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TEMPORARY REPEAL IN THE ESTATE TAX: WHAT YOU NEED TO KNOW

DATE RELEASED: 01/25/2010

By: Steve Armstrong, J.D., LLM
Director, Transactional Tax Planning, Rehmann

Prior to its recess last month, Congress was unable to pass an estate tax bill. That means, as of January 1, 2010, there is no estate tax or generation skipping transfer (GST) tax in effect. There is still a gift tax, however, with limited exceptions, on accumulated lifetime gifts which exceed $1,000,000 per individual donor. It is likely that Congress may still take some action this year in respect to the estate and GST tax. However, although we have our educated guesses, there is no certainty as to what this law might look like or if there are changes whether they will relate back to January 1st of this year or shall only affect those transfers that take place following the date the law is signed by the President. Further, any changes in the law that might take place this year may not carry over to next year.

With that in mind, it is critical that individuals are aware of what the current law provides for this year as well as 2011. In addition consideration should be made to potential changes that Congress may consider yet this year. It is suggested that you meet with your trusted advisor to develop a plan that best suits your individual needs.

What does the current law provide?

It’s important to look closely at what the current law provides for both 2010 and 2011. First of all, while there was a $3.5 million exemption and a 45 percent top rate for the estate tax through December of last year, the estate tax (and GST tax), but not the gift tax, is repealed for one year.

In addition, there is a new income tax rule that that results in considerable hardship for a large number of persons. Previous to this year, property acquired from a decedent – with the exception of certain asset classes such as retirement plan benefits – would be entitled to a step up in basis. What this means is that a decedent’s beneficiary could sell the property acquired from the decedent and only pay income tax on the appreciation that occurred following the death. For deaths occurring this year, the basis of property acquired from a decedent is the lesser of the decedent’s adjusted basis or the fair market value of the property on the decedent’s death. Now when assets are sold, the sale will more likely be subject to income taxation based on the difference between what was originally paid for the assets and the current value. This is called a “carryover” basis.

Determining the decedent’s basis may be extremely difficult for many assets. For example did grandma keep records of how much she paid for that prime parcel of land she bought in Florida in 1950? What was the initial purchase price for the stock great grandpa bought 70 years ago in a company that has since been through several mergers?

The carryover basis will likely result in many more persons being subject to tax upon a decedent’s death. It’s important to note that the tax affected by this particular change in the law is an income tax rather than an estate tax. House officials have estimated that had Congress extended the previous estate tax rules (with a $3.5 million exemption, 45 percent rate) it would have affected only 6,000 estates. It has been estimated that the new provision requiring a carryover basis may affect more than 70,000 estates.

Are there exceptions to the “carryover” basis?

There are two exceptions to the general rule for carryover basis:
(1) The executor can allocate up to $1.3 million (increased by unused losses and loss carryovers) to increase the basis of assets; and
(2) The executor can also allocate up to $3.0 million to increase the basis of assets passing to a surviving spouse, either outright or in certain types of trusts.
The above allocation will not benefit everyone to its fullest extent. For instance where estates hold highly appreciated assets and where there is no surviving spouse to take advantage of the $3.0 million basis increase, to the extent that appreciation in the estate assets exceeds $1.3 million, the beneficiaries may incur a large income tax upon the sale of these assets.

What will happen in 2011 if the law remains unchanged?

For those who long for the “good ole days,” please note that the estate tax returns in 2011 with a $1 million exemption (the GST exemption will likewise be $1 million, indexed for inflation) and a 55 percent top rate. The gift tax will return to the pre-2001 system ($1 million exemption, 55 percent top rate) in 2011. The old basis step up provisions would return as well in 2011.

What planning opportunities may be available in early 2010?

Early 2010 (before Congress acts) may be a great time to create generation skipping trusts (a special trust that can pass assets on for multiple generations without being subject to estate taxes). Under prior law, the amount that could be transferred in this manner was limited; but under current law the limitation has been removed.

