As Congress was tangled in the health care reform debate it let another important decision fall by the wayside: What to do about the estate tax, which, as it stands right now, is set to be repealed for 2010.

Earlier this month, the House voted 225-200 to extend the estate tax, setting it at 45% permanently for individual estates worth over $3.5 million -- $7 million for married couples -- instead of allowing the tax to expire at the end of this year and then revert to a higher tax rate of 55% in 2011 with a $1 million exemption.

Industry observers expected the Senate to follow suit since no one believed the government would allow the tax to expire altogether and give up the much needed revenue. But the Senate opposed extending the estate tax at its current rate even temporarily, until Congress could come up with a more permanent resolution.

 “It’s insane what Congress has done. It is just outrageous,” said Martin Shenkman, an estate tax lawyer. “Nobody imagined they’d be so foolhardy.”

Most tax experts believe that at some point next year, Congress will retroactively reinstate the 2009 tax rate of 45% with a $3.5 million exemption for individuals back to Jan. 1.

The danger, Shenkman said sarcastically, is that if Congress doesn’t retroactively reinstate the estate tax in 2010 “there will be some people pushing mom from the train.”

All joking aside, how are financial advisors meant to advise their clients when no one knows what the estate tax will be? “They’ve left everybody in limbo,” Shenkman said.

Rep. Earl Pomeroy (D-ND), who introduced the estate tax bill in the House, called the Senate’s opposition disappointing. “In the last days of the legislative year, Republican Senators chose to protect the one year repeal of the estate tax during 2010 at all costs, not even allowing current estate tax law to continue for two months, As a result, a secret tax hike will fall on middle class families when heirs sell assets that they inherit due to a death during 2010,” Pomeroy said. “This is an absurdity of the current estate tax law that the same Republican Senators helped to create in 2001.  The fact that the Senate could not find a way to fix this absurdity is disappointing.” 

The “secret tax hike” Pomeroy referred to is a one-year change in how the capital gains tax on the sale of inherited assets will be calculated. This change could effect up to 70,000 estates, instead of the 5,500 wealthy families that would have been impacted by an extension of the estate tax. The change in the capital gains tax would leave heirs to potentially pay taxes on the appreciated value of an asset from the time it was first acquired by their benefactor. So if, an heir was left an estate, he will have to pay taxes on the appreciated value of that estate from the time it was purchased, though the first $3 million in capital gains will be exempted for spouses, while the first $1.3 million will be exempted for other heirs.

Many fear that the change in capital gains tax could end up snagging much smaller estates. Currently an asset that is inherited, when later sold, is taxed on the gain over its value at the time of the benefactor’s death. So if the estate is valued at $1 million at the time of the benefactor’s death and the heir sells it for $1.3 million, he would only pay tax on the $300,000 gain.

“Without a change to estate tax law, many families especially those with family farms and small businesses will face capital gains taxes for the first time in 2010 on the growth in the value of inherited assets from their original purchase prices when parents or grandparents acquired the properties,” Pomeroy said. 

Even the wealthy taxpayers, who Congress tried to benefit with the repeal of the estate tax when President George W. Bush took office in 2001, have been hurt by the estate tax battle because they can’t plan for the future. And as confusion grows, so does resentment. “We have a voluntary tax compliance system in this country,” said Shenkman. “We basically rely on people to pay their fair share of taxes, but you can’t treat people so unfairly and expect them to voluntary comply. You’re undermining the tax system.”