A recently released Congressional Research Service (CRS) study examines various estate tax options that Congress may consider in addressing the uncertain state of affairs resulting from the fact that the estate tax currently doesn't apply to estates of decedents dying in 2010 but is scheduled to come back at higher rates for those dying after 2010.

Background. The 2001 tax act provided for a gradual reduction and elimination of the estate tax. Under the 2001 law, the estate tax exemption rose from $675,000 in 2001 to $3.5 million in 2009, and the rate fell from 55% to 45%. In 2010, the estate tax was eliminated. Estate tax repeal for 2010 includes changes to the income tax basis rules for property acquired from a decedent. However, the estate tax changes will sunset in 2011 and go back to 2001 levels; the exemption will become $1 million and the tax rate will return to 55%. The carryover basis provision effective in 2010 would be eliminated (so that heirs will not be taxed on gain accumulated during the decedent's life when they inherit assets).

Estate tax likely to continue. The CRS study notes that most agree that the 2010 provisions will not be continued, and, indeed, may be repealed retroactively. President Obama proposed a permanent extension of the 2009 rules (a $3.5 million exemption and a 45% tax rate), and the House of Representatives voted for that permanent extension on Dec. 3, 2009.  The Senate Democratic leadership has championed a plan to retroactively reinstate the 2009 rules for 2010 and beyond. Senate Minority Leader McConnell proposed an alternative of a 35% tax rate and a $5 million exemption. Senators Lincoln and Kyl offered a similar proposal for a $5 million exemption and a 35% rate, with the ability of the surviving spouse to inherit any unused exemption of the decedent. Others have argued for a permanent estate tax repeal.

The CRS study notes that certain structural reforms might be considered. They include inheritance of spousal exemptions, and some reforms directed at abuses. Provisions in President Obama's budget outline include restricting discounts for estates left to family partnerships and conforming fair market value for purposes of the estate tax and future capital gains realizations for heirs.

Options for revision. According to the CRS study, the principal components of any policy that continues the estate tax are the amount of the exemption and the tax rate. Absent a change in the statute, the estate tax will revert to an exemption of $1 million in 2011. The two most common levels exemption levels being considered are $3.5 million and $5 million. The level of the exemption affects not only the revenue but the number of estates that are subject to the tax.

The second principal component of a continued estate tax is the rate, which will return to 55% absent legislative change. The two most common rates being considered are 45% and 35%. However, some proposals would apply the capital gains tax rate (currently 15% but scheduled to go to 20% in 2011) or some multiple of it.

Another issue is whether to index the exemption for inflation. Over time, as prices rise, a fixed exemption causes more estates to be subject to tax. Without indexing, Congress may return from time to time to reconsider the exemption.

A final issue is the potential carryforward of an unused estate tax exemption to the surviving spouse. Since bequests to the spouse are excluded from the estate, the couple together can have a larger total exemption if the first spouse to die leaves assets to the children or other heirs large enough to absorb his or her estate exemption. This action will reduce the size of the estate subject to tax when the second spouse dies. There are reasons, however, that the taxpayer may prefer to leave more assets to a spouse. A proposed change would permit the second spouse to inherit any unused exemption and add it to his or her own future exemption.

Proposals have also been made to increase the percentage or dollar limits of special use valuations and conservation easements. At the same time, there are proposals to restrict practices considered as abuses.

Coverage of decedents. The CRS study notes that the estate tax has never affected more than a small fraction of decedents. If the law reverts to the $1 million exemption, less than 2% of decedents would pay an estate tax. Restoring the $3.5 million exemption 0.25% of decedents pay the tax. Moving to a $5 million exemption reduces the share to 0.14%.

Historically, the estate tax has been highly progressive, according to the CRS study. The rate reductions tend to benefit, relatively, a wealthier group of estates than exemptions, and thus reduce progressivity. However, rate reductions also reduce the average marginal tax rate more than exemption increases, which could matter for economic efficiency.

Effects on small businesses and farmers. An issue that has played an important role in the debate over the estate tax is the possible impact on small businesses and farms. Although concerns have been raised about the effects of the tax on small businesses and farmers, the CRS study observes that estimates indicate that the share of estate taxes paid by small business estates under the proposed revisions would be small (16% to 18%) and the share of estates of small business owners taxed is small (about 0.2% of decedents with at least 50% of their assets in businesses). Evidence suggests that the number of returns with inadequate liquid assets to pay the estate tax is negligible, according to the CRS study.

Bottom line. The analysis in the CRS study reveals that the estate tax is relatively small, in revenues, in coverage, and in its effects on family businesses, savings, charitable contributions, and tax administration and compliance. One-fourth of 1% or less of all estates and of family businesses are expected to be subject to tax under an exemption of $3.5 million or $5 million. This share would grow slightly over the 10-year budget horizon, but indexing the exemption would not be very important over this time period. The estate tax is a small, but highly progressive, element of the tax system. Under the proposals being considered (the $3.5 million exemption and the $5 million exemption), the majority of the tax would fall on estates of $20 million or more, which in turn constitute only .03% of decedents.