Senate Majority Leader Harry Reid (D-NV) has introduced legislation implementing the tax-cut deal that President Obama struck with Congressional Republicans. As expected the legislation restores the estate tax for two years with an exemption of $5 million and a 35 percent tax rates for estates over that amount, but the bill also contains several unexpected provisions that would make it easier for the well-off to transfer their wealth tax-free. One of the provisions would be such a bonanza for the affluent that it could by itself be too much for Democrats, or even some Republicans, to swallow.

One of the surprise provisions would make the new $5 million exemption and 35 percent rate retroactive to January 1, 2010. In other words, the heirs of those dying in 2010 will have a choice between applying the new rules or electing to be covered under the rules that have applied in 2010 -- no estate tax but only a limited step-up in the cost basis of inherited assets. This would benefit the heirs of tens of thousands of more modest estates which, under current rules applying for 2010, are subject to capital gains tax on inherited assets above a certain threshold. (For more on this, click here.)

A second provision of the Reid legislation would make the estate tax exemption "portable" between spouses. This means that if the first spouse to die does not use all of his or her $5 million exemption, the estate of the surviving spouse could use it.

Both these provisions "are pretty popular and so would likely pass," according to estates attorney Kevin Staker, author of the Estate Tax News Blog.

But a third provision is another matter. It would set the gift tax and generation-skipping transfer tax exemptions at $5 million as well. (For 2010 there is no generation-skipping tax, while the gift tax exemption has been $1 million for a number of years.) A 35 percent tax rate would apply to gifts or transfers over the $5 million threshold. These high exemption levels mean that "[t]he rich will have a two-year window in 2011 and 2012 to protect huge amounts of their estates from taxation for generations," Staker writes.

Passage of the bill in the Senate appears certain, but the House is a different story, with the estate tax provisions being the most controversial part. In a non-binding vote, the House Democratic caucus voted nearly unanimously not to bring the tax-cut bill to the House floor in its current form. Rep. Chris Van Hollen (D-MD) said passage of the bipartisan compromise plan is being jeopardized by the estate tax, calling it a "bridge too far" for most Democrats.

"We will continue discussions with the President and our Democratic and Republican colleagues in the days ahead to improve the proposal before it comes to the House floor for a vote," said House Speaker Nancy Pelosi (D-CA).

Reid's legislation was introduced as an amendment to H.R. 4853, the Middle Class Tax Relief Act of 2010. For the legislation, titled the "Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010," click here.

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