Return of the Death Tax

The modern version of the Death Tax (Estate Tax) was enacted with the Revenue Act of 1916. In essence, it means that a portion of your estate, or total holdings at the time of your death, is subject to confiscation by the government. In many cases, much of the assets have already been taxed and therefore are subject to double taxation. This tax historically hit business owners and their heirs particularly hard – often forcing the beneficiaries to sell a family business to satisfy the government.

In 2001 new legislation was passed to phase out the Death Tax. At that time the Exclusion Amount (the point at which the Death Tax kicked in) was $675,000 and the top rate was 55%. So if you owned a business that was worth $2M, your heirs would be on the hook to the government for 55% of 1.325M (or $728,750) when you passed to your greater reward. Since 2001 the Exclusion Amounts have been raised and the tax rates lowered until 2010 when the hated Death Tax expired.

According to this story (from the Wall Street Journal) congress is set to re-institute the Death Tax for 2011. It will have an Exclusion Amount of $1M and a top rate of 55%. This presents a macabre choice for many large estate holders – Do I die this year and pass my whole estate on to my heirs or hold on and let them be slammed by this tax? What a choice…

It has come to this: Congress, quite by accident, is incentivizing death.

When the Senate allowed the estate tax to lapse at the end of last year, it encouraged wealthy people near death’s door to stay alive until Jan. 1 so they could spare their heirs a 45% tax hit.

Now the situation has reversed: If Congress doesn’t change the law soon—and many experts think it won’t—the estate tax will come roaring back in 2011.

Not only will the top rate jump to 55%, but the exemption will shrink from $3.5 million per individual in 2009 to just $1 million in 2011, potentially affecting eight times as many taxpayers.

The math is ugly: On a $5 million estate, the tax consequence of dying a minute after midnight on Jan. 1, 2011 rather than two minutes earlier could be more than $2 million; on a $15 million estate, the difference could be about $8 million.

Of course, there is a “death incentive” whenever Congress raises the estate tax. But it hasn’t happened in decades; the top rate has held steady or fallen since 1942, according to tax historian Joseph Thorndike of Tax Analysts, a nonprofit group. In fact, the jump from zero to 55% would be “the largest increase in a major tax that we’ve ever seen,” Mr. Thorndike says.

It’s important to remember that your estate includes not only your tangible assets, but also the payout from all life insurance policies. This could present some difficult choices for some people.

Advisers say the estate-tax dilemma is especially awkward for heirs. “At least in December 2009, people wanted to keep their relatives alive,” says Ronald Aucutt, an estate-tax attorney with McGuire Woods in the Washington area. Now he and others are worried that heirs may be tempted to pull plugs on Dec. 31. Economists might call the taking of a life to reap a tax advantage a “perverse incentive.” District attorneys might call it homicide.

Congress has had 9 years to fix this and they’ve failed to do so. With all the uncertainties hampering economic recovery, this only adds to it.

Many Washington insiders are betting Congress won’t act this year because of an overflowing to-do list, the fall election and fewer than 40 working days left in 2010. At least one near-deal has failed the Senate this year.

Pressure to act will likely grow following the November elections, when Congress is expected to address many other expiring Bush-era tax breaks, including income taxes and capital-gains rates.

Meanwhile, the living and their relatives face a complex calculus with unknown variables. The Internal Revenue Service has yet to issue guidance explaining current estate-tax law, and no one knows if Congress will include retroactive elements when members deal with the tax.

Since the majority of congress are hungry for major revenue streams, the return of the Death Tax is welcome relief.

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