Fiscal Cliff Will Force Estate Tax Changes, Andy Friedman Predicts

A deal will likely include an estate tax exemption between $3.5 million and $5 million, and a 45% estate tax rate; gift tax exemption 'less clear'

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While the bulk of the fiscal cliff debate Washington is now embroiled in focuses on the income tax, the estate tax rate and the estate and gift tax exemptions also come into play. Any deal is likely to include an estate tax exemption somewhere between $3.5 million and $5 million, and a 45% estate tax rate, according to Andy Friedman of Washington Update.

Friedman, a political analyst, made these predictions in his latest commentary released Tuesday. As Freidman notes, the estate and gift tax exemptions are scheduled to fall and the estate tax rate to rise if Congress fails to address them during the current lame duck session.

As it stands this year, the combined lifetime estate and gift tax exemption is $5.12 million per person, and the estate tax rate is 35%. If Congress fails to act, in 2013 the combined estate and gift tax exemption drops to $1 million and the estate tax rate rises to 55%, Friedman says. “To the extent an investor uses his lifetime gift tax exemption, he is not permitted to use that portion of his estate tax exemption when he dies,” Friedman writes. “Essentially, by making the gift, he is accelerating his estate tax exemption and using it during his life. Doing so may make sense because the gift can appreciate during the remainder of the donor’s life and the full value at death is entirely free of estate tax.”

Andy FriedmanSo where will Congress and the administration end up on estate taxes? Friedman (left) predicts that if a deal is reached on taxes “generally”–either by year-end or retroactively after the new Congress convenes in January–any deal will likely follow what President Obama has already proposed: an estate tax exemption somewhere between $3.5 million and $5 million, and a 45% estate tax rate.

“I don’t believe that most members of Congress want to return to a $1 million estate tax exemption,” Friedman says. “Even the Democrats (who typically are less concerned about higher taxes on the wealthy) believe a $1 million exemption could require too many forced sales of family farms and businesses upon death to pay estate taxes. Similarly, both parties seem to feel a 55% tax rate on estates is too high.”

But where the gift tax exemption ends up is “less clear,” Friedman says. “Although Democrats believe a higher estate tax exemption is needed to keep family businesses intact for future generations, many do not see the need for a high gift tax exemption, which they view as a loophole allowing the wealthy to transfer significant assets tax-free during life.”

Thus, a final deal, Friedman predicts, “could ‘decouple’ the estate and gift tax exemptions (the situation that prevailed until 2011), and leave the gift tax exemption at $1 million.”

Once a deal is reached, Congress also is likely to extend the “portability” rules currently in effect but scheduled to expire at year-end, Friedman adds. “These rules allow one spouse to use any estate tax exemption not used by a previously deceased spouse,” a rule that he says is “relatively non-controversial.”

But Friedman says it’s important to note that both the president and members of the congressional tax-writing committees have proposed curtailing some sophisticated wealth transfer techniques, such as intentionally defective grantor trusts (IDGTs), grantor retained annuity trusts (GRATs), and family limited partnerships (FLPs).

For instance, Obama’s budget proposal, released last February, “would require a ten-year minimum term for GRATs and would include in an estate assets held in a trust the income of which is taxed to the donor,” he says. “Due to their complexity, Congress is unlikely to include these changes in legislation passed to address the fiscal cliff. More likely, these changes will be included in tax reform legislation to be considered next year. Any such changes presumably would not apply to assets transferred prior to the effective date specified in the law, although this result cannot be guaranteed.”

One final point, Friedman makes is that although “President Obama seems determined to extract more income taxes from affluent taxpayers, his public pronouncements have been much less focused on the estate tax.” Thus, he continues, “there is a possibility he might agree to extend the current estate and gift tax rules in exchange for Republican concessions to raise the income tax. Given his stated determination to impose his election ‘mandate,’ of course, such a result is far from assured.”

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Check out these stories on Andy Friedman at AdvisorOne:

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