No Estate Tax in 2010 - Good and Bad News

There is currently no tax on the estates of those dying during 2010.   Although it is possible that Congress could reinstate the tax retroactively in 2010, the possibility is uncertain, at best.  If Congress fails to act, however, although a few wealthy families will benefit, many families with smaller estates will pay capital gains on inherited assets.  Moreover, executors and successor trustees must contend with new, and what may prove to be significant, administrative burdens.

Under the provisions of a Bush-era tax-cut bill enacted in 2001, the value of estates exempt from the tax has increased over the past eight years while the tax rate on estates has been reduced, so that in 2009 only an individual estate worth $3.5 million or more is taxed, at a rate of 45 percent. For the year 2010, according to the 2001 law, the estate tax disappears entirely, only to be restored in 2011 at a rate of 55 percent on estates of $1 million or more.

For persons with larger estates, their estate plans will need to reviewed and reconciled with the lack of
existence of an estate tax.  The funding of "B" trusts (bypass, credit shelter, and QTIP trusts) is of particular concern.  Usually, the estate plan for a married person who wants to maximize the use of his or her unified credit (or federal estate tax exemption) provides for his or her estate to be divided into two broad shares: one equal to the amount of the federal estate tax exemption and the balance in a form qualifying for the estate tax marital deduction. Generally, there are three broad ways to effect this division: (1) make the amount of the federal exemption a fixed sum of money, (2) make the amount of the marital deduction a fixed sum of money, or (3) make each a fractional share. In each case, a formula is used to define at least one of these amounts. Sometimes, it defines the federal exemption—and although there are several variants, all essentially say to determine the maximum taxable estate the married person could have at death without paying federal estate tax on account of the unified credit (and, perhaps, other credits). Other times, it defines the amount of the marital deduction. Again, there are several ways to phrase it, but essentially it says to determine the minimum amount necessary as the federal estate tax marital deduction in order to reduce the federal estate tax to zero. Defining either the federal exemption or the marital deduction

works well in most tax years.

But just what does either formula produce if no federal estate tax is in effect when someone dies? If there is no federal estate tax, what is the maximum taxable estate one can have without increasing his or her federal estate tax? The concept makes no sense because there will no longer be a taxable estate. Alternatively, what is the minimum marital deduction necessary to reduce the federal estate tax to zero when there is no marital deduction or federal estate tax? Again, the concept makes no sense if there is no marital deduction. One can imagine, in a case in which the spouse of a second marriage succeeds to the marital deduction amount and the children from a prior marriage of the decedent succeed to the exemption amount, that the widow(er) and the children would take diametrically different positions over what each receives.

Even if there is no dispute among the surviving family members (they all agree everything passes under the disposition of the exemption share, for example), the IRS may not agree. And it will have an interest in the outcome in at least two ways. First, it is likely that the exemption share will pass into a trust, and the income earned thereon will not necessarily be taxed to the surviving spouse or to other family members. If the property passes to the surviving spouse (or to a marital deduction trust), the income will be taxed to the surviving spouse (except trust income allocated to corpus and not distributed). Second, the IRS will have a keen interest in the surviving spouse receiving more because the survivor likely will die in a later year when there is an estate tax. 

These complications mean, simply, that every estate plan for an estate that exceeds one million dollars should be reviewed, and an amendment prepared, at least as would pertain to deaths that occur in the year 2010.  So, the federal governments gift for 2010, although welcome, will mean some burden in order to ensure that the gift is realized.

But, old adage is that the federal government doesn’t give anything with one hand that it doesn’t take with the other.  And so it is with the elimination of the estate tax in 2010.  The catch for taxpayers is that for 2010 the estate tax is replaced with a 15 percent capital gains tax on inherited assets that are later sold.  Before this year, anyone inheriting property receives a "step-up in basis" in the property. That is, the value of the property for determining capital gains tax due is calculated at the time it is inherited, not when it was originally purchased by the deceased.  Before 2010, if dad bought property for $25,000, but the value of the property at death was $200,000, when the beneficiaries sell the property after death, there is no taxable capital gain of $175,000 ($200,000 - $25,000), because the basis becomes the fair market value on the date of death ($200,000 - 200,000 = 0).

But the law eliminating the estate tax in 2010 also largely does away with the basis step-up rules. This means that those inheriting estates will have to pay capital gains taxes on any assets sold based on the original price paid for the asset, after an exemption for the first $1.3 million in capital gains (plus $3 million for assets transferred to a surviving spouse).

Let's say your father dies and leaves you a home worth $1.5 million and a $500,000 portfolio of stocks purchased at various times over the past 40 years. If you decided to sell any of these assets, you'd normally pay little or no capital gains tax on the sales. The new provisions mean that you have to calculate capital gains based on the value of the home and the stocks when your father bought them, not when you inherited them. That could be very expensive, not to mention time-consuming in trying to ascertain the original price your father paid for everything.  If you are unable to prove the basis of the property, the basis is effectively “zero.”

The chief tax counsel for the House Ways and Means Committee estimated that while extending the 2009 estate tax law would affect about 6,000 estates, 71,400 estates could face new capital gains taxes if the estate tax disappears. According to the Center on Budget and Policy Priorities, at least 62,500 of these are estates that would not owe any estate tax if the 2009 rules were continued and that thus would be adversely affected by estate tax repeal. Farm and business estates would constitute a disproportionately large share of this group. Small farms and businesses are the groups whose interests opponents of the estate tax have claimed they are defending.

The new world of no estate tax also places at particular risk couples who have so-called "credit shelter" or "bypass" trusts that are designed to allow both spouses to take advantage of their respective estate tax exemptions. These are common arrangements used in estate planning for married couples. With the estate tax gone, the wording of these trusts could be interpreted as completely bypassing the surviving spouse when the first spouse dies, meaning a surviving spouse would get nothing without the expensive process of claiming her "elective share.”  Married couples with such trusts should consult their attorney.

Sen. Baucus has pledged to try to restore the estate tax retroactively in 2010. This would undo the capital gains increase, but it could also create fertile ground for lawsuits by those whose family members die between January 1, 2010, and the date when any retroactive law is enacted.

For an excellent discussion by Forbes.com of the mess that a lapse in the estate tax could create, click here.

This writer does not believe that the Senate will pass such legislation, however.  In a 1994 decision, the U.S. Supreme Court ruled that the Constitution's ban on the enactment of ex-post facto laws does not preclude tax legislation, provided the retroactive application is "supported by a legitimate legislative purpose furthered by rational means". United States v. Carlton, 512 U.S. 26 (1994).  One wonders on what basis Congress can articulate a legitimate purpose furthered by rational means for legislation that is retroactive.  Regardless, since most estates don't file tax returns until nine months after death, if Congress can reach agreement quickly in 2010, the problems caused by a retroactive law can be limited.

Finally, one more thing: the "gift" of estate tax repeal for 2010, is only for one year, while the carryover basis rules survive 2010.  The new adage is is that the federal government doesn’t give anything with one hand that it doesn’t take with the other, while simultaneously charging you the cost of the original gift!  Ok, its an adage in progress.

For more on the implications of the disappearance of the estate tax, see CBS MoneyWatch's "Estate Tax: What You Need to Know for 2010," SmartMoney's "The Federal Estate Tax Is Dead: Now What?," and Kiplinger's "FAQs on the Death of the Estate Tax."

See also, Elder Law Answers.