2010 Estate Tax Repeal & Estate Planning Implications

Oops! This post was originally scheduled for publication at the beginning of the year, but due to a user error on my end, the post was never published. Better late than never I suppose.

I’m pleased to share the following, posted with the permission of the author, my colleague Attorney Mike Lichterman of Lichterman Law, PLC in Western Michigan, first appeared on his blog here.

Mike makes some excellent points around the New Year’s expiration of the federal estate tax, especially regarding the change in treatment of tax basis for estate assets and the 55% tax rate set to return in 2011 on the then-$1 million federal exemption.

After reading, if you have any questions, please ask away in the comments section and I will answer them as soon as I can.

“Hasta La Vista, Estate Tax” by Mike Lichterman, Esq

As you may (or may not) have heard in the popular press, your favorite news site, or from reading this post at South Florida Estate Planning Law written by my colleague David Shulman, the estate tax is officially repealed as of 12:00am January 1, 2010. Seeing as Congress has mere hours to pass legislation to change that, I see the repeal being a pretty sure thing.

So what does that mean? As it currently stands (for the remaining hours of 2009), an individual has a $3.5 million estate tax exemption (a couple can increase that to $7 million with proper planning). The estate tax is set to disappear for 2010, as stated above. Some are calling it the “throw mama’ from the train” year . . . as in, die in 2010 so that your estate is not subject to estate tax. That’s all well and good, and I’m sure it will benefit many folks who pass away in 2010. However, as Paul Harvey used to say, “now . . . the rest of the story.”

Accompanying the repeal of the estate tax is a change to the “basis” treatment for estate assets. Basis is (typically) what you paid for an asset. As you likely know, when you sell an asset, you pay tax on the “gain” – the amount you sold it for minus what you paid for it (basis) – sometimes more commonly referred to as “profit.” In 2009 (and many years before), you get a “step up” in basis on the assets of someone who passes away. This means that the beneficiaries who receive your assets have a basis in those assets equal to the assets’ value on the date of death. They get to use that basis if/when they later sell the assets. Here’s an example:

Date of death: 12/31/2009
Total asset value: $3 million
Dying person’s basis: $1 million
Estate tax: $0 (under the $3.5 million exemption amount)
Asset basis for beneficiaries: $3 million (”stepped-up” to value on date of death)

If the beneficiaries later sell the assets for $3.5 million, they will pay tax on only $500,000 – the amount the assets sold for minus their basis. With the 2010 estate tax repeal comes a change to those basis rules. For 2010, the stepped-up basis is limited to $4.3 million in assets passing to a spouse and (more importantly, I think) $1.3 million in assets passing to non-spouses. So, the estate doesn’t pay any federal estate tax, but what does it mean for the non-spouse beneficiaries?

Let’s use the same example as above:

Date of death: 1/1/2010 (what a difference a day makes!)
Total asset value: $3 million
Dying person’s basis: $1 million
Estate tax: $0 (estate tax repealed)
Asset basis for beneficiaries: $2.3 million ($1 million basis of the person who died + $1.3 million “step up”)

If the beneficiaries later sell the assets for $3.5 million, they will pay tax on $1.2 million – the amount the assets sold for minus their basis (which had only the limited step up).

As you can probably imagine, the amount of tax on the additional $700,000 is a fairly significant number, especially when you consider that it is very unlikely that taxes will go down anytime soon (sorry for getting a little bit political). On top of that, there is a looming paperwork nightmare. Can you imagine? How are you going to prove what the dying person’s basis was, especially for some of the more uncommon assets? Valuation will become a larger headache than it already is. Sure it can be done, but what an incredible hassle. As a matter of fact, a friend of mine is a supervising attorney in the estate and gift tax department of the IRS and she said that the IRS is sorely prepared to deal with such a paperwork avalanche. For sure there will be a lot of additional searching, researching, and organizing that will need to be done. It will be interesting to see how much additional cost will be associated with this, in professional fees (lawyers, CPAs, financial advisors, etc.) and otherwise.

Oh, and one more thing. Did you catch the missing word? Gift tax. Nope, gift tax is not going away. It stays in full effect throughout 2010. Apparently, Congress was concerned that if the gift tax went away, wealthy taxpayers would make large gifts to family members in lower income tax brackets (a valid concern). So, the gift tax exemption remains at $1 million.

And wait . . . there’s more! The law that put the estate tax repeal into effect (the Economic Growth and Tax Relief Reconciliation Act of 2001) is set to “sunset” in 2011, returning the estate tax and gift tax to what they were before the law was in effect. Curious to know what that was? I knew you would be. The estate tax exemption was (and will go back to) $1 million. That’s right . . . $1 million! And the tax rate will be 55%! Sure, that’s a significant amount of money and you may be thinking “no big deal, it’s a million bucks,” but consider the example above. If all goes as scheduled, if our example person died in 2011, the estate tax on the estate would be $1.1 MILLION (55% of $2 million)! The beneficiaries will miss out on $1.1 million of additional inheritance. Now THAT is a significant number. Keep in mind that this can be “fixed” with proper planning.

So there you have it. That is what is supposed to happen as things stand on the books right now. Will it actually happen? Well the repeal will definitely occur if Congress doesn’t act today. The question is, for how long. Consensus seems to be that Congress will address the issue next year. What will they do? I’m not sure and I don’t think anyone knows for sure. The most common idea I’ve heard is that they will retroactively extend the current $3.5 million exemption and 45% tax rate. We’ll see. 2010 will be a very interesting year for us estate planners, that’s for sure!

One thing I am fairly sure of (cue the Arnold voice) . . . It will be bbbaaaacckk!

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