(Don’t Fear) The Tax Reaper

The vague future of the estate tax could make 2010 the worst year to be an estate planner, but if the current law holds it will also be a tough year for the inheritors of family farms and businesses.

The absence of the tax is a result of both inaction by Congress and the phasing out of the tax by the Bush tax cuts. The 2001 and 2003 Bush tax cuts began reducing the rates of the estate tax until ultimately phasing it out this year.

At the end of last 2009 many assumed that Congress would extend the 2009 rate (which had a top tax rate of 45% and the basic exemption of $3.5 million) into 2010, but so far that hasn’t happened. If Congress falls to act this year the tax will revert back to its pre-Bush tax cut state in 2011 with the top rate of 55% for the largest estates and an exemption of $1 million.

In failing to act this year there’s more at stake than the missed tax revenue from those wealthy estates. A report by the Center for Budget and Policy Priorities points out that while many opponents of the estate tax claim that it negatively affects small businesses and family farms, if the 2010 law holds the opposite will be true. Farmers and small businesses will face increases in the capital gains tax – a little known provision of the 2001 Bush tax cuts.

The 2009 tax treatment of capital gains is important to the discussion on inheritance tax because much of inherited wealth is unrealized capital gains. Under that 2009 law the inheritor only pays capital gains tax on the increase of value in the asset at the benefactor’s death.

So, for example, if the deceased person purchased stock and paid $10 per share and when he died it was worth $100 per share, his heir would only have to pay capital gains tax on the value the stock accrued after the benefactor’s death. If the inheritor sells the stock immediately she would pay no capital gains tax and if she sold it in 10 years she would only pay tax on the gain over those 10 years.

As it stands now, the 2010 law reverses direction. The estate tax is gone in name, but taxes on capital gains expand in reach. Heirs who sell inherited assets will have to pay capital gains tax on the difference between the original price the benefactor paid and the current value of the asset. In our example of the inherited stock, the inheritor would have to pay tax on the $90 gain in the stock that happened between the purchase of the stock and the benefactor’s death.

There is a provision that exempts the first $1.3 million ($3 million for a surviving spouse) of the unrealized capital gain. But the group of Americans that are losing out are those, like the family farm or small business, that are beyond the $1.3 million exemption, but not larger than $3.5 million. Those individuals wouldn’t have paid either the estate tax or the capital gains tax in 2009.

According to the Tax Policy Center it’s likely that many more people will pay an increase in taxes if the estate tax is repealed than if the 2009 tax cuts are allowed to continue. Under the 2009 rules only about 5,490 estates nationwide would owe any taxes, and of those it’s estimated that only about 100 are small businesses or family farms.

In contrast, if the repeal stays in place for 2010 heirs of approximately 71,400 estates could faces these new capital gains taxes – this according to analysis by the House Ways and Means committee. In 2009 at least 62,500 would have faced no estate taxes, many of these family farms.

So what is the likely fate for 2010? The Fiscal Times outlines a number of possible outcomes, one being gridlock and inaction. It seems unlikely, but with mid-term elections and intense political bickering it can’t be completely ruled out. The longer they wait to act this year, the tougher it will be to reach agreement. Another very likely option is reinstating the 2009 law with the $3 million exemption, 45% tax rate and the lesser capital gains tax. This is the approach that is being recommended by President Obama’s budget and that most analysts predicted would have already happened this year.

Or a compromise between the two could be reached. There is a possibility of increasing the top rate to 35% and the exemption to $5 million or using the 2009 law, but tweaking the law by permanently making the exemption $3.5 million and indexing it for inflation in future years and making it easier for spouses to transfer money to each other.