Estate tax: Cancel the death knell

NEW YORK (CNNMoney.com) -- Next year was supposed to be a great year for you to die. Not great for you, of course, but for your heirs who would inherit your wealth completely tax free.

It turns out that probably won't be the case.

The federal estate and gift tax is set to expire on Dec. 31 and be repealed for all of 2010.

But no one expects lawmakers will let that happen.

And those who have been campaigning for its permanent repeal are likely to be disappointed, too.

The debate is no longer whether to get rid of the estate tax altogether, but rather what the parameters should be for the long run.

The House on Thursday voted 225 to 220 in a mostly party-line vote to permanently extend the tax in its current form.

That means the first $3.5 million of a person's estate - and the first $1 million of gifts - would be exempt from the tax. And the highest rate applied to the taxable portion of an estate would be 45%.

Those levels don't snag a lot of folks. Of the roughly 2.5 million Americans expected to die in 2009, only 5,500 - or 0.25% - will have estates large enough to be taxable, the Tax Policy Center estimates.

The House bill would increase the deficit by $234 billion over 10 years, according to the Joint Committee on Taxation. That's because even though current law would repeal the tax for one year, it reinstates it by 2011 at an exemption level of just $1 million, which would mean an increasing number of estates would be subject to the tax as years went by.

The House bill now moves to the Senate, but its prospects there are less clear.

For one thing, there are competing ideas in the upper chamber for what a permanent estate tax should look like. One leading bipartisan proposal in the Senate would set the exemption amount at $5 million and set the top estate tax rate at 35%.

Most Republicans advocate for the lowest estate tax possible, but Democrats "are not of one mind on this," said Clint Stretch, managing principal of tax policy at Deloitte Tax.

So there is a chance that a lower estate tax could garner sufficient support when the Senate takes up the issue.

Practically speaking, however, it's unlikely to do so before the end of the year. With health care dominating the day, it will be hard to get serious legislation in edgewise.

But don't be fooled: The Senate is likely to rally around a short-term fix and pass a one-year extension of the tax at 2009 levels by Dec. 31.

"The Senate is a wondrous place. The impossible becomes possible when it has to," Stretch said.

Here's why: If Congress waits until next year to temporarily extend the tax, making it retroactive to Jan. 1, it creates a lot of headaches.

Consider the person who makes a large gift in early 2010 before lawmakers act. He would make the gift assuming that it has no tax consequences because, in fact, that would be the case when the gift is made.

But if lawmakers then turn around and restore the tax, making it retroactive to Jan. 1, the gift could be retroactively subject to tax or reduce the gift-giver's $3.5 million lifetime exemption.

If that's the case, lawmakers can expect to hear some serious what-for from wealthy constituents.

Of course, while the federal estate tax may be a headache for the few, far more Americans will have to pay another estate tax. Nearly half of all states have an estate tax, an inheritance tax or both. And typically states' exemption levels are much lower than the federal estate tax exemption.