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ESTATE TAX REFORM FAILS. NOW WHAT?

August 04, 2006

This year's estate-tax battle came to an end last night when the estate tax reduction bill - lashed to a minimum-wage hike and a package of tax breaks in an attempt to gain support - fell three votes short of the 60 needed to clear the Senate. This "Trifecta" bill would have increased the lifetime estate tax exemption to $5 million, with a graduated system of two rates - 15% and 30% - on amounts in excess of $5 million.

THE ROLE OF OVERREACH IN THE ESTATE TAX

One theme runs through the long-running battle over the estate tax: overreach.

In the 1990s, supporters of the estate tax - we'll call them "Democrats" as a convenient shorthand - put the tax in jeopardy by ignoring its creep into the lives of middle class taxpayers. With its $600,000 exemption unchanged since 1976, inflation and rising housing values were forcing many merely comfortable taxpayers to deal with estate planning lawyers, two-trust wills, and the like to avoid a confiscatory and numbingly complex tax with rates starting at 37%.

The folks that were having to consult with estate planning lawyers are also the folks best able to donate to politicians. They are a powerful constituency, even if they aren't a majority of the electorate. With a complacent belief that "only a few" folks were really subject to estate tax, many Democrats stuck with a "soak the rich" approach and failed to notice the rising opposition until it was almost too late to prevent repeal.

Then it was the turn of the opponents of the estate tax - let's call them "Republicans" for convenience - to reach beyond their grasp. They first did this in 2001 when they voted in the current version of the estate tax law. It increases the lifetime exemption and reduces the top rate until the estate tax disappears entirely in 2010. The estate tax then rises from the grave in full force in 2011 with a $1,000,000 exemption and a 60% top marginal rate.

The one-year repeal was all that Congress could do under its budget rules, but the repeal authors assumed that they would have plenty of time to kill the estate tax entirely. Egged on by the dodgy disciple of total estate tax repeal, Grover Norquist, and his allies, the Republican leadership refused to consider any solution short of total repeal. But their political strength ebbed and the Republican opportunity to enact an estate tax with much lower rates and a much higher exemption slipped away.

Senator Frist finally gave up on total repeal this year and fell back on a "compromise" estate tax bill. His understanding of "compromise" was flawed, though; "compromise" involves getting somebody to agree with you. The new proposal failed to attract enough Senate Democrats, even when tied in an ugly bundle with a higher minimum wage and a grab-bag of politically popular tax breaks.

NOW WHAT?

No estate tax legislation is likely to pass until after elections. If the Democrats make the predicted gains this November, it may be their turn to overreach again and stonewall estate tax reform, and the wheel will start another turn.

In an ideal world, the politicians would enact a rational estate tax with much lower top rates and a much larger exemption, while eliminating valuation games and uncertainty and repealing the raft of special interest breaks that become unnecessary when rates fall. Just adjusting the original 1976 lifetime exemption for inflation would result in a lifetime exemption in excess of $2 million. Alas, hope for a rational estate tax has receded beyond the horizon.

Meanwhile, taxpayers and their advisors have to muddle along with a tax law that's here today, gone tomorrow, and back the next day. Advisors will encourage taxpayers fall back on the basic estate tax planning tools. These include:

-Making full use of the $12,000 per donor, per donee annual gift exclusion. Two parents with two kids can put $480,000 out of the reach of the estate tax over 10 years this way alone.

-Using the lifetime estate tax exclusion through gifts, to the extent it doesn't result in gift tax. While the lifetime estate tax exclusion is currently $2 million, only $1 million can be used before gift taxes apply. Using the $1 million exemption now to gift assets likely to go up in value puts inflation on your side in the estate planning process, as the inflated value of the $1 million will pass tax-free at death.

- Consider how you own your assets. If one spouse has assets that exceed the estate tax exclusion, giving some to the other spouse might be all that is required to avoid the estate tax.

- An old-fashioned two-trust will - leaving enough assets to use up all of the first spouse to die's lifetime exemption to a trust for the children, passing the rest tax-free to a trust for the surviving spouse - will continue to be part of the standard estate planning toolkit.

Links:

Washington Post
New York Times
Wall Street Journal ($link)
TaxProf Blog roundup
Mauled Again

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