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How to deal with estate taxes

Although the federal estate tax -- sometimes referred to as the "death tax" because it's levied on assets people leave to their heirs when they pass away -- is currently dead, few experts believe it will stay that way.

What happened here?
History of the federal estate tax
repeal schedule

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Year

Tax Rate

Exemption Level

2002

50%

$1 million

2003
49%

$1 million

2004
48%

$1.5 million

2005
47%

$1.5 million

2006
46%

$2 million

2007
45%

$2 million

2008
45%

$2 million

2009
45%

$3.5 million

2010
0%
Tax Repealed
2011
55%

$1 million

The most pressing issue is not if, but when, Congress will pass new legislation.

Almost all estate tax experts expected Congress to take action on a new tax before it expired at the end of 2009 after a decade of gradual decreases. Before the Bush Administration-backed changes began taking effect in 2002, estates beyond a $1 million exemption paid a 55 percent tax. By 2009, the exemption had increased to $3.5 million (or $7 million for a couple), and the tax rate on the balance had dropped to 45 percent -- before both expired on Dec. 31, 2009.

Unless Congress acts this year, the estate tax will, in 2011, return to the 2001 levels of a $1 million exemption and a 55 percent tax rate.

Number of estates affected could skyrocket

If Congress doesn’t take action, the number of estates affected by the tax will increase, according to the Tax Policy Center (TCP), a joint venture of the Urban Institute and the Brookings Institution. The TCP estimated that, of individuals who died in 2009, roughly 5,500 owed taxes totaling almost $14 billion. (This number is an estimate because estates have nine months after the death of the estate's owner to file a tax return.) If the law returns to the pre-Bush tax cut levels in 2011, that number would soar to 44,200 estates paying taxes totaling $34.4 billion, according to the TCP.

The current uncertainty over what will happen to the estate tax is exacerbating the anxiety felt by many wealthy Americans by the volatile financial stock markets, said John Dedon, a principal in the trust, estate and tax planning for the Odin, Feldman and Pittleman law firm in Washington, D.C. "You have the moving target of 'What are my assets worth?' and the moving target of 'What does the [estate tax] law provide?'" he said.

What to expect in estate tax law changes

The complexity of the estate tax and the changing legislation has prompted some common questions -- and predictions by tax experts:

Before its expiration this year, who paid the estate tax? The richest 10 percent of Americans paid virtually all of the tax, with almost half paid by the wealthiest one-thousandth, according to the TCP.

Will Congress resurrect it in some form? Almost certainly, although experts disagree on when it will happen. "It will be adjusted," predicted Chuck Marr, CBPP's director of federal tax policy. "The question is, when will that change occur?" Permanent repeal would cost almost $1.3 trillion over the first 10 years, according to the non-partisan Center on Budget and Policy Priorities (CBPP), which fears that repeal or a significant reduction of the estate tax will lead to higher tax burdens for lower-income and middle-class Americans.

Assuming Congress re-enacts the estate tax, what will the exemption amount and tax rate be? Bruno Graziano, a senior estate and gift tax analyst at CCH Inc., a tax and business law information and software solutions company, said that one of several scenarios could play out. One is that Congress adopts a provision of the proposed "pay-as-you-go" legislation that would continue the estate tax at the 2009 levels for two more years. Another option would build in an inflation factor. Some congressional groups favor a more generous $5 million exemption and a maximum 35 percent tax rate.

Marr believes the exemption ultimately will range from $3.5 million to $5 million. Dedon said he could see the tax returning to its 2009 levels next year, so that Congress could take credit for enacting a tax cut when it establishes a less aggressive rate in 2011. He counsels his clients that $3.5 million is the "best-case scenario" for planning purposes.

Will Congress retroactively apply the tax so that it's levied against all estates owned by individuals who die before Congress acts? Marr and Dedon both say that the longer it takes Congress to act, the less likely the tax will be retroactive. Although some precedent exists for retroactive levy of taxes, very wealthy estates that pass to heirs in 2010 would have ample impetus to challenge any such attempt. Dedon cited Houston billionaire Dan Duncan, who died March 28, 2010 with an estimated $9 billion estate. Rather than a retroactive tax, Congress could give estates of anyone who dies in 2010 the choice of paying taxes under the 2009 law or under the new law once it is enacted, Dedon predicted.

Given the uncertainty, what's the best strategy for wealthy families? For families with estates valued at or below $2 million, the default exemption of $1 million ($2 million for a couple) that will be reinstated in 2011 without any Congressional action would protect their assets from federal estate taxes, Graziano and Dedon said. Estates valued at more than $2 million should consider creating an irrevocable trust that owns a survivorship or "second-to-die" life insurance policy whose proceeds are allocated to covering some or all of the estate tax bill. An irrevocable trust shelters the life insurance proceeds from the estate tax. However, such a trust is permanent, meaning the policyholder assigns binding control of the policy to the trust's trustee.

Another consideration is inheritance and estate taxes levied by some states. Nineteen states -- primarily in the Northeast and Midwest, as well as Washington, Oregon, and the District of Columbia -- levy estate or inheritance taxes, or both, as of 2010. Rates range drastically from 0.8 percent to 16 percent, depending on the size of the estate, said Jim Walschlager, a senior estate tax analyst with CCH who specializes in state taxes. (Forbes has published an interactive map summarizing inheritance and estate taxes for each state.)

Life insurance benefits to help cover estate tax liabilities

All of these factors underscore the importance of life insurance in estate planning. "If we continue to have this inaction [by Congress], we have the return of the $1 million exemption and 55 percent tax rate in 2011," Dedon said. "That should really turbo-charge the life insurance business because it would create a real need for a lot more people to have life insurance to cover estate taxes."

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