Repealing Estate Tax Not Good for Any of Us

Don't believe what you read elsewhere: Repealing the estate tax is not in your best interest.

Fewer than 2% of estates face the estate tax as the law stands now, and the 2001 tax law provides for increasingly generous exemptions. That is, the exemptions increase until 2010, when the estate tax will be repealed for one year only. The House of Representatives already voted to make that repeal permanent, but last week the Senate voted against a permanent repeal. This issue is far from dead -- it's just in stasis. And there's been a lot of congressional obfuscation about whom the estate tax affects and how much of a burden it really is. So before Congress takes another pass at the issue, let's work through some of the details.

Under the 2001 tax law, the estate tax will be gradually phased out until it's totally repealed in 2010. But the law has a "sunset" provision, meaning that unless Congress acts, virtually the entire 2001 tax law will be repealed on Jan. 1, 2011, and we go back to the way things were before -- estate tax and all.

Under the current scenario, the size of an estate that can avoid tax will rise to $3.5 million by 2009. That means anyone who dies in 2009 can leave up to $3.5 million to any heir completely tax-free. Bequests of any size can always be left tax-free to a spouse or charity.

But once the estate tax is repealed in 2010, it's not exactly a free-for-all.

Step Up to the Plate

A particularly onerous aspect of the estate tax repeal centers on assets that increased in value (read: stocks, a home) after they were acquired by the person who died.

Right now, heirs get what's called a "step-up" in the cost basis of inherited assets. In other words, the heir would not ever be taxed on any appreciation that occurred before the death of the asset's owner.

It works like this: Say an investor bought 10,000 shares of Intel (INTC Quote) 15 years ago, when it was trading at a split-adjusted $0.914 a share (the investor's basis). Now the stock is worth $21.58 per share. If the investor sold all her shares, she'd owe $41,330 in capital gains tax. However, if she dies and leaves it to an heir, that heir's basis would be "stepped up" to the current fair market value. If the heir sold the stock immediately, he would reap the entire $210,580 (the fair market value of 10,000 shares of Intel) completely free of capital gains tax.

Under the new law, this stepped-up basis would be limited once estate taxes are completely repealed in 2010. The departed's estate would be permitted to increase the basis of its assets by $1.3 million; anything beyond that would be considered taxable gain when the asset is sold. Bequests made to a spouse can have their basis adjusted by an additional $3 million, making the total basis adjustment for a spouse $4.3 million, if everything goes to the spouse. Not exactly small potatoes, but not a great deal considering that just the year before, someone could have left any amount tax-free to a spouse, who would have received the full step-up in basis, as well as leaving an additional $3.5 million to anyone else tax-free.

Here's an example: An unmarried man with $3 million estate dies in 2009. The aggregate basis of asset in the estate before his death is $700,000. Because in 2009 he can leave $3.5 million tax-free, his estate would not be taxed at all, and his sons would receive a step-up in basis. Essentially, the heirs could sell everything immediately and collect the $3 million tax-free.

Now assume the poor guy dies in 2010. There's no estate tax whatsoever, but his sons would be limited to the nonspousal basis step-up of $1.3 million, bringing the aggregate basis up to $2 million ($700,000 plus $1,300,000). A sale of the assets at that point would generate a capital gains tax on $1 million -- some $200,000 in tax that wouldn't have been owed if there had been an estate tax as in the prior year.

"If more people really understood what eliminating the estate tax meant, they wouldn't be for it," says Jeffrey Condon, an estate planning attorney in Santa Monica and author of Beyond the Grave: The Right Way and the Wrong Way of Leaving Money to Your Children and Others. "But people are idiots. They don't know what they don't know."

If the estate tax is repealed, people inheriting estates that are worth, say, $1 million to $3.5 million and have appreciated significantly in value could easily end up paying substantial amounts of income tax (including capital gains tax), even though under current law they wouldn't owe any estate tax, according to Mark Luscombe, a CPA with tax law research firm CCH. "There's much greater potential for big income tax bills if there's no estate tax," he says.

And that doesn't even address the issue of state tax. Most states take advantage of a federal credit, which means that for every $1 an estate owes in state estate tax, the federal estate tax will be reduced by $1. But the 2001 law started chipping away at that provision immediately, meaning that the states saw their share of estate tax proceeds shrinking by 25%.

As a result, 10 cash-strapped states and the District of Columbia have "de-coupled" from the federal estate tax credit, and will act as if the 2001 law doesn't exist. The upshot: Those 11 entities will take a slice of estates that go beyond the current tax-free exemption amount, according to Jeff Pretsfelder, a CPA with tax research firm RIA Group.

Not all states will increase their grab on estates; 15 have promised that they would not.

"But just because a state legislature says something today doesn't mean they won't change their mind tomorrow," Pretsfelder says. And the trend is definitely toward decoupling, and higher state taxes.

No Rest for the Wealthy

There's also a trend toward heated conflict around this issue. The Republicans have already promised to raise the matter again in October, in an effort to tie up Congress when it should be focused on more pressing budget and spending issues, says Gary Bass, executive director of OMB Watch, an independent watchdog for the White House's Office of Management and Budget.

But the estate tax issue is unlikely to be resolved this year. Expect it to be a campaign issue in the fall, and anticipate a more concerted effort toward reform -- rather than outright repeal -- in 2003.