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The Estate Tax Dillema Is Over! Oh Really?

The estate tax has been a major source of uncertainty during the last decade since Congress voted to repeal it in 2001 under George W. Bush. However, as Wall Street Journal reported, in lieu of dropping the decades-old tax altogether and costing the government $1.35 trillion dollars, Congress voted to phase-out this tax over the following decade.

This phase-out was suppose to slowly increase the exemption every few years until 2010 when the tax would be repealed permanently. However, because of the wording of the law, most politicians and legal analysts felt that the phase-out would never “phase out”—and they may have been right.

The phase-out of the estate tax exemption started at $1 million with a 50% tax rate in 2002 and gradually increased to its current level of $3.5 million with a 45% tax rate. If you were married and set up your estate properly, you could double the exemption. In 2010, the estate tax was to be repealed completely so that there would be no estate tax upon death regardless of the size of an estate.

Last week, Congress voted to completely eliminate this repeal by a vote of 225 to 200, according to Bloomberg. However, when this bill reached the Senate, they couldn’t agree on it and have decided to tackle it next year. As a result, the current exemption of $3.5 million and the corresponding 45% tax rate will remain intact indefinitely.

Since it now appears that the estate tax will be repealed completely in 2010, what happens next? Although there are many possibilities, here are the most likely scenarios.

The most widely expected is that the bill will be revised and passed in 2010. This may be a permanent passage or just a one-year extension that would carry through only until 2011 when the estate tax is scheduled to be reinstated. Normally, when a bill is approved, it becomes effective as of the date of passage or at some point in the future. In this case, it is believed that the bill would actually become effective retroactively to January 1, 2010. In effect, the government is saying that if someone dies in 2010 there may or may not be estate tax due because the exemption has not been established. Moreover, they can’t tell you how much tax is owed because the tax rate isn’t final yet. Imagine the nightmare this creates for folks who are trying to set up their estate plan.

A second possibility is that Congress and the Senate don’t ever approve the bill and the repeal for 2010 remains permanent. In this case, an estate would completely avoid the estate tax. However, there would be another tax to consider: the capital gains tax, which has been conveniently swept under the rug.

Under current law, a beneficiary of an estate can step-up the basis on certain property to its current value as of the date of death. This allows the heirs to reduce or eliminate the capital gains tax altogether. If the estate tax remains repealed, this law would cap the maximum step-up of the basis to $1.3M for estates and $3M for spouses, according to MarketWatch.com. Moreover, if this occurs, the estate tax will become effective again in 2011 with an exemption of $1M and a 55% tax rate.

In short, here is how the estate tax has worked and will presumably continue to work although the exemption amounts may be different. Under current law, if an estate has a net value of $3.5M or less ($7M if you’re married and have set up your estate properly), it is completely exempt from estate tax. Any amount over that however would be taxed at 45%. Therefore, if a single estate owner dies with a net estate of $4.5M, the first $3.5M is exempt but the remaining $1M would be taxed at a whopping 45% which would translate into $450,000. The beneficiaries are required to pay this tax within nine months from the date of death.

This phase-out provision over the last decade has caused much uncertainty about estate planning since, obviously, no one knows when they are going to die. An estate tax obligation would potentially be much higher if someone died in 2005 as opposed to 2009, for example.

If an estate owner was setting up their estate in 2002 to reduce or even avoid the estate tax, the plan would most likely be much different if they were planning for death in 2005 as opposed to 2009. Furthermore, as a general rule of thumb, the lower the estate tax exemption, the greater the need for professional planning and the greater the potential cost of legal advice.

The predicament has been that an estate owner may potentially spend tens of thousands of dollars to reduce their estate tax liability only to live until 2010 and have no estate tax obligation at all. As a result, many individuals avoided this type of planning altogether in the hopes that they would make it to 2010.

If you’re reading this, the good news is that you’ve made it! Or at least you only have a week to go and the odds are in your favor that the estate tax will most likely be repealed. The bad news is, there is still some uncertainty as to what the next step will be.

If you are one of the individuals who have waited it out until 2010 in the hopes of a repeal and your estate is greater than $3.5 million, I would highly encourage you to seek legal advice. There are multiple ways to reduce or eliminate this tax, but not without the proper guidance.

As always, you are welcome to call us so we can discuss your situation. Should you decide to move forward, we would be glad to refer you to a number of the trusted attorneys that we work closely with. Visit our Contact page to get in touch with us.

 

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