The Estate Tax Mess

The so-called “death tax” on estate transfers was repealed at the start of 2010 but is scheduled to spring back to life in January. The 12-month window for tax-free estate gifts raises some interesting questions—and a whole host of hypotheticals. Billions are at stake, but uncertainty reigns. What is going on?

By Daniel Gross

Winter 2010

In 2010, signs of dysfunction in Washington, D.C., have been as abundant as the cherry blossoms alongside the Tidal Basin each spring. There have been the relentless filibusters, the rancorous debate over health care, and the unbecoming shouting episodes on the floor of the House. But for its sheer unpredictability and bizarreness, you can’t help but be impressed by the situation surrounding the
estate tax.

In big-picture terms, the estate tax—the federal tax levied on the value of property left to the designated heirs of a few thousand extremely wealthy Americans—is small change. Falling on only one in every 400 estates, it brought in about $23.4 billion in 2009, only 1.1 percent of federal revenue. But the estate tax has long occupied an outsized place in the debate over taxation. In 2001, Congress passed, and President Bush approved, a law that would decrease the tax gradually over eight years
before repealing it entirely in 2010—only to stipulate that it return from the dead, zombie-like, in its pre-2001 form in 2011 to menace the accounting and
legal professions.

Even in a practice area known for its complexity and occasional irrationality, the estate tax conundrum stands out. “Many tax provisions are passed on a temporary basis; many last for one or two years; some have retroactive provisions,” says Alex Raskolnikov, the Charles Evans Gerber Professor of Law at Columbia Law School. “But this one has a twist: In addition to a tax cut that stays for 10 years, in the last year it disappears altogether.” The upshot: A citizen slipping her earthly coil at 11:59 p.m. on December 31, 2010, can leave her entire $10 million estate to her heirs, tax free. But if she were to live just two more days, the total value of the gift would be only $6.4 million—a 36 percent difference. The same hypothetical person expiring on December 31, 2009, would have left about $7.1 million to her heirs. 

This legislative train wreck could be seen coming a mile—and nine years—away. When the law containing the estate tax’s death sentence and revival was passed in May 2001, New York Times columnist and economist Paul Krugman dubbed it the “Throw Momma from the Train Act,” since it would provide powerful incentives for people to kill off wealthy elderly relatives in 2010. And yet no evasive action was taken. “Everybody was confident in 2009 that nobody would allow January 1, 2010, to arrive without having done something to fix this crazy situation,” says Michael J. Graetz, the Isidor and Seville Sulzbacher Professor of Law and the Columbia Alumni Professor of Tax Law. The strange tale of the long-awaited demise and impending resurrection of the estate tax, known to its critics as the “death tax,” is a case study in the triumph and ultimate failure of interest group politics.

The estate tax’s long
history is largely bound up with efforts to finance national security. Congress enacted the first direct tax on inheritances during the Civil War; it was repealed five years after Robert E. Lee surrendered at Appomattox. In 1916, as the nation was gearing up for World War I, the Revenue Act of 1916 levied taxes ranging from 1 percent—after a $50,000 exemption—up to 10 percent for estates valued at more than $5 million. During the New Deal era, Franklin D. Roosevelt repeatedly raised the estate tax, partly in an attempt to lessen the impact of the Great Depression. The levy stuck and lived on for the next several decades, although it was frequently tweaked.

“A lot of things had to come together for the estate tax to be repealed,” says Michael Graetz. In Death by A Thousand Cuts: The Fight Over Taxing Inherited Wealth, the 2005 book he co-authored with Yale political scientist Ian Shapiro, Graetz describes how advocates worked for nearly 25 years to cobble together an extremely unlikely coalition—African-American tree farmers and billionaires, conservative Republicans and liberal Democrats—that turned a tax that only affected elites into a populist cause. The booming stock market led many Americans to believe they would inevitably amass large, taxable fortunes, and on the campaign trail in 2000, George W. Bush “found that when he talked about killing the ‘death tax,’ which is the way he phrased it, it was one of his biggest applause lines,” says Graetz.