Similarly, clients who are considering making large gifts that would be subject to the gift tax may want to make these gifts in 2010, when the gift tax rate would be reduced to 35 percent. Also, installment sales of family property where there may be a gift element could benefit from a transfer this year. For example, this would apply if the IRS determines that the sales price exceeds the actual fair market value of the property transferred.

Remember, that the gift tax has been reduced to a maximum 35 percent rate, but that it still exists for all transfers over the $1 million exemption and $13,000 annual exclusions. So the potential for a gift tax on any transfers still needs to be considered.

In addition there may be planning opportunities for those of you who are either beneficiaries or trustees of current GST trusts. In 2009, a trust that was subject to the GST tax upon a distribution or termination was subject to a 45 percent GST tax on each transfer. This would be true for example, in cases where assets were passed to beneficiaries two or more generations below the original donor (i.e. a trust set up for a child that would subsequently pass on to a grandchild or great grandchild). If the trust makes a distribution or terminates early this year and assets pass to such younger beneficiaries, there may be no GST tax imposed.

The above planning opportunities would need to be analyzed keeping in mind that any changes in the law might be retroactively applied.

Other planning opportunities that may expire soon

The Administration has proposed dramatic changes to some other planning opportunities that affect the gift or estate tax cost to transfer assets to your beneficiaries. For instance one such planning opportunity affects the method of valuing interests in family investment entities or undivided interests in real property that are transferred to family members. Under current law these interests may be transferred at a substantial discount under certain circumstances. This provides for a significant estate or gift tax savings on these transfers. If there is an estate and gift tax reform package adopted later this year, it could eliminate this planning option. For those of you considering making gifts of such interests, you may want to act sooner than later.

Under the current temporary repeal of estate and GST taxes, how will my estate tax planning be impacted and should I have my estate planning documents reviewed?

Many estate plans for married individuals are structured to set aside as much as possible for subsequent heirs (children and grandchildren) without generating any immediate federal estate tax. These types of plans may be impacted dramatically under current law.

For example depending on the specific wording of your trust document, your plan to leave as much as possible in trust for your children or grandchildren with the balance of the estate passing to your spouse may be construed as leaving the entire estate in trust for the children. That might unintentionally cut out your spouse from receiving anything when you die. Current law may also present unintentional results where there are special trust provisions established in the case of second marriages or under other circumstances.

Furthermore, you may wish to take into account the new basis system for inherited property. Planners have generally assumed we would never get to the point of having a carryover basis system, and it is not likely that they have included provisions in estate planning documents to provide flexibility to take advantage of the $1.3 million (for any recipients) and $3.0 million (for surviving spouses) basis increase allocations by executors. Including these provisions in the plan can be complex but may be necessary to obtain the optimum income tax result. Any change in the plan should, of course, take into account the very strong possibility that the estate tax will be reenacted and that the carryover basis provisions will be repealed. This important item should be reviewed with you advisor.

If the estate and GST taxes are reinstituted later this year, will they be effective retroactive to January 1, 2010?

There is no clarity in this area. However, it is strongly recommended that your planning should take this possibility into consideration. A retroactive application of the law could result in estate tax, generation skipping tax or increased tax rates being imposed on transfers of assets by a decedent, or other transferor, that occurred anytime during this year including those that occurred prior to any proposed change in the law.

The bottom line

This is an extremely challenging time from an estate planning perspective with no certainty that there will soon be clarity in the law. With this in mind, there are planning issues and opportunities that should be addressed immediately. Please contact your advisor today to discuss what you should do now to protect your estate.



The information contained in this material is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information there can be no guarantee that such information is accurate as of the date received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular circumstances. Any advice contained in this communication is not intended or written to be used, and cannot be used by a client or any other person or entity for the purpose of: (I) avoiding penalties that may be imposed on any taxpayer or: (II) promoting, marketing or recommending to another party any matters addressed herein.