Understanding the Implications of the Temporary Repeal of the Federal Estate Tax

Understanding the Implications of the Temporary Repeal of the Federal Estate Tax

As the New Year arrived on January 1 with confetti and champagne, so did a very significant change in U.S. tax law:  the temporary repeal of the federal estate tax laws.  Although some would see repeal as another cause for celebration, for many it will create more problems than it solves.  In addition, the repeal of these laws - even though it is only scheduled to last for one year - requires individuals to consider whether their wills and trusts still operate as planned or instead leave their beneficiaries facing unintended consequences.  This article describes the new estate tax landscape so attorneys and their clients can consider what steps they may want to take (pending any action by Congress) in order to avoid unintended consequences.

How Did We Get Here?

In 2001 Congress passed the Economic Growth and Tax Relief Reconciliation Act ("EGTRRA"), a $1.35 trillion tax cut package that contained several changes to the federal estate, gift, and generation-skipping transfer tax laws - the trio of taxes commonly known as the federal "transfer" taxes.  Before EGTRRA, every individual could have left his or her beneficiaries $1 million, free of estate tax:  the "estate tax exemption" amount.  After EGTRRA, the estate tax exemption amount gradually rose to $3.5 million in 2009 and the top estate tax rate declined from 55% to 45% over the same period.  EGTRRA provided ultimately for full repeal of the federal estate tax in 2010, but not as a permanent repeal.  In order to meet budgetary restrictions, EGTRRA contained a "sunset" provision that called for reinstatement of the estate tax in 2011 - but at its 2001 levels; i.e., with a $1 million exemption amount and a 55% top tax rate.1  

From 2001-2009: Much Talk, But Nothing Happened

From 2001 through 2009, the scenario of the 2010 estate tax repeal and the 2011 reinstatement of prior law created increasing uncertainty for taxpayers and their estate planners.  This problem was so large and well-reported that nearly everyone expected Congress to address the situation before the end of 2009.  Some legislators did introduce tax bills, and the House was even successful in passing a bill late last year that would have permanently extended the 2009 estate tax rates and exemptions through 2010 and beyond.  To many this seemed like the most reasonable approach, because the 2009 rates and exemptions were considered relatively generous:  a per-person exemption of $3.5 million ($7 million for married couples), and a top tax rate of 45% for estates in excess of that.  However, the Senate did not take similar action to provide a temporary fix.

Capital Gains Rules Through 2009

One other component of EGTRRA must be mentioned.  For decades, assets in a decedent's estate have received a tax-free "step-up" in income tax basis to their value on the date of the decedent's death.2 This basis step-up for appreciated assets allowed a decedent's beneficiaries to sell inherited property without having to realize the gain or appreciation that had accrued during the decedent's lifetime.  (By contrast, when a beneficiary receives an asset by gift from a living donor, the asset retains the donor's "carry-over" tax basis, which can result in significant capital gains taxes payable by the donee if the asset appreciates significantly between the donor's acquisition and the donee's sale.)  This basis step-up at death provided a valuable benefit to a decedent's beneficiaries.

2009 Rules No Longer Apply

With the absence of any federal legislation, the estate tax system disappeared on January 1.  The media has focused on the benefits of repeal, in some cases without much attention to another one of its features:  the loss of the unlimited basis step-up for appreciated assets.  Instead of allowing beneficiaries to receive all of a decedent's assets with a basis equal to their value as of the decedent's date of death,3 now only $1.3 million of appreciation (or unrealized gain) will qualify for a basis step-up; and the starting point will be the lower of the decedent's basis or the fair market value of the asset on the decedent's date of death.4

Additional Basis Step-up For Assets Received By A Surviving Spouse

Assets left to a surviving spouse either outright or in a qualifying trust5 will be allowed an additional $3 million in gain/appreciation that qualify for the basis step-up.  For spouses domiciled in community property states, this additional basis step-up can also be allocated to the surviving spouse's one-half interest in appreciated community property.  This feature was likely included as a rough substitute for the marital deduction that was available under the federal estate tax system through 2009 for estates of married taxpayers.  The marital deduction was unlimited if the estate was properly structured and the surviving spouse was a U.S. citizen.  But this year, a surviving spouse who receives assets with aggregate unrealized gain exceeding $4.3 million will - when the assets are sold - be subject to capital gains tax on the gain or appreciation in excess of $4.3 million that accrued during the lifetime of the first spouse.    

Difficult Administrative Problems

Of course, the $1.3 million basis step-up ($4.3 million maximum for a surviving spouse) will still mean that many estates and trusts in this country escape federal taxation.  However, the rules in place this year will add new burdens in administering estates and trusts.  Every decedent's executor or trustee ("fiduciary") will be responsible for choosing which assets will receive this valuable basis step-up.  Think of the difficult decision a fiduciary will face when a decedent leaves assets with unrealized appreciation of over $1.3 million to multiple beneficiaries, and the fiduciary needs to choose which beneficiaries will receive the basis step-up (effectively reducing the beneficiary's capital gains taxes later on), and which beneficiaries will receive assets with a lower carryover basis (and future capital gains tax liabilities). 

