Two Steps Ahead: Estate Tax “Repeal”: Ramifications and Outlook

The Economic Growth and Tax Relief Act of 2001 gradually phases out the federal estate tax until its complete repeal in 2010. However, under the same law, the estate tax is scheduled to return in 2011.

Since 2001, there have been a number of failed attempts to make the estate tax repeal permanent. In fact, there are still several bills in Congress that include provisions to eliminate this tax. While it's clear President Bush would sign such legislation, the recent changes in Congress make it less likely he'll get the chance to do so. The question remains, though: Will permanent repeal become law, and if so, what are the potential ramifications?
Good-bye estate tax, hello capital gains tax

Repeal does not mean that tax on wealth transfers from one generation to the next will disappear. While currently a tax is imposed on estates, after repeal, a tax will be imposed indirectly on inheritances in the form of capital gains tax. Here's a simplified explanation:
Under the current tax system, property that is transferred to heirs at the owner's death typically gets a "step-up" in tax basis. Generally, tax basis refers to the cost the owner paid to acquire the property, and is used to compute capital gains tax when the property is sold. For example, let's say Mr. Smith buys property for $50,000, which becomes his tax basis, and sometime later sells the property for $60,000. Mr. Smith's computed capital gain for tax purposes is $10,000.

When property is transferred by gift, the recipient receives a "carryover" basis; the tax basis in the hands of the person making the gift generally becomes the recipient's tax basis. So, let's say that Mr. Smith gives the property in the above example to his son, John. Mr. Smith's $50,000 tax basis carries over to John, and when John subsequently sells the property for $60,000, John recognizes the $10,000 capital gain.

However, when property is transferred because of the owner's death, the tax basis is stepped up to its current fair market value. Again using the first example, let's say that John receives the property through his father's will. John's tax basis is stepped up to $60,000, the property's fair market value. When John subsequently sells the property for $60,000, John recognizes no capital gain on the transaction.

One of the consequences of estate tax repeal in 2010 will be that the step-up in tax basis will be lost. Heirs will receive a carryover basis on inherited property, and will recognize the capital gain (or loss) when the property is sold at some point in the future.

What will this change in the tax system mean for American families? According to the IRS, estate tax affects only 2% of the most wealthy Americans. Capital gains tax, though, can affect anyone who owns capital assets. Therefore, unless the step-up in basis remains, estate tax repeal is likely to result in creating a higher tax bill for a greater percentage of less wealthy Americans. Further, repeal will create a paperwork headache for heirs who will have to determine the decedent's tax basis in the property they've inherited.

Pros and cons of permanent repeal

Proponents of permanent repeal regard the estate tax as morally unfair and an obstacle to family business continuity and growth. Critics call permanent repeal a boon to the mega-rich and fiscal suicide in a time of budget deficits, a Social Security and Medicare crisis, and war. The confusing reality is that there is statistical evidence both for and against the arguments presented by each side.

One thing is certain, however: Dealing with the uncertainties of the current state of the estate tax is a burden on Americans and their financial planning professionals who must re-evaluate estate planning options every year. For many on both sides of the issue, sensible reform is a preferable alternative to the success or failure of permanent repeal.

Outlook

In 2007, the Democrats regained power in Congress after 12 years of Republican control. The new Congress has been pursuing a fresh agenda, putting estate tax relief on the back burner. When the issue does resurface, it's likely that Congress will support reform over full and permanent repeal. Reforms such as lowering the estate tax rates to match capital gains tax rates and/or increasing the exemption amount have been proposed. Other options that have been discussed include doubling the exemption amount for married taxpayers, phasing out the tax over a five- or ten-year period, and replacing the estate tax with an inheritance tax (which would merely move the tax burden to the heirs). It remains to be seen what will be done, if anything.

Adapted from material provided by Forefield Inc.