Federal Estate Tax Awakens From Lengthy Coma

Mr. Federal Estate Tax, who had slipped into a coma on New Years’ Day 2010, came out of his year-long stupor on December 17, 2010, much to the surprise of his friends and adversaries. “The reports of my death have been greatly exaggerated,” he declared in a prepared statement released shortly after his awakening. His medical team cautioned that he would remain in a weakened state for a considerable period of time.

His many admirers hailed his recovery and predicted he would regain his old vigor by the end of 2012. His many detractors expressed confidence that he would never again have the strength to strike terror into the hearts of American taxpayers.

His twin brother Mr. Income Tax, and his much younger sibling Mr. Gift Tax, left their brother’s bedside without issuing any statements. They seemed relieved that their year long vigil had ended. Members of the Tax Family have long been viewed as immortal. Many speculated that if Federal Estate Tax could die, the lives of other family members could also be at risk.

So much for my attempt at Explanation-through-Anthropomorphism. Here’s a more straightforward description of the estate tax and gift tax legislation that passed in mid-December.

Background. Prior to Election Day, Democrats who wanted to raise income tax rates and reinstate the estate tax seemed to hold a winning hand. If Congress did nothing, the Bush Tax Cuts would expire on the last day of 2010, and the tax laws that were in effect on January 1, 2001 would be reinstated automatically. In particular, the federal estate tax, which had been repealed for calendar year 2010, would be back with a maximum rate of 55% and a per person exemption of only $1 million.

But elections matter. The Republicans captured the House of Representatives on Election Day, and within 24 hours, President Obama’s key domestic advisor signaled his willingness to accept a temporary across-the-board extension of the Bush Tax Cuts. On December 17, the President did just that, signing into law the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. Paul Gigot, editor of the Wall Street Journal, was one of many conservatives to engage in a moment of triumphalism, crowing how he loved the symbolism of two Democratic presidents endorsing the heretofore hated Bush Tax Cuts.

Key Changes in Estate Tax and Gift Tax Laws. The Temporary Estate Tax Relief provisions found in Title III are of the most interest to me, as an estate planning and estate administration attorney. Here are the most significant changes in the estate and gift tax laws.

1. Federal Estate Tax Reinstated. The federal estate tax has been reinstated. The reinstatement is retroactive to January 1, 2010.

2. Per Person Exemption Increased. The per person exemption from the estate tax is raised to $5.0 million. It was $3.5 million per person in 2009. It was 1.0 million in 2001.

3. Estate Tax Rates. The maximum tax rate on an estate in excess of the exemption is 35%. In 2009, the maximum estate tax rate was 45%. It was 55% in 2001.

4. Stepped Up Basis Rules Reinstated. Carryover basis is repealed for 2010. Click here for an explanation of these rules. Instead, the assets in the estates of decedents who died in 2010 are entitled to a stepped-up tax basis under the rules in effect since the early 1980’s.

5. Executor Can Elect Estate Tax Repeal for Those Dying in 2010. For the estate of decedents who died in 2010, an executor may elect out of the estate tax and instead be governed by the rules that had been in effect throughout 2010, prior to December 17, 2010. In those cases, there will be no estate tax. However, those estates will not be entitled to a stepped-up tax basis for appreciated assets, but instead will be governed by the rules of carryover basis. So, the estates of wealthy men and women who died in 2010 will forever escape estate tax.

6. Changes in Gift Tax Begin in 2011. The gift tax rules for 2010 are not changed. The gift tax exemption remains at $1 million and the gift tax rates on gifts not shielded by the exemption remains at 35%. However, the gift tax rules change dramatically in 2011. The gift tax exemption will increased to $5 million per person. Thus for the first time since 2004, the estate tax exemption and the gift tax exemption will be “unified.” Beginning in 2011, a person can use up all or any portion of his $5 million exemption during his lifetime or at his death.

7. Portability. The new law allows for the “portability” of the unified credit between spouses. Starting in 2011, a widow or widower can add the unused estate tax exemption of his or her deceased spouse to his or her own exemption. I plan to write more on portability in a future post, but my initial thought is that most married couples will still want to create by-pass trusts in their estate plans to preserve the exemption of the first spouse to die. The portability option should only be used as a backstop for spouses who did not do proper planning.

8. These New Rules Are Temporary. One final but important point: all these provisions will expire on December 31, 2012 unless the current Congress passes and the President signs legislation to extend these provisions or make them permanent. And if nothing is done, the tax laws that were in effect on January 1, 2001, would be reinstated automatically. While it would be a travesty for the federal government to allow that to happen, virtually everything that has happened with the estate tax laws in the past few years has caught me by surprise.

So strap yourself in. The next two years promise to be another wild ride.

One Drawback To Estate Tax Repeal

I cannot imagine we will ever see another year like 2010. There is no estate tax, that is, there is no tax on the transfer of wealth at death. For thousands of American families, this has resulted in tax savings that would have been unimaginable only a few years ago.

Some of these families have been highlighted by the popular media. Yankee owner George Steinbrenner, real estate developer Walter Shorenstein, energy magnate Dan Duncan, and Albemarle’s John Kluge, billionaires all, died in this calendar year. By a remarkable stroke of good fortune, the federal tax laws permitted them to pass on their lifetime of accumulated wealth to their families without paying any transfer tax.

Surely there are thousands of other unremarked-upon millionaires who have died or will die in 2010, and who were nimble enough in their estate tax planning to take advantage of this one-year-only estate tax holiday.

The stage was set for all this back in 2001, when President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”). The per-person estate tax exemption was raised in steps from $1.0 million in 2001 to $3.5 million in 2009, culminating in the complete repeal of the federal estate tax for one year only – 2010 – and a return to 2001 levels of taxation on January 1, 2011.

But few (if any) estate and gift tax attorneys ever thought 2010 would arrive without Congress making some legislative fix to prevent a one-year-only repeal. Despite the conventional wisdom that it would never happen, on January 1, 2010, the estate tax was repealed. It called to mind British Prime Minister Lord Melbourne’s remark, that “what all the wise men promised has not happened, and what all the damned fools predicted has come to pass.”

While estate tax repeal is a taxpayer bonanza for some, it contains a dark underside for everyone who inherits assets from a person who died in 2010. I am referring to the change in the laws relating to the “tax basis” of assets passing from a decedent’s estate to the decedent’s beneficiaries. These rules prior to estate tax repeal were explained by Robert J. Kolasa, an Illinois estate planning attorney.

[W]hen a taxpayer sells an asset, there is generally an income tax on the difference between the sales proceeds and ‘cost basis’ (what was paid for the asset). Under the pre-2010 rules,… when a person died the cost basis was generally increased (‘stepped up’) to its value on date of death. When the asset is later sold, only the difference between the sales proceeds and date of death value would generally be taxed.

Assets inherited in 2010 no longer qualify for automatic “step up” to the fair market value on the date of the decedent’s death. Under Section 1022 of the Internal Revenue Code, the beneficiary takes the asset with a basis equal to the lesser of (i) the decedent’s basis or (ii) the fair market value of the asset on the date of the decedent’s death. The basis can then be increased under two possible basis adjustments.

In the first basis adjustment, the decedent’s executor may allocate up to $1.3 million to increase the basis of an asset passing to any beneficiary to its fair market value on the date of the decedent’s death. The second adjustment allows an executor to allocate an additional $3 million in basis to assets passing to a surviving spouse, outright or in trust. Of course these allocation rules are subject to many limitations.

1. The basis increase is limited to the property’s fair market value. If the asset is publicly traded stock, the fair market value is easily determined. But what if the asset is a closely held corporation or investment real estate? Even though there may be no estate tax return to be filed, the executor will still have to hire appraisers and provide the information to the IRS.

2. The basis increase must be applied to assets owned by the decedent at death. Thus, for example, property held in a QTIP trust for the decedent’s benefit will not qualify for the basis adjustment.

3. Certain assets are specifically excluded from basis adjustment, including proceeds from a qualified retirement plan account (e.g., IRA or 401-k plans) and assets acquired by the decedent by gift within three years of the decedent’s death.

There is no doubt these new rules will greatly complicate the administration of a decedent’s estates. I have already had a number of clients inform me of the position certain brokerage houses are taking with respect to reporting the basis of the publicly-traded stock acquired from a decedent who died in 2010 on the monthly brokerage statement. They insist upon listing the lower of (i) the decedent’s basis on the date of death or (ii) the fair market value of the asset on the date of death.

I suspect they will correct the basis upon presentation of an IRS tax form reflecting the executor’s allocation under the rules set forth above. But such a form does not yet exist. Apparently, the IRS never expected estate tax repeal either.