Estate Taxes: Past, Present & Future

An Overview of Estate Taxes in the U.S.

Matlin & Associates, P.C. — Northbrook, Illinois

If you a fortunate enough to have an estate tax “problem”, then estate planning has added importance. What follows is a look at estate taxes today, how we got here, and where estate taxes and inheritance tax planning might be headed in the future.

Currently:

Estate taxes are something to think about, and prepare for, if your net worth exceeds the “applicable exclusion amount”, which is the amount that is taken off the top of a person’s estate at death before federal estate taxes kick in. At this time, no one knows what the exclusion will be after 2009, but this is the current schedule:

Year Exclusion Top Rate

• 2008 $2 million 45%
• 2009 $3.5 million 45%
• 2010 No exclusion amount, because there is a complete elimination of estate taxes
• 2011 and Beyond $1 million 55%

Saying it another way, the exclusion from federal estate taxes is scheduled to go up for people dying in 2009 and disappear for people dying in 2010. Then, for people dying in 2011, the controversial “Sunset Provision” kicks in and the exclusion for estate taxes becomes ½ of what it is in 2008.

There is no limit to gifts between spouses who are citizens, during lifetime or upon the death of the first to go. Gifts to charities can also be unlimited without an estate tax.

Timeline

In 1906, when Theodore Roosevelt first proposed a federal tax on inheritances, he said that a “man of great wealth owes a particular obligation to the State because he derives special advantages from the mere existence of government.”

Ten years later, in 1916, an estate tax was first implemented to help pay for the financial burden of the Great War. After an exclusion of $50,000 (equal to about $1 million in today’s dollars), the top rate was 10%. The tax became permanent in 1926 with a top rate of 20%. The top rate and exclusion amounts grew and contracted over the years, hitting a high of 77% in the 1970s, until it was rolled back to 55%, coupled with a $600,000 exclusion (plus another 5% surtax on estates between $10 million and $17.184 million).

The Tax Reform Act of 1997 scheduled the $600,000 exclusion to rise in 2006 to $1 million. This is the law that will re-establish itself automatically if no superseding law is passed prior to 2011.

In 2001, back when there was a federal budget surplus, the Bush administration was in full tax-cutting mode. President Bush sought federal estate tax repeal and managed to accomplish it, but only for one year (2010). Embedded in the Economic and Tax Relief Reconciliation Act of 2001 (“2001 Act”) is the Sunset Provision whereby estate tax laws after 2010 revert to what they would have been as if there had never been a 2001 Act, namely: an exclusion of $1 million for federal estate taxes and 55% top rate (plus the 5% surtax).

Voices in Favor of a Permanent Repeal of the Estate Tax:

For a few years after 2001, a big push was made by the Bush administration and some members of Congress, mostly Republicans, who sought permanent repeal of the estate tax. Changing the terminology of the discussion, they relabeled the estate tax as the “death tax” in an attempt to evoke a visceral disgust with the tax. Retired Sen. William Frist (R-Tennessee), was the Majority Leader in 2006 when he wrote in favor of ending the “death tax” forever:

“America is a nation taxed from the moment it awakes until the moment it sleeps…We are an overtaxed nation, and hardworking Americans deserve a break. There’s a lot of senseless taxes out there. But no tax seems to make less sense to me than taxing you after you’re dead... it is immoral: the amounts subject to the death tax have already been taxed once. More to the point, death should not be a taxable event.”

Sen. Charles E. Grassley (R-Iowa) ranking Republican on the Senate Finance Committee agreed during hearings in late 2007, saying that the estate tax repeal should be made permanent because “death should not be a taxable event”, but at the same time he indicated that he might be willing to compromise his position as long as lawmakers “are looking out for small-business owners and family farmers.”

Voices Against a Permanent Repeal of the Estate Tax:

Politicians and pundits who are opposed to estate tax elimination have referred to the “Paris Hilton Tax Cut”, belittling the image of the celebrity heiress and others born into a lifetime of wealth, lacking any motivating factors to be productive.

Recently leading the charge for retention of a federal estate tax is the wealthiest man in the world, investor and philanthropist Warren Buffett. In remarks to the Senate Finance hearing, he said (quoted and paraphrased):

• Of the more than 2.4 million Americans who die this year, only about 12,000 will leave an estate that will be taxed if the exemption goes to $3 million. That would leave 99 ½ % estates tax-free. You would have to attend 200 funerals to be at one at which the decedent's estate owed a tax. He pointed out the dis ingenuousness of using the term “death” tax, because, in fact, far greater numbers of people who die receive a large tax benefit, namely the stepped-up basis on assets that have grown in value. (The stepped-up basis sets basis at date of death value, which eliminates huge amounts of capital gains taxes on appreciated assets sold after someone’s death, and is itself scheduled for one-year elimination in 2010.)
• Citing various wage statistics, Mr. Buffet said that “in a country that prides itself on equality of opportunity, it is becoming anything but that, as the gap between the super rich and the middle class widens in dramatic fashion…Dynastic wealth, the enemy of a meritocracy, is on the rise. Equality of opportunity has been on the decline. A progressive and meaningful estate tax is needed to curb the movement of a democracy toward a plutocracy.”
• The exemption should remain at $2 million.
• Money raised by a tax on the wealthiest 12,000 Americans can help 50 million Americans in a “material” way.

