The federal wealth transfer taxes are imposed on any gift (with certain exceptions), and any estate, no matter how small. In order that these taxes only actually get paid by "the wealthy," everyone is given a "unified credit" against these taxes. We usually do not talk about the credit itself; rather, we refer to the "exemption equivalent," which is the amount of wealth that the credit "pays" the tax on.
When I started practicing law, and for a long time thereafter, the exemption equivalent was $600,000; that is, the credit was equal to the tax on $600,000 of lifetime gifts and/or wealth transmitted at death. Once the credit ran out, the tax rate on the 600,001st dollar was 37%, and the rate brackets topped out at 55% once you got to $3 million.
By making full use of both spouse's credits, a married couple could transmit $1.2 million to the next generation before incurring a federal tax. At the time these numbers were established, $1.2 million was a net worth that few couples could attain. After fourteen years of cumulative inflation and rising standards of living, however, the tax was starting to hit a lot of farmers, small business owners, and other upper middle class taxpayers who were rich enough, in terms of assets, to be hit by the tax, but who often weren't liquid enough to raise the cash with which to pay the tax without selling or borrowing against their main assets--the house, the farm, or the business.
The 1997 tax act.addressed this by scheduling a series of irregular increases in the unified credit that would eventually raise the exemption equivalent to $1 million. The increase was "back-loaded" so that most of it occurred in later years. By 2001, we were about halfway through the process, and the exemption equivalent was $675,000.
The 2001 tax act--which enacted what reporters, pundits, and politicians like to refer to as the "Bush tax cuts"--provided for the complete phase-out of the federal estate tax over a ten year period. The exemption equivalent for estates was increased immediately to $1 million, and scheduled to go to $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2009. In 2010, the estate tax was scheduled to disappear completely. While this was going on, the top rate was decreasing from 55% to 45% in a series of irregular jumps. The exemption equivalent for lifetime gifts was capped at $1 million, and after the estate tax went out of existence there would still be a 35% tax on lifetime gifts, with a $1 million exemption equivalent.
The 2001 tax act also contained a "sunset" clause under which all the changes it worked in the tax code would be undone on January 1, 2011, which would un-repeal the estate tax and cause a return to what the 1997 tax act was working toward: an estate and gift tax with a $1 million exemption equivalent and a 55% top rate. The reason for this is because one of the rules governing the federal budget process provides that no legislation affecting revenue can be in effect for more than ten years unless it passes with at least 60 votes in the Senate. As you might remember, we had a closely-divided Senate at that time, and the 2001 tax act passed by only a small majority.
Those of us in the estate planning business expected that Congress would change things again well before 2010 so we wouldn't have that strange temporary repeal, but that didn't happen. In late 2009, there had been several bills introduced to extend the estate tax past 2009 with a $3.5 million exemption equivalent (and one that would have reduced it to $2 million!), but none of these got through the legislative process because Congress was then focused intensely on the pending "Obamacare" health care reform bill.
Consequently, there was no estate tax for nearly all of last year, but with a scheduled automatic reinstatement of the tax (and a lot of other changes to other parts of the tax code) on January 1, 2011. In December, Congress passed, and the President signed into law, legislation which prevented the sunset from taking place. For the most part, it provided that the changes to the tax code made by the 2001 tax act would continue in effect through the end of 2012--what the media, pundits, and politicians described as "an extension of the Bush tax cuts." Part of this bill reinstated the estate tax--but with a $5 million exemption equivalent, a 35% top rate, and a new "portability" provision which allows a widowed spouse to make use of any unified credit the deceased spouse did not use on his estate tax return or on lifetime gifts. This is the most taxpayer-friendly that the federal estate tax has been since 1931.
However, things may soon change for the worse. The 2010 tax act was a bundle of compromises, and one of those compromises was a provision that "sunsets" the 2010 act at the end of 2012. Unless Congress changes the tax code again before the end of next year, we will "snap back" to the 1997 version of the estate tax--an estate and gift tax with a $1 million exemption equivalent and a 55% top rate--on January 1, 2013.
There are many members of Congress who have come out in favor of making the 2010 estate tax scheme permanent. President Obama has stated on numerous occasions that he is opposed to "further extensions" of the "Bush tax cuts," which seems a pretty clear signal that he would oppose making the 2010 estate tax scheme permanent. It is probable that any legislation to address the estate tax would be introduced and debated next year--in the middle of a long and contentious national election campaign.
No one can safely predict what will happen next, and estate planning for families with small businesses and farms has gotten a lot more complicated as a result.
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