“Federal Estate Tax Repealed: Good News?” by Thomas D. Peebles and Emily J. Kembell
As a result of Congressional inaction, and after more than 8 years of uncertainty, federal estate and generation-kipping transfer taxes were repealed on January 1, 2010. The “repeal,” however, is only in effect for one year. Perhaps more significantly, the step-up in basis rules for inherited assets were also repealed for calendar year 2010 and replaced with a modified carryover basis system. The federal gift tax remains in effect with a lifetime exemption of $1 million, although the tax rate is reduced to 35% for gifts in 2010.
This surprising turn of events has created a great deal of uncertainty about how best to proceed with estate planning and estate administration. Although the repeal of the federal estate tax will bring tax relief to large estates whose owners are “fortunate” enough to die in 2010, these changes in the tax law make it uncertain how provisions of some existing estate planning documents may now be interpreted, and the carryover basis provisions will negatively impact a substantially larger number of taxpayers than were affected by the estate tax.
How did we arrive at this current state of affairs? In 2001, Congress enacted and President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). Under that law, the maximum federal estate tax bracket was gradually reduced from 55% to 45% and the estate tax exemption was gradually increased from $675,000 to $3,500,000. The law then provided that, in calendar year 2010 only, the estate tax was “repealed.” The problem is that EGTRRA is scheduled to “sunset” and cease to apply on December 31, 2010. As a result, unless changes are made, federal estate taxes are “revived” on January 1, 2011, but with an exemption of only $1 million adjusted for inflation and a top tax bracket of 55%.
When EGTRRA was passed, it was believed that Congress would act to provide some sort of certainty regarding estate tax issues before the “sunset” provisions were to apply. The House of Representatives, in fact, passed a bill in December, 2009, which would have permanently extended the $3,500,000 estate tax exemption and the top bracket of 45%. The Senate, however, failed to act.
Perhaps even more alarming than the current state of the federal estate tax is the current state of basis calculations for property owned by decedents dying in calendar year 2010. Up until January 1, 2010, the income tax basis of an asset generally was “stepped-up” to its fair market value on the date of the owner’s death. As a result, all built-in capital gain was effectively eliminated for income tax purposes. For example, consider a decedent who died in 2009 owning an asset with a basis of $100,000, which had increased to a value of $250,000 at his death. The beneficiary who inherited that asset would have received a stepped-up basis of $250,000, with the result that if the beneficiary immediately sold the asset, no capital gain would be reported.
Under EGTRRA, for 2010 only, these step-up in basis rules are replaced with modified carryover basis rules. As a general rule, then, individuals inheriting assets in 2010 now also inherit the decedent’s basis in those assets (“carryover” basis) rather than getting a “step-up” in basis equal to the current fair market value. As a result, upon the sale of assets inherited in 2010, any built-in gain will be taxable. In the example above, the individual would have a carryover basis in the inherited asset of $100,000 and the sale of that asset for its fair market value of $250,000 will result in a taxable capital gain of $150,000. According to some estimates, as many as ten times more families will be negatively impacted by the carryover basis rules than would have been effected by the federal estate tax, assuming a $3,500,000 exemption.
The carryover basis law currently in effect for 2010 does allow for some basis adjustment: $1.3 million in basis adjustments can be allocated among the decedent’s assets and an additional $3 million in basis adjustments can be allocated to assets passing to a surviving spouse. However, in order to take advantage of these basis adjustments, taxpayers will now be forced to determine the decedent’s basis in those assets (no easy proposition) and will be required to report this information and the allocation of basis adjustments to the IRS. Unfortunately, the IRS has not yet provided any sort of guidance on these reporting requirements which makes it difficult to advise clients on exactly how we will need to proceed in the administration of the estate of persons dying in 2010.
A final concern with the current state of affairs is the challenge in interpreting certain estate planning documents that include formula clauses tied to the federal estate tax. If there is no federal estate tax in 2010, how are such formula clauses supposed to apply?
To add just one more level of uncertainty, certain members of Congress now claim that they will pass new federal estate tax laws which will be retroactive to January 1, 2010. Any retroactive attempt to “repeal the repeal” will almost certainly face constitutional challenge.
What, then, are clients to do in the face of these confusing changes in the tax law? We strongly encourage clients to review their existing estate planning arrangements to ensure that they continue to meet their objectives while minimizing all taxes (estate and income). Please feel free to contact a member of the CECB Estate Planning Practice Group if you wish to schedule an appointment for an estate plan review.