Impending Estate Tax Quagmire

Congressional inaction raises constitutional issue

It appears that an attempt to prevent a temporary lapse in the estate tax has failed, according to remarks of a key legislator reported by Dow Jones Newswires. Tax legislation passed in 2001 slated the tax for temporary repeal, applying only to individuals dying in 2010. It was widely expected that Congress would act to prevent this temporary repeal, but negotiations broke down over issues such as the tax rate and the size of the exemption. Earl Pomeroy (D-ND), a member of the House Ways and Means Committee, was quoted as saying "the prospects are 100%" that Congress will reinstate the tax next year, retroactive to January 1. The result will be a legal quagmire that will take many years to resolve.

The constitutional issue

The Supreme Court has never suggested that tax laws with retroactive application are automatically unconstitutional. On the contrary, it has rejected a number of challenges, acknowledging that a tax law enacted during the course of a year can take effect at the start of that year, and perhaps even earlier in appropriate circumstances. Congress does not have an entirely free hand, however. Retroactive application of a tax law may be an unconstitutional violation of due process if it is found to be harsh and oppressive.

It is axiomatic that all taxes are considered harsh and oppressive by the persons required to pay them. The question of when the Supreme Court will agree is another matter. There is reason to believe a challenge to retroactive reinstatement of the estate tax would have a fighting chance. The strongest support for such a challenge would come from precedent involving the gift tax. A later case involving the minimum tax refused to apply that precedent because the minimum tax applies to an annual period, whereas  "the gifts in question were made and completely vested before the enactment of the taxing statute." A transfer of wealth as a result of a death is similar to a gift, so it would not be as easy to reject a similar argument in connection with the estate tax.

This is not to say that invalidation of the estate tax for this period is a certainty — in fact, it's probably a long shot. We can't be certain it will fail, however. Meanwhile we can be sure of the following. If Congress fails to take action before January 1, some individuals with large estates will die before Congress can pass a law reinstating the tax. Administrators or beneficiaries will mount a constitutional challenge to the retroactive application of the new law, and the final outcome of that challenge will not be known for at least several years.

It gets ugly

If you're a beneficiary of an estate that is challenging this law, you don't know for sure how much money you inherited until the Supreme Court issues its ruling. The difference may be substantial, affecting decisions you make about your lifestyle and your investments over a period that may last many years.

What's more, you don't know the tax basis of the assets you inherited, because the answer is different depending on whether the new law is allowed to apply retroactively. This means there is a question mark hanging over the income tax return for any year in which you sell any of these assets.

Beneficiaries of an estate that does not challenge the law are not immune from issues. A ruling that retroactive application of the law is unconstitutional may come too late for these individuals to recover the estate tax unless they file protective claims. Even if they're prepared to forgo any benefit from such a ruling, they may face uncertainty regarding the income tax consequences when they sell inherited assets.

If not retroactive it's still ugly

While Pomeroy rates the prospects of reinstatement as of January 1 at 100%, the same dynamic that is preventing action now could continue into next year, perhaps standing in the way of a retroactive law. The constitutional issue would go away, but a host of other issues would arise. The unique circumstance of having a brief period when the estate tax doesn't apply will almost surely lead to questions as to whether wills and trusts drafted under the assumption that the tax would remain in force truly reflect the intent of the decedent. Consider, for example, a provision giving the children the amount they can receive free of estate tax and the rest to a spouse. Elimination of the estate tax would disinherit the spouse under such a provision.

Under current law, beneficiaries generally receive assets with a basis equal to their value on the date of death. They don't need to know the decedent's basis in the assets. This adjustment in basis doesn't apply if the estate tax Without the basis step-up that goes along with the estate tax, beneficiaries will have to learn the decedent's tax basis in the assets they inherit, some of which may have been acquired many years before the decedent's death.

The possibility of a temporary lapse in the estate tax may seem like a small concern in comparison with the weighty matters on the congressional agenda, but the costs of delay in addressing this issue will be with us for many years to come.

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