2010: "Repeal" of the Federal Estate Tax
The Economic Growth and Tax Relief Reconciliation Act of 2001 (the "2001 Act") made headlines at the time of its passage because it contained provisions that would repeal the estate tax and the generation-skipping transfer ("GST") tax.
The truth is that the 2001 Act replaces the federal estate tax and GST tax (but not the gift tax) with a capital gains tax for one year, beginning January 1, 2010 and ending on December 31, 2010. The capital gains tax may apply because the beneficiaries will receive the decedent’s assets with a basis, for income tax purposes, equal to fair market value or the decedent’s basis, whichever is less (referred to as a transferred basis).
The decedent’s assets may be given a step-up in basis (limited to fair market value), to the extent that the fiduciary administering the decedent’s estate has "basis increase" to allocate selectively among the decedent’s appreciated assets. The basis increase is $1,300,000 (augmented by certain unused net operating loss carry forwards and capital loss carryforwards) generally, with additional basis increase of $3,000,000 for a surviving spouse (but only under certain circumstances). The "transferred-basis" rules will be difficult to administer.
On January 1, 2011 the federal estate tax and GST tax rules (as they existed prior to the 2001 Act) will spring back into effect.
Few (if any) in the estate planning community ever dreamed that Congress would allow the "repeal" provisions of the 2001 Act to take effect. Proposals for legislation to supersede the 2001 Act began circulating almost immediately; however, Congress has failed to reach a consensus on permanent estate tax reform before the stroke of midnight on December 31, 2009 (or since).
This article describes some of problems that may arise for estate planning documents written based upon the gift/estate tax rules, but not the transferred-basis rules.
Every estate planning client (especially clients in fragile health) should contact (or should be advised to contact) his or her estate planning attorney to schedule a review. In most cases, minor revisions to the post-death allocation provisions may be sufficient to alleviate the potential problems described in this article. Certain problems that are likely to arise because of the "repeal," will require litigation.
Federal taxation of gifts during life and after death
The federal estate and gift taxes are taxes on the transfer of property as a gift (i.e., for less than the property’s fair market value). While California does not impose a separate estate tax, a number of the states do. This Articles does not discuss state estate taxes, other than to mention that they exist.
Until January 1, 2010, the federal estate tax and GST tax1 applied to transfers of property at death. The federal gift tax continues to apply without interruption to certain transfers of property during the donor’s lifetime. Transfers of property during life or after death to a person two or more generations below the decedent or donor (referred to as a "skip person") were potentially be subject to GST tax.
The 2001 Act increased the gift and estate tax exclusion amounts to $1,000,000 (effective January 1, 2002). Thereafter, the estate tax exclusion amount increased gradually to $3,500,000, while the gift tax exclusion amount remained at $1,000,000. The GST tax exemption increased in step with increases in the estate tax exclusion amount. The top gift and estate tax rate was reduced in steps from 55% to 45%.
While the estate tax was in effect, a beneficiary of a decedent’s estate received property with a basis for income tax purposes equal to fair market value as of the decedent’s death. Upon a later sale of the property, the beneficiary would have a taxable capital gain limited to the appreciation in value of the property occurring between the decedent’s date of death and the date of sale. Appreciation in value during the decedent’s lifetime was extinguished for purposes of the capital gains tax.
Property passing by gift during the donor’s lifetime would be received by the donee with a transferred basis. Upon a later sale or other taxable disposition, the donee’s gain would be based upon all appreciation in value occurring since the donor acquired it (subject to all basis adjustments during the donor’s ownership).
The tax rules applicable to property transferred from a donor or decedent in 2010
In 2010 while the estate tax and GST tax are suspended, a beneficiary receives property from a decedent’s estate with a transferred basis.
During 2010, the gift tax remains in effect, with a $1,000,000 exclusion amount and a maximum rate of 35%. The donee continues to receive the gift property with a transferred basis.
To mitigate the effect of the transferred basis for property passing at death, the 2001 Act provides for a limited basis increase. The basis increase is $1,300,000 (which can be augmented by certain unused net loss and capital loss carry forwards.) An additional $3,000,000 in basis increase can be allocated to property passing directly to a surviving spouse or to a special form of trust (a "marital trust") for the sole benefit of the surviving spouse.
The basis increase cannot be applied to IRAs, qualified plan benefits, residual payments from works-for-hire or other property having the status of "income in respect of a decedent." Such property will continue to be taxed as ordinary income in the hands of the beneficiary; however, those assets will not be diminished by the estate or GST taxes during 2010.
The basis increase is allocated by the executor (if there is probate proceeding). If the basis increase is not fully used by the executor, any other person in actual or constructive possession of the decedent’s property can claim the basis increase. Other persons who may be in actual or constructive possession include a trustee of a revocable living trust or a person taking a decedent’s interest by right of survivorship, and such persons can claim the available basis increase. Each person claiming a share of the basis increase must file a "Return Relating to Large Transfers at Death"2 ("2010 Returns"). Depending upon how an estate is divided, any number of 2010 Returns may need to be prepared and filed for one decedent.
At this time, no guidance exists to resolve possible conflicts regarding allocation of the basis increase between or among executors, trustees and/or any other persons in actual or constructive possession of the decedent’s property.
How the suspension of the estate tax may affect decedent’s estates and their beneficiaries
Replacing the estate tax with a tax on capital gains will affect beneficiaries in a variety of ways depending upon the circumstances.
