What Will Happen With the Federal Estate Tax?

Tax Preparation

The fate of the federal estate tax is still unclear. What is clear is that the results of the next election will play a significant role in the future of the federal estate tax system. Here is a little bit of historical background and the most likely future scenarios.

Recent Federal Estate Tax Law Changes

In December 2010 a tax compromise was reached between the President and Republican lawmakers which provides for a $5 million gift and estate tax exemption ($10 million for a married couple). Assets in excess of that level are taxed at a 35 percent rate. The $5 million exemption is indexed for inflation beginning in 2012 ($5.12 million).

The act unifies the gift and estate tax exemption so that the $5 million exemption can be used to make lifetime gifts and/or testamentary bequests. The act also provides for portability, a feature that eliminates the need for a married couple to establish an “A-B type” trust to ensure that their heirs receive the benefit of both spouse’s estate tax exemptions.

Sounds great right? Unfortunately, legislators did not make these changes permanent. Instead, the Tax Relief Act of 2010 that established the current estate tax rules is set to automatically (e.g. – if Congress takes no action) expire on January 1, 2013.

Pursuant to the Budget Control Act of 2011, the so-called super committee had until November 23, 2011 to issue a formal proposal containing at least $1.2 trillion in deficit reduction for the full Congress to consider. The rumors were that the gift tax exemption amount would be decreased to $1 million effective January 1, 2012, instead of January 1, 2013. In the end, the Super Committee did nothing.

President Obama’s 2012 budget proposes to bring the estate tax exemption back to 2009 levels – $3.5 million with a maximum 45 percent tax rate. The president also wants to eliminate unification by making the gift and generation-skipping tax exemption $1 million, with a top rate of 45 percent.

In addition, the president proposes to make the portability provision permanent so that married couples may continue to carry over unused exemptions, but the exemption amount that would be preserved would be limited to the estate and gift exemption in effect in 2013 and beyond.

In contrast to the president’s proposal, all Republican candidates for president call for the federal estate tax repealed. Most Democrats counter that reducing or eliminating estate taxes for the richest 1 percent of Americans is inequitable, given the large deficits facing the U.S. So clearly, the fate of the federal estate tax lies in the results of the next election.

Accordingly, at this time, here are the most likely scenarios:

Scenario No. 1

If Congress does what it does best – nothing – it could allow the new law to “sunset” (as it is scheduled to do on December 31, 2012). Since this scenario is already in place, it requires no further congressional action. If this happens, then a $1,000,000 estate tax exemption and 55 percent estate tax rate will begin on January 1, 2013.

Scenario No. 2

In November 2011, Congressman McDermott introduced the Sensible Estate Tax Act of 2011. The bill would, among other things, roll back the top estate tax rate to 55 percent, with a $1 million exemption ($2 million for married couples) indexed for inflation. The bill would also retain both unification and portability.

Scenario No. 3

If neither party has complete control over tax legislation, Congress “punt it forward” and extend the 2010 law in 2013 and beyond. This would mean that the estate tax exemption would be indexed for inflation above the $5,120,000 exemption that will go into effect in 2012 and the top rate would remain at 35 percent. Under this scenario, unification and portability remain intact.

Scenario No. 4

If the Democrats control tax legislation, Congress could pass some form of an estate tax compromise that will lower the estate tax exemption and increase the estate tax rate to something more in line with the 2009 numbers, as the president has proposed for his 2013 budget.

Scenario No. 5

If the Republicans control tax legislation, Congress could permanently repeal the federal estate tax. If a Republican wins the White House, this is a distinct possibility, given that Republicans are in control of the House and have gained significant ground in the Senate (where 60 votes are needed to repeal the estate tax).

Support for repealing the estate tax comes from various studies which show that

repealing the estate tax would increase GDP and because the estate tax represents a negligible amount of the government’s revenue.
The bottom line is that it’s impossible to know how and when lawmakers will act (and whether any new law will be permanent or just another extender bill). This makes it very difficult for clients (and their advisors) to do any intelligent estate planning.

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