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A Whole New World of Tax Law: Understanding 2010 Changes to the Federal Estate Tax

05.25.2010

On January 1, 2010, we entered a whole new world of tax law, at least for the rest of 2010. Why? The Federal Estate Tax ("FET") has been repealed for decedents who die in 2010. This "temporary" repeal of the tax presents opportunities and potential perils that attorneys, financial planners and individuals should be aware of in both 2010 and 2011.

In a nutshell, U.S. citizens and resident aliens who die in 2010 will not owe FET on wealth transmitted to non-spouse and non-charitable heirs and devisees. Under the previous law, which is due to come back in 2011, transfers in excess of a certain dollar amount ($3.5 million in 2009) were taxed at various rates that ranged from 37 percent to as high as 55 percent depending upon what year a person died. (In 2009, the rate was a flat 45 percent on taxable estates in excess of $3.5 million. However, in 2011 the top marginal rate will be 55 percent while the exemption amount will decrease to $1 million). Needless to say, this is unfamiliar terrain for just one year (or until a fix is enacted).

Isn't this good news? Why should we be concerned? Legal and financial advisors should convey their concern to clients for two reasons. First, the one year FET repeal carries with it new tax law governing the income tax basis of inherited property, which if not addressed correctly in a client's testamentary instruments (i.e. a Last Will and Testament or Revocable Trust) could result in higher income tax liability for a client's heirs. Second, for those clients who have tax driven formula testamentary instruments, the instruments need to be reviewed to ensure that they will still carry out the client's testamentary intent.

Has the Income Tax Rule Changed?

For starters, it is important to understand "basis." A quick refresher course -- Basis is most commonly interpreted as the amount one pays for an asset. If a taxpayer purchases marketable securities for $10,000, his/her basis would be $10,000. Basis becomes important when one sells the asset since the difference between the amount received by the taxpayer from the sale and his/her basis is the amount of gain (or loss) that must be recognized for income tax purposes. The higher one's basis in an asset, the less taxable gain he or she will have on the sale of the asset (assuming of course that the amount received from the sale exceeds the taxpayer's basis).

Traditionally, most appreciated property inherited from a decedent received a "step-up" in basis from the decedent's adjusted income tax basis (i.e. what he or she paid for the asset) to Fair Market Value (FMV) determined as of the decedent's date of death. This is also referred to as the "step up in basis" rule. For example, if a decedent during lifetime purchased 100 shares marketable at $5 per share, his or her basis in the stock would be $500. If he/she sold the shares during his/her lifetime and the share price was $100 per share, he/she would have realized and recognized a capital gain of $95 per share or $9,500 in the aggregate. If, however, the decedent had died when the FMV was $100 per share, the decedent's estate (or the decedent's heirs if the property was distributed in kind) would have an income tax basis of $100 per share in the securities (hence the term "step up"). Any subsequent gain or loss would be measured against that stepped up share value. The theory behind the rule was very straight forward- since assets owned by a decedent at date of death were theoretically subject to the Federal Estate Tax (FET), the Internal Revenue Code provided for the step up in order to avoid "double taxation." With the repeal of the FET in 2010, this double taxation avoidance mechanism is no longer needed. Thus, for decedents dying in 2010, there is no automatic basis step up and it is now necessary to determine the decedent's adjusted basis in the property. Needless to say, this will be a very interesting exercise for people holding assets that they purchased decades ago and for which they are clueless about their basis.

Under the law in 2010, the Personal Representative of the decedent's estate has the ability to step up the basis in the securities to the $100 per share amount thereby obtaining relief. However, for very wealthy clients (net worth including the value of any life insurance of greater than $1.3 million) this becomes a very important exercise since it will be necessary to ensure that the $3 million of additional basis increase for transfers to spouses will be fully utilized.

Review your estate planning docs, now! Many wealthy married individuals have "tax driven" testamentary instruments that were executed when the FET was in effect. These formulas were used to minimize their combined FET liability. Most of these instruments make references to estate tax sections in the Internal Revenue Code that are currently repealed. Consequently, for these clients, their estate plans may produce the bizarre result of disinheritance of their spouse (depending upon how the document was structured). While Maine does recognize a surviving spouse's right to claim a share of the decedent's estate (what is called the "Elective Share"), this generally involves a court proceeding and can be both expensive and time consuming. The point is that everyone should have their documents reviewed.

