Estate tax: Try again in 2010

NEW YORK (CNNMoney.com) -- Lawmakers will start 2010 with a hefty to-do list thanks to a lot of unfinished tax business they left on the table in 2009. The chief example: the estate tax.

Senate Democrats failed to reach a deal with Senate Republicans to temporarily extend the estate tax into 2010, when it is scheduled to be repealed for one year.

But that doesn't necessarily mean there won't be any tax on inheritances in the year about to start.

Senate Finance Chairman Max Baucus, D-Mont., and House Ways and Means Chairman Charles Rangel, D-N.Y., have said they will try to get it reinstated for 2010 after the new year.

"We would clearly work to do this retroactively so when the law is changed, however it is changed, or if it is extended next year, it will have retroactive application," Baucus said on the Senate floor earlier in December.

Baucus and others were pushing to temporarily extend the estate tax in 2010, when lawmakers are expected to debate what permanent changes they wish to make to the tax.

The temporary extension would have kept the 2009 estate tax levels in place: the first $3.5 million of an estate would be exempt from the estate tax and the highest rate on the taxable portion of an estate would be 45%.

Those levels don't capture a large number of estates. 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.

Imposing a tax retroactively can create administrative and planning headaches for accountants, lawyers and heirs of estates. And it is almost a guarantee that the IRS will get an earful from heirs of large estates arguing that they don't owe the estate tax, if a decedent died during the months when the repeal was in place.

"If it's my client, I'm challenging that baby," said Chuck Schultz, director of private wealth and tax advisory services at RSM McGladrey. "It's going to be a real mess to have a two-month repeal."

But, Schulz said, practically speaking, the counterpoint to such challenges is the fact that even if the repeal is in effect through February or March, executors still have nine months from the date of death to file the federal estate tax return, and they have the choice of valuing the estate either at the date of death or six months from the date of death.

So that window of time is arguably sufficient to allow an executor to plan for a reinstated estate tax.

Given that there are not 60 votes yet in the Senate to support a temporary extension of the estate tax, it's not clear whether there will be a sufficient number of votes next year either.

If the attempt to make the tax retroactive fails and the repeal stands, that still doesn't mean there won't be any tax consequences for those who inherit assets.

That's because along with the repeal of the estate tax, the so-called "step-up" in basis for heirs of any estate, no matter how large or small, would be limited to the first $1.3 million in assets -- plus up to an additional $3 million for a beneficiary who is the surviving spouse of the deceased.

The step-up simply means that when heirs sell an inherited asset, they only owe capital gains tax on the asset's appreciation from the day the asset was inherited to the date of sale rather than from the day the asset was originally purchased by the decedent.

Say a parent buys stock at $20 a share, dies and leaves it to his son when the stock is trading at $60 a share. If the son later sells the stock at $80, he only owes capital gains tax on the $20 gain ($80-$60), rather than the full $60 gain that his parent would have owed.

Under estate tax repeal, however, the son could owe capital gains tax on the full $60 gain assuming the assets in his father's estate exceed the $1.3 million threshold.

So any heirs of estates that fall between $1.3 million and $3.5 million next year will pay more in capital gains tax than if there were an estate tax in place, said Roberton Williams, a senior fellow at the non-partisan Tax Policy Center.