Attorney & Counselor at Law
ROBERT M PHILLIPS
At the time I started putting this article together, everyone (and I do mean everyone in the United States of America) expected Congress would “fix” the 2001 federal estate tax laws which were set to expire at the end of 2009, thus restoring at long last a sense of stability, certainty and predictability to our tax laws. There was no conceivable way the Congress could bicker and be so neglectful so as to let the tax laws fall into such disarray! But, as we now know, they did, they have, and they will continue to do so.
Here's the score, for those of you who tuned out several innings ago: No Estate Tax for persons dying in 2010, but that comes at a cost of the loss of step-up in basis (more on this later). And then, in 2011, a brutal Estate Tax returns but the loss of step-up in basis goes away. Can they make it any more complicated? There was talk earlier this year of changing the law retroactively as of January 1, 2010. Or, perhaps, giving estates a choice of the version of taxes they might enjoy paying in 2010. But hope for any relief now seems to be shrinking as fast as the value of the Euro.
In early May, Senator Baucus (D-Mont.) was touting "we are getting very close" as Senator Kyl (R-Ariz.) and Senator Lincoln (D-Ark.) were "leading the negotiations." Just three weeks later, the news out of Washington is that negotiations appear to have been wrecked, with both sides pointing fingers. And Senator Lincoln is in a surprise fight to just be renominated by her own party. This business of governing for the people will just have to wait. At least until after the November elections.
So, instead of an article about the current, new, or expected tax law and how it works, the theme now is that it is time to be pro-active and ultra-defensive in anticipation of anything the folks in Washington may or may not throw our way. Just a warning, but next year is shaping up as a brutal tax year for those who depart this life. But, at least for this year, 2010, there is no estate tax! And, that is a good thing. Right? Well….
Yes, the estate tax is repealed for this year. As the law now stands (which itself is a shaky statement) the estates of those who die in calendar year 2010 will not be subject to federal estate tax. That is a good thing. Compared to 2009 when the value of all property one owned at death exceeding $3,500,000 was taxed at 45%, paying no estate tax sounds like a very good thing. For some families, this will undoubtedly be true. But for many many other families, they will wish we had the old estate tax laws of 2009 on the books now.
The problem stems from the fact that Congress likes to make "revenue neutral" laws. The 2001 tax act that brought us to where we are today was no exception. Like a balloon you push in one place, it pops out in another. If taxes are cut one place, they must be increased somewhere else to make up for the loss in revenue. Thus, revenue neutrality.
So, the 2001 tax act repealed the estate tax for 2010 (the "push in"), but it also repealed that part of the tax code that has given every asset, in every decedent's estate, a new basis equal to its fair market value on the date of death (the "pop out"). The basis of an asset is important because it is the difference between an asset's basis and the selling price of the asset that determines how much income tax (capital gains tax) the seller has to pay to Uncle Sam. Increase the basis and you shrink the amount of taxable realized gain, and hence a smaller tax bill.
Here is an example: Assume grandpa owned 100,000 shares of General Electric. Over the years grandpa acquired these shares at various times, paying in the aggregate about $65,000 for all of these shares. That $65,000 is grandpa's basis in the stock.
Now suppose grandpa died on October 1, 2009, and left you all 100,000 shares. On that date those shares would have been worth about $1,500,000. If you later sold them all for that same amount, you would not have had to pay a single penny in capital gains (income) tax. That is because under the 2009 tax law the basis in those shares would have been stepped-up from grandpa's old $65,000 to the value of those shares on the day grandpa died. Thus, as far as the IRS is concerned, when you sold the GE stock there was no taxable gain-you broke even!
Now consider the same facts except grandpa was fortunate enough to live three months longer and died in January, 2010. Again, you sell your newly inherited stock, only this time you received about $1,800,000 (the value on grandpa's date of death). As in 2009, the IRS will want to collect capital gains tax on the taxable gain you realized when you sold the stock. Only this time there is taxable gain because your basis in the stock is not stepped-up to the value on grandpa's date of death. Instead, you get to keep grandpa's basis ($65,000) forever! So, the gain you realized is $1,800,000 less your basis ($65,000), or $1,793,500 of taxable income reported on your Form 1040 income tax return. Translation: you could owe about $270,000 in tax!
This example is, of course, too simple. For some estates, avoiding the estate tax in 2010 will be far more beneficial to the heirs than avoiding capital gains when they sell the assets. But the truth is that many more families of persons dying in 2010 will be hit with an income tax (capital gains) than would have been hit with a 2009 estate tax. And even if a 2010 estate does not have to pay estate tax, it is more likely to have to prepare and file an additional new tax form with the decedent's final income tax return due by April 15, 2011, so the IRS has a record of all of those old basis numbers. In 2009, estimates are that about 6,000 - 8,000 families had to file estate tax returns. In 2010, the estimate is that from 60,000 to 80,000 families may have to prepare this new income tax form.
So, what do we do now? Here is my short list:
Have Your Will or Trust Reviewed. If you have a Will or Revocable Trust, congratulations. (More than half of you do not.) This is not a sales pitch to make work for attorneys. Rather, this recommendation reflects a very real, but unexpected and potentially dangerous situation that exists for some families. Without getting into the details, planning documents written prior to 2009 may have a trap built into them that could preclude your spouse, or your kids, or other primary beneficiary of yours from receiving anything from you at your death!
This is because sophisticated estate planners often use "formula gifts" in Wills that are tax-driven. These formulas are designed to minimize estate taxation, and actually refer to the tax code to calculate how much to give a surviving spouse, or how much to put into the Marital Trust or the Family Trust or even the amount of outright gifts to others. If there is no estate tax law (as this year, 2010), references to the estate tax code could be meaningless and cause these formula clauses to unintentionally pass all (or nothing) to the wrong (or correct) beneficiaries, contrary to your wishes and intent. A few states have recently tried to address this trap, but you should not rely on state legislatures to solve this problem. You must be pro-active and have your estate planner carefully review your documents.
Some good news: After 2010, this problem may go away as the estate tax law comes roaring back into force and gives meaning to all these sophisticated clauses. But, that leads me to my second "what to do."
Have Your Will or Trust Reviewed. Now. No, that is not a typo. This second review is actually broader in scope and looks ahead to tax years 2011 and beyond. Under the current law, the estate tax is set to return in 2011 with a maximum tax rate of 55% on all of the property you own at your death in excess of $1 million. This is the same tax rate and exclusion that existed a decade ago.
Just as no one anticipated that we would have a repeal of the estate tax this year, there are many who are certain that Congress would never let the estate tax laws return to only a $1 million exclusion and a max rate of 55%! The buzz I hear is that Congress may just quietly let the existing tax law return to these levels, thinking any other course is political suicide with today's current deficits.
More than likely, your own plan was put together sometime in the last decade when we all anticipated the gradual reduction, if not elimination, of the estate tax. Planning ideas and techniques that seemed important when the exclusion was only $1 million seemed less relevant and important as the exclusion kept rising and the rate kept dropping over the past decade. It is time to dust off those ideas and techniques again.
If we are all pleasantly surprised and Congress does change the tax law, it is important that any planning undertaken today should anticipate and be pro-active to such changes. Fool me once, shame on you! Fool me twice….
Consider Life Insurance as Estate Tax insurance. I am not suggesting you consider life insurance for income replacement (the most common reason to acquire life insurance). Rather, if you think taxes, and in particular estate taxes, will be going up in future years there will be a need for quick liquidity in your estate. Life insurance (second-to-die coverage is ideal) fills that need precisely. Remember, you will never be healthier and younger than you are today, so while you may qualify for inexpensive life insurance today, you may not later when you wish your estate had such coverage. Establishing an irrevocable life insurance trust to own the insurance is an efficient and tax-advantaged technique frequently used in the 90's and early 2000's that I expect will once again come to the forefront in many estate plans.
If you take only one message away after reading this article, it should be that this is a time for diligence and action, not passivity and complacence. We have seen what Congress is capable of and it behooves each of us, on behalf of our families that will survive us, to prepare and act in our own best interests.
The information contained in this article was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer; it was written for informational and educational purposes only and does not constitute legal advice; the taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
Here's the score, for those of you who tuned out several innings ago: No Estate Tax for persons dying in 2010, but that comes at a cost of the loss of step-up in basis (more on this later). And then, in 2011, a brutal Estate Tax returns but the loss of step-up in basis goes away. Can they make it any more complicated? There was talk earlier this year of changing the law retroactively as of January 1, 2010. Or, perhaps, giving estates a choice of the version of taxes they might enjoy paying in 2010. But hope for any relief now seems to be shrinking as fast as the value of the Euro.
In early May, Senator Baucus (D-Mont.) was touting "we are getting very close" as Senator Kyl (R-Ariz.) and Senator Lincoln (D-Ark.) were "leading the negotiations." Just three weeks later, the news out of Washington is that negotiations appear to have been wrecked, with both sides pointing fingers. And Senator Lincoln is in a surprise fight to just be renominated by her own party. This business of governing for the people will just have to wait. At least until after the November elections.
So, instead of an article about the current, new, or expected tax law and how it works, the theme now is that it is time to be pro-active and ultra-defensive in anticipation of anything the folks in Washington may or may not throw our way. Just a warning, but next year is shaping up as a brutal tax year for those who depart this life. But, at least for this year, 2010, there is no estate tax! And, that is a good thing. Right? Well….
Yes, the estate tax is repealed for this year. As the law now stands (which itself is a shaky statement) the estates of those who die in calendar year 2010 will not be subject to federal estate tax. That is a good thing. Compared to 2009 when the value of all property one owned at death exceeding $3,500,000 was taxed at 45%, paying no estate tax sounds like a very good thing. For some families, this will undoubtedly be true. But for many many other families, they will wish we had the old estate tax laws of 2009 on the books now.
The problem stems from the fact that Congress likes to make "revenue neutral" laws. The 2001 tax act that brought us to where we are today was no exception. Like a balloon you push in one place, it pops out in another. If taxes are cut one place, they must be increased somewhere else to make up for the loss in revenue. Thus, revenue neutrality.
So, the 2001 tax act repealed the estate tax for 2010 (the "push in"), but it also repealed that part of the tax code that has given every asset, in every decedent's estate, a new basis equal to its fair market value on the date of death (the "pop out"). The basis of an asset is important because it is the difference between an asset's basis and the selling price of the asset that determines how much income tax (capital gains tax) the seller has to pay to Uncle Sam. Increase the basis and you shrink the amount of taxable realized gain, and hence a smaller tax bill.
Here is an example: Assume grandpa owned 100,000 shares of General Electric. Over the years grandpa acquired these shares at various times, paying in the aggregate about $65,000 for all of these shares. That $65,000 is grandpa's basis in the stock.
Now suppose grandpa died on October 1, 2009, and left you all 100,000 shares. On that date those shares would have been worth about $1,500,000. If you later sold them all for that same amount, you would not have had to pay a single penny in capital gains (income) tax. That is because under the 2009 tax law the basis in those shares would have been stepped-up from grandpa's old $65,000 to the value of those shares on the day grandpa died. Thus, as far as the IRS is concerned, when you sold the GE stock there was no taxable gain-you broke even!
Now consider the same facts except grandpa was fortunate enough to live three months longer and died in January, 2010. Again, you sell your newly inherited stock, only this time you received about $1,800,000 (the value on grandpa's date of death). As in 2009, the IRS will want to collect capital gains tax on the taxable gain you realized when you sold the stock. Only this time there is taxable gain because your basis in the stock is not stepped-up to the value on grandpa's date of death. Instead, you get to keep grandpa's basis ($65,000) forever! So, the gain you realized is $1,800,000 less your basis ($65,000), or $1,793,500 of taxable income reported on your Form 1040 income tax return. Translation: you could owe about $270,000 in tax!
This example is, of course, too simple. For some estates, avoiding the estate tax in 2010 will be far more beneficial to the heirs than avoiding capital gains when they sell the assets. But the truth is that many more families of persons dying in 2010 will be hit with an income tax (capital gains) than would have been hit with a 2009 estate tax. And even if a 2010 estate does not have to pay estate tax, it is more likely to have to prepare and file an additional new tax form with the decedent's final income tax return due by April 15, 2011, so the IRS has a record of all of those old basis numbers. In 2009, estimates are that about 6,000 - 8,000 families had to file estate tax returns. In 2010, the estimate is that from 60,000 to 80,000 families may have to prepare this new income tax form.
So, what do we do now? Here is my short list:
Have Your Will or Trust Reviewed. If you have a Will or Revocable Trust, congratulations. (More than half of you do not.) This is not a sales pitch to make work for attorneys. Rather, this recommendation reflects a very real, but unexpected and potentially dangerous situation that exists for some families. Without getting into the details, planning documents written prior to 2009 may have a trap built into them that could preclude your spouse, or your kids, or other primary beneficiary of yours from receiving anything from you at your death!
This is because sophisticated estate planners often use "formula gifts" in Wills that are tax-driven. These formulas are designed to minimize estate taxation, and actually refer to the tax code to calculate how much to give a surviving spouse, or how much to put into the Marital Trust or the Family Trust or even the amount of outright gifts to others. If there is no estate tax law (as this year, 2010), references to the estate tax code could be meaningless and cause these formula clauses to unintentionally pass all (or nothing) to the wrong (or correct) beneficiaries, contrary to your wishes and intent. A few states have recently tried to address this trap, but you should not rely on state legislatures to solve this problem. You must be pro-active and have your estate planner carefully review your documents.
Some good news: After 2010, this problem may go away as the estate tax law comes roaring back into force and gives meaning to all these sophisticated clauses. But, that leads me to my second "what to do."
Have Your Will or Trust Reviewed. Now. No, that is not a typo. This second review is actually broader in scope and looks ahead to tax years 2011 and beyond. Under the current law, the estate tax is set to return in 2011 with a maximum tax rate of 55% on all of the property you own at your death in excess of $1 million. This is the same tax rate and exclusion that existed a decade ago.
Just as no one anticipated that we would have a repeal of the estate tax this year, there are many who are certain that Congress would never let the estate tax laws return to only a $1 million exclusion and a max rate of 55%! The buzz I hear is that Congress may just quietly let the existing tax law return to these levels, thinking any other course is political suicide with today's current deficits.
More than likely, your own plan was put together sometime in the last decade when we all anticipated the gradual reduction, if not elimination, of the estate tax. Planning ideas and techniques that seemed important when the exclusion was only $1 million seemed less relevant and important as the exclusion kept rising and the rate kept dropping over the past decade. It is time to dust off those ideas and techniques again.
If we are all pleasantly surprised and Congress does change the tax law, it is important that any planning undertaken today should anticipate and be pro-active to such changes. Fool me once, shame on you! Fool me twice….
Consider Life Insurance as Estate Tax insurance. I am not suggesting you consider life insurance for income replacement (the most common reason to acquire life insurance). Rather, if you think taxes, and in particular estate taxes, will be going up in future years there will be a need for quick liquidity in your estate. Life insurance (second-to-die coverage is ideal) fills that need precisely. Remember, you will never be healthier and younger than you are today, so while you may qualify for inexpensive life insurance today, you may not later when you wish your estate had such coverage. Establishing an irrevocable life insurance trust to own the insurance is an efficient and tax-advantaged technique frequently used in the 90's and early 2000's that I expect will once again come to the forefront in many estate plans.
If you take only one message away after reading this article, it should be that this is a time for diligence and action, not passivity and complacence. We have seen what Congress is capable of and it behooves each of us, on behalf of our families that will survive us, to prepare and act in our own best interests.
The information contained in this article was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer; it was written for informational and educational purposes only and does not constitute legal advice; the taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
ESTATE TAX: WHAT DO WE DO NOW?