The Estate Tax Quagmire

Posted by Jeffrey N. Berman on

What a mess Congress has created! We are now in a year where there is no federal estate tax – but hold the cheers. Congress has substituted another method of taxation that will collect more taxes from many families than the estate tax. Additionally, as has been reported in the local and national press, these changes will, for some, greatly alter the planned distributions among family members and heirs.

A brief review of the law will help explain why this is so significant. The 2001 tax act, signed into law by President George W. Bush, gradually reduced the maximum rate of the federal estate tax (and generation-skipping transfer tax on transfers to grandchildren) from 55% to 45% and increased the amount of property that could pass free of federal estate tax from $675,000 per person in 2001 to $3.5 million per person in 2009. As a result, a married couple could, with some basic planning, pass up to $7 million free of federal estate tax, if they both died in 2009.

Then, in 2010 only, the 2001 tax act repeals the estate tax. But under the existing law the estate tax returns again on January 1, 2011 with a lower $1 million exemption and a higher maximum 55% tax rate!  This strange effect is the result of a rule in Congress that attempts to limit budget deficits.

Paying for Estate Tax Repeal
To pay for this one-year repeal of the estate tax, Congress eliminated the step up in basis at death. Before 2010, the cost basis of inherited property was adjusted to its fair market value on the date of the decedent’s death. Thus, when a beneficiary or heir sold any inherited asset (like securities or a home) that had increased in value, they would not have to pay capital gains tax on growth that occurred during the decedent’s life.  (This is referred to as a “step-up in basis”).  For many heirs this meant huge tax savings, oftentimes tens of thousands of dollars or more.

But in 2010 inherited property does not automatically receive this step-up in basis. Instead, only a limited amount of property in each person’s estate can be “stepped-up” in value at death. Property that does not receive this step-up will be subject to tax on all growth from the date the decedent first acquired the property, potentially creating tens of thousands of dollars of capital gains tax liability for your heirs!

Not surprisingly, these rules are complex and very different from the old law. In fact, Congress attempted to institute a similar tax structure in the 1980s which was repealed, retroactively, because it was too difficult to administer. Based on past experience and anticipated difficulties in calculating such a tax, it was believed that Congress would change the law before January 1, 2010, but it did not.

How Are You Affected?
This law can affect you in several ways. You need to first make sure that your property will be divided according to your desires, and not as dictated by Congress.  For many years it has been common to use a mathematical formula to divide the assets of a married couple when the first spouse dies to maximize estate tax savings. Similar formulas were used to provide funds for charitable causes and to benefit family and friends. Now, in 2010 when there is no estate tax, these formulas may not work. If a spouse is not your sole beneficiary (e.g. if you have children from a prior marriage), the existing formula could result in the disinheritance or substantial reduction of resources provided for the surviving spouse.

What Should You Do?
Review your estate plan and make any necessary changes to ensure that your property is positioned to receive the maximum step-up in basis available under current law. This is a time that demands a new approach to your planning, building in flexibility to see that your wishes are fulfilled no matter what Congress does next. We have solutions that will meet your planning objectives with the least amount of tax impact.