Federal Estate Tax: A Closer Look
By Deanna Lyon, Elizabeth Engh and Judith Tang
[Originally published as a Wendel Rosen Client Update, January 22, 2010.]
To the surprise of estate planners, Congress failed to address the temporary repeal of the estate tax and let the estate tax expire for 2010. What does this mean for you?
Estate tax repealed for one year
The estate tax was repealed on January 1, 2010, at least temporarily. Under the current tax law, there will be no federal estate tax on the estates of individuals who die in 2010 and there will be no generation skipping transfer (“GST”)1 tax on transfers made in 2010. The federal gift tax will remain in place and the maximum rate will be 35% for gifts made in 2010. Each person will continue to have a $1 Million lifetime exemption from the federal gift tax. Also, with certain exceptions the heirs of a person who dies in 2010 will take the decedent’s cost basis rather than receive a new basis (a “step up” in basis) for the inherited assets.
Gift and Estate Tax Table
Year |
Lifetime Gift |
Estate Tax & GST Exemption |
Highest |
Highest |
2009 |
$1 million |
$3.5 million |
45% |
45% |
2010 |
$1 million |
Unlimited |
0% |
35% |
2011 |
$1 million |
$1 million |
55% |
55% |
Estate tax returns in 2011
On January 1, 2011, the federal estate, gift and GST taxes and the step-up in basis rules are all scheduled to return. The marginal rate for the federal estate, gift and GST taxes will increase to 55% and a person will be allowed only $1 Million of estate, gift and GST tax exemptions, although the latter is adjusted for inflation as noted in footnote 2.
How did we end up with this unusual repeal and resurrection of the estate tax?
President George W. Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRA”), to provide estate tax relief and with the intention of repealing the estate tax altogether. EGTRA gradually increased the estate tax exemption (the amount that a person can leave free of estate tax), and the estate tax was repealed in 2010. However, because 60 Senators did not vote for the repeal of the estate tax, EGTRA has to expire on December 31, 2010, at which time the estate tax will return at the 2001 pre-EGTRA rates.
It was widely expected that Congress would act by December 31, 2009 to avoid the scheduled one-year repeal of the federal estate tax. The U.S. House of Representatives passed a bill in December to extend the 2009 federal estate tax and GST tax rates and exemptions, but the U.S. Senate did not act to provide any similar extensions.
Income Tax Basis Step-Up and Capital Gains Tax
Although inheriting an estate while there is no estate tax seems like a great benefit, some heirs may be worse off due to a change to the income tax treatment of receipt of a decedent’s assets.
Cost basis is what a person paid for an asset, plus or minus certain adjustments. When a person sells an asset for more than its cost basis, capital gains tax is due on the difference between the sale proceeds and the cost basis. Under the prior law when a person died, the cost basis of appreciated assets was stepped up (or stepped down if the asset had declined in value) to their fair market value on the date of death. When the asset was sold, only the post-death appreciation was subject to capital gains tax.
For decedents dying in 2010, appreciated assets will not receive a full step up in basis to their fair market value as of the date of death. Instead, the beneficiaries of the decedent’s estate will receive a “carryover” basis in the appreciated assets, which is the same cost basis as the decedent’s. However, the basis of assets can also be stepped down to current fair market value as of the date of death, thereby depriving the heirs of being able to take advantage of the decedent’s losses.
There are exceptions to this rule. In general, certain assets passing to a surviving spouse that have up to $3 Million of appreciation over the decedent’s basis will receive a step-up in basis to the date of death value. In addition, any assets passing to the spouse or to any other beneficiaries with up to $1,300,000 total appreciation over the decedent’s basis may receive a step-up in basis to the date of death value. Certain of the decedent’s losses and loss carryovers can also be used to increase the basis of the inherited assets. By proper planning, full advantage of these adjustments can be taken.
Furthermore, the decision by an executor or trustee on how to allocate the step-up in basis among various assets could potentially be quite contentious where there are multiple beneficiaries receiving different assets.
Will there be retroactive resurrection of the estate tax?
There is case authority for a retroactive change to the 2010 estate tax laws; however, it is impossible to predict what Congress will do. In the past few years, Congress has considered exemptions ranging from $1 Million to $5 Million, as well as permanent repeal of the estate taxes. There is also a great deal of uncertainty as to whether any law in 2010 will simply provide for an extension of the 2009 rates and exemptions, or whether there will be a more permanent fix with entirely new rates and exemptions.
Review estate plans
We strongly recommend that your estate plan should be carefully reviewed to ensure that your objectives are met, and to determine whether your documents should be amended.
Some estate plans for married couples contain a formula bequest designed to have the estate tax exemption amount pass to someone other than the surviving spouse – such as the couple’s children. In 2009, this would have resulted in up to $3.5 Million being distributed to heirs other than the surviving spouse. For a death in 2010, the decedent’s entire estate could potentially go to these heirs, disinheriting the surviving spouse.
If a person dies in 2010, certain other formulas could result in all assets going outright to the surviving spouse, potentially resulting in increased estate taxes upon the surviving spouse’s death.
Changes may have to be made to wills and trusts to enable full utilization of the step up in basis if a person dies in 2010.
A number of bequests to charity are defined with reference to the federal estate tax laws. Since the federal estate tax laws are repealed for persons who die in 2010, charitable bequests should be reviewed to ensure that your charitable goals are being met. Testamentary charitable remainder trusts and charitable lead trusts must also be carefully reviewed.
If a person owns assets in a State other than California, changes may also be needed.
Special planning considerations also apply to gifts in 2010 and any proposed 2010 gifts are best reviewed, in advance, with our estate planning attorneys.
Flexibility recommended
Due to the far reaching problems caused by the current estate, gift and GST laws, we recommend that you contact one of our estate planning attorneys to discuss how these changes may affect your estate plan and to draft or revise documents to minimize your exposure to transfer taxes.
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1 Tax on transfers benefitting “skip persons,” e.g., grandchildren or subsequent generations.
2 Unlike the estate tax exemption, the GST exemption is indexed for inflation from 1998, starting with a base of $1 Million and projected to be $1,350,000 in 2011.
