By Bob Wheat, CPA, J.D., AEP
ESTATE TAX PLANNING
You may have heard that the federal estate tax rules have dramatically changed this year and, unless Congress passes new legislation, could radically change again in 2011. This article will briefly outline these changes, what caused them to occur and the current status of the federal estate tax law.
THE 2011 TAX ACT
To put the changes into perspective, it is important to note that Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) in 2001. Phased in over several years, this act provided significant estate and gift tax relief, which took the form of progressively lower rates, as well as increased estate and generation skipping tax (GST) exemptions. These exemptions reached $3.5 million per decedent in 2009, with a flat tax rate of 45%. This was a sharp contrast to the $1.0 million exemption and top rate of 60% that was in effect for 2001.
EGTRRA also contained a provision to completely repeal the federal estate and GST tax for 2010, while the federal gift tax exemption stayed at $1.0 million with a lower flat rate of 35%. The basis step-up rules, which gave a fresh start adjustment to fair market value for most assets under the traditional estate tax regime, are replaced by an adjusted carry-over basis system. A carry-over basis system had been previously passed by Congress in 1976. However, it was generally deemed unworkable and the mandatory provisions were repealed in 1980 before ever going into effect.
Finally, EGTRRA is automatically repealed on January 1, 2011. The result is that the estate and GST tax goes from a $3.5 million exemption and 45% rate in 2009, to no estate and GST tax in 2010, and then back to the $1.0 million exemption and top 60% rate in 2011. This results in a tax planning quagmire for many individuals that most advisors never anticipated.
CONGRESS FAILED TO ACT IN 2009
From the time of its passage, estate planning practitioners have speculated on whether the 2010 estate tax repeal would ever happen. Conventional wisdom indicated that the repeal would be replaced by a system similar to the 2009 exemptions and rates, and the stage was set in November to carry over the 2009 rules to 2010. However, the House failed to act on a one-year extension and instead sent a bill to the Senate making the 2009 rules permanent. The Senate was preoccupied with health care reform and could not agree on the estate tax issues. As a result, Congress failed to enact any changes to EGTRRA, and effectively repealed the federal estate and GST tax as of January 1, 2010 for one year.
A PLANNING DILEMMA
When Congress failed to act on estate tax legislation in 2009, it created tremendous uncertainty in planning for estate and income taxes. Some experts believe that Congress will let the repeal stand in 2010 in exchange for increased income tax collections and much higher estate and GST tax rates that return in 2011. Without the automatic step-up in basis to fair market value, Congress estimates that over 70,000 heirs will pay more income tax in contrast to the 6,000 decedents who might benefit from no estate tax. Recent statistics show that only 2% of all Americans currently have an estate that would exceed $782,000.
WHAT ARE THE RULES FOR 2010?
The first problem planners encounter when adjusting to the 2010 changes is the vast amount of uncertainty regarding what Congress might do next. As mentioned, Congress may let the current law stand, which presents a number of pitfalls for individuals with planning documents based on the old rules. These include:
1. Wills and trusts drafted with formula clauses to minimize taxes in 2009 might unintentionally cause heirs or a spouse to be ‘disinherited’ under certain by-pass trust provisions.
2. Passing assets directly to a surviving spouse might result in higher estate tax in 2011.
3. Asset basis conflicts could arise between heirs and estate fiduciaries, and unexpected income tax consequences could result from asset dispositions.
4. Inadvertent GST taxes could result after 2010.
On the other hand, Congress may address the estate tax issue in 2010 in a couple of ways. First, it might restore the 2009 rules for this year effective January 1, 2010, but there is a debate over whether it would be constitutional to make such a provision retroactive (it would not be the first time tax legislation carried an effective date prior to its enactment). If Congress takes this approach, it is likely to be challenged in the courts and may take several years to get the Supreme Court to decide the issue. An alternative approach would be to give the decedents of those individuals dying in 2010 prior to enactment a ‘free pass’ on estate taxes and make any restoration effective at some point during the year or on January 1, 2011.
If Congress does act in 2010, most professionals envision rules similar to those in effect for 2009, possibly with lower rates and a lower exemption. Also, proposals to eliminate or at least limit valuation discounts are always on the table with any new estate and GST tax legislation.
WHAT ARE THE RULES FOR 2011?
As previously mentioned, there are a number of automatic changes in the federal tax law that takes effect on January 1, 2011. These include:
- The estate tax exemption drops to $1.0 million per decedent and the 2001 rates go back into effect (55% above $3.0 million and 60% above $10 million in the taxable estate).
- Higher income tax rates return (capital gains rates go up at least 5%, tax on dividends goes up by 24.6% and the top income tax rates increase by at least 4.6%).
- States that are coupled to the federal estate tax have their state inheritance tax restored.
- The basis step-up to fair market value is restored for most estate assets.
Regardless of what happens in 2010, it is apparent from the current spending and deficit predictions that taxes will substantially increase in the future. Most commentators believe this will not occur until 2011, when the provisions of EGTRRA are automatically repealed. Based on that scenario, and the current uncertainty with the estate tax, it would be wise to take maximum advantage of planning opportunities in 2010. These include:
- Roth IRAs - in 2010 taxpayers can convert traditional IRAs to Roth IRAs and elect to either pay the tax in 2010 or defer it until 2011 and 2012. This can produce a significant benefit but it can also be a trap for those who do not fully explore the tax effects.
- Increased gifting and taking advantage of valuation discounts.
- Accelerating dividend and capital gain income into 2010, when it will be taxed at the current, reduced rates.
Because of the unique circumstances that 2010 presents, it may be prudent for you to reevaluate your estate and income tax situation as soon as possible.
WE CAN HELP
Based on your goals, Decosimo professionals can help you assess different options and make better-informed decisions concerning your estate and income tax planning. Please contact Bob Wheat, one of Decosimo's tax professionals, to discuss how we can help you improve your current estate and income tax plans.
Bob Wheat, CPA, J.D., AEP | Senior Tax Manager