More Than Just $5 Million

H.R. 4853, the bill that President Obama signed Friday to extend the Bush tax cuts, changes estate planning in some major ways besides increasing the exclusion amount to $5 million. Newspaper coverage of the estate planning sections of the bill has been superficial, leaving out important new provisions that will affect many estates.

l. The gift tax exemption has been increased to $5 million from the previous amount of $1 million. This means a married couple can give away $10 million of their net worth without paying any gift taxes. The drawbacks are the same as before, however: Gifts don't get a step-up in basis, and gifts made under this provision will reduce the unifed credit of $5 million per person.

2. Portability of the exemption from the estate tax is a subject that has been discussed, but never enacted until now. In the future surviving spouses get the benefit not only of their own $5 million exemption, but also their deceased spouse's $5 million exemption. This change benefits procrastinators who never get around to signing an estate plan, or updating their current plan. In the past the deceased spouse's exemption has been lost if it was not used in an A-B trust, for example, or inherited by someone other than the surviving spouse. This innovative change to the law could eventually make A-B trusts obsolete.

3. Estates of decedents who died in 2010 have been stuck in a tax world that did not have an estate tax, and also lacked a step-up in basis for assets exceeding $1.3 million (or $4.3 million for surviving spouses). Those estates now have the option of paying the estate tax and also getting a step-up in basis, or skipping the estate tax and dealing with the lack of step-up. The answers to these situations are less obvious than appear at first glance because of the difference in tax rates (35 percent for the estate tax and 15 percent for the capital gains tax), and the fact that some estates have few appreciated assets.

4. Indexing for inflation will be allowed for the $5 million exemption, which will go up in multiples of $10,000. The annual gift tax exclusion is already indexed for inflation at multiples of $1,000.

5. But there's a catch related to all of these developments: The Bush tax cuts and all of the new tax benefits will expire on Dec. 31, 2012. After that we're back to where we were in 2001, with a $1 million exemption from the estate tax. Will Congress give the Bush tax cuts a last-minute reprieve in 2012? Unfortunately nobody knows the answer, so don't give up on those A-B trusts yet.

What the Agenda Doesn't Include

The Senate will meet tomorrow (Saturday, Dec. 4) to discuss extending the Bush tax cuts for the middle class. The bill under discussion, H.R. 4853, was passed by the House on Thursday, but newspaper coverage of the details of the bill was, as usual, minimal.

But reading the summary of H.R. 4853 on Thomas shows that this is an income tax bill only. Although the estate tax was one of the original Bush tax cuts, it is not part of H.R. 4853. Whether the Senate passes this bill will make no difference to the estate tax, scheduled to return to 2001 levels in just 28 days.

The Senate would have to consider H.R. 4154, which is an estate tax bill, if it wanted to prevent the estate tax from affecting middle class taxpayers. H.R. 4154 would restore the estate tax to its 2009 levels, which include a $3.5 million exemption from the tax. But H.R. 4154, passed by the House last Dec. 20, doesn't seem to have much support in this lame duck session.

Of course, the provisions of H.R. 4154 could always be tacked onto H.R. 4853, which is already an odd collection of tax subjects, starting with the Airport and Airway Tax Fund. When it was strictly an airport bill, H.R. 4853 was passed by the Senate earlier this year and sent to the House, where it has stagnated until the House suddenly decided it really ought to be called the Middle Class Tax Relief Act of 2010. That's the bill that will be on the Senate calendar tomorrow.

What's The Hurry?

The Senate will return to its lame-duck session at 2 pm on Monday, Nov. 29, and once again the senators will avoid any debate about the estate tax. Starting at 2 pm? Most of us start our day a little earlier than that, but the Senate apparently isn't concerned about the lack of time remaining to wrap up a multitude of important issues.

Congress will have only four weeks to work on bills concerning nuclear weapons, immigration, Don't Ask Don't Tell, the federal budget, and the sunset of the Bush tax cuts. The Senate, of course, will discuss none of these subjects on Monday, because the schedule calls for debate of the Food Safety Modernization Act. I'm sure that's a worthy subject, but it is obvious that finally resolving the tax issues is far more important at this point.