But the coalition of lobbyist-backed small businesses and very wealthy families had somewhat divergent interests. There are two vital components of the estate tax—the exemption (the amount that can be passed down free of tax) and the tax rate (the percentage levied on the value of the estate above the exemption). Very wealthy families 
cared less about the exemption and much more about reducing tax rates. (For an estate of $300 million, the difference between being taxed at 35 percent and 45 percent comes to $30 million.) For small business owners, however, whether the exemption rate stood at $3 million or $5 million meant the difference between avoiding the tax and being subject to it. As a result, says Graetz, “the only thing they could agree upon was repealing the tax altogether.”

The same rules that forced the Senate to pass President Obama’s health care reform proposal through the so-called “reconciliation” process pushed President Bush and his congressional allies to make the estate tax repeal—and all the other tax cuts—essentially temporary. Measures that cause revenue loss beyond the 10-year budget window must be approved by 60 votes. But there were only 58 votes in the Senate in support of the package. To delay its fiscal impact, the plan was structured to be phased in slowly. The rate would fall from 55 percent in 2000 to 45 percent in 2009, with the exemption rising from $1 million in 2002 to $3.5 million in 2009. Then the tax would vanish altogether in 2010, only to bounce back to the 2001 level—a $1 million exemption and maximum rate of 55 percent—in 2011. The theory, says Alex Raskolnikov, was that Washington wouldn’t allow the law simply to expire, “because the expiration would be sold as a big tax hike.” When the tax cuts passed, a White House official told CNN, “We can’t envision a scenario in which the U.S. Congress will want to re-impose” the tax on married couples and the tax on estates.

Famous last words.

“I don’t think anybody thought Congress would be so irresponsible to let this situation arise without a resolution,” says Alan Halperin ’85, a partner and co-chair of the personal representation department at Paul, Weiss, Rifkind, Wharton & Garrison. Over the past decade, the changes were phased in, and collections generally fell—from about $29 billion in 2000 to $23.4 billion in 2009. But Congress routinely misses its own deadlines and has difficulty focusing beyond the next news cycle. While the Republican-controlled House voted for permanent repeal of the estate tax several times, it never got through the Senate.

Then the culture, the politics, fiscal dynamics, and the zeitgeist began to shift—and fast—against permanent repeal. The 2008 election swept Democrats into control of the White House, as well as into large majorities in both chambers of Congress. Few Democrats favored outright repeal. Given the bailouts on Wall Street, the outrage over 
executive compensation, and rising income inequality, measures that appeared to favor the wealthy grew increasingly unpopular. In addition, the return of massive deficits clouded the prospect for the continuation of all the Bush-era tax cuts.

The larger narrative was changing, too. Early 20th-century proponents of the estate tax, such as Theodore Roosevelt, had argued that the idea of multigenerational inherited wealth was contrary to the idea of American equality. “Andrew Carnegie thought that if you left too much money to a child, you would ruin him or her,” says Graetz. But modern-day critics had tagged the estate tax as a penalty on hard work, owning your own business or firm, and thrift. In their book, Graetz and Shapiro suggested the conversation focus on beneficiaries. “We said it’s not a tax on Conrad Hilton; it’s a tax on Paris Hilton,” Graetz notes. As pundits and politicians ran with this meme, the “death tax” repeal began to be framed as a measure that benefitted a spoiled reality-TV star.

Meanwhile, in Washington, D.C., congressional Republicans, the chief advocates for estate tax reduction, adopted an all-or-nothing mentality that frequently proved self-defeating. And the coalition that had formed around repeal 10 years earlier began to split. It became clear over the course of last year that an extension of the 2009 regime—a 45 percent rate and a $3.5 million exemption—was the most likely outcome for the estate tax going forward. But, Graetz notes, wealthy families held out for a lower rate, while the small business advocates were pushing for a higher exemption. The House of Representatives voted in December of last year to make the 2009 law permanent, but advocates in the Senate were unable to produce 60 votes for a long-term solution, and Senate Republicans refused to allow a vote on
the measure.