Under the estate tax rules, a primary goal is the efficient use of the decedent’s credit against the estate tax. While the estate tax is suspended, the goal will be to allocate the decedent’s basis increase in accordance with the decedent’s wishes without wasting any of the decedent’s available basis increase.
Plans with formula allocation provisions
Suspension of the estate tax may result in unintended consequences for beneficiaries of estate plans containing formula allocation provisions.
A formula that allocates property among multiple classes of beneficiaries by reference to the estate tax exclusion amount will not work properly while the estate tax is suspended. A common allocation formula segregates the maximum amount of the decedent’s estate as can pass free of the estate tax to a class of beneficiaries (such a children, extended family or friends), while allocating property subject to the estate tax to a different class of beneficiary (such as a spouse or charity). In a no-estate tax environment, the allocation scheme described above can inadvertently disinherit an entire class of beneficiaries. Estate plans most at risk for this malfunction include the following:
- An estate plan that divides the estate between a spouse and children of the decedent from a prior marriage could result in the children receiving the entire estate, while disinheriting the surviving spouse.
- An estate plan that segregates a share comprised of property equal in value to both the estate tax exclusion amount and the GST exemption could potentially disinherit every class of beneficiaries other than grandchildren or other skip-persons (if the GST exemption corresponds to the estate tax exclusion amount.
Waste of the Basis Increase
When the decedent is survived by a spouse, a formula allocation provision may divide the entire estate between the bypass trust and a marital trust that qualifies for the unlimited estate tax marital deduction (known as a "QTIP" trust). If the spouse is the beneficiary of both trusts, he or she is not disinherited. However, the spouse’s additional $3,000,000 of basis increase may be wasted. With rare exceptions, the bypass trust will not qualify to absorb the spouse’s additional basis increase; however, the QTIP trust should qualify. If applying the formula provision allocates the entire estate to a bypass trust, the surviving spouse will not be disinherited, but $3,000,000 of additional basis increase could be wasted.
Estates comprised of assets with unrealized gains in excess of the aggregate available basis increase will put the administrator of the estate in a no win situation. Even if the decedent’s overall plan for the distribution of his or her estate at death will be implemented as desired to maximize the basis increase, the allocation of the basis increase is likely to present difficulties for the executor/ trustee or beneficiary.
- Should the basis increase be allocated to some bequests and devises, but not others?
- Should the basis increase be allocated in proportion to the unrealized gain?
- Should the basis increase be allocated in proportion to the value of property received by each beneficiary?
- Should a probate proceeding be opened so that an executor will be appointed who will have authority over the allocation of basis increase?
In the absence of an executor, should the trustee seek court approval of his or her allocation of the basis increase?
Other issues arising because of suspension of the estate tax
With an estate tax exclusion amount of $3,500,000, the estate tax is predicted to apply to fewer than 2% of the estates of all US persons dying in 2009.
In contrast, the transferred basis rules will affect all beneficiaries.
The recipient of property from a person who died while the estate tax was in force knows that his or her basis for income tax purposes in property received from a decedent will equal the fair market value of the property when the decedent died.
The recipient of property from a person who dies while the transferred basis rules are in effect will need to know the following:
- The basis of the property in the hands of the decedent.
- Whether unused loss carry forwards may be available to supplement the decedent’s basis increase.
- Whether, or how much of, the decedent’s basis increase has been, or can be, allocated to the property he or she receives.
Depending upon the circumstances, each person claiming the basis increase must file a separate 2010 Return. Since few people maintain records necessary to ascertain the exact basis in his or her property, there is little chance that the decedent’s basis increase will be allocated efficiently.
Is 2010 a good year to die?
A few clients have asked whether 2010 will be a "good" year to die (as if there is such a thing). The answer, as always is: "it depends."
A would-be beneficiary who is disinherited by operation of a formula allocation provision will derive little comfort knowing that the decedent’s estate passed free of the estate tax to someone else.
Even though the capital gains tax is lower than the estate tax rate, beneficiaries receiving highly appreciated assets can be counted upon to protest about the way the executor or trustee allocates the decedent’s basis increase.
A surviving spouse may be unhappy if the spousal property basis increase is wasted.
Litigation over allocation of the basis increase should be anticipated.
Litigation over whether Congress can enact retroactively effective estate tax reform (should Congress attempt to do so) should also be anticipated. Administration of decedents’ estates while there is no estate tax may be subject to uncertainty for years, as the challenges to the retroactive tax provisions are resolved.
What to do next
Everyone with an estate having a net value (including IRAs, qualified plan benefits and life insurance) in excess of $1,000,000 should be encouraged to review his or her estate planning documents for problematic formula allocations provisions. The threshold is $1,000,000, because if Congress remains paralyzed, in 2011, the estate tax will be back and the coordinated gift and estate tax exclusion amount will be $1,000,000.
A person with highly appreciated property should consider how his or her basis increase ($1,300,000 + applicable loss carry forwards, and the additional spousal basis increase of $3,000,000 (if there may be a surviving spouse) should be allocated. Written guidance should be provided to individual or institutional fiduciaries of his or her estate.
A qualified estate planning attorney can advise whether the estate planning documents in question may require amendment.
1 The GST tax applies to most gifts or bequests to a skip person and is imposed as an additional tax at the highest estate tax rate.
2 The new name of Section 6018 of the Internal Revenue Code, which until 2009 and beginning again on January 1, 2011 bears the name, "Estate Tax Returns."