This Billion-Dollar Question Is Still Up in the Air

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It's not the first prediction I've ever gotten wrong. For some people, though, it could have a huge impact on the financial lives of their families for generations to come.

Earlier this year, I warned investors that changes to the estate tax system were imminent. At the time, I believed that the odds were virtually zero that Congress wouldn't take some sort of action to fix what could become a huge issue for those with large enough estates to have potential estate tax liability. As it turns out, though, I was wrong -- and the consequences could be colossal.

Where we are
The uncertainty in the estate tax has existed ever since 2001, when a tax law change slowly increased the estate tax exemption over time. Since that time, the amount that each individual can pass to heirs without paying estate tax has risen from $1 million to its current level of $3.5 million. Beyond that, estates are subject to a 45% tax on the excess amount.

In 2010, though, the estate tax is scheduled to disappear for a single year, only to be replaced in 2011 by a tax taking effect back at the original $1 million level. For years, professionals have opined that there was no way that those provisions would actually be allowed to stand -- either opponents of the tax would find a way to repeal it permanently, or proponents of the tax would restore it during 2010.

As recently as a few weeks ago, it appeared that the latter would happen. But Congress adjourned without taking action, meaning that at least for a short time next year, the estate tax will be off the books.

Billions at stake
Given that the current exemption is relatively high, the disappearance of the estate tax may not seem like that big a deal. According to the Wall Street Journal, about 5,500 estates pay tax each year. That's not a huge contingent of people who'll be affected by estate tax repeal. Moreover, the tax generated only $25 billion in revenue during 2008 -- not insignificant, but just a small part of the overall federal budget.

Proponents of the tax, however, point to the impact that it has on the wealthy. Many wealthy people actually support an estate tax, arguing in part that it acts as an incentive for the rich to use their wealth for charitable purposes. For instance, by giving a steady stream of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) shares to the charitable foundation established by Microsoft (Nasdaq: MSFT  ) co-founder Bill Gates, Warren Buffett could reduce a potential multi-billion-dollar estate tax bill to nothing at his death.

One shouldn't dismiss the motives of philanthropists to do good things with their wealth. Many corporate leaders, including Whole Foods (Nasdaq: WFMI  ) CEO John Mackey, share a view of conscious capitalism, in which wealth maximization isn't the sole goal of business enterprise.

But it would be naive to think that tax avoidance doesn't play a role in why so many entrepreneurs establish foundations, including founders and major shareholders of companies like Hewlett-Packard (NYSE: HPQ  ) , Ford Motor (NYSE: F  ) , and Eli Lilly (NYSE: LLY  ) .

How to plan
In the meantime, the uncertainty is throwing a major wrench into estate plans. Because so much of estate planning addresses how to minimize potential estate tax, its disappearance makes many of the tools you commonly find in wills and trusts at best moot and at worst potentially disastrous. If you have a will or trust that was designed with estate taxes in mind, it's worth having it reviewed in light of these new circumstances to make sure it will still work the way you want.

The real issue for most taxpayers will come in 2011, when the estate tax comes back with a vengeance, affecting anyone with $1 million or more. Most experts are predicting that Congress will address the issue early on when it reconvenes after the New Year's holiday and believe that lawmakers will attempt to make any changes retroactive to Jan. 1. But most of those experts will also admit that they expected a resolution long before now.

Moreover, the estate tax is just the tip of the iceberg. Many popular, relatively new tax reductions, including lower rates on ordinary income and preferential treatment for dividends and capital gains, are slated to come to an end next December.

Already, 2010 promises to be an interesting year for those who follow income tax law. To avoid making major missteps with their money, you'll need to follow developments closely throughout the year.

Want to make sure your estate plan is okay? Dayana Yochim has one piece of advice: don't die without reading this.

Fool contributor Dan Caplinger probably won't have to worry about estate taxes for a long, long time. He owns shares of Berkshire Hathaway. Berkshire Hathaway, Ford Motor, and Whole Foods Market are Motley Fool Stock Advisor picks. Berkshire Hathaway and Microsoft are Motley Fool Inside Value recommendations. The Fool owns shares of Berkshire Hathaway. Motley Fool Options has recommended a diagonal call strategy on Microsoft. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy answers all your questions.

Read/Post Comments (6) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 31, 2009, at 11:52 AM, catoismymotor wrote:

    The estate tax is a death tax. The state goes after your carcass when you're dead, because after all, they think you owe them something after paying taxes your whole life. And they choose to do this at the same time your family is in mourning. Theft is the most tame of words or expressions I have for government idea.

    And I know there are thousands of CLUs out there that sell policies that cover what your estate would owe the state upon your death. That does not make me feel any better. A CLU and insurer makes money buy selling you a financial instrument that will pay out protection money to the state so they keep their greedy paws off your stuff. I have nothing against CLUs. Most of them are good people. They have a right to make a living. But there should be no reason to have sell something like that.

    Am I in danger of having my estate taxed like this?No. I have just started my journey to building wealth. But many of you may be in a position to have to think about this, and I don't think you should have to. You have been taxed unfairly for your ablility to succeed throughout your life. And that needs to change. And so does the government's ability to tax what you have spent a lifetime building that is meant to serve your family after you have passed.

    And so far that the idea of the estate tax being viewed as a way to foster charitable giving before you die to decrease the amount owed to the government in taxes, I say it is a shame that such a choice is made under duress. Charity under threat is not real charity.


    One last thought: In my early twenties I was exposed to an idea put forth by a man of fifty years. He said his kids, upon his death, would each receive $250,000 as seed money for building their own fortunes, and all of them were aware. The rest of the money would go to taking care of his wife. He said that in his opinion heaping a few million onto a young person makes them take the money for granted, makes them unproductive. This is idea I undersand and think has merritt.

  • Report this Comment On December 31, 2009, at 12:00 PM, catoismymotor wrote:

    "And so far that the idea of the estate tax..." should read "And the idea of the estate tax..."


    Thank you for putting this article together for us.


  • Report this Comment On January 01, 2010, at 6:40 PM, epsmarts wrote:

    In 2009 less than 1 percent of the population needed to be concerned about estate taxes. Estate planning goes far beyond taxes. Above all, it is a way to take care of yourself and the people you love. We shouldn't let all the talk about taxes obscure this fact. --Deborah L. Jacobs, author, Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide.

  • Report this Comment On January 05, 2010, at 4:49 PM, BaumgrenzeJohn wrote:

    Congress ignores one aspect of the rules for 2010 at its peril. The current rules do away with the step up in basis along with doing away with the 'death tax.'

    Mark my words, as taxpayers begin dealing with estates that contain equities or equity based mutual funds, as they discover that they cannot establish a basis for the investments they are inheriting, the phones will ring off the hook in congressional offices around the country.

    One of my senators seems to believe that the provisions of the budget resolution have established "provision(s) similar to President Obama's request to permanently freeze 2009 estate tax levels at a 45 percent rate with a $7 million exemption for couples."

    Dan Caplinger, were the provisions of the budget resolution binding law or just the 'sense of the Congress?'



  • Report this Comment On January 29, 2010, at 5:26 PM, wjcost wrote:

    WAKE UP! DON'T DIE IN 2010!

    Tere is no estate tax BUT the basis of your assets WILL NO LONGER STEP UP AT DEATH!

    Rich people are better off but Nana's estate, whose only asset is her house, will have to pay capital gains tax on the appreciation! Years and years of appreciation!

    I just can't believe that the middle class has not gotten it and still supports an estate tax repeal that will hurt them and be a windfall for the really wealthy.

  • Report this Comment On January 29, 2010, at 6:41 PM, ChannelDunlap wrote:

    There is only 1 solution to this dilemma that I can find; don't have kids and squander your wealth.

    Problem solved.

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