When the ball dropped in Times Square at the end of 2009, a new vista emerged. Wealthy Americans were suddenly given a 12-month window in which they could, in effect, massively increase their net worth if they were to die in the coming year. The idea sounds laughable. But, as Alex Raskolnikov notes, it’s an accepted fact in economics and finance that the tax code can be a powerful spur to behavior. Investors sell stocks to lock in tax losses in December; babies are more likely to be born in late December than early January, as parents try to take advantage of the tax credit in the current year.      

Wojciech Kopczuk, a professor of economics at Columbia University, has charted how mortality rates of the wealthy changed when estate tax modifications were looming. The conclusion of a 2003 paper he co-authored with Joel Slemrod of the University of Michigan, titled “Dying to Save Taxes: Evidence from Estate Tax Returns on the Death Elasticity,“ notes: “Evidence from estate tax returns suggests that some people will themselves to survive a bit longer if it will enrich their heirs.“

Kopczuk says that since the data was old and the effect may reflect ex post doctoring of the reported date of death, it is not possible to draw a strong conclusion 
from that paper. But the idea that heaven can be made to wait is not all that far-fetched. In the first week of 2000, hospitals in New York saw 50.8 percent more deaths than they had in the last week of 1999—the theory was that people were essentially willing themselves to live a few extra days in order to see the new millennium. Ceasing to live, though, would seem to be a radical, irreversible effort to avoid taxation. “I wouldn’t expect to see a lot of rich people prematurely dying in 2010,” says Kopczuk.

Nonetheless, the volatility and uncertainty has resulted in additional work for estate lawyers throughout the nation. Some clients have taken the temporary disappearance of the generation-skipping transfer tax to make large outright gifts to grandchildren, and the need to inform clients of the current state of the law has been paramount. “One of the areas of some concern is the use of formula clauses in wills,” says Frank P. Reiche ’59, of counsel at the Haddonfield, N.J.-based law firm Archer & Greiner. For instance, standard provisions in wills may stipulate that assets pass to children to the extent the Internal Revenue Service allows them to do so tax free, while the rest goes to the spouse. In a regime where there is no estate tax, notes Raskolnikov, “a will with this language could effectively disinherit a spouse.”

Meanwhile, lawyers and clients have to brace themselves for the possibility that, on January 1, 2011, rates will return to the much higher levels of 2001. With one quarter of the year gone, Washington hasn’t acted. As things stand, the entire package of 2001 tax cuts—on income tax, capital gains, and estates—is slated to expire next January. The Obama administration and its congressional allies have placed a premium on extending some of the cuts—e.g., the lower income tax rates on households making less than $250,000—and on cushioning the rise of taxes on capital gains. But the administration’s budget calls for the estate tax to be extended at its 2009 rate for several years—a move that would bring in $274 billion in revenues over the next 10 years. Repeal, which would decrease federal revenues by $630 billion between 2012 and 2021, according to the Center on Budget and Policy Priorities, would seem to be off the table. “We are dying for revenues,” says Raskolnikov. “It’s just a question of how high the rates are going to be next year.”

More significantly, the coalition that was so successful in eliminating the death tax—if only for a year—may have split for good. “The small business crowd is focused on the exemption, and others are focused on the rates,” says Michael Graetz. “And Democrats are much more attuned to arguments about the need for progressivity in the tax code today than they were a couple of years ago.” Plus, in an age when many Americans are feeling much poorer than they were a few years ago, there is likely to be little sympathy for the few affected by the tax. If the 2009 rates are extended, only one in 400 Americans who die, or .25 percent, will owe any estate tax in 2011, according to the Urban-Brookings Tax Policy Center. It’s entirely possible, of course, that rates will simply revert to their pre-2001 levels. Then it would be as if the whole decade simply didn’t happen. “Everybody assumes that this will all get fixed in 2010,” says Graetz. “Of course, that’s what everybody thought last year.”

Daniel Gross is a senior editor at Newsweek and writes the "Moneybox" column for Slate.

Illustration by David Plunkert