With election results pointing toward a change in control in Congress, political analysts will shortly be making a number of observations about the likely impact. Pundits are already pointing to potential legislative gridlock, and the hopes of passing certain pieces of legislation are rapidly fading.
One such legislative goal was to repeal the federal estate tax. Although the tax cuts contained in the Economic Growth and Tax Reconciliation Act of 2001 enacted substantial reductions in estate tax rates, as well as the number of estates subject to estate tax, its provisions only repealed the estate tax outright during a single calendar year, 2010. In 2011 and beyond, the estate tax not only reemerges, but returns to its pre-2001 state, which will potentially cause a dramatic increase in the number of families that will face estate tax liability. Although Congress tried on several occasions to enact additional estate tax relief that would make the provisions of the 2001 law permanent, it was not successful in passing such a bill.
It seems likely that any changes in the estate tax will involve permanently increasing the amount of assets that a person can pass to heirs upon death without tax, rather than eliminating the estate tax entirely. Therefore, many of the estate planning techniques that planners had hoped to be able to dispense with in the future may well continue to be valuable and necessary in order to minimize tax liability.
The gridlock scenario
If it turns out that Congress is unable to pass any sort of changes to the estate tax, then the provisions of the 2001 law will continue to apply until they expire. Currently, estates in excess of $2 million are subject to estate tax at a rate of 46%. In 2007, the estate tax rate will fall to 45%. The $2 million exemption amount remains in effect through the end of 2008 and then increases to $3.5 million for 2009. In 2010, no federal estate tax will apply.
Without additional action from Congress, the favorable provisions of the 2001 law will expire at the beginning of 2011, and the former estate tax laws in effect before 2001 will control estate tax rates. These laws provide only a $1 million exemption from estate tax, and marginal rates ranging from 41% to 55% will apply. The lower exemption amount will dramatically increase the number of people who have to pay estate tax, along with the amount of tax they have to pay. For instance, people with a $2.5 million taxable estate would pay $230,000 in estate tax if they were to die this year, $225,000 in tax if they die next year, no tax if they die in 2009 or 2010, but more than $1 million in tax if they die in 2011 or after.
The estate tax is a subject of intense political debate. Although the tax raises relatively little revenue for the federal government -- about $24 billion in 2005 -- its status as a tax on the wealthy often causes issues of fairness and accusations of class warfare into discussions about repeal. People on both sides of the issue present vivid imagery to support their beliefs, ranging from land-rich, cash-poor farmers and ranchers stung by the need to find cash to cover unexpected estate tax liability to giga-rich corporate executives seeking to maintain financial dynasties indefinitely into the future.
The most likely compromise between those who want the estate tax repealed and those who wish to preserve it is to keep the tax in place while substantially increasing the amount that people can shelter without tax liability. Figures released by the Center on Budget and Policy Priorities indicate that the increase in the estate tax exemption to $2 million has already reduced the number of estates subject to tax by nearly 75% compared with 2000 levels. If Congress were to compromise with an exemption amount of $5 million, the number of estates subject to tax would be about a tenth their pre-2001 levels, but the majority of current estate tax revenues that currently come from larger estates of $5 million and up would largely be preserved. Given that a higher exemption amount would protect all but the wealthiest from estate taxation, it's a prudent political choice.
What you should do
If you were counting on estate tax repeal to solve your estate planning problems, think again. While it is still possible that outright repeal could happen, even with Congress controlled by Democrats, the danger in not planning for the more likely alternative is too great to ignore. Yet trying to figure out what the estate tax environment will look like, even within the next one or two years, makes planning for your future particularly challenging.
To make sure you cover all contingencies, your estate-planning attorney will likely recommend strategies that give you and your family the flexibility to take advantage of whatever new changes in estate tax law happen to be enacted. During your lifetime, you should consider passing unneeded assets to children, grandchildren, and other family members through the use of annual gifts. You can make gifts of up to $12,000 in 2006 to as many different people as you wish without incurring any gift tax, and if you are married, you can double your tax-free gifts.
If you're not comfortable giving money to your family outright, you can use certain types of trusts that take advantage of annual tax-free gifts while letting you retain some control over the assets you give. If you can spread your wealth across your family rather than holding onto all your money, even as your net worth heads toward the stratosphere, even compromises on new estate tax laws may give you enough protection to avoid having to pay estate tax at your death.
With Tuesday's election results, estate tax repeal may be a thing of the past. However, by managing your own estate and taking advantage of the opportunities currently in place, you can minimize any tax you may eventually have to pay.
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