For some time, experts have been predicting major changes with respect to the Federal Estate Tax. These changes could either broaden or narrow the scope of the “Death Tax” and will, necessarily, impact a significant number of wealthier American families.

The modern estate tax was first adopted in 1916 as a means of financing U.S. involvement in World War I and as a progressive response to the consolidation of wealth in the early 1900s. The “Applicable Exclusion Amount,” which is the amount of each person’s estate that is exempt from federal estate tax, is currently $3.5 million. The highest marginal rate is 45 percent. The estate tax is a relatively small contributor to the federal budget, ranging between 1 percent and 2 percent since World War II. According to Internal Revenue Service data, over the past 30 years, only about 2 percent of all adult deaths have resulted in a taxable estate.

Under current law, the federal estate tax is scheduled for complete elimination in 2010, only to return in 2011, with an Applicable Exclusion Amount of $1 million. This situation has caused uncertainty and anxiety for estate planners and has caused many to predict that Congress will take action to clarify the future of the federal estate tax law before the end of 2009. As year end approaches (and with congressional attention focused on the economy, health care and national security), it is still unclear what, if any, changes may be made.

The Obama administration supports a permanent estate tax with a $3.5 million Applicable Exclusion Amount and a tax rate of 45 percent on all transfers exceeding the exclusion. This proposal has been introduced in the House (H.R. 436) and it appears a majority of the Senate supports this general approach. While many still hope for a repeal of the estate tax (which would happen, at least for 2010, if Congress fails to act before year end), that scenario appears unlikely. It seems more likely that Congress will simply extend the $3.5 million Applicable Exclusion Amount into 2010, thereby avoiding repeal of the tax, but not providing clarity beyond next year. Should this happen and should Congress fail to act in 2010, a much lower Applicable Exclusion Amount of $1 million would return, greatly expanding the number of families impacted by this tax.

A permanent law with an Applicable Exclusion Amount of at least $3.5 million would be welcomed by estate planners and would greatly benefit most American taxpayers. Still, there are a number of issues and questions to be resolved beyond the exclusion amount and the tax rate. Specifically, will the exclusion amount be indexed for inflation? Before the current law, the exclusion was stuck at $600,000 from 1987 to 1997. This created a situation where, over time, a greater and greater percentage of estates were subject to federal estate tax.

Will the Applicable Exclusion Amount be portable between spouses? One intriguing feature of some congressional proposals is the possible portability of the Applicable Exclusion Amount between spouses – meaning that if one spouse failed to take full advantage of the exclusion at their death, the surviving spouse could use the first spouse’s unused portion. In theory, a husband and wife would always be able to protect $7 million in assets from tax, regardless of how their assets were allocated between them.

Will new legislation protect the step up in basis? Under current law, inherited appreciated assets receive a step up in basis to the value as of the decedent’s date of death. This means that if a beneficiary later sells the appreciated asset, they pay capital gain tax only to the extent of the appreciation subsequent to the inheritance. Some proposals for estate-tax reform have included an elimination of the step up in basis, though this change now appears highly unlikely.

Will the federal estate tax rate be flat? Some proposals under discussion, including H.R. 436, include a 5 percent surtax on larger estates, meaning an effective rate of 50 percent, instead of 45 percent.

Will new legislation include any sweeteners for certain taxpayers? In recent years, many proposals have included targeted relief for certain small businesses, including family farms.

Stay tuned as Congress wrestles with these and other important issues.

Timothy J. Krumm is an attorney at Meardon, Sueppel & Downer PLC in Coralville. He can be reached at timk@meardonlaw.com or (319) 338-9222.