The Center on Budget and Policy Priorities has lobbied for continuation of a federal estate tax. In an October 2007 statement, it called the loss of family farms a myth and cited the American Farm Bureau Federation’s acknowledgment to the NY Times that it possessed no evidence of a single “family farm” being sold to pay a federal estate tax debt. Beyond the hundreds of billions in lost tax revenue posed by an elimination of estate taxes, it pointed to the potentially disastrous decline in tax-advantaged gifts to charity as a major public policy reason to keep the tax.

In 2005 the Congressional Budget Office wrote a study entitled Effects of Federal Estate Tax on Farms and Small Businesses. It projected that in the year 2000, 65 farms nationally would have paid estate tax if the 2009 exclusion of $3.5 million had been in effect. Of those 65 farms, less than 15 would have faced any liquidity issues caused by the tax. Numbers for “Qualified Family Owned Businesses” were not too different: Of 94 such businesses that would have paid estate taxes, a projected 41 would have had liquidity issues.

Middle of the Road:

Sen. Max Baucus, (D-Montana), chairman of the Senate Finance Committee is on record favoring permanent abolition of estate taxes. He said that the reason he held hearings in November 2007 was to solicit ideas for replacing the current uncertainty of the current law with something fair, acknowledging that elimination of the estate tax lacks political support. He referred to the “fewer than 1% of American households” who pay federal estate taxes and said that estate planning should not have to be so complex that multiple trusts are needed to mitigate the tax.

What’s Going to Happen Next? Three Possibilities:

1. The repeal of the Sunset Provision. This would amount to the elimination of the federal estate tax permanently rather than for just one year. Since the Republicans lost control of Congress in 2006 and federal spending deficits have skyrocketed, the “death” of the death tax is now considered by most to be a dead issue.

2. The federal estate tax exclusion reverts to $1 million, as it is scheduled to do in 2011. If no new law is passed, this is what will be the automatic default. The top tax rate, currently about 45% will rise to 55% (plus the 5% surtax). If this happens, the basis step-up will also return automatically.

3. A new estate tax with a new exclusion and top rate greater than zero (even for people with tens of billions) but less than half (even on relatively modest Americans whose estate exceeds $1 million).

Pure Prognostication, and More Possibilities

The law that existed before the 2001 Act will probably be modified with a new one in place before 2010. The 2001 Act was signed into law on June 7, 2001, just over 3 months before the World Trade Center was destroyed. Costly events that have strained the federal budget since then include the Iraq War and Hurricane Katrina. The annual federal budget deficit is now in the hundreds of billions per year and the Congress is no longer controlled by Republicans.

Not only do I believe that there will there not be a complete and permanent elimination of estate taxes, but it will not even happen in 2010. The combination of a one-year elimination of estate taxes combined with a one-year elimination of basis step-up is already wreaking havoc on financial and estate planning. It’s not only a bean-counter nightmare (or dream of a lifetime, depending on your point of view), but it may also cast a suspicion on heirs of super rich people who die in 2010. While complete political gridlock is possible, a new law will be in place before then.

Other possibilities and twists, based upon various proposals made by and to the 110th Congress (based upon various Senate Finance Committee hearings, including those that took place on April 3, 2008 "Reviewing Ideas to Simplify Planning):

Extend the planned federal estate tax exclusion and lower the rate for most estates.  The 2009 exemption of $3 ½ million per person would be made permanent, indexed for inflation, with rates hitting a top of 35-40%. A lower rate, between 15 and 25%, will apply to the first $25 million. There are many, though, that believe the current $2 million exclusion should continue.

Continuation of the basis step-up. The bookkeeping difficulties of using a “carryover” basis (basically, the original cost plus capital improvements) to measure capital gains after the sale of assets that follow a person’s death constitute an argument that the basis step-up at death continue, and that the U.S look elsewhere for additional tax revenue.

Bringing back and increasing the qualified family-owned business-interest (QFOBI) deduction that existed prior to 2004 to alleviate the impact of estate taxes on family-owned businesses and farms whose vulnerability to the tax make the issue so politically sensitive. In addition to allowing for increased deductions, the QFOBI allowed a stretched payout over 15 years, giving qualifying businesses the time to pay their taxes (instead of the usual 9 months from the date of death).

