Don't get excited. It never really went away. But the big news today, Thurs, Dec. 3, 2009, is that the House passed a bill which is of great importance to anyone who is planning his estate -- and that should mean just about everyone.
While the larger topic of estate planning is an essential one and we will discuss it in greater detail in an upcoming News and Notes article, we are going to focus only on the estate tax, what was going to happen in 2010, and why this legislation is so important.
Let's start with some background about the federal estate tax.
After a person dies, the collection of all the money and property that person accumulated during his lifetime becomes his estate. If he's planned properly, his estate will be distributed according to his desires as efficiently and effectively as possible. In this context, "efficiently" means as much as possible gets transferred without losses due to such things as taxes or other expenses. And "effectively" means mainly that things go where the individual wanted them to go.
For many years now, the federal government has imposed a tax on the estate. Note that this is not a tax on one's inheritance. There is a difference -- the estate is the collection of assets prior to being distributed, and the estate tax is imposed on the estate itself. Some states have, instead of an estate tax, an inheritance tax. That means that the individual who received something from the estate then pays a tax. There is no federal inheritance tax.
One of the goals of good financial planning is to try to minimize the impact of taxes -- including the estate tax. Note, however, that the estate tax has a fairly high threshold. Most folks estates are just not so big that they get hit by this tax. Moreover, any assets that get passed on to a surviving spouse are usually exempt from the tax.
In 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 set the exemption such that estates under $1 million in 2002 would not pay taxes, and that threshold increased until it reached $3.5 million in 2009. And in 2010, the estate tax was to be repealed -- for only that one year. Then, in 2011, the old pre-EGTRRA rules were to take effect again, which would return the threshold to $1 million. Congress made this dizzying compromise because a permanent repeal of the estate tax would have cost the government too much revenue in the future, but with the hope that a future Congress would come along and fix the problem - either making the repeal permanent, or at least fixing the threshold at some reasonably higher level.
The problem for individuals and the planners who work with them is that the rules keep changing. Estate planning requires some kind of stability and predictability so that the structures we put in place - some of them permanent such as irrevocable trusts and gifts - continue to do what we meant for them to do.
So the bad news is that the Estate tax is back. It was looking like 2010 would be a year in which the estate tax was to go away and save some (very small number of) folks a lot of money. Note that 2010 was much more complicated than just the elimination of the estate tax. Something folks rarely seem to mention when they talk about it was that 2010 also got rid of one of the benefits of the existing estate tax system -- "step-up basis" -- whereby the cost basis of highly appreciated assets was "reset" when someone died. Then when heirs went to sell those assets, they'd not owe much (if anything) in capital gains taxes. To a certain extent, 2010 turned estate taxes imposed on the estate into capital gains taxes to be imposed in the future on inheritors (which could then cause other unintended consequences to the inheritors, too). Nevertheless, overall, the repeal of the estate tax was definitely a huge savings for certain large estates.
However the good news is that the Estate tax is back. The good part is that if the House bill becomes law, the estate tax will be set with a threshold of $3.5 million, rather than the $1 million that it was going to fall to in 2011 under current law. And the House bill makes this change permanent. No more bouncing around and, at least until Congress messes with this politically dangerous topic, highly predictable for the foreseeable future.
While having an estate tax at all means that we have to plan for it and work to minimize its impact, if it's predictable (and the threshold is high enough), we can make sure the impact isn't too bad. And bear in mind that the repeal of the tax which was supposed to have happened in 2010 didn't mean we didn't have to plan -- it just changed the plans a whole lot. Changing plans frequently may be good for the folks people have to pay -- their lawyers and accountants and planners -- but it certainly wasn't good for the individuals who have to pay those professionals.
Now the permanent fix to the existing estate tax mess isn't a done deal. The Senate is very likely to make some changes. And the President still needs to sign it. It's very possible that the Senate will only make it a one-year fix, extending the current $3.5 million levels into 2010 and doing away with that one-year repeal that's set to take place under current law. But even so, it still leaves the system more predictable than the current law which repeals it for one year and then repeals the repeal again a year later.
We'll be keeping an eye on the estate tax and related issues and will post updates when there are further developments.
UPDATE Jan 6, 2010: As of now, more than a month since the House passed that extension of the 2009 Estate Tax rules, the Senate hasn't passed anything, and of course, nothing's been signed into law. There is some speculation that a fix will be passed soon which will be retroactive to the beginning of the year, but that hasn't happened yet, either. In the meantime, as of now, the Estate Tax is gone for 2010 (and the new rules regarding capital gains exclusions on inherited property are in effect).