tax: What You Need to Know for 2010,” SmartMoney’s “The Federal Estate Tax Is Dead: Now What?,” and Kiplinger’s “FAQs on the Death of the Estate Tax.”