On January 1, 2010, due to Congressional inaction, we entered a new decade and uncertain times in terms of estate and gift tax laws. The Economic Growth and Tax Relief Reconciliation Act of 2001 contained a sunset provision that eliminated the estate tax, generation skipping transfer tax and carry-over cost basis adjustments for tax year 2010 and then reinstated the $1 million applicable exclusion amount, unified estate and gift rates, the generation skipping transfer tax and the 55 percent maximum tax rate for tax year 2011.
While many bills were proposed and one even passed the House, no joint resolution was passed by both the House and Senate before midnight on December 31, 2009. Consequently, we began a period of uncertainty as to whether and when new legislation will be passed which may retroactively extend the 2009 exclusion amount of $3.5 million through 2010 or beyond.
We wish that we could predict with some certainty whether estate tax repeal will remain permanent in 2010 and beyond. Unfortunately, the only certainty is that if there is no action from Congress in 2010 on this issue, the estate tax will remain repealed for 2010, only to be reinstated in 2011 with a applicable exclusion amount of just $1 million.
In view of the dramatic changes to the federal transfer tax system for 2010, precise planning is difficult. After the dust settles, your estate plan may not be materially affected by the changes. For instance, if you live until 2011, the current law's restoration of the estate tax (but at a higher rate and a lower exclusion amount) means that your estate plan may be structured in a manner that still fulfills your family’s planning goals. Alternatively, depending on the amount of the exclusion then in affect, your estate plan may need adjustment in order to achieve its originally intended goals. Accordingly, you should consider reviewing your estate plan in light of these risks and in consideration of the concerns raised below by the repeal of the federal estate tax.
Repeal of the estate tax raises potential concerns as to how certain provisions of estate planning documents may be interpreted by the courts. For instance, many Wills or Revocable Living Trusts divide a spouse's probate or trust estate according to a formula that provides for two broad portions. One portion is equal to the deceased person’s available exclusion amount and is allocated to what is known as the “exempt,” “credit shelter,” “family trust” or “bypass” portion. The other portion is equal to an amount known as the “optimum marital deduction” or “marital share”. The exempt portion, which escapes estate tax at the death of the first spouse and the second spouse, typically benefits the deceased person’s surviving spouse and children. The marital share portion, which is not subject to estate tax when the first spouse dies, but is subject to estate tax when the surviving spouse dies, benefits only the surviving spouse during his or her lifetime. This approach has traditionally been the most effective way for a married couple to minimize their exposure to the estate tax. However, now that the tax has been repealed, this approach may result in a division of an estate in a manner contrary to the couple’s wishes. For instance, suppose the family trust in such a Will was designed to hold all of the assets that comprise the exempt portion of an estate, with the balance passing to the marital share for the surviving spouse. Now that the entire estate is considered “tax exempt,” potentially the entire estate, except for personal items, could be transferred to the family trust, while the spouse’s share could be allocated nothing. This result may be particularly troubling for couples with children from prior marriages.
Another change for 2010 relates to the income tax basis of inherited property. Prior to 2010, the income tax basis of an inherited asset was increased or “stepped-up” to its current value on the decedent’s death. A “step-up” in basis means that regardless of what the decedent paid for property, the heirs inherited the property at its fair market value on the date of death. This step-up in basis effectively eliminated built-in gains on inherited assets. However, effective January 1, 2010, the estate tax liability was essentially “replaced” by the capital gains tax (on estates in excess of $1.3 million), as heirs inherit assets from decedents with a carry-over basis versus a step-up in basis at death(1). Documents drafted prior to 2010 may not account for the possibility of this carry-over of basis issue.
The foregoing changes are effective only for 2010.1 As discussed, the federal estate tax is scheduled to be reinstated on January 1, 2011, with a higher maximum rate (55% vs. 45%), lower exclusion ($1,000,000 vs. $3,500,000), and with the reinstatement of the tax cost basis adjustments effective under the 2009 rules.
If any of the issues outlined above trigger questions or concerns that you would like to discuss further, or if you would like us to review your estate planning documents in light of the estate tax repeal, please contact any of the following attorneys in our Trust & Estates Service Group:
- J. David Porter (firstname.lastname@example.org), Member, Chair of the Personal Services Group, Lexington office
1For taxpayers who die in 2010, the basis step-up at death is eliminated, subject only to an exceptions applicable to (i) the first $1,300,000 of gain in a taxpayer's estate and (ii) an additional $3,000,000 of gain on assets bequeathed to (or in a qualifying trust for) a surviving spouse.