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TRUSTS AND ESTATES
CLIENT E-ALERT
February 2010

 
 
 

REPEAL OR NO REPEAL — THAT IS THE QUESTION

In our 2009 Year-End Review newsletter we reported that, without Congressional action, 2010 would be the year of the unlimited exemption from Federal Estate Tax. Although in December the House of Representatives passed a bill to retain the 2009 estate tax exemption of $3,500,000 for deaths occurring in 2010 and thereafter, and the 2009 top estate tax rate of 45%, the Senate failed to act and the bill died. While at first glance this may sound like good news, there are some definite downsides to Congressional inaction.

REPEAL IS ONLY TEMPORARY

If Congress's inaction continues through 2010, the so-called repeal of the estate tax will be in effect for only one year. The federal estate tax will return in 2011 with a much lower exemption — $1,000,000 — and a much higher tax rate — the top estate tax rate will increase to 55%.

We expect that the Senate will act to restore the federal estate tax sometime this winter and make it retroactive to the first of January. Although the outcome is uncertain, the prospect of a Constitutional challenge may prompt Congress to avoid retroactive application.

NOW WHAT DO WE DO?

Needless to say, this amount of uncertainty makes it very difficult for advisors as well as clients. Notwithstanding the uncertainty, it is as important as ever to plan and it is especially important to ensure that your estate planning documents have appropriate and flexible funding formulas in them.

Virtually all trusts that contain tax planning provisions contain a formula to allocate funds between a family trust (also called a bypass trust or a credit shelter trust) which is completely tax exempt and a marital trust which is tax-deferred. These formulas should be examined to ensure that they are flexible enough to produce the optimum result in an environment where we do not know the future of the exemption — will it be unlimited, limited to $1,000,000, $3,500,000, or more, and which also factors in Massachusetts's $1,000,000 threshold for imposing its own estate tax. It is critical to review this if you have different beneficiaries of two different trusts. For example, in a second marriage situation, you might have chosen to have children of a first marriage as the only beneficiaries of the family trust and have your second spouse as the beneficiary of the marital trust. Before “repeal” both trusts would have been funded. Now, depending on the wording of the funding formula, all of your assets might pass into the family trust, leaving the marital trust unfunded and leaving your second spouse without funds to live on.

Even with no concerns about estate taxes, there are still many reasons to implement an estate plan. Among them are:

  1. If you own a business, succession planning is critical.
  2. If you have minor children, a guardian must be designated.
  3. If your children are not sophisticated enough to handle a significant inheritance after age 18, a trust will ensure ongoing supervision by a dependable trustee.
  4. If you have been married more than once and have a blended family, a trust will balance the interests of all of your beneficiaries.
  5. If you are concerned about the stability of a child's marriage, a trust is useful to control the disposition of that child's portion of your estate.
  6. If a beneficiary is disabled, the ongoing services of a trustee will insure that funds are protected and disbursed appropriately.

What Congress Giveth, Congress Taketh Away

If the unlimited exemption remains in effect, the heirs of people dying in 2010 will not benefit from a complete step-up in the basis of assets for capital gains purposes. In contrast, when the estate tax is in effect, the basis of inherited assets is stepped up to the fair market value as of the date of death. For example, if you had inherited a home in Nantucket in 2009 from Uncle Joe who purchased it in the 1950's for $30,000 and it was worth $1,500,000 at the date of Joe's death, your basis in the home was stepped up to $1,500,000. If you had sold it the next day for that amount there would have been no capital gains tax to pay. Without the step-up in 2010, the gain would be $1,470,000, taxed at the rate of 15%.

Under this new regime, the capital gains tax will not be imposed on the sale of every asset. Each estate will have $1,300,000 of 'phantom' basis (referred to in the Internal Revenue Code as aggregate basis increase) that can be allocated to assets of the estate; in addition, a surviving spouse will have $3,000,000 of phantom basis to allocate to property he or she received either outright or through certain types of marital trusts. Basis cannot be allocated to items of “income in respect of a decedent” (e.g., assets in a retirement plan) or property acquired by the decedent by lifetime transfer during the three-year period before death. For example, if the decedent received a gift of a property from a relative a year before death, no basis adjustment can be made to that property.

It has been reported that while only 5,500 estates per year were subject to estate tax when the exemption was $3,500,000, over 70,000 families will be subject to capital gains tax on inherited estate assets this year.

Headaches for the Executor

The carryover basis regime creates logistical problems for the executor of an estate. It will be up to the executor to determine the basis of every single asset in the estate. If the property of the estate, other than cash, exceeds $1,300,000, the executor will have to file a Basis Return (substituting for the Estate Tax Return) and allocate the $1,300,000 of allocable basis, item by item. In order to know how much basis to allocate to a particular asset, the executor must be able to determine the decedent's basis in the property. For real estate this involves not only knowing the original purchase price but also knowing the value of capital improvements made over the years and any depreciation taken on the property. For securities, the executor will have to determine the original purchase price, whether there have been stock splits or mergers or breakups of the company (e.g. Ma Bell breaking up into the so-called Baby Bells). An executor's failure to report the transfers at death of noncash assets in excess of $1,300,000 can result in a penalty of $10,000.

While repeal or the possible expansion of the exemption may well save estate tax to the benefit of your heirs, it has added many new planning complications. We invite you to contact our office to set up an appointment to reexamine your estate plan, and ensure its efficiency in this changing environment.

CONTACT

If you have any questions about this alert, please contact the author, Marjorie Suisman.

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This article is provided as a courtesy and may not be relied upon as legal advice, or to avoid taxes and penalties. Distribution to promote, market, or recommend any arrangement or investment to avoid or evade taxes, including penalties, is expressly forbidden. Any communication with the author as to its contents, does not, of itself, create a lawyer-client relationship. Under the ethical rules applicable to lawyers in some jurisdictions, this may be considered advertising.

IRS Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding U.S. tax penalties.