The 2001 Bush Tax Cuts  lowered estate taxes, phasing in rates that brought the existing estate tax rate from a maximum of 55% to 35% over 10 years.
Under that deal, the 35% estate tax rate was to stay in effect through the end of 2009. Estate taxes were set to disappear altogether in 2010, and then return to pre-2001 levels at the start of 2011.
Most people thought that Congress would act to change the estate tax system in 2009, before the estate tax went to zero. But that didn’t happen, and so the families of the very rich enjoyed their inheritances completely tax free in 2010.
The recent Obama tax compromise  included provisions for reinstating the estate tax in 2011, but brought it back at levels lower than those seen in both 2009 and 2001.
Estate Tax Basics
The Estate Tax was created to tax transfers of wealth at death. Currently less than 2% of deaths result in the payment of estate tax, or inheritance tax, as it is sometimes referred to.
In 2009, the last year that estate taxes were collected, an estate was taxed up to 35% on gross assets over $3,500,000.
Deductions  allowed on estate tax returns include the payment of final medical/funeral expenses  and any outstanding debt. Unlimited deductions also mean that no estate tax is paid on assets left to a surviving spouse or charity. Of course there are any number of strategies  for avoiding or reducing estate tax payment.
Previously, if one spouse did not “use” all of the $3.5 million exemption at his death, the other spouse lost that exemption – meaning that if one spouse claimed a $1.5 million estate and one spouse claimed a $5.5 million estate, the second spouse’s estate owed estate taxes on $2 million. Financial planners and tax attorneys helped married couples structure trusts  to ensure that this did not happen, instead having each spouse claim the full $3.5 million at death.
2010 Estate Tax Changes
The new tax law includes retroactive provisions for taxes on the estates of those who died in 2010. Beneficiaries typically enjoy what’s known as a “stepped up basis” upon inheritance, meaning that the initial value of those assets for tax purposes is set to the value on the day of death. If the beneficiary sells the assets later, any gain made between the time the original owner purchased the asset and the time the beneficiary assumed ownership is essentially ignored for tax purposes.
Under the new provisions, beneficiaries can continue to enjoy a stepped-up basis, but pay at 2011 estate tax levels. Alternatively, the estate can owe no tax, as was scheduled for 2010, but beneficiaries must instead use the original owner’s basis with an additional step-up of $1.3 million plus $3 million additional for a spouse, rather than the fully stepped-up basis. Estates under $5 million should obviously use the first option since the estate would not owe anything. Calculations must be performed for estates over $5 million to see which option is the best for beneficiaries of those estates.
If you are the executor of someone who died in 2010, and the estate is now subject to estate taxes, you have until September of 2011 to file the estate tax return.
2011 and 2012 Estate Tax Changes
The new tax law sets the federal estate tax rate at a flat 35%. Estates under $5,000,000 are not subject to any taxation – this is a significant increase from the previous $3,500,000 exemption. In addition, the $5,000,000 estate tax exemption is now portable, meaning that the two spouses together can exclude $10 million regardless of how much each individual spouse claims. This eliminates the need for trusts to equitably distribute assets between two spouses.
The new law also increases the total lifetime exclusion for gift giving to $5,000,000, but unifies the gift and estate taxes so that the amount exempt from estate tax is reduced by taxable gifts given during life. Individuals could previously give away  up to $1,000,000 in life. The new law means that you can give away up to $5,000,000 tax free during life, but if you do give away the entire $5,000,000 then your full estate is taxable at death. If you give away $2,000,000 during life, you can still exclude $3,000,000 at death, and so on.
It is the responsibility of the executor to file any required estate tax return (Form 706 ) and pay the estate taxes before distributing any assets. The executor typically has 9 months to do so. Note that there are special valuations  allowed for some assets, including farms and small businesses.
The current plan only enacts these changes for tax years 2011 and 2012. The estate tax is again set to return to its pre-2001 levels at the beginning of 2013, unless new legislation is enacted before that time.
Updates: Gift Tax and Estate Tax Limits to Change in 2013 
More estate tax rule information: