Estate Planners to Congress: 'Thanks, This is One Fine Mess You've Gotten Us Into

Estate Planning and Tax Advisor & Alert

PUBLISHED ON: June 23, 2010

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"A complete Congressional fiasco.” That’s the verdict of Representative Earl Pomeroy, a member of the House Ways and Means Committee, regarding the current state of confusion and uncertainty concerning the federal estate tax.

Background of How We Got

Here In 2001, the federal Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was enacted. The law provided, starting in 2002 and ending in 2009, for the top estate and gift tax rates to be reduced, and for the unified credit exemption equivalent amount for estate tax and generation-skipping transfer (GST) tax purposes to be increased in phases. In 2002, the maximum amount that could pass free of federal estate and gift taxes was $1 million, the maximum amount that could pass free of GST tax was $1.1 million (due to indexing for inflation), and the highest estate, gift and GST tax rate was 50%. By 2009, the maximum amount that could pass free of federal estate and GST taxes was $3.5 million, the gift tax exemption was fixed at $1 million and the highest estate, gift and GST tax rate was 45%.

Then came 2010, with its complete repeal of the estate tax and GST tax. The gift tax exemption this year remains at $1 million, and the maximum gift tax rate is 35%.

However, to comply with Congressional budgetary rules, EGTRRA contained a so-called sunset rule, so that, beginning in 2011, the estate, gift and GST taxes are scheduled to return with a vengeance, with the exclusions limited to approximately $1 million and the maximum tax rates a whopping 55% (plus a 5% surcharge on certain large estates).

Very few in the estate planning community believed that the 2010 tax repeals would ever happen, and that the 2011 reinstatement of the taxes would be allowed to occur. Although members of Congress appear to recognize what a horrendous situation they have created, they have thus far been unable to agree on a solution to correct it.

The following chart summarizes this changing landscape of wealth transfer taxation:

The Hidden Tax Increase for the Beneficiaries of Those Dying in 2010

Along with the repeal of the estate tax for 2010, EGTRRA also repealed the law providing that assets inherited from a decedent’s estate would receive a new basis, equal to their values as of the date of the decedent’s death (or, in some instances, six months after death, if lower). Before 2010, many clients and their investment advisors, rather than pay capital gains tax on assets that had greatly appreciated in value, held those assets until death, paid little or no estate tax and then sold the assets soon after death, when there would be no gain from date of death values.

For the estates of those dying in 2010, EGTRRA changes all this, and provides, subject to certain exceptions, that the basis of property acquired from a decedent is the decedent’s basis (i.e., cost basis). The fair market value as of the date of death can be used only if it is lower than the decedent’s basis. Even though the executor is permitted under EGTRRA to allocate up to $1.3 million in basis adjustment, and a further $3 million to assets distributed to a surviving spouse or held in a qualified trust for the benefit of the surviving spouse, many estates that would have incurred no estate or income taxes if the decedent had died in 2009, may instead face significant income taxes if the decedent dies in 2010.

Assume that an unmarried individual dies with an estate worth $3.5 million, consisting of investments that he had made long ago, at a cost of only $1 million. His estate sells the entire portfolio very soon after his death. If he had died in 2009, the entire estate would have been free of federal estate tax, due to the $3.5 million exemption, and it would have avoided any income taxes, too, because the new basis would have been the $3.5 million date of death values, resulting in zero gain.

Now, assume the hypothetical client above dies in 2010. There will be no federal estate tax, due to the repeal of the estate tax for 2010. But the new basis will be the decedent’s cost basis of $1 million. Even if the executor uses the maximum basis adjustment of $1.3 million, for a new basis of $2.3 million, there will still be a gain of $1.2 million. At a long-term capital gain rate of 15% — and there is even some question as to whether this would qualify for long-term capital gain — there would an income tax of $180,000 on the $1.2 million gain in 2010. Under the EGTRRA sunset rules, if the sales occurred in 2011, the long-term capital gain rate would be 20%.

Wills and Trust Agreements May Need to be Reviewed

Many wills and trust agreements provide formula clauses for credit shelter trusts and for residuary dispositions that are either outright or in further trust. With the one-year repeal of the federal estate and GST tax, it may be necessary to amend the documents, so that a surviving spouse is not inadvertently disinherited. An increasing number of states, it should be noted, are enacting curative legislation to provide, in effect, that pre-2010 law shall apply in interpreting certain types of formula clauses.

Helpful Tip: Under the law as it currently exists, if the cost basis of an asset owned by a decedent at death is unknown, it will be deemed to be zero, thereby exposing more and more estates to income tax on the subsequent sales of assets. That is why it is important to keep careful records of the cost basis of assets. Even if Congress acts to repeal or alter the changes made by EGTRRA, beginning in 2011 brokers and custodians reporting gross proceeds of sales made for a customer’s account (and reported on Form 1099-B) must in many cases include the customer’s adjusted basis. In some instances, the customer must furnish the information to the broker.