Federal Estate Tax Repeal -- WBO's Should Look Closely at the Fine Print

Most folks don't understand that the much ballyhooed estate tax repeal carries a nasty surprise for smaller estates. Writing in the Washington Post today, Allen Sloan, the Post's Business Columnist and Newsweek's Wall Street editor, points out the negative impact of the change from stepped-up basis to carry-over basis for what he calls the estates of the "small rich."

Under current law, when someone dies, the estate pays a tax if it's over a certain size, but the tax basis of inherited property for the heirs is the market value at the date of death (stepped-up basis). Under the law if estate tax repeal is made permanent as now drafted, the estate won't pay a tax if it's small enough but the tax basis of inherited property for the heirs will be the same as the tax basis for the person from whom they inherited (carry-over basis).

Here's Sloan's example that illustrates the adverse impact of this change coupled with current and future exemptions:

Under current law, when you die your heirs get stepped-up tax basis. That means the assets you bequeath are valued for income-tax purposes at what they were worth the day you died -- not what you originally paid for them. Say you paid $50,000 for stock that's worth $500,000 when you die. Your heirs can sell it for $500,000 and owe no tax on the $450,000 gain. As long as your total estate doesn't exceed the exemption limits, there's no estate tax, either.

Now watch. Under the 2009 rules, estates of up to $3.5 million ($7 million for a married couple) would be exempt from federal estate tax. The tax rate on assets above that level would be 45 percent. Inheritors would be able to step up the basis of $3.5 million (or $7 million) of inherited assets to their value the day they inherit them. Fast-forward to 2010, when the estate tax is repealed. Yes, the estate tax would be gone. But heirs would be able to step up only $1.3 million in assets to their value on the day of death. (Don't ask why; that's just how it is.)

Assets beyond $1.3 million would be valued for tax purposes at carry-over basis -- their cost (for income-tax purposes) for the person who died. So any estate with $1.3 million to $3.5 million in assets ($2.6 million to $7 million for a married couple) is worse off under full repeal in 2010 than it would be in 2009. Inheritors in the $1.3 million-to-$3.5 million range would face higher taxes if they sold inherited assets than they would under the 2009 rules. At the very least, they would have complicated paperwork to deal with. They'd be much better off inheriting in 2009 than in 2010. But if you're dealing with an estate of $3.5 billion rather than $3.5 million, you'd be far better off inheriting in 2010.

How many folks will get the fuzzy end of this lollipop?

Sloan says that a Joint Tax Committee study estimates that only 7500 people will have estates over $3.5 million in 2009, but 63,900 will have estates between $1.3 and $3.5 million.

Now, if we do nothing and we revert to the law before temporary estate tax repeal, the estate tax exemption will go back to $1 million in 2011 which will hurt a lot of small businesses and family farms. None of us should want that to happen.

But, as Sloan says, that doesn't mean that our only choice is to make permanent the 2010 rules that will subject 63,900 estates to higher taxes while helping out only the 7500 people with mega-estates.

His recommendation?

It seems to me that adopting the 2009 rules, indexing the exemption for inflation and allowing stepped-up basis would get us back to the original intent of the estate tax. Taxing 7,500 estates a year doesn't seem unfair. And it would generate significant revenue.

That may not be the "right" solution for everyone, but every woman business owner should look carefully at how her estate would or would not be affected by the change in the rule governing the tax basis of inherited property before signing on to support the current proposal to make the 2010 estate tax rules permanent.