Death to the Death Tax?

We’ve had a federal estate tax since 1916. For many years, there’s been a fierce push to put this tax out of its misery. Only a handful of votes have prevented its complete demise on a few occasions. It actually disappeared for 12 months in 2010, but it’s back now and, absent Congressional action by end of this year (2012), it will be as mean as ever starting in 2013.

Is it time to finally kill the federal estate tax? Many on the right, some on the left, and all the Republic presidential hopefuls say the time has arrived. Others passionately argue that we should not trash a 95-year old tax that’s targeted squarely at the top players in the top one percent.

Those who advocate death to the tax argue that it’s just plain wrong to strip a family of a major portion of its wealth when death occurs – to send the taxman in with the undertaker. Plus, they point to the huge generational transition risks to successful, illiquid businesses and family farms, the gross inefficiencies of a tax based on property values that can easily be disputed, and the fact that the tax, relatively speaking, contributes peanuts to the federal coffers.

Proponents of the tax argue that death is a great time for the government to strike, that massive intergenerational wealth transfers should not be encouraged, and that the tax will start paying off once the right people start dying. In the prologue to their book Wealth and Our Commonwealth (Beacon Press 2003), Bill Gates, Sr. and Chuck Collins, two of the leading proponents of the tax, write, “Americans who possess great wealth have a special obligation to pay back a debt to society…Preserving the estate tax will ensure that our society values the inherent worth of the individual – rather than the inherited worth.” (Pages xi-xii).

Of course, the estate tax poses no direct threat to the masses that aren’t rich. This is because the estate tax does not kick in until a person’s estate exceeds a certain amount – known as the unified credit exemption equivalent or, as some say, the “free amount.”

Most remember the heated battle in Congress over the extension of the Bush tax cuts that occurred during the final days of 2010. A compromise was finally reached, amidst a whole slew of political theatrics. As part of this compromise deal, the Republicans got their dream deal for estate taxes (short of complete repeal) for two years – 2011 and 2012. For these two years, the estate tax free amount was set at an all-time high – $5 million in 2011 and $5.12 million in 2012. And for a married couple, there is a provision that automatically doubles these amounts – again something brand new. But these rules work only for those who die in 2011 or 2012.

If Congress does not reach an agreement on the extension of these breaks by the end of 2012, this estate tax free amount will plummet back to only $1 million starting in 2013, with no automatic doubling between spouses. And the tax rate will jump to as high as 55 percent. So the ultimate fate of this tax, like nearly every other important tax provision, was just kicked over to 2013 as our country struggles to crawl out of a debilitating recession and our elected representatives wrestle with unprecedented deficits that threaten to bring down everything.

Many reasonably ask: Given the high threshold of this tax, why should we even give a hoot about the tax? If you’re like most, it’s not about the direct impact of this tax on you; it’s about the potential harm you many suffer if the tax is imposed on others. There are two potentials – one rare, one not-so-rare.

The first potential, the rare one, is if your parents have an estate tax exposure. If they do, sooner or later it will end up in your lap – and directly impact (in a big, negative way) your financial future. Smart planning over time can seriously reduce or completely eliminate the pain. So you may have a real vested interest in the quality of your parents’ planning.

The second not-so-rare scenario is the person who works for a company that has an owner who faces a serious estate tax exposure. Fearful of not having enough liquidity (cash) to cover the estate tax hit and transition the business to a second generation, the owner elects to convert his illiquid business into a pot of cash or liquid securities by selling out to a big corporate enterprise. The corporate buyer gets a new revenue source, and the former owner of the business walks with millions. The big losers in this scenario are the employees, half of whom lose their jobs as the company’s operations are consolidated into the corporate buyer, and the local community that loses a solid employer that used to support local vendors and community efforts. Business consolidations often are bad for employees and communities, and few things encourage such destructive consolidations more than an ugly estate tax exposure.

So what is Congress going to do with this tax in the future? No one has a crystal ball nearly powerful enough to predict this one with any certainty. Many members of Congress complained bitterly in the 2010 tax extension debates, claiming that they were being held hostage – being forced to make a sweetheart deal on the estate tax to secure an extension of unemployment insurance benefits that many Americans desperately needed. They vowed to fight any extension of these tax breaks for the rich.

Looking ahead, there are four potential scenarios. First, Congress could be deadlocked and end up doing nothing, in which case the old, low $1 million free amount would return in 2013, along with the maximum 55 percent rate. Second, some believe that the stage has been set for a negotiation that will result in a complete repeal of the estate tax (the ultimate dream of many rich) as a quid pro quo for something much bigger that those on the left badly want. Third, there is the possibility that such a negotiated deal could result in the big breaks for 2011 and 2012 being made permanent or being extended for an additional term. And finally, the negotiation could result is the current breaks being watered down a bit. Many (including Obama in his newest budget) suggest that the free amount be set at $3.5 million and the maximum rate at 45 percent.

What should happen to this tax? For me, that’s an easier question. I don’t think it should be eliminated. It’s not that I like sending in the taxman at death or socking it to the ultra-rich when they’re down and out. It’s that the opportunity costs of killing the beast are just way too high. The cost-benefit ratio is lousy. But if the tax is going to live on, smart changes should be made to strengthen the tax, eliminate abuses, and soften the risks to family-owned businesses and farms. I’ll lay out my ideas in the next post. Stay tuned.

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