Estate tax repeal seen bringing chaos

By Kim Dixon

WASHINGTON (Reuters) - The scheduled expiration of the tax on wealthy estates in the United States, unthinkable just days ago, has whipped the wealthy and their estate planners into a flurry of confusion over the changes to the controversial tax.

Under a quirk in the law, beginning on January 1 there will be a one-year repeal of a 45 percent tax on the value of estates over $3.5 million for individuals and $7 million for families.

"I'm going to be fending calls from people saying, 'Should I keep mom plugged in?'" said Carol Harrington, head of the private client group at law firm McDermott Will & Emery. "This is a disaster even if you are in favor of repeal."

Now, those who die on December 31 will pay the tax, while those who die a day later will not. In addition, the law's expiration unleashes a slew of changes, including for capital gains treatment of estates.

And because of the same quirky 2001 law that repeals the tax for a year, the estate tax is due to spring back to life in 2011 at a higher rate of 55 percent rate, which would be levied on estates with a value over $1 million for individuals.

The conventional wisdom had been that the Democrat-controlled Congress would pass an extension of current law. But opposition from Republicans to the tax and a U.S. Senate mired in a partisan health-care debate has prevented that from happening.

Once the current estate tax expires on December 31, those inheriting states will have to pay capital gains taxes on any assets sold based on the original price paid for the asset, after an exemption for the first $1.3 million in capital gains.

That is changed from the current law, which uses the market value of an asset at the time the estate is inherited as the basis for calculating capital gains on any future sale.

This will mean higher taxes for as many as 70,000 taxpayers, according to House Democrats, many more than will be impacted by elimination of the estate tax itself.

Tax experts say that the change will create a major problem because of the paperwork needed to establish the original investment price. Without documentation, the original basis goes to zero, meaning that the full sale price would be taxable after $1.3 million.

"Many people don't keep records," said Brenda Schafer, manager of tax analysis at the Tax Institute at H&R Block. "It's not like we can go back in time and get those records."

The estates of about a quarter of 1 percent of Americans would be subject to the estate tax under an earlier bill introduced by Democrats to extend it permanently, according to the Brookings Institution-Urban Institute Tax Policy Center.

CONSTITUTIONALITY OF A FIX

An aide to Senate Finance Committee Chairman Max Baucus said Baucus still holds out hope for an 11th-hour extension of the current tax, though most analysts are dubious.

"I am stunned that the Democrats, who have professed undying support for estate taxation all these years, have been in power for now this time, and not enacted" an extension," said Bill Ahern, policy and communications director at the conservative Tax Policy Foundation, which backs a repeal of the estate tax.

The tax has divided some Democrats, with conservatives from the party teaming with Republicans to propose a lower tax with a greater exemption level.

The battle will likely begin anew next year. Baucus said he will aim to retroactively reenact the tax at current levels, a policy backed by most Democrats.

But Clint Stretch, a former legislative counsel to the joint congressional committee on taxation, said there is a debate about the constitutionality of such a fix.

"Since scholars are divided in their opinions on whether the Constitution allows Congress to retroactively reimpose those taxes, litigation will result," he predicted.

And the politics are complicated by the reinstatement of the tax at a higher rate in 2011.

Progressive groups such as the Citizens for Tax Justice see this as the silver lining of a one-year repeal.

The specter of higher rates has led traditional opponents of the tax, such as the Chamber of Commerce and small business groups, to back a permanent extension of current policy.