Automatically allocating the applicable exclusion amount of the first spouse to die, eliminating the need for shelter trusts that are used by married couples solely for estate tax reasons. This would also render unnecessary the typical division of assets whose sole purpose is to fully fund, as much as possible, the trust of the first spouse to die. This proposal could allow a married couple to exclude $7 million from taxes (if indeed the exclusion is set at $3.5 million), without the need for shelter trusts by making the exemption "portable." Extending portability to the GIST tax exemption has also been proposed. Married couples who have non-tax control reasons to use a shelter trust will still be able to do so. Portability will not benefit those in LGBT and other non-traditional relationships.

A tax on inheritances, rather than the estate itself. Typical planning tactics would then shift to spreading the wealth around more broadly by naming additional beneficiaries, as multiple smaller gifts would be taxed less than larger concentrated ones.

Coupling estate tax reform with AMT (alternative minimum tax) relief on the middle class. As this article is written, proposals have been made to permanently alleviate the burden of AMT on many middle-class Americans for whom neither tax was originally intended. If the two taxes are eventually packaged in one bill, this at least seems less cynical than tying the elimination of the estate tax to an increase in the minimum wage, which was part of a 2005 proposal.

Reduce potential abuse of Charitable Lead Trusts (CLTs) by revising valuation calculations and/or statutory rates to lessen taxpayer ability to overstate tax deductions and understate tax liabilities for beneficiaries. Instead of the donor's tax deduction being based upon an estimated future value at the time of transfer, it would taken when the charity actually receives its full benefit. The risk of assets underperforming would remain with the donor and would prevent larger than deserved deductions to be taken on underperforming assets based upon promises that don't materialize.

What Do the Presidential Candidates Say?

Barack Obama:

“First of all, let's call this trillion-dollar giveaway what it is - the Paris Hilton Tax Break. It's about giving billions of dollars to billionaire heirs and heiresses at a time when American taxpayers just can't afford it.” June 7 2006

“We have to stop pretending that all cuts are equivalent or that all tax increases are the same. Ending corporate subsidies is one thing; reducing health-care benefits to poor children is something else. At a time when ordinary families are feeling hit from all sides, the impulse to keep their taxes as low as possible is honorable. What is less honorable is the willingness of the rich to ride this anti-tax sentiment for their own purposes.”

“Nowhere has this confusion been more evident than in the debate surrounding the proposed repeal of the estate tax. As currently structured, a husband and wife can pass on $4 million without paying any estate tax. In 2009, this figure goes up to $7 million. The tax thus affects only the wealthiest one-third of 1% in 2009. Repealing the estate tax would cost $1 trillion, and it would be hard to find a tax cut that was less responsive to the needs of ordinary Americans or the long-term interests of the country.” The Audacity of Hope, first published in 2006.

John McCain:

He is on record as opposing the permanent elimination of estate taxes, having voted against such measure when brought to a vote in the Senate. He was one of two Republican senators who voted against the 2001 Tax Act.

On March 21, 2007, McCain voted for the Kyl Amendment, raising the exemption to $5 million per person, with a top rate not to exceed 35 percent (Obama and Clinton both voted “no”). More recently, in December 2007 on Lawrence Kudlow’s CNBC program, McCain agreed with actress Whoopi Goldberg that estate taxes should be eliminated. Following that, however, while campaigning in Iowa he said: “I think the estate tax level ought to be at about $10 million, and then at approximately 15% in taxes at that point. In other words, so we take care of 99% of the family farms, businesses in America... not complete elimination of the estate tax, but certainly at a level that would take care of 99½% of all American families, farms, and businesses in America."

Increased State Estate Taxes

The 2001 Act actually contained a hidden estate tax increase for many people that will probably continue past 2010. Prior to 2001 many states, including Illinois, had their own “pick-up” estate taxes that were salaciously “coupled” with the federal estate tax in an arrangement that provided money for the state coffers, but did not result in any additional estate tax burden. The state estate taxpayer, received a dollar-for-dollar credit on the federal return. By “de-coupling” the federal estate tax from the state estate tax, the U.S. government grabbed a larger part of each estate tax dollar paid and the states’ estate tax of as much as 16% has become an additional separate estate taxpayer burden.

If the laws don’t change in the meantime, a typical shelter trust for a married couple, intended to reduce overall estate taxes upon the death of the surviving spouse, if fully funded in 2009 with $3.5 million upon the first death, may result in a state estate tax of more than $200,000 at that first death if your state, like Illinois and so many others, has retained a $2 million state estate tax exclusion.

When the dust settles, not only is a “re-coupling” of state and federal estate taxes unlikely, but the possibility exists that the state estate tax may not even get a deduction (as opposed to a dollar for dollar credit) on the federal estate tax return. Elimination of that deduction has been argued. Besides the potential migration of Americans for climate and other reasons, this will be an additional reason for some very wealthy people to shop the proper state to die in.

The confusion over estate taxes will continue until a resolution, which is unlikely to happen until a new president is elected and the 111th Congress is convened.

For more in-depth understanding, I recommend History, Present Law, and Analysis of the Federal Transfer Tax System prepared for the November 14, 2007 hearings by the staff of the Joint Committee on Taxation.