A catastrophe coming: One year to goArticle added by Al Jacobs on January 25, 2010

Al Jacobs

Laguna Beach, California, CA

Joined: August 21, 2010

My Company

On the Money Trail

Welcome to the New Year! With 2010 upon us, it's appropriate to remind all Americans, once again, of a tax law time bomb that continues to tick methodically. There are now only twelve months to go before detonation. What is the cause of this coming disaster? Let me take you back nearly nine years so you may witness its creation.

On May 26, 2001, the U. S. Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001. Twelve days later, newly elected President George W. Bush signed it into law. Judging by the orchestrated pronouncements at the time, Americans finally obtained tax relief. The most immediate consequence of the new law, and on which attention focused, seemed to be one-time refund checks mailed out the following summer -- up to $300 to individual taxpayers and $600 to married couples. As expected, politicians seized on what many citizens perceived as a windfall to take credit for this munificence.

Time has passed since then, with few persons ever understanding the actual details of this very complex legislation, not widely publicized, which included a stipulation designed to override everything: All the modifications enacted by the tax act expire on January 1, 2011. Known commonly as a "sunset provision," the result will be a reversion to the 2001 rules on that date. Whatever the mixed blessings, by and large the substance remains buried in accolades.

At the risk of sounding contrary, let me give you a different analysis of the bill. It's necessary, as with so many other aspects of life, to separate illusion from reality. There's a time-honored adage: The devil is in the details. In this case Satan in all his horror is firmly imbedded in one specific element of the act's estate tax portion. I am convinced this provision, if not rescinded beforehand, will prove to be the most massive tax increase in our nation's history. I'll explain -- but first, a little background.

The estate tax law exists mostly unchanged over the years. Upon death, the deceased's assets are valued. A portion of the estate known as the unified credit is subtracted from the total. The remainder is then subject to tax at rates that in 2001 started at 18 percent on the first $10,000, rapidly increased through 16 separate brackets until it reached 55 percent on sums exceeding $3,000,000. The changes purported to address this by gradually increasing the credit while reducing the rates. However, under the sunset provision, Nirvana will be short lived. On January 1, 2011, the credit and brackets revert to the status in 2001. Instead of waking up from a nightmare, it will be more like waking up to a nightmare.

If this concluded the story, I might concede some tax relief resulted -- albeit temporary -- particularly for those with the good judgment to die before 2011. However, there is a matter known as "stepped-up basis" which inserted an entirely new element into the mix. I'll illustrate with the following example. Aunt Emma, having eaten four too many cannolis' at her 74th birthday party in 2003, passed on to her great reward, leaving behind the home she purchased forty years earlier for $20,000. Upon her demise its market value hovered at $400,000. In any event, her nephew Rollo -- probably an undeserving lout -- became sole heir to her estate. His first thought: sell the house. Let's see how he fared on its sale. The sales price less his cost basis determined taxable income. In the hands of an inheritor, cost basis of property becomes the market value at the time of decedent's death, known as stepped-up basis. So Rollo's tax consequences on the sale appear simple to calculate: sales price $400,000; cost basis $400,000; taxes owed on the difference: zero, zip, nada.

Let us now fast-forward to January 1, 2011. Presume Aunt Emma displayed the good sense to avoid those cannolis eight years earlier, thereby percolating on happily for a time. However nothing is forever, and the New Year's Eve dinner --consisting of gnocchi, di patate, pappardelle with stuffed tomatoes, and a double serving of tiramisù -- proves more than her 82-year-old digestive tract can handle. This time there is no escaping the inevitable -- Aunt Emma's chips are irrevocably cashed. It's time to do Rollo's math once again, but under the rules which will exist in 2011. Sales price: still $400,000 (sorry, but a sour economy prevented an increase in value during those eight years). Cost basis: What do you guess this time? If you expect it to be market value at the time of death, you are wrong, wrong, wrong! The 2001 "tax cut" did away with the stepped-up basis after 2010. In its place will be decedent's adjusted cost basis. In short, Rollo's basis will be the same as Aunt Emma's: $20,000. This time the tax consequences on the sale work out a little differently: sales price $400,000; cost basis $20,000; Rollo incurs a $380,000 taxable capital gain. Now multiply this by the tens of millions of estates to be affected and you get an idea of what occurred. Whatever its description, one thing is certain -- tax relief it was not.

How did we come to this? I suspect few members of congress possessed any inkling of what they voted into law, nor did President Bush and his advisors realize what had been slipped into the statute. They all merely engaged in the time-honored practice of enacting feel-good legislation, with the real culprits probably long-tenured staff members of the House Ways and Means Committee who plotted for decades to accomplish this goal. But for a last minute reprieve, they almost managed it in the late 1970s. Whether they've pulled it off this time, we shall see.

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