Understanding the Federal Estate Tax Repeal
Despite having eight years in which to address the 2001 Federal Estate Tax Law, which repeals the federal estate tax for one year (2010) and reinstates it with a $1 million exemption on January 1, 2011, Congress failed to take any action to address this absurd law before it went into effect on January 1, 2010. So what now?
No Federal Estate Tax For 2010
As of right now, estates of individuals who die in 2010 will not be subject to federal estate taxes regardless of the sizes of the estates. So, an individual with $10 million who dies in 2010 may pass his entire estate to his children free of any federal estate tax. Better yet, he can leave his $10 million to his grandchildren because the generation skipping transfer tax, which imposed tax at the rate of 45 percent on assets passing to grandchildren and more remote descendants, is also repealed for one year.
Of course, this only holds true if Congress does not re-enact the estate tax and make it retroactive to January 1, 2010, which many people speculate will happen. Whether or not the retroactive effect of the federal taxes will be considered constitutional is a separate question.
Carry Over Basis
While many laud the repeal of the estate tax, also known as the death tax, most people do not realize that this repeal comes with a price, which is much more likely to negatively affect them than the 2009 estate tax would have.
In 2009, the federal estate tax law allowed estates valued at $3.5 million or less to pass free of any federal estate tax. This meant that with proper planning a married couple could leave $7 million to their children without any federal estate tax.
The law in effect prior to January 1, 2010, provided for a step-up in the tax basis of inherited assets. The tax basis of an asset is the starting point for measuring the gain or loss realized on the sale of the asset. Gain realized on the sale of an asset is subject to capital gain tax.
For example, say Grandma purchased 500 shares of a certain stock 30 years ago for $10,000. Her basis in that stock is $10,000. Now that stock is worth $80,000. If Grandma sells it, she will have a capital gain of $70,000 ($80,000 - $10,000 = $70,000) and will owe capital gain tax of about $10,500.
However, if Grandma died prior to January 1, 2010, owning that stock, then the basis in the stock will be 'stepped-up' to its value as of the date of Grandma's death – in this case, $80,000. When the stock is sold, the gain will be the difference between the date of death value and the sale price. You can see how obtaining a step-up in basis for inherited assets could save a family a significant amount of tax dollars.
Beginning in 2010, there is no longer an automatic step-up in basis for inherited assets. While the new law does provide for $1.3 million of step-up, which can be allocated to certain assets by an executor, not all assets will qualify for this additional basis. For example, retention of a life estate in real property would, under the old law, allow for a step-up in basis for the entire value of the property upon the death of the life estate holder. Such property will not be eligible for step-up under the new rule.
Law Benefits Very Rich – Hurts Middle Class Families
The bottom line is that the repeal of the federal estate tax, which allowed for a $3.5 million exemption, will benefit only the very rich. Repeal of the step-up in basis rules will hurt the middle class for whom life estate planning, for example, is a common Medicaid planning tool to protect the home.
In addition, the new carry-over basis rules are complex, require an enormous amount of record keeping and will mean that tens of thousands of families who would not have been required to file estate tax returns under the old law will be required to file returns under the new law in order to establish the tax basis in inherited assets.
Massachusetts Estate Tax Not Affected
For individuals domiciled in Massachusetts, or in another state that has its own estate tax system, or for individuals who own real property in such states, the change in the federal estate tax law will not impact the filing requirement or estate tax liability to such states.
Massachusetts continues to have a $1 million filing threshold for taxable estates. An individual who dies domiciled in Massachusetts with a taxable estate of less than $1 million does not owe any estate tax to the Commonwealth of Massachusetts. Estates of $1 million or more may have a liability to the Commonwealth of Massachusetts and, in any event, do have an estate tax filing obligation.
What Happens in 2011?
Under the current law, the federal estate tax returns with a vengeance on January 1, 2011, with a $1 million exemption and a taxable rate of 55 percent for estates in the highest bracket. Although many practitioners believe that Congress will act to prevent this from happening, there is a school of thought that says Congress will do nothing to prevent the estate tax from returning. If that happens, it will be imperative to meet with your estate planning attorney and review your situation to ensure that you are aware of the opportunities for tax saving so you can take advantage of those that are right for you and your family.
What to Do Now?
If you are married and have created a so-called credit shelter or bypass trust estate tax savings plan, which in Massachusetts typically consists of two trusts, one for each spouse, then you may want to review those trusts with your lawyer to ensure that the distribution provisions will continue to operate in the way that you intend. Because many of the formulas contained in these trusts refer to the federal estate tax law to allocate assets between trust shares, the repeal of that law may result in an unintended allocation of assets at the death of the first spouse.
Other than reviewing your current plan in the context of the new law, taking a “wait and see” approach to this situation may make sense. Many people speculate that Congress will act to reinstate the estate tax law, which was in effect in 2009, within the next few months, and make it retroactive to the beginning of 2010.
At Samuel, Sayward & Baler, LLC, in Dedham, Massachusetts, we will continue to keep you updated on these developments, so check our website periodically for the latest on this changing environment. You can also contact us at 781-708-0115 or online for more information about how this repeal affects you.
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United States Department of Treasury Regulation Circular 230 requires that we notify you that, with respect to federal tax penalties only, unless expressly stated otherwise above, (1) you cannot rely on this advice for protection against federal tax penalties; (2) nothing contained in this message was intended or written to be used, can be used by any taxpayer or may be relied upon for the purpose of avoiding any federal tax penalty under the Internal Revenue Code; and (3) nothing contained in this message may be relied on to support the promotion or marketing of any federal tax transaction or matter that may be subject to federal tax penalties. Any taxpayer may seek advice based on the taxpayer's particular circumstances from an independent tax advisor with respect to any federal tax transaction or matter contained in this message as it relates to federal tax penalties.
