Just a few weeks ago, it was unthinkable that Congress would allow the federal estate tax to temporarily disappear next year.

At the very least, Congress was expected to adopt a short-term patch that would maintain the estate tax and give legislators time to craft a permanent solution.

But the Senate - let's put the blame where it belongs - has failed to act while consumed by health care reform. Unless there's a legislative miracle, the federal estate tax that's been around since 1916 will cease Friday. It's set to come back in 2011, but under much more stringent rules than today.

"Everybody is really annoyed and confused. And there is not a lot of planning you can do," says Laura Peebles, a director of Deloitte Tax.

Adds Lutherville estate planning lawyer Jason Frank, "I can't believe they are going to do this. This is insane."

A Senate leader has promised to make a retroactive fix early next year so this doesn't happen. But some tax experts suggest that a retroactive tax increase may be unconstitutional.

Obviously, even a brief repeal of the federal estate tax is a potential boon for the wealthy who die early next year. (Well-off Marylanders could still be hit by the state's estate tax.)

But you don't have to be super-wealthy to experience consequences of a temporary repeal - and not all of them in your favor. Your current estate planning documents might suddenly be out of date next year, experts say.

And if you inherit assets, you might have to go through a documentation nightmare if you want to sell them and owe capital gains tax that you otherwise wouldn't have had to pay.


How did we get here? The 2001 tax act under President George W. Bush began the phase-out of the estate tax. The amount of assets exempt from the tax went up over the years, while the tax rate on bigger estates went down. This year, you can shelter up to $3.5 million from the federal estate tax, or $7 million if married. Estates above that are taxed at the top rate of 45 percent.

Estate tax opponents had hoped when the Republicans were in charge of Congress they would bury the tax for good, or at least make it even more generous. Those attempts failed. Now as we approach the last year of the Bush tax cuts, the estate tax is scheduled to disappear for a single year. And if nothing is done, the estate tax returns under 2001 rules. Then you will be able to shelter $1 million from the estate tax, while larger estates will be taxed at a maximum rate of 55 percent.

The U.S. House passed legislation earlier this month to make today's estate tax limits permanent, but that didn't go anywhere in the Senate, where some want more generous terms.

For decades, less than 2 percent of estates have been big enough to owe the tax. And even this number has been shrinking in recent years as the exemption amounts have risen, according to the Congressional Budget Office.

Pros and cons

Tax opponents argue they should be able to pass the fruits of their hard work to heirs without getting whacked again by taxes.

But some of the nation's richest support the tax, saying it's bad for the country to have a concentration of wealth among a small number of families.

The wealthy didn't independently make all their money, but they benefited from living in a country with stable markets and a government that pours billions into research and subsidizes schooling for an educated workforce, says Bill Gates Sr., father of Microsoft's founder.

"Society does have a just claim on these fortunes, and it goes by the name of the estate tax," Gates said during a recent news conference on the tax.

Tax and legal experts say it's difficult to advise clients now, other than telling them where things stand at the moment. Right now we're facing a repeal on Jan. 1. And some doubt that the Senate can remedy the situation early next year.

Clint Stretch, managing principal of tax policy at Deloitte, says some argue that it's unconstitutional to impose a tax on an estate retroactively if, say, a wealthy person dies next year before the Senate's fix. He predicts such cases will lead to legal challenges that could drag on for years.

Mark Luscombe, principal tax analyst with CCH, says Congress has made retroactive tax changes before without a problem.

But Luscombe adds there is concern about letting the estate tax lapse for too long, and how that might cause heirs to react.

"We joke about people pulling the plug on people. I think it could really happen," he says.

Unless the Senate is able to address the problem, we'll be left with three significantly different estate tax rules for 2009, 2010 and 2011.

"It's complicated enough to do planning without them changing the law every year," says Jack Edgar, a Baltimore estate planning lawyer.


Of course, heirs will like that a relative's estate won't be diminished by an estate tax. But they could face other problems from a temporary repeal.

For instance, they will no longer get the benefit of a step-up in basis next year. This is where once you inherit, say, stock, the new cost basis for tax purposes will be the fair-market value of the shares at the time of your relative's death. A step-up in basis reduces or eliminates any capital gains tax you might owe when you sell the securities.

But next year, heirs will need to find out the original purchase price of assets when they sell them, which could be a nightmare if dealing with stocks acquired decades ago that have undergone splits and reinvested dividends, Stretch says.

And while the law still allows a sizable step-up in basis, if assets have greatly appreciated, heirs could be hit with a capital gains tax bill, Luscombe says.

Baltimore estate planning lawyer Jeff Gonya also points out that estate documents often refer to the federal estate tax, and now those documents will be out of date next year because the tax won't exist. This could have some unintended consequences, he says, such as disinheriting a child from a first marriage or a spouse from a second.

It's a confusing situation, and one that has tax and legal experts still shaking their heads that Congress let it get to this point.

"Three weeks ago, I thought everything in life was uncertain, but if there was anything certain, it was they would fix this problem," Stretch says. "It's stunning they did not do this."

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