By Attorney Maria Baler

The estate tax has traditionally been a topic of concern primarily for estate planning attorneys and their clients whose estates will be subject to the estate tax at death. However, in the past couple of months the estate tax has been written and spoken about extensively, as significant changes to the federal estate tax laws occurred on January 1. Although these changes had long been scheduled to occur, most estate planners were surprised that Congress did not act to prevent them from taking effect.

Here are five important facts you should know about the current status of the federal and Massachusetts estate tax laws.

1. The Federal Estate Tax Laws Changed Significantly on January 1, 2010

To understand the recent changes to the federal estate tax, you need to look back to 2001 when President Bush proposed and Congress enacted modifications to the federal estate tax that phased in a reduction over seven years. During the phase-in period from 2002 to 2009, the federal "exemption" amount (the amount that a person can transfer free of federal estate tax at death) increased gradually from $1 million in 2002 to $3.5 million in 2009. In addition, the federal estate tax rates were reduced over that period. The law provided for a complete repeal of the estate tax in 2010. The purpose of the 2001 law was to reduce the number of estates subject to tax and reduce the estate tax paid by those estates.

When this law was enacted in 2001, Congress was not convinced the country could afford to reduce the amount of estate tax it was collecting, let alone eliminate it completely. Therefore, the law contained a provision that if Congress did not act to change the law, on January 1, 2011, the repeal of the federal estate tax would end, and the federal estate tax would return with an exemption amount of $1 million.

It was commonly believed in the estate planning community that Congress would act to change the 2001 law prior to the estate tax repeal on January 1, 2010, either to extend the provisions of the law or to change them, and that Congress would never allow a complete repeal of the estate tax to take effect. No one expected that Congress would not take action and that the law would take effect as written in 2001. However, as some commentators have said, "the unthinkable has happened."

The important provisions of the new law as they relate to the estate tax are:

• The federal estate tax has been repealed for 2010. The estates of persons who pass away in 2010 will not have to pay an estate tax to the federal government, no matter how large the estate.
• On January 1, 2011, the federal estate tax law will change again. Estates of persons who pass away with assets valued at $1 million or more will be subject to a federal estate tax.

The implication of this new law is that far more estates will be required to pay a federal estate tax beginning in 2011.

2. The Future of the Federal Estate Tax Remains Uncertain

As prominent estate planner Irving Schloss wrote recently, "Right now may represent the zenith of legal chaos or pea soup fog in the world of estate taxation, but it seems probable that uncertainty and change will continue for some time to come."

The reason for the current uncertainty is that many believe Congress will act in a "better late than never" fashion and take action in 2010 to halt the repeal of the estate tax and prevent the estate tax exemption amount from decreasing to $1 million on January 1, 2011. Congress may re-instate the 2009 provisions of the law for a year or two, either prospectively or retroactive to January 1, 2010, effectively un-doing the estate tax repeal, and giving Congress some time to enact a new, more permanent estate tax law. It is also possible that Congress may take this opportunity to enact extensive estate tax reforms. Alternatively, Congress may continue to do nothing and allow the estate tax repeal to continue and the new estate tax provisions to take effect on January 1, 2011 with a $1 million exemption. Some commentators have suggested there may be political reasons why a "do nothing" approach is an attractive option for many in Congress.

3. The Massachusetts Estate Tax is Alive and Well

Massachusetts is one of several states that has an estate tax separate from the federal estate tax. The Massachusetts estate tax is imposed on residents of Massachusetts (or people who reside out of state but own real estate in Massachusetts) if the total value of their estate is $1 million or more.

Whether or not the federal estate tax repeal continues throughout 2010, and regardless of the provisions of the federal estate tax law going forward, the Massachusetts estate tax laws remain unchanged. Estates of $1 million or more are and will continue to be required to file a Massachusetts estate tax return and pay any tax that may be due.

4. Significant Changes to the Capital Gain Tax Rules Relating to Inherited Assets

Another significant change related to the federal estate tax law is the way the tax basis of inherited assets is determined. News of this change has not been as publicized, but is likely to have a negative effect on a large number of estates.

These changes impact the tax basis of assets a person inherits. Prior to January 1, 2010, if a beneficiary inherited a capital asset (such as stock or real estate) from a deceased person, the beneficiary's tax basis in the asset (the value on which capital gain or loss is computed when the asset is sold) was equal to the value of the asset at the deceased person's date of death. This was referred to as the "step-up" in basis on inherited assets. The new federal estate tax law eliminated the step-up in basis rules and replaced them with complex carry-over basis rules. These new rules provide that the beneficiary's tax basis will be equal to the deceased person's tax basis. However, the new rules also allow the executor of a deceased person's estate to increase the basis of certain inherited assets by up to $1.3 million, and by up to an additional $3 million for assets passing to the deceased person's spouse.

These rules promise to create a record-keeping nightmare and a confusing situation for beneficiaries and executors alike. The future of these rules will also depend upon whether Congress acts to change the current estate tax laws, and whether those changes are applied retroactively to January 1, 2010.

5. Timely and Accurate Advice Crucial

The current status of the federal estate tax and carry-over basis rules are complex and confusing. Although the federal estate tax has been repealed for 2010, new laws scheduled to take effect in 2011 mean the estate tax will be payable by many more estates than in past years. The new basis adjustment provisions will significantly affect the capital gain tax payable by beneficiaries selling inherited assets.

People who need to pay particular attention to the new rules and any changes that are enacted this year are:

• People who have completed estate tax planning in the past and have so-called credit shelter trusts in place, the provisions of which could be significantly affected by the change in the estate tax laws. These trusts may need to be changed to ensure that they continue to work as intended.
• People who are concerned a death will occur in 2010, to themselves or a loved one, and need to understand the current law as it affects their situation. They need to receive timely advice on planning that can take the best advantage of the provisions of the law as it currently exists
• Executors of estates of individuals who pass away in 2010, who must be fully informed of their estate tax filing obligations and also the implications of the new carry-over basis rules.

Looking to 2011, if Congress does not act to change the federal estate tax laws in 2010, whether retroactively or prospectively, people with estates of $1 million or more should have their estate plans reviewed and discuss whether tax planning is necessary in order to avoid what will be a significant federal estate tax for estates of individuals who pass away after January 1, 2011.

If you are impacted by the new law one way or another, it is important to seek out the advice of an experienced estate planning attorney regarding these matters.

Attorney Maria Baler is an estate planning attorney and a partner with the Dedham firm Samuel, Sayward & Baler LLC. She is also a director of the Massachusetts Chapter of the National Academy of Elder Law Attorneys (MassNAELA). For more information on the changes to the federal estate tax and other estate planning topics visit www.ssbllc.com.