I Don’t Need to Worry About the Estate Tax—or Do I?

To best understand where we’re going, we should take a look at where we’ve been. The year 2001 would be a good place to start. One of George W. Bush’s first items of business in his new administration was the Economic Growth and Tax Relief Reconciliation Act of 2001. This law was a sweeping piece of tax legislation in the United States. The 2001 Act made significant changes in several areas of the US Internal Revenue Code, including income tax rates, estate and gift tax exclusions, and qualified retirement plan rules. In general, the 2001 Act lowered tax rates and simplified retirement plan rules such as IRAs, 401(k) plans and pension plans.

Perhaps the biggest change brought by the 2001 Act was the eventual elimination of the estate tax. Before the enactment of the 2001 Act, the estate tax was a tax up to 55% on assets in excess of $675,000 owned by an individual at the time of his or her death. The estate tax exemption (the threshold above which estate taxes were incurred) was scheduled to increase by steps: $1,000,000 in 2002, $1,500,000 in 2004, $2,000,000 in 2006, and $3,500,000 in 2009, with a complete repeal of the estate tax scheduled for 2010. From 2002 through 2009, the estate tax rate was reduced gradually down to 45%. The gift tax, however, was not repealed, which meant that the exemption remained at $1,000,000 for gift tax purposes.

This was hailed as a victory by many Republicans, who had long sought the elimination of the estate tax. Although the Republicans held a majority of the votes necessary to pass the Act, there were insufficient votes to allow the 2001 Act to extend beyond 10 years. As a compromise, a curious characteristic of the 2001 Act was that it would “sunset” in 2011. This meant that the laws enacted by the 2001 Act would simply revert back to the 2001 laws on January 1, 2011.

During the period the 2001 Act was in effect, and especially during Barack Obama’s administration, few people (if any) expected Congress to allow the estate tax to go away, even if for only one year. Naturally, Congress, at some point along the way, would pass a new law that would make permanent an estate tax before 2010 when the estate tax went away, right?

Congress was busy arguing about Obama’s proposed health care reform during the last half of 2009. So busy was Congress with health care that little attention was paid to the seemingly less important problem of the upcoming, vanishing estate tax. January 1, 2010 came and went and no new estate tax law. For the first time since 1916 the estate tax simply vanished.

The feeling among tax practitioners and estate planners (and most taxpayers) was one of utter shock. How could such a huge tax simply fall through our government’s cracks. During 2010, many assumed that the lawmakers would pass a bill to reinstate the estate tax retroactively effective for everyone dying in 2010. However, this did not happen.

What did happen was almost as surprising as the lapse of the estate tax in 2010. On December 17, 2010, Congress made effective the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. The 2010 Act, among other laws, reintroduced the estate tax. But the real surprise of the 2010 Act was the exemption amount that was increased to $5,000,000 and made effective for gift taxes as well. The estate tax rate was reduced to 35%. Again, however, this estate tax reform was temporary. The estate and gift tax figures in the 2010 Act are scheduled to sunset on January 1, 2013 back to 2001 figures.

Here we are in the middle of 2012. As of now, an individual could die with $5,120,000 and a married couple could die with combined assets of $10,240,000 before estate taxes are incurred. Especially in light of the recent economic downturn, these amounts far exceed what most folks have. Most of you reading this will probably feel that you don’t need to worry about the estate tax. Furthermore, the gift tax exclusion amount of $5,120,000 is almost irrelevant even to those folks who have that sort of wealth because they simply don’t want to make gifts that large during their lives (remember 2008?).

Before you get too complacent, consider this: On January 1, 2013, the estate and gift exemption amount is scheduled to drop to $1,000,000 (adjusted for inflation). How many of you reading this have an estate greater than $1,000,000. As the economy improves, most balance sheets will also improve. Also keep in mind that death benefits of life insurance policies are often included for estate tax calculations. You can see how many more taxpayers will be affected by estate taxes in the very near future.

This was a nice history of recent tax laws, but what really does this mean? For one thing, it shows that we cannot count on Congress to act rationally or act at all when it matters. How are those debt ceiling discussions coming along? Fortunately, as taxpayers, we currently find ourselves in a very favorable environment. For those who have (or plan to have) assets above $1,000,000, the ability to make gifts up to $5,120,000 (if just temporarily) opens up a world of possibilities to reduce estate taxes if Congress doesn’t change its mind before 2013, or if it changes its mind later. After all, no estate plan should anticipate that Congress will do the right thing.

Any time there is a major change in estate and gift tax laws, you should look at your estate plan and give it a “stress test,” that is, envision various scenarios based on different assumed values of your estate as well as dates of death for you and your spouse. How does your estate plan hold up compared to the current estate tax laws. How does it compare to future estate tax laws? If you haven’t done so recently, it’s a good idea to discuss these issues with your estate planning attorney or tax advisor.