Written By:  Daniel Kwak
Researched By:  Amanda Husted
Edited By:  Casey E.R. Sanders
Managing Editor:  Mary Anne Nash

Perhaps God himself put it best when he said, “[n]aked a man comes from his mother’s womb, and

as he comes, so he departs.” While many have tried to take earthly possessions with them, often in unusual ways, the fact is that one’s property is generally left to living friends or relatives. For the very wealthy, this process may be more complicated in 2010 than in past years. Congress’s next move in the estate tax arena is clouded with uncertainty, and that has left wealthy families with large estates in a state of confusion. In the wake of the massive healthcare overhaul, Congress has now set its eyes on addressing the estate tax system. The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) phased out the estate tax over ten years and ended with a complete repeal of the tax in 2010. While Republicans had hoped to make the repeal permanent, the current Democratic Congress has affirmed its temporary status.

Congress has yet to officially address the estate tax lapse with new legislation. As such, estate taxes will not be imposed this year, making 2010 the cheapest year to die in recent American history. According to some estate and financial planners, however, it is also the most confusing year to die. Sarah Spear, director of policy and public affairs at the Association for Advanced Life Underwriting, has stated that the need to finance the implementation of new healthcare provisions makes the estate tax mess even messier. Estate planners expected a change in the law before the 2010 repeal, and Congress’s inaction came as a surprise to most. Legislators are now scrambling to clean up the mess created by the 2010 repeal and have discussed a variety of solutions to the problems it created. One of these possible solutions is a retroactive application of 2009 rates.

A Brief History of Estate Taxes

Americans have always known that nothing’s certain but death and taxes, but how did that come to be? Governments have imposed estate taxes on citizens as early as 700 B.C. Historians estimate that three thousand years ago, there may have been a 10 percent tax on property transfers at death in Egypt. Augustus Caesar imposed a tax on any transfers made to anyone except close relatives. In the United States, estate taxes began with the Stamp Act of 1797. Although the Act was repealed in 1802, the federal government continued to use estate taxes as a means of generating revenue during national emergencies.  This was especially true during times of war, when extra financing was needed. In December 1906, President Theodore Roosevelt, concerned about the growing concentration of wealth and power in the United States, urged Congress to pass a federal estate tax that would “put a constantly increasing burden on the inheritance of those swollen fortunes, which it is certainly of no benefit to this country to perpetuate.”

Ten years later, Congress changed its pattern of sporadic and temporary estate taxation by introducing a permanent federal estate tax and a personal income tax as part of the Revenue Act of 1916. During the late 1960s and early 1970s, legislators were set on closing loopholes in the Tax Code and passed the Tax Reform Act of 1976, leaving us with the current estate tax system.

The Current Taxonomy:  Estate Taxes in the Twenty-First Century

Under § 2001 of the 2009 Internal Revenue Code (“IRC”), a tax is imposed on the transfer of the estate of any deceased person (decedent) who is a citizen or resident of the United States. The amount of tax is determined in accordance with rate tables provided by the Tax Code.  In 2009, the highest tax rate was forty-five percent for estates of $3.5 million and higher. Although there is no estate tax rate for 2010, it is set to go back to the initial EGTRRA rate of a fifty-five percent maximum for estates over $1 million in 2011.

In addition to the estate tax lapse, a carryover basis has been introduced for 2010. Under the IRC, basis is defined as the cost of the property. The previous estate tax system used a decedent’s date of death value in determining basis. This resulted in a large break for beneficiaries inheriting property that had increased in value since the decedent purchased it. Essentially, beneficiaries were not taxed on the appreciation the decent enjoyed while the decedent owned the property—which can be a huge windfall for beneficiaries.

For 2010, however, people who escaped estate tax liability may end up paying taxes on a higher amount of capital gain than they would have in 2009. For example, assume your grandfather purchased a house in 1950 for $10,000 and died in 2010 when it was worth $100,000. If he left that house to you, and you sold it for $110,000, under the old system your gain on that sale would have been only the $10,000 you made above the $100,000 it was worth at the time of his death. You would then pay capital gains tax on the $10,000 you made above the value of the house at his death. However, using the new carryover basis rule under the same facts, the IRS would say that you had a gain of $100,000 because the house was originally worth $10,000 and you sold it for $110,000. This means that you would end up paying capital gains tax on $100,000 this year, rather than on $10,000. As you can see, the new carryover basis rule results in a substantial change in one’s tax liability.

Now that Congress has turned to addressing the estate tax system, some experts speculate that legislators may decide to give taxpayers the option of paying either an estate tax or capital gains tax. House Committee on Ways and Means Chair Sander Levin has stated that the House prefers to keep the estate tax at 2009 levels and make those levels retroactive to January 1, 2010. While some in the Senate are against retroactively reinstating the estate tax, Representative Levin said that he is willing to negotiate a compromise that allows taxpayers to pay lower capital gains tax rates in exchange for a retroactive tax. Legal scholars, however, disagree as to whether Congress should be allowed to retroactively apply the tax.

A Taxing Problem

Under Article I, Section 9 of the United States Constitution, ex post facto laws are expressly prohibited. Ex post facto laws are essentially laws that are applied retroactively. However, a large body of federal case law provides that retroactive tax laws are not ex post facto, and are thus constitutional. In a landmark decision, the U.S. Supreme Court in U.S. v. Carlton unanimously upheld as constitutional a change in the Internal Revenue Code that was applied retroactively. The Court held that the Due Process Clause was not violated because the law had a legitimate purpose—to address a mistake in the Tax Code. Because Congress made the Code amendments promptly after discovering the loophole, the Court rejected detrimental reliance arguments. This means the taxpayer argued that it was unfair to apply the law retroactively because the taxpayer relied on the old law to its detriment. Additionally, the Court stated in dicta that passing limited retroactive revenue statutes is a “customary congressional practice,” and that these statutes are typically “confined to short and limited periods required by the practicalities of producing national legislation.”

It is likely that a legislative fix applying 2009 estate tax rates retroactively would be considered an attempt to address a mistake in the Tax Code. However, whether this action would be considered prompt and timely is unclear. The Tax Code amendment in Carlton was introduced approximately one year after the government discovered the loophole. On the other hand, although retroactive estate tax application would be addressing the estate tax repeal within a year of its lapse, Congress was fully aware of the lapse well before it took place, making detrimental reliance arguments by taxpayers a little more persuasive.

The State of the Estate Tax

Taxing the transfer of wealth from one generation to the next has been a common government practice in the United States since the early twentieth century. The estate tax generates billions of dollars in revenue annually, even though less than 2 percent of estates actually pay an estate tax. The fact that this is an extremely valuable source of government funds suggests that Congress will address this issue sooner rather than later, and retroactive application of 2009 rates appears to be a frontrunner among possible legislative fixes.

Congressional inaction and rumors of possible legislation have left both wealthy taxpayers and the estate planning community waiting in anticipation. Estate tax consultants who are accustomed to seeing clients every few years are now being advised to maintain regular contact with clients because of this “fluid situation.” However, with the future of the estate tax in limbo, attorneys are as confused as clients and will likely respond to most client questions with one answer: “God only knows.”