Fiscal Cliffhanger: Uncle Sam keeps changing the estate tax rules

Call it the estate tax, its more formal name  – or the death tax, the nomenclature politicians and opponents of the levy like to use due to its more visceral impact. By whatever name you call it, the tax presents another topic in the debate over how, or if, the looming fiscal cliff issue will be addressed in Washington.

And while the number of people affected by that one tax is extremely small in comparison with other issues up for debate in the Capitol Hill imbroglio, the financial impact on anyone who is affected could be substantial.

Case in point: This year, estates valued at just over $5 million or less are exempt from the tax. Amounts above that are taxed up to a top rate of 35 percent. However, if there’s no agreement between Congress and the Obama administration, the amount subject to exemption falls to $1 million and the top tax rate climbs to 55 percent.

The matter becomes more complicated because most congressional Republicans and even some Democrats want to repeal the estate tax completely. The president has suggested a compromise setting the exemption level at $3.5 million, with a top tax rate of 45 percent.

But wait. The tax rates and exemptions noted here don’t apply when property and assets in the estate of a married person pass to the surviving spouse. That’s because they qualify for the marital deduction.

If your head is starting to spin and/or your eyes are beginning to glaze over, you’re not alone. Joseph Griffard, a Ballwin-based financial planner, fears many people, including those who potentially could be affected by decisions that leave some form of the estate tax in effect, may not fully understand all the details.

“Long-term and widespread clarity isn’t likely when the amount subject to taxation and the tax rates involved have changed so frequently,” Griffard said. Since 2000, the amount of assets exempt from the estate tax has changed seven times and the top estate tax rate has been at nine different levels.

In a recent blog on his website, Griffard likened the situation to a young child playing Monopoly with his uncle and beating him handily until the uncle – Griffard names him Uncle Sam – changes the rules. The youngster adjusts his strategy and regains the upper hand, until Uncle Sam again changes the rules. The scenario is repeated over and over.

Griffard asked, “At some point, would you decide the game was no longer worth playing?

Griffard pointed to a hypothetical case in which a married woman inherits her husband’s $1.5 million estate when he dies and, due to the marital exemption, pays no estate tax. The amount may seem large, but when the value of a nice home, retirement savings, insurance and other assets are added up, an estate of that amount or more isn’t out of the question.

The problem arises if she dies soon thereafter and/or if the value of the estate increases before her passing. At that point, the entire value of the estate could be subject to the estate tax even though it was exempt originally, leaving a sizable tax bill to be paid.

“Another problem is that the constant changes in the rules make it difficult to plan anything,” Griffard continued. “You really need some stability to make the kind of assumptions needed for good planning.”

With tongue only slightly in cheek, Griffard added, “About the only people who benefit from all the changes and the possibilities we’re facing now are attorneys who will be called on to prepare new legal documents related to people’s estates and insurance companies who will be selling policies to cover the potential tax liabilities.

“The unfortunate reality is there aren’t many voters who are touched by this tax, which makes it  an easy target to exploit for tax revenue.”

The independent Tax Policy Center (TPC) confirms the number of taxable estate tax returns, as a percentage of adult deaths, is negligible – an estimated 0.13 percent or 3,250 returns in 2011.

If nothing is done and the exemption falls to $1 million, the number would jump to an estimated 52,500 in 2013, the TPC predicts. Under the Obama proposal, some 7,500 estates would be affected next year.

“Politicians who favor increasing the death tax talk frequently about greedy billionaires while those opposed use the more sympathetic image of the family farmer or other small businessman,” Griffard noted, referring to the emotions and biases of politicians.

Similarly, it helps explain why Democratic lawmakers from states with substantial rural and small-town constituencies are breaking ranks with President Obama on the estate tax issue. Among them is Missouri’s Claire McCaskill, who has supported extending current estate tax provisions.

It’s worth remembering that taxing the value of estates at death is not new. In 1932, Congress enacted the gift tax to prevent persons from avoiding the estate tax by transferring their wealth to heirs before they die.

One less-visible wrinkle in the estate tax debate is the possible impact on states, the TPC noted. Early in this century, all 50 states and the District of Columbia had estate taxes directly linked to a federal estate tax credit for such levies. With the credit, states had another revenue source without boosting the overall tax burden on their residents.

The 2001 tax act phased out the federal credit and later replaced it with a less-valuable deduction. In the aftermath, most states, including Missouri, did nothing. Their statutes explicitly reference the federal credit but, with that credit gone, the states no longer have had their own estate tax.

According to the TPC, if nothing is done to avoid the fiscal cliff and the 2001-10 tax cuts expire on Jan. 1, 2013, the federal estate tax will revert to its 2001 status, bringing back the credit and, with it, the estate taxes of Missouri and 29 other states.