Suppose your client dies next year (2011) - what happens? In 2011, the FET comes back into existence in full force. The automatic step up in basis regime is reinstated and there is no need to worry about the basis adjustment rules discussed above. The bigger problem is that when the FET reappears, we will be facing a less generous FET. The FET Exemption Equivalent (which had risen to $3.5 million per decedent in 2009) will be much lower ($1 million per decedent) and the maximum FET rate will rise to 55% on taxable estate's in excess of $3 million.

How did we get here? In 2001, Congress passed and President Bush signed into law the Economic Growth & Taxpayer Relief Recovery Act of 2001 ("EGTRRA 2001"). As part of this sweeping legislation, Congress (the Republican Party had a majority in both houses) had initially wanted to repeal the FET in its entirety. Since the bill would affect government revenues for more than ten years, Senate protocol required that 60 senators had to vote in favor of the bill or else one senator could stand up during the voting process and kill the bill by objecting to it. Unfortunately for proponents of the bill, the Republicans only had 56 senators who were in favor of the bill, so total FET repeal was not an option. Instead, Congress decided to reduce the impact of the FET on most estates by raising the FET exemption equivalent over a period of time and eventually repeal the FET for one year (in 2010). In order to comply with the protocol, EGTRRA 2001 contained a "sunset provision" which essentially stated that in 2011 the FET would be reinstated. The Republicans probably thought that they would eventually capture enough seats in the Senate in one of the subsequent elections and somehow make the repeal permanent. As we all know, this did not happen and the Republicans fired their last salvo in this battle in 2005 when Senators Frist and Kyl tried very hard to push through a repeal of the tax (the famous Frist Tri Fecta Bill). After that, things remained dormant in this area until the fall of 2009 when the House passed its extender bill. However, with each passing year since 2005, no the issue has gone unresolved.

When can we expect Congress to resolve this? The House has already passed an extender's bill to keep the tax in place for 2010 using 2009 exemption numbers. It is the Senate that still needs to take action, and when they will move remains uncertain. In January of 2010, when he was asked about the Senate's prospects of passing an estate tax bill in the near future, Senator Baucus (Chair of Senate Finance Committee) indicated that nothing was on the horizon, but (to use his words) "it's over the horizon, but maybe pretty close to the horizon." Obviously, uncertainty lingers.

If Congress passes a new bill in 2010, can they make the legislation retroactive to decedent's who died prior to enactment? The U.S. Supreme Court has upheld the retroactive application of tax law (see Carlton vs. United States, 512 U.S. 26 (1994). If you do read the case, you might want to look at Justice Scalia's concurring opinion for some insight into how the current court might examine the retroactive application of an estate tax law.

What about the Federal Gift Tax- was it repealed as well? The Federal Gift Tax is left intact with one small modification. The maximum amount of total aggregate intervivos gratuitous transfers (taxable gifts) that a taxpayer can make during his or her lifetime to non-spouse and non-charitable beneficiaries remains at $1 million. The marginal tax rate for gifts in excess of this amount in 2010 is 35% (the maximum federal income tax rate for individuals in 2010).

What about State Death Taxes- does the repeal of the Federal Estate Tax have any effect on ME's Estate Tax ("MET")? The MET will be unaffected by this new law. Maine taxes a decedent's total aggregate testamentary transfers to non-spouses and non-charitable beneficiaries that exceed $1 million in value as of date of death at marginal rates ranging from 5.6 percent to 16 percent depending upon the aggregate amount of the transfer. New Hampshire has no state death tax so this law has no impact on New Hampshire individuals.

Next Steps:

· Be sure you, or your clients, understand the income tax basis of inherited property. A Will or Revocable Trust could result in higher income tax liability for a client's heirs.

· Be sure your clients tax driven formula testamentary instruments are reviewed to ensure that they will still carry out the client's testamentary intent.

· Advise your clients to seek out a qualified Trusts and Estates attorney to have all of their estate planning documents thoroughly reviewed to ensure their documents will address the issue of temporary repeal.

Contact the Author:

Richard Ploss is a Certified Public Accountant, a Certified Financial Planner (CFP®) Professional and an Of Counsel attorney with Preti Flaherty. He welcomes your questions on the Federal Estate Tax law, and other estate planning and trust administration issues. He may be reached at rploss@preti.com or at 207.791.3000.

tax law, estate planning, wills, federal estate tax, estates, trusts, family law, richard ploss, ploss, preti flaharty
2010 Changes to Federal Estate Tax Law