If you're worth a lot of money and your main concern is leaving as much of it as possible to your children, 2010 might be a good year to die. On the other hand, if you want to stick around awhile, you might want to follow the advice Bruce Bartlett offered in Forbes last year and include a provision in your will requiring an autopsy should you mysteriously expire before the end of the year.
The incentives that give rise to this perverse counsel are a result of an equally perverse tax situation. Back in 2001, a phase-out of the federal estate tax was included in the Bush tax cuts. Before the tax cuts, estates were taxed at a top rate of 55 percent, with a $1 million exemption. Congress phased in reductions of the top rate to 45 percent and increases in the exemption, which topped out at $3.5 million in 2009.
Then, in 2010, the estate tax disappeared entirely — but for just one year, after which it goes back to what it was before 2001. This curious situation came about because the estate tax phase-out and the other Bush tax cuts were passed via the reconciliation process in order to avoid a filibuster by the Democrats' then-minority in the Senate, and budget measures passed this way were required to sunset after 10 years.
Back then, nobody expected we would end up in this situation. It was generally assumed that sometime before the end of 2009, Congress would either reinstate the estate tax — probably with a higher exemption and a lower top rate — or make the repeal permanent. It did neither.
So if you die before midnight Dec. 31, your heirs will make out like bandits, right? Maybe — but maybe not. Although the heirs of billionaire Yankees owner George Steinbrenner, who passed away last month, may benefit from the perfect timing of his exit, others who are heirs to moderately but not obscenely large estates may actually be worse off.
That's because when the death tax died (pardon the pun), so did the feature permitting a step-up in the tax basis of the estate's assets to whatever their value was on the date of death. For assets inherited from those who die this year, the decedent's basis will be carried over to the heirs, potentially triggering a huge capital gains tax liability when the heirs go to sell them.
There is some relief from this, but not much. Up to $1.3 million (plus an additional $3 million for surviving spouses) can be added to the tax basis as long as the adjusted basis does not exceed the estate's actual value. Still, heirs of many modestly large estates likely will end up paying taxes they wouldn't have had to pay under last year's rules.
Hardly anyone believes this situation will continue. Either the draconian pre-2001 estate tax will return automatically on Jan. 1, or Congress will put something else in its place. Republicans and small business groups would like to kill the beast forever, but they don't have the votes to do it. President Barack Obama has proposed resurrecting the 2009 tax — a 45 percent top rate with a $3.5 million exemption.
Meanwhile, Sens. Blanche Lincoln of Arkansas, a Democrat, and Jon Kyl of Arizona, a Republican, have proposed a compromise that would set a top rate of 35 percent with a phased-in $5 million exemption, but so far the Senate's Democratic leadership has shown scant interest.
Proponents of the estate tax point to the need for revenue to reduce the budget deficit and to its role in redistributing wealth. However, both of these arguments run up against the 2 percent barrier. Even before 2001, estate and gift taxes rarely amounted to more than 2 percent of federal revenue from all sources. And a study by liberal economist Alan Blinder concluded that only about 2 percent of inequality can be attributed to inherited wealth.
Much of what the estate tax collects comes at the expense of revenue that otherwise would be raised by the income tax. The stepped-up basis allows heirs to claim smaller capital gains when they sell inherited assets and take larger deductions for depreciable assets, and it gives older folks an incentive to hold on to — and avoid paying a capital gains tax on — long-held assets. Realistically, any projected revenue "gain" from the return of the estate tax has to be reduced by these income tax effects.
Collecting taxes from dead people is not socially efficient. Compliance costs amount to $1 for every dollar collected — five times the cost per dollar for income taxes — and strategies used to minimize death taxes misallocate resources, leading to significant deadweight losses.
But, one way or another, the estate tax is almost certain to come back. If so, perhaps the Lincoln-Kyl compromise is the best we can hope for.
Phil Manger, a Cockeysville resident, blogs at philmanger.com and may be contacted at firstname.lastname@example.org.