Thu, December 31, 2009
Congress Fumbles Estate Tax Fix for 2010 and Beyond
It looks like Congress won’t get around to fixing the estate tax before this year ends. Aside from boosting the incomes of estate planning attorneys, this doesn’t help anyone.
Under current law, the estate and generation-skipping taxes expire at the beginning of 2010. But then in 2011 there would be another switch: estates would receive a $1MM exemption and the maximum estate tax rate would be 55%. For the last several years, knowing this change was in the works, anyone engaged in estate planning was assuming that Congress would do something to change this turn of events; it seemed almost a no-brainer that it would be crazy to have one year when the tax disappears completely and then have it come back the next year. But as 2009 ends, Congress hasn’t been able to finalize a decision on how the tax will change.
The law, for now
In 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 (a.k.a. “EGTRRA”) established gradual increases in the estate tax exemption and reductions in the top estate tax rate. At the time, financial realities were such that advocates of abolishing the tax completely could only arrange for its abolition to last for a year. Then in 2011 the changes had a “sunset” provision that would cause everything to go back to pre-EGTRRA estate tax rules. At the time, it was believed that the abolition of the estate tax could be made permanent before 2011, but today that seems pretty unlikely. Yet it’s also likely that some sort of change will be made in the estate tax during 2010.
With no corrections made to the laws so far, the situation becomes interesting. Normally, one would assume that some sort of change would be made to re-establish the estate tax and make it retroactive to January 1, 2010. But according to the Wall Street Journal, the political climate is such that a retroactive extension of the estate tax may be a hard sell. Moreover, some have suggested that making the tax retroactive would violate the Constitutional provision forbidding ex post facto laws. A retroactive change would be an invitation for litigation if a large enough estate tax bill were involved.
There might actually be a period of time next year during which there will be no estate tax at all, but no one can say with certainty whether that will be so. With such uncertainty, it’s difficult to do estate planning.
Basis Confusion: To step up, or not to step up?
If the estate tax goes away as scheduled under EGTRRA, there will be another twist for heirs. Under the old law, when you inherited property, you received a “step-up” in the property’s basis. Let’s say, for example, that your Great-aunt Emma left you a million dollars in IBM stock that she received as a gift. Her basis in the stock might have been $25,000. If you inherited it on June 1, 2009 and sold it for $1MM the next day you’d owe no capital gains tax, because your basis would be “stepped-up” to the market value at her death. But if the basis rules under EGTRRA take effect and you inherited the stock in 2010, your basis would be the same as Emma’s: $25,000. In that case, sale of the stock would trigger a long-term capital gain of $975K (inherited property generally receives long-term treatment) and a large tax liability.
To make matters more annoying, with stock splits, dividends, and so forth, heirs may not find it easy to determine the original basis for inherited stock, and if an inherited asset isn’t a publicly-traded security, determining its basis could be a huge headache.
Mangled Estate Planning Strategies
Another problem that the change next year could cause involves a common estate tax strategy used by couples.
For years, some amount of an estate has been exempt from federal estate tax. For many years it was $1MM, under EGTRRA it rose to $3.5MM in 2009. There’s also a special spousal exclusion rule; the first spouse to die can exclude an unlimited amount of inheritance to the surviving spouse from estate tax. At the death of the second spouse, applicable estate tax is levied on what remains.
If a couple has children or other heirs, a common estate planning strategy has been to have a will provision stating that a portion of the estate of the first-to-die passes to the other heirs, with the remainder going to the surviving spouse. The amount given to the other heirs is equal to the exemption amount. This strategy keeps the federal estate tax exemption for the first-to-die from being wasted.
For example, if a couple had an $7MM estate and the husband died in 2009, $3.5MM could go to other heirs exempt from estate tax and $3.5MM would go to the wife free from tax (under the spousal exclusion). At the wife’s death, if her remaining estate was below $3.5MM, all of it could pass to the heirs without federal estate tax. Without using this strategy, the whole $7MM would go to the wife tax-free at the husband’s death, but the husband’s $3.5MM estate tax exemption would be lost to the heirs. If $7MM remained at the wife’s death, the heirs would owe tax on $3.5MM after using the wife’s exemption.
The problem that the change causes is that the language of these provisions is often written generally to allow for future changes in amount of the exemption. As things currently stand, there will be no federal estate tax in 2010. So in the example above, if the will says that the maximum amount that is exempt from federal estate tax passes to the children, in 2010 that could mean that they get all $8MM – not what was intended.
Another snag here is that many states have estate tax rules that are in some way tied to the federal estate tax exemption. Confusion over the federal estate tax could also confuse matters at the state tax level.
Clearly, unless Congress acts quickly to sort out the estate tax, there could be some headaches for estate trustees and heirs in 2010. Individuals with large estates and provisions in their wills linked to the federal estate tax exemption would be wise to have their estate documents reviewed by their attorneys to avoid unintended consequences.
Please note: Estate planning strategies mentioned here may or may not be appropriate for your specific situation. As always, tax strategies should be discussed with a qualified estate tax adviser before doing something that you’ll regret.