2010 – The Estate Tax Oddity

Article in Summary:


  • The Estate and Generation-Skipping Taxes are repealed for 2010.
  • The Gift Tax Exemption stays at $1 million, but the gift tax rate moves down from 45% to the highest income tax rate.
  • The previous step up in basis for noncash assets to the fair market value on the date of death is replaced with a system that utilizes carryover basis.

 

Three! Two! One! Flat-line!!! While greedy beneficiaries of wealthy estates bring in the New Year by pulling the plug on their relatives, the rest of us are scratching our heads trying to understand if the changes ushered in on Jan. 1 will stick, and if so, how does it affect our situation.

When the Senate decided to spend the remainder of 2009 debating health care, the default rules defined under the Economic Growth and Tax Relief Reconciliation Act of 2001 went into effect. According to that bill the following changes would take place in 2010:

  • The Estate and Generation-Skipping Taxes are repealed for 2010.
  • The Gift Tax Exemption stays at $1 million, but the gift tax rate moves down from 45% to the highest income tax rate, which is currently 35%.
  • The previous step up in basis for noncash assets to the fair market value on the date of death is replaced with a system that utilizes carryover basis.

The change that will create the biggest headache for executors of estates in 2010 is the new requirement for carrying over the original cost basis. This new requirement forces people to list a new basis for an asset as an amount equal to the lesser of the basis of the property in the hands of the decedent or its fair market value on the date of death. Even though the change in method for tracking cost basis will be tedious for wealthy individuals, it still won’t affect the majority of decedent estates in 2010. This is because of the level of an additional exemption that is granted to people with built-in gain assets. According to the rules, individuals will receive a $1.3 million-per-person exemption, plus $3 million marital exemption that can be allocated to the built-in gains of the estate. In addition to the allocable exemption amount, decedent estates will also benefit from the ability to carry over losses on a going-forward basis.

Besides doing a diligent job of tracking the cost basis for your assets, people should review their documents to see how the following issues are handled:

Trust Funding–A lot of trusts use a formula-based on the existence of an estate tax to determine how much of an individual’s assets go into a “credit shelter” trust and a marital trust. Under ordinary circumstances, people’s estate planning documents typically fund the credit shelter portion of their trust, so they are able to soak up the available amount of estate tax exemption, which was $3.5 million in 2009. If there is a surviving spouse, the leftover assets beyond the exemption amount are then used to fund the marital trust, which further shelters the estate from an estate tax via a marital estate tax deduction.

In larger estates, people tend to put more restrictive provisions on the credit shelter assets, because they may want to give assets away to children at the first death or they want to be more restrictive with assets utilizing an individual’s estate and generation-skipping tax exemptions. As a result, it is entirely possible that a surviving spouse could end up on the short end of the stick at the worst possible time.

Power to Allocate Basis–Since the law in effect gives executors the ability to allocate the exemption to increase basis in whatever manner they choose, having documents that reflect this flexibility can give the executor an advantage in lowering the tax bill. For example, the ability to send the low-cost basis property over to a charity and apply the exemption to the remainder or the ability to apply the exemption to real estate that is subject to an ordinary income recapture can help you minimize taxes by efficiently managing the exemption.

Is the 2010 Estate Tax Repeal a Reality?
Before you lawyer up and go down the expensive road of aggressive estate tax planning, you may want to consider the possibility that Congress has the will and ability to retroactively impose the estate tax on decedent estates going back to Jan. 1, 2010. While an aggressive move by Congress retrospectively imposing a “repealed” tax might not be constitutional, a precedent established in the Clinton years regarding a retrospective rate increase on estates back in 1993 eventually made it to the U.S. Supreme Court and the case did rule in favor of the Government. This case along with the temporary nature of the repeal should be enough ammo for the government to make a compelling argument, and if the government decides to go down this path you can be sure that they will be making their case to the bitter end.

Conclusion
Due to the overwhelming Democratic majority in Congress and the fact that we are facing record budget deficits, it is entirely possible that we will have a new law that will go into effect this year. That said, it is hard to say whether the government will want to make the repeal retrospective or focus their fight on estate tax rates going forward. As a result, trying to harness the potential benefits created by the current estate tax vacuum is a gamble that could come back and bite you.

 

About the author

John Pitlosh, CFP®

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