At this point it looks like Congress will not reach agreement on the tax issues, meaning that starting Jan. 1:

1. Most taxpayers will wind up in a higher income tax bracket.

2. Dividends will no longer be taxed at 15 percent; instead they will be taxed at the taxpayer's marginal rate, which could be as high as 39.6 percent for some taxpayers.

3. Capital gains taxes will go up from 15 percent to 20 percent.

4. And, of course, the estate tax will affect thousands of decedents whose estates are larger than $1 million.

We are not optimistic about the chances that the Congress will find a compromise on the estate tax issue. A House bill, H.R. 4154, has been sitting on the Senate calendar for the past 11 months and no action has been taken. That bill would restore the estate tax at its 2009 level, with a $3.5 million exemption and a 45 percent tax rate. For a married couple it would allow $7 million of the couple's assets to avoid the estate tax.

However, the Republicans want a $5 million exemption and a 35 percent tax rate for the estate tax. The Democrats are digging in at $3.5 million for the exemption and a 45 percent tax rate. Is there room for a compromise here? How about a $4.25 million exemption and a 40 percent tax rate? Is that too reasonable to be suggested inside the Beltway?

Whether it is reasonable or not, it looks like we are 37 days away from a $1 million exemption and a 55 percent tax rate. At that point the House will change leadership and there will be bills coming out of the House to correct this problem. Those bills will get a chilly reception in the Senate, and the few bills that get out of the Senate will probably get vetoed by the president.

In other words, once we get back to a $1 million exemption, don't expect any major changes until after the 2012 election, if then. That's right, we're going to be stuck with the $1 million exemption and 55 percent tax rate for at least two years. It will be good for the federal budget, bringing in an additional $250 billion per year, and it will be good for estate planning attorneys and CPAs, but it will be bad for the taxpayers.

How Much Is A Million Bucks?

It's enough to get your estate into the dreaded land of the federal estate tax, starting in January.

That's assuming that Congress is unable to take action on the estate tax, when the lame-duck session convenes in mid-November. If Congress can't agree on the estate tax before the end of this year, the estate tax will be revived, and any estate that totals more than $1 million could be subject to the tax.

That means a 41 percent (and somewhat higher) tax rate for smaller estates, and estates greater than $3 million of taxable assets will be paying at a 55 percent rate. Substantially larger estates will be paying a 60 percent tax.

Why shouldn't Congress finally reach agreement on an important issue such as this? Because Congress hasn't been able to do that all year, and it is unlikely that the lame-duck session will produce anything new. We are talking about exactly the same cast of characters, right? And even if the Republicans have an enormously successful election, they won't have 60 votes in Senate next year, where House bills go to die because they can't surmount the vote level needed to prevent a filibuster.

My advice to clients these days is to include protections in your estate plan that will reduce the estate tax, such as an A-B trust, or a gifting plan, or an insurance trust, or any other means of reducing your estate. These protections might not be needed, but we'll worry about that unlikely event later.

We're getting ready for a year with a $1 million exemption, and a 55 to 60 percent tax rate. Are you?

No Hurry Is There?

Don't expect any action by Congress on the federal estate tax before mid-November. There are still several appropriations bills to take care of, and Senate Majority Leader Harry Reid also wants to bring up an immigration bill. Those topics should take care of the Senate's free time between now and Oct. 11, when the election recess starts.

What will happen in November? If the Republicans win big, we can expect that they will want to wait until January to discuss tax law. But that means that the $1 million exemption for the estate tax will return on January 1, and could affect the estate of every decedent with a net worth of more than that amount until a bill is passed (although it could be retroactive to January 1.)

If the Democrats win or at least hold their own, a stalemate on taxes is a possibility because that is exactly what happened last year. On Dec. 20 the House passed a bill that extended the $3.5 million exemption, but the Senate went home for the holidays without taking action. Democrats in the Senate don't have 60 votes on this issue, and if no action is taken, the Bush tax cuts expire and we're back to a $1 million exemption.

Either way the results don't look good, and if you have an estate that is greater than $1 million for single persons or $2 million for married couples, you should start thinking about revising your estate plan to avoid the tax.

