Estate Tax "Repeal" in 2010: A Wolf in Sheep's Clothing?

To illustrate the bizarre nature of the current estate tax, consider a hypothetical couple, John and Mary Smith. John and Mary are in their early 80s and have amassed a $14,000,000 estate, primarily appreciated stocks, over their lifetime. They have strong charitable intent and have decided to divide their estate 50/50 between charity and their three children upon the surviving spouse’s death. After hearing about changes to the estate tax laws for years, they looked forward to the year 2010 when the estate tax would finally be repealed, possibly for good. However, now that 2010 is here, they are dismayed to learn that “estate tax repeal” for them is transitory, results in higher taxes, unnecessary legal costs, and increased uncertainty. Surely this is not the state of affairs that they, and many others, expected.

With the health care bill signed into law, Congress may finally be able to turn some of its attention to other legislative priorities, including reform of the on-again, off-again federal estate tax system. Before contemplating the future, let’s retrace the path of the rules put into place by the current law. Congress passed the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”) legislation in 2001. As shown below, EGTRRA gradually increased the “unified credit equivalent” - the amount a person can bequeath estate tax-free.

However, EGTRRA retained the $1,000,000 unified credit for gift tax purposes so one must die to take full advantage of the unified credit increase. On top of that, the entire EGTRRA law expires at the end of this calendar year and the unified credit then returns to its 2001 level of $1,000,000. Lastly, the estate tax rate, which was 45% in 2009, returns to 55% in 2011.

For John and Mary, the estate tax changes from 2009 to 2010 would not reduce their estate tax bill. Under the rules in effect last year, had they both died in 2009, they could have transferred up to $7,000,000 (each had a $3.5 million exemption) to their children without tax. However, if John and Mary survive until 2011, they are faced with the prospect of paying more than $2,000,000 in estate tax on the same bequests to their children. Several bills have been introduced in Congress to prevent the unified credit from returning to $1,000,000, but you can be forgiven if you have lost confidence in Congress’ ability to pass any permanent estate tax legislation. Indeed, some members of Congress are against legislative change because they favor a return to 2001 rules, a $1,000,000 unified credit, and a 55% estate tax rate.

Where’s My Basis Step-up?

A lesser discussed part of the EGTRRA legislation that carries significant costs for many taxpayers is the elimination of the unlimited step-up in tax basis at death, effective January 1, 2010. Under long-standing step-up rules, the tax basis of appreciated property is increased to the date of death fair market value used in calculating the estate tax. This step-up permits heirs (including a spouse) to sell the inherited property without the imposition of a capital gain tax on the pre-death appreciation. Under the rules in effect for a death in 2010, only $1,300,000 in gain can be “stepped-up” tax-free. An additional $3,000,000 in gain may be eliminated by basis step-up on transfers between spouses. However, most traditional husband/wife estate plans do not qualify for the additional $3,000,000 step-up without a change to their plan. For all other assets, the heirs must determine the decedent’s basis in the assets (typically the price the decedent paid for them), which will often be time consuming, expensive, and sometimes impossible. Without any evidence to the contrary, the tax basis on inherited property could be presumed to be zero, leaving 100% of the proceeds on the later sale of such property subject to capital gains tax.

Under the rules in effect for 2010, John and Mary will not be able to step-up the basis in all their assets if one of them were to pass away in 2010 - despite not getting any benefit of the estate tax repeal. If the survivor later sells their assets, he or she will incur income tax to the extent the assets sold had more than $1,300,000 in gain. To take advantage of the increased $3,000,000 spousal basis step-up, John and Mary will have to incur legal costs to amend their current estate plan to include a “2010 Patch” that reallocates assets upon a death in 2010. This 2010 Patch should not have a material impact on the estate plan, but could save millions in income tax. However, underscoring the fleeting nature of the current situation, this amendment is only necessary if either John or Mary pass away in 2010 since the step-up in basis rules are fully restored in 2011 when the EGTRRA law expires. Therefore, for younger clients in good health or clients with less than $1,300,000 in gain, incurring the legal expense to amend their estate plan may not be advisable.

Uncertainty Reigns

Another problem with the current estate tax system is the continued uncertainty – which is never a useful attribute of a taxation system. In December of 2009, knowing that no legislation could be passed until 2010, some members of Congress threatened to reinstate the 2009 rules and make them retroactive for anyone who dies in 2010. Until that “retroactivity” issue is resolved, the heirs of taxpayers who pass away in 2010 face a conundrum. If the decedent would have owed an estate tax under the 2009 rules, the heirs will be unsure whether the estate owes estate tax or whether the assets are entitled to a step-up in basis. For example, if someone passed away on January 5, 2010 with an estate of over $50,000,000, an estate tax of over $22,000,000 would be due on October 5, 2010, assuming the 2009 law is extended retroactively. But without clarity on which rules...2009 or 2010...will apply, the heirs are uncertain of the tax treatment on the sale of assets to raise the cash needed to pay the estate tax, since the assets only receive a full step-up in basis if the estate tax is retroactively reinstated. If you think this is a big mess, join the club.

In sum, the estate tax law changes in effect in 2010 may not provide all the tax savings promised and could result in some taxpayers paying higher income taxes. At a minimum, the current situation forces all taxpayers to better document the price paid for all their property and might require some taxpayers to incur unnecessary legal expenses to implement the “2010 Patch” to their estate plan. While Congress may act to rectify the problem soon, there is a lack of confidence in Congress’ ability to overcome deep philosophical differences to pass any sensible permanent estate tax legislation. So, for clients like John and Mary Smith, the estate tax “repeal” in 2010 may turn out to be a wolf in sheep’s clothing.

Clay Stevens

Next Article