Not only will the basis allocation choices present difficulties in many estates and trusts, but consider the problems in determining a decedent's basis.  Now families, fiduciaries, and beneficiaries may be faced with the task of combing through a decedent's records to find out what the decedent paid for each asset, and amounts spent thereafter to improve it.  Certain tax penalties may apply if inadequate basis information is provided to the IRS.  It will still be necessary to value the assets as of the decedent's date of death in order to calculate the application of the basis step-up.  All this data, together with details about the basis allocation, will need to be reported on a tax return that will be due on April 15 of the year following the year of the decedent's death.  Filing extensions are available, but provide only limited additional time for fiduciaries to assemble this data. 

Law Will Change Again In 2011

The system in place today will only last until the end of this year.  On January 1, 2011 - barring legislative action - the estate tax will reappear.  But it will be an older version of the estate tax, with a $1 million exemption amount and a 55% top estate tax rate.  In other words, for a decedent who dies next year with a net taxable estate valued at more than $1 million, his or her estate will pay a 55% tax on the amount over $1 million before the remaining assets pass to his or her beneficiaries.  On the positive side, all those assets should again qualify for an unlimited basis step-up.

What, If Anything, Will Congress Do?

Many believe that this difficult situation will be fixed by Congress this year.  One possibility is that estate tax repeal could be made permanent.  A more likely possibility is that the 2009 exemption amount and and tax rate may be extended through 2010.  Of course, any legislation would require enough consensus and political will in Congress to forge an agreement.  Consensus may be in short supply this year, given the continuing health care debate, competing revenue needs, and midterm elections on the horizon.  With the current Senate makeup, it is difficult to predict what will occur, or when.  If Congress were to pass a retroactive estate tax, it would probably face a constitutional challenge and protracted litigation by estates and trusts of decedents who died between January 1 and the date of the legislation.  If tax legislation does not pass soon, some sources in Washington predict that there will be no change in the laws as they currently exist, because tax legislation is too polarizing for Congress to deal with as the 2010 Fall election season approaches.    

What Type Of Plans Might Require Changes?

While waiting to see if Congress acts, it may make sense to focus most attention on estate plans that employ a formula keyed to the federal estate tax exemption in effect at the time of death to allocate assets between or among different beneficiaries.  In these plans the beneficiaries who would receive the "exempt" portion may now receive everything if a death occurs this year, leaving nothing for the other beneficiaries.  For example, in a plan that leaves the decedent's exemption equivalent to children from a first marriage, and the remainder to a second spouse, the second spouse could receive nothing.  This may be very different from the client's intended outcome.

Other clients who might require immediate attention to address deaths that may occur this year are:  (1) clients who may not survive until next year, to make sure their plans (however structured) will be effective; (2) clients whose estate plans define amounts passing to charities using a definition of the available charitable deduction under old estate tax rules, (3) clients with buy-sell agreements or similar contracts that would establish sales price based on estate tax return data.  This list is not exhaustive.

From a practical standpoint it might be helpful to advise clients on these issues:  (1) if family discord is likely, consider amending an estate plan to provide specific direction regarding who (or which assets) should benefit from any basis step-up, and/or to excuse the fiduciary from any liability for basis allocations, and (2) gathering data that establishes their cost basis in key assets, particularly those assets that are difficult to value or which have been improved over time; if gathering document is difficult, at least consider writing down notes regarding the history and cost of the major assets acquired over the years, and keeping those notes in an accessible place.

From a planning standpoint, consider whether any state inheritance tax laws might impact a client's estate; many states' inheritance or estate tax laws have changed signicantly in recent years.  Also, now might be a good time to consider advising clients about making taxable gifts while the top gift tax rate is only 35%, asset values remain depressed due to the weak economy, and interest rates are still low.  This involves some risk, however, and may not provide an economic payoff if estate tax repeal is made permanent.  There is an additional risk that Congress could impose a gift tax rate higher than 35% that is retroactive to January 1 of this year.  Finally, more creative planning may be available, such as gifts to grandchildren while there is no GST tax.  It will be easier to evaluate the risks and benefits of these types of planning options after seeing whether Congress addresses the estate tax situation over the next few months.

Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6296 or PMcCabe@mofo.com.

© Copyright 2010 Morrison & Foerster LLP.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

[1] This Article will focus primarily on the estate tax. The generation-skipping transfer ("GST") tax exemptions and rates were the same as for the estate tax from 2001-2009, and the GST is similarly repealed this year and reinstated in 2011 at 2001 rates.  The gift tax - which applies to lifetime gifts so wealthy individuals won't give everything away in order to avoid future income, estate, and gift taxes - stayed fairly constant from 2001 through 2009, with a $1 million exemption and a top rate that declined from 55% to 45%; however, this year the top gift tax rate drops to 35% before springing back to 55% in 2011. [2] Or a step-down for assets that have declined in value during the decedent's lifetime.

[3] Or six months later in certain cases. 

[4] Any unused capital loss carryforward of the decedent will be added to this $1.3 million amount.

[5] This trust must meet the requirements of a "qualified terminable interest" (or "QTIP") trust.