Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the federal estate tax was repealed for 2010. This repeal, however, is only effective through December 31, 2010. The federal estate tax returns in 2011, at the rates and exemptions in effect in 2001 when EGTRRA was effective.
Although bills were introduced in Congress in 2009 to repeal the repeal, possibly to retain the $3.5 million estate tax exemption and 45% maximum tax rate in effect in 2009, nothing was accomplished. So we have reached 2010 with less taxes on the books – why is this a bad thing?
First of all, the federal estate tax has not been permanently repealed, but only disappears for one year. At midnight on January 1, 2011, it returns with a vengeance – with an exemption of only $1 million and a maximum tax rate of 55%. In addition, most commentators and practitioners are unsure that the estate tax has truly disappeared for 2010. The Democratic leadership of both the House and the Senate has indicated that they may attempt to pass legislation with an effective date retroactive to January 1, 2010. This retroactive imposition of a tax will undoubtedly face legal challenges, specifically that such a law is unconstitutional. The U.S. Supreme Court, however, has upheld such retroactive legislation in the past, most recently during the Clinton administration.
Review Your Estate Plan
Those clients who will be primarily affected by the 2010 estate tax repeal are those clients whose Wills or Trusts use a formula clause to divide property into shares, usually between the surviving spouse and children. One typical formula that has been used by attorneys for their clients for many years allocates as much property as possible to children or other descendants without triggering a federal estate tax, with the balance passing to the spouse. In 2009, this type of formula would have directed $3.5 million to the children, since that was the federal estate tax exemption in 2009. In 2010, this same formula will direct the entire estate to the children, since there will be no estate tax due, and nothing will pass to the surviving spouse.
Another type of formula clause that has often been used directs the exclusion amount to the children, and the balance to the spouse. This formula, however, will result in nothing passing to the children since there is no exclusion amount in 2010, and everything will pass to the surviving spouse. Although there will be no estate tax due at the first spouse’s death in 2010, this may actually be a worse scenario than the first: if the surviving spouse dies in 2011, owning all of the property previously held by both spouses, and with only a $1 million exemption available, there may be substantial estate tax paid at the second spouse’s death.
New Basis Rules
Now here’s the real bad news — the repeal of estate tax in 2010 brings with it a change to the rules on carryover basis. Congressional officials estimated that an extension of the 2009 estate tax ($3.5 million exemption, 45% maximum rate) would have resulted in taxes on approximately 6,000 estates, but the carryover basis changes will result in taxes on over 70,000 estates.
Prior to 2010, the carryover basis rules provided for a “stepped-up” basis as of a decedent’s date of death. The beneficiaries inherited property from an estate at the property’s fair market value on the date of death, not the decedent’s basis (usually the purchase price). If an asset was sold by the estate or the beneficiary fairly close to the date of death, this often resulted in little or no capital gain, and little or no corresponding capital gains tax, since the stepped-up basis would have been close to the sales price.
The basis rules for inherited property have drastically changed for 2010. The basis of property received from a decedent will now be calculated at either the decedent’s basis or the fair market value as of the date of death, whichever is lower. For example, if the beneficiary inherits the decedent’s residence, which the decedent purchased in 1970 for $50,000, and which is now worth $400,000, the beneficiary receives the property with a basis of $50,000. When the beneficiary sells the residence at its fair market value, the beneficiary will pay capital gains tax on the difference between the basis of $50,000 and the sales price of $400,000.
The new rules include a “Special Basis Adjustment” of $1.3 million. This provides that this amount may be added to the basis of various estate assets (as allocated by the executor or administrator) to increase the basis of such assets from the decedent’s basis to the fair market value at the date of death. In addition, the surviving spouse will have an additional $3 million that may be added to the decedent’s basis for various assets passing to the spouse, to increase the basis to the fair market value at the date of death.
What To Do Now?
The changes to the estate tax, and the changes that may occur within the next year, make it an uncertain future, with no clear overall answer for everyone. These changes must be considered in light of each client’s individual circumstances, and in fact, may have to be reviewed again if Congress changes the law. Should you wish to review your Will and estate planning documents, or have any questions as to how your estate plan may be affected, please do not hesitate to contact us.
IRS Circular 230 disclosure: In order to comply with requirements imposed by the IRS, please be advised that any tax advice contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein.