Estate Tax Is Dead (For Now): What to Do?

It unexpectedly happened: Congress let the federal estate tax die for 2010. Lots of people are confused about what it all means. It's no wonder ... the current situation is a huge mess that creates uncertainty for those with large estates.

 

Here is a brief discussion of how the United States arrived at this strange destination along with some ideas to discuss with your estate planning professional.

 

Repeal for 2010 but the Story Is Not Over

 

Ever since the Economic Growth and Tax Relief Reconciliation Act of 2001 became law, the estate tax has been a two-party story:

 

•    The federal estate tax was scheduled to be repealed this year. (This happened after the top estate tax rate gradually went down and the exemption amount on estates that didn't have to pay the tax went up.)

 

•    The estate tax is scheduled to come roaring back in 2011 and beyond. In those years, estates worth as little as $1 million are scheduled for a tax whipping (versus estates worth more than $3.5 million in 2009), and the maximum federal estate tax rate is set to rise to 55 percent (versus 45 percent last year).

 

Tax professionals never thought Congress would allow this two-part story to be played out because, taken together, it makes no sense. Why would we have the top estate tax rate go from 45 percent to zero to 55 percent?

 

Most people assumed Congress would step in and continue the relatively generous (by historical standards) $3.5 million federal estate tax exemption with a maximum estate tax rate of 45 percent (the same as last year). More optimistic observers were hopeful the exemption would be bumped up to $5 million or so with a maximum rate well below 45 percent.

 

But Congress did nothing about the estate tax last year, and it could be weeks, or even months, before lawmakers get around to tackling it this year. By then, the issue may be so contentious that all previous predictions about what might happen could get tossed out the window.

 

So to sum up so far, we are in a bizarre place where there is technically no federal estate tax on those who happen to die right now but there is a harsh federal estate tax looming over those who happen to die in 2011 and later years.

 

Observation: Most tax professionals still believe Congress will resurrect the federal estate tax sometime in 2010 and that the effective date of the new rules (whatever they turn out to be) will be sometime in 2010. Some experts believe that making the new rules retroactive to January 1, 2010 would be unconstitutional. Imagine the uproar if Congress waits several months to retroactively impose an estate tax on wealthy people who died early in the year. The issue is likely to wind up in court, which will lead to delays and additional burdens for heirs.

 

Naturally, if you have a large estate, you want to know what you should do today. Here are three scenarios with potential problems. 

 

Scenario #1: You Are Married With a Joint Estate Worth More than $3.5 Million. If you fall into this category, you may already have a tax-saving estate plan in place. If so, you should probably leave it alone unless you have one of the two problems explained below.

 

Problem: Too Much Goes to the Kids

 

Some existing estate plans may be flawed because they call for leaving as much money as possible to the children or grandchildren without triggering a federal estate tax, with the rest then going to the spouse.

 

Last year, this type of plan would have directed $3.5 million to the kids. That $3.5 million bequest would have been federal-estate-tax-free because it matched last year's federal estate tax exemption.

 

But with the federal estate tax now repealed, the current exemption is unlimited. Therefore, dying today with this type of estate plan could mean all the assets go to the kids with absolutely nothing left for the spouse. If this is not what you intend, contact your estate planning adviser about how to proceed in fixing your estate planning documents.

 

Problem: Not Enough Goes to the Kids

 

The second potential problem is less serious, and some folks might decide it is not worth worrying about. Let's say your current estate plan calls for leaving the specific amount of $3.5 million to the children (last year's federal estate tax exemption amount), with the rest then going to your spouse. In 2009, this was a good plan. It would have avoided any federal estate tax hit by taking full advantage of last year's $3.5 million exemption.

 

As of today, however, you can leave as much as you want to the youngsters with no federal estate tax due. So if your existing plan gives your spouse more than he or she really needs, you may want change the documents and leave more to the youngsters and less to your spouse.

 

Scenario #2: You Are Single with an Estate Worth More than $3.5 Million. Last year, you could not have left more than $3.5 million to loved ones without triggering a federal estate tax liability. Your existing plan might still call for your estate to make enough deductible charitable donations to whittle its net worth down to $3.5 million, before giving that $3.5 million to loved ones. Since you can now leave an unlimited amount with no federal estate tax due, you might want to make changes to leave more to loved ones and less to charities.

 

Scenario #3: You Are Married or Single with an Estate Worth Less Than $3.5 Million. There won't be any federal estate tax liability if you die today, and there would not have been one if you had died last year. We can only hope the same will be true if you die next year. In any case, you do not need to make any tax-saving estate plan changes right now.

 

No matter what scenario you are in, if your plan was set up several years ago, it is still a good idea to revisit it to make sure it reflects your current wishes. And depending on what Congress decides in the next couple years, you may want to revise your documents.

 

There is a Also New Basis Rule for Inherited Assets

 

In conjunction with the 2010 repeal of the federal estate tax, we also get a new rule for determining the federal income tax basis of inherited assets. If it is not changed, it could result in heirs paying more capital gains tax.

 

Under the old rule, the basis of inherited assets were generally "stepped up" (or stepped down) to equal their date-of-death fair market values (FMVs). However, there was no basis step-up for an amount attributable to income in respect of a decedent (IRD). Basically, IRD is ordinary income that was accrued as of the decedent's death but was not yet included in the decedent's gross income for federal income tax purposes. The two most common examples of IRD assets are tax-deferred retirement accounts and CDs and taxable bonds with accrued interest that was not paid as of the decedent's death.

 

Under the new rule that exists today, the federal income tax basis of inherited assets can still be stepped to reflect their date-of-death FMVs, but there is a limit on this tax-saving benefit. In a nutshell, the new rule says the basis of inherited assets start off equal to the decedent's carryover basis amounts (generally equal to cost). Then, those carryover basis amounts can be stepped up by as much as $1.3 million to reflect date-of-death values, or by as much as $4.3 million for assets inherited by a surviving spouse. As under prior law, there is no basis step up for amounts attributable to IRD.

 

Observation: Most tax advisers expect the old stepped-up basis rule for inherited assets to be brought back as part of the resurrection of the federal estate tax.

 

Don't Forget About Estate Taxes in Your State

 

It is not just Uncle Sam that charges estate taxes. So if you decide to update your estate plan because of the federal estate tax considerations mentioned here, make sure the changes don't unnecessarily increase your exposure to any taxes in your state.

 

What Does the Future Hold?

 

The repeal of the estate tax leaves us in uncharted waters. For the past 93 years, the United States has relied on the estate tax as a source of funding (before that, there were various other taxes imposed on estates during times of national emergencies). So almost no one thinks that a permanent repeal will be enacted, especially during these tough economic times.

 

So what will the estate tax look like in the next few years? No one knows for sure but one thing is certain: Estate planning will be challenging. Documents may have to be changed now and revised again before too long. Consult with your estate planning adviser to ensure your documents are up to date and your wishes are carried out.