Let's Talk Taxes

One month from today the Senate will return to talk about a number of new subjects, including taxes. At least that's what some commentators are predicting, but only Harry Reid knows for sure. In the event that the Senate actually discusses taxes, and, in particular, the estate tax, here are three issues that deserve attention:

1. Predictability of the Estate Tax. As things stand know, we don't know which way the estate tax will go, and the possibilities range from no tax at all to a harsh $1 million exemption. Planning estates is difficult in this freeform climate and will likely lead to mistakes in the future. We need some tax laws that will remain the same for the indefinite future.

2. Retroactivity of the Estate Tax. If the tax is reinstated, it should be retroactive to Jan. 1 of this year. But the retroactivity should not be mandatory because it would be quickly overturned by the courts. Retroactivity is needed for trusts that include a funding clause for an A-B trust that will not adequately fund the trust during the repeal year. If there had been an estate tax this year, funding these exemption trusts would be simple - the maximum amount is the amount of the exemption. But when the exemption amount doesn't exist, thanks to repeal, the amount that can be funded to an A-B trust is zero. There may be funding formulas that provide otherwise, but many will not adequately fund the exemption trust in a typical trust. That can be corrected by making the estate tax retroactive, provided the trustee or executor has the authority to elect retroactivity.

3. Step-up in Basis at Death. For the past eight months, the step-up in basis for capital gains purposes has been limited to $1.3 million worth of assets for transfers at death to beneficiaries other than a spouse. This is a confusing issue that is causing many taxpayers problems as they try to research decedent's records to find out what the purchase price was, or how the value was changed by mergers, etc. Stepping up the basis for all of a decedent's appreciated assets has been the law for decades, and it is time to return to the full step-up rules. This also should be retroactive to Jan. 1.

Although I am hopeful that some action will be taken on the estate tax next month, I realize it is more likely that Congress will wait until after the November election to make decisions on these issues. But even that will be better than no action at all this year.

Six Months to Go

The federal estate tax has been repealed for six months now, and the loss to the treasury has been about $12 billion. We never thought the Congress would allow the repeal to go this long, but this is a Congress that doesn't like compromise.

As the months pass, the future of the estate tax is becoming more obvious. The tax will be back on January 1, 2011. Estates greater than $1 million will be taxed, and the highest tax rate for many estates will be 55 percent. Estates with extraordinary bad planning could see higher rates, such as more than 80 percent. How do you get that high? Just give your $20 million estate to your grandchildren and trigger the generation skipping tax in addition to the estate tax.

But why would the Democratic leadership in Congress allow the estate tax to make a comeback? The reason is simple: Taxes can be raised and the deficit can be decreased without having any member of Congress vote on federal estate taxes. Do nothing and the Bush tax cuts will expire without any outside help. They are part of a 10-year bill that expires on Dec. 31 of this year.

How much will the death of the Bush tax cuts raise? About $250 billion a year from the new estate tax and about $150 billion a year from higher income tax brackets, a 20 percent capital gains tax, and other increases. That's $400 billion a year.

All of this can be accomplished by having the Congress do nothing. But don't blame the House for this little problem. The House has sent hundreds of bills to the Senate this year, and not gotten much in return. The Senate will be the place where nothing will get done because of the 60 percent cloture votes needed to stop filibusters.

Failure to pass these cloture votes has stopped the Senate from taking action on several issues, but the Bush tax cuts won't be one of them. There will be no cloture vote needed to take no action on the Bush tax cuts. All the Democrats need to do is take it easy until Dec. 31.

The Republicans will be apoplectic, of course, but what are their options? The Democrats don't have to compromise on the tax issue, and the solutions that appeal to the Democrats are not acceptable to the Republicans. The Republicans can't push bills through the Senate because they're not in charge. There might even be some Republican deficit hawks who like the idea of cutting $400 billion out of the deficit. And, of course, they don't need to vote on this issue either.

I'd rather see a compromise solution to the tax problem right now so I can go back to helping my clients with their estate tax problems. But you have to admit that the non-action on the Bush tax cuts is going to become much more interesting and humorous as the months pass. It might even become the biggest political prank of the decade.

For more estate planning, go to California Living Trusts.