Estate Tax Reform a Front Burner Issue Next Year

The next president and the new Congress will revamp, not junk, the estate tax in 2009.

By Joan Pryde, Senior Tax Editor, the Kiplinger letters

April 18, 2008

Congress is already eyeing estate tax reform, even though lawmakers won't hammer out a bill until next year. They're debating a complete overhaul of the estate tax system, but that probably won't fly. Instead, count on passage of an overhaul with a multimillion dollar exemption and a new benefit for surviving spouses.

A change in the law is needed to avoid a train wreck: Presently, the estate tax is scheduled to be eliminated after 2009, but only for one year. It returns to life in 2011 with a paltry $1 million exemption, down from $2 million in 2008 and $3.5 million in 2009. Lawmakers realize this makes little sense, but election year politics will keep taxwriters from developing a solution until next year.

When they do get around to reforming the estate tax, lawmakers will stop short of permanent repeal. Look for Congress, which is almost certain to stay under Democratic control, to OK an exemption amount of $3.5 million or more. The top estate tax rate will be at least 45% if Democrats also win the White House -- slightly lower if Sen. John McCain becomes president.

One of the big changes likely to the system will be to make tax planning easier for surviving spouses by permitting "portability." Nowadays, if one spouse dies without fully using up his or her $2 million exemption, that amount is wasted. This can happen when the first spouse to die doesn't own enough assets in his or her name or when many or all assets go to the survivor. To fix that problem, Congress will allow unused exemption amounts to pass to surviving spouses and be available for use when the spouse dies. This will eliminate the need for spouses to have to establish trusts in their wills solely to save on estate taxes.

There's some talk of junking the estate tax in favor of an inheritance tax, which would be levied on bequests in lieu of taxing the estate of the individual who died. One plan being reviewed would tax heirs once the total they have inherited in their lifetime tops $1.9 million. Heirs would owe income tax on the amount over $1.9 million plus a 15% surtax. To ease the tax hit, taxpayers could elect to spread the tax evenly over a five year period. This is projected to bring in as much revenue as the estate tax, even though it would allow some large estates to escape tax completely.

No inheritance tax would be due, for example, on an $11 million estate split evenly among three children and their spouses. Such a plan would be significantly more generous than the current $2 million exclusion for estates not left to spouses.

But there are potential problems that make passage of an inheritance tax unlikely. Most states would have to revamp their systems as well because they’re pegged to federal estate taxes. Plus all bequests would have to be reported to IRS so that it could track usage of the exemption. Charities would be concerned that there would be less incentive to donate by will. And transitioning over to the new tax system would be tricky.

For weekly updates on topics to improve your business decisionmaking, click here.