The U.S. Senate, distracted by the debate over health care, has decided not to act before year end to extend the estate tax. As a result, it now appears that the estate tax will be repealed for persons dying on or after January 1, 2010. At the same time, taxes will rise for thousands of middle-class heirs.

The troubles began with the enactment of estate tax reforms in 2001 which led to a gradual decrease in estate taxes. The current tax of 45% on estates worth more than $3.5 million is slated to expire in 2010. But it doesn't go away permanently. In 2011, without congressional action, it will revert to a rate not seen since the 1990s: up to 55% on estates worth more than $1 million. Earlier this month, the House passed a bill to avoid this "here-today, gone-tomorrow, back-with-a-vengeance-next-year" mess by permanently extending the 2009 estate tax exemption and rate. But the Senate, hampered by partisan squabbles and consumed by the heath care debate, has halted progress; it now appears virtually certain that they will not act before the end of the year.

The 2001 statute that repeals the estate tax for one year contains another surprise for taxpayers. While the estate tax will disappear in 2010, its departure coincides with a new tax on capital gains. The new tax potentially applies to anyone who inherits property from an estate worth more than $1.3 million in assets next year. For example, suppose someone dies leaving property worth $1.5 million, and the executor or the beneficiaries decide to sell it. Under the current law, there would be little or no capital gains tax on the sale; the estate receives a new "cost basis" equal to the value of the property on the date of death. But, for the estate of someone dying in 2010, the new provisions limit the amount of new basis allowed to $1.3 million (plus an additional $3 million if the beneficiary is the spouse). This new law means that heirs may have to calculate their capital gains based upon the basis of the property when it was owned by the decedent, and not upon its value when it was inherited. (Incidentally, the law doesn't tell us how we are supposed to know what the decedent originally paid for the property). This new measure could prove to be very expensive. House officials estimate that extending the estate tax would have affected 6,000 people, but the new capital gains provisions will affect more than 70,000 taxpayers.

The problems don't end there. Congress has signaled that they plan to extend the current tax next year (thus imposing estate taxes and undoing the capital gains hike) and make the changes retroactive to January 1, 2010. If Congress purports to make these tax charges retroactive to January 1, there are sure to be numerous lawsuits over the constitutionality of the provision. In all likelihood, these challenges will ultimately be resolved by the U.S. Supreme Court only after years of litigation in the lower courts. (John Buckley, Chief Tax Counsel to the House Ways and Means Committee, has expressed his opinion that reinstituting the estate tax retroactive to January 1, 2010 would be unconstitutional.)

Meanwhile, these uncertainties are rendering responsible estate planning extremely difficult. In the words of Senator Max Baucus, Chairman of the powerful Senate Finance Committee, at this point there is “massive, massive confusion.” We will continue to monitor this situation.