In 2009, estates up to $3.5 million, or $7 million for married couples who planned appropriately, were exempt from federal estate tax. This year, the estate tax has been replaced by a fiendishly complex levy on the assets of those with little as $1.3 million. It will affect the heirs of at least 50,000 U.S. taxpayers who die this year, whereas the old law would probably have affected less than 15,000 estates this year, according to the Tax Policy Center.
"The new system is far worse for many people who have assets between $1.3 million and $3.5 million," says veteran estate lawyer Ronald Aucutt, of McGuire Woods.
This little-understood law was enacted as part of a deal brokered in 2001 with the expectation that Congress would never let the estate tax actually expire. It isn't clear when, or even if, a badly polarized Congress will take up the estate tax this year.
If lawmakers do bring back the estate tax, another set of problems could conceivably accompany it. Many inCongress advocate bringing the estate tax back retroactive to January 1, 2010. Such retroactive reinstatement of the tax will undoubtedly bring legal challenges from wealthy estates that could take years to resolve. Reinstatement without retroactivity will allow the estates of those who die during the estate tax hiatus to get a free pass on the tax. But if some version of the old estate tax system isn't reinstated, heirs of smaller estates will suffer.
To see what is at stake, consider how differently this year's and last year's regimes treat the same asset held by two fictional individuals: Hugo M. Pire has total assets of $20 million, while Justin P. Nuts' total is $2 million. Each owns a $110,000 block of the same stock bought for $10,000 years ago. This simplified example uses a block of stock, but its logic applies to all appreciated assets, including houses and land.
Under current law Mr. Pire's heirs prosper. If he dies this year and the stock is sold, his heirs will owe only a $15,000 capital-gains tax, whereas if he had died last year his estate would have incurred nearly $7,500,000 in estate tax (but no capital gains tax). By contrast, Mr. Nuts' heirs would have owed nothing last year because the estate was below the $3.5 million exemption. This year they would owe the same $15,000 capital-gains tax Mr. Pire's heirs do.
The reason: Under the old estate tax, assets could be written up to their full value at the death of the owner, and neither Mr. Pire's heirs nor Mr. Nuts' heirs would have had to pay capital-gains tax on the $100,000 increase in the stock last year. But current law fully taxes gains while imposing no tax on estates. Quite simply, the demise of the 45% estate tax helps the much wealtheir Mr. Pire's heirs more than the 15% tax on appreciation hurts them. For the much less wealthy Mr. Nuts, the reverse is true.
Winners and Losers
Beth Shapiro Kaufman, an attorney with Caplin & Drysdale, made estimates showing who is better off under last year's versus this year's system. She found that heirs of estates with assets totaling between $1.3 and $4.3 million would often have been better off last year, while those with bigger estates will do better this year.
Current law does give some relief to heirs of smaller estates. All estates receive at least $1.3 million of exemption from the tax on appreciation. The executor can "cherry-pick" assets after death and assign the exemption to maximize its value.
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