Federal Estate Tax Repeal

As of January 1, 2010, the Federal estate tax has been repealed… but only for a period of 12 months.

Exemption Amount Changed
As part of the 2001 tax act, Congress increased the amount persons were permitted to give away tax-free at death (the “Exemption Amount”), with the increases phased in over a ten year period. The Exemption Amount increased over the years, reaching $3,500,000 in 2009 and ultimately became unlimited this year. However, because the votes of 60 Senators could not be obtained back in 2001, the tax law changes were limited to a duration of 10 years, meaning that in 2011, the estate tax will be reinstated with an Exemption Amount of only $1,000,000 and a rate of tax equal to 55%, the exemption and rate of tax that were in effect before the 2001 tax act was passed. Certain larger estates will be subject to an extra 5% surtax that was repealed altogether in 2001, but which will also be reinstated in 2011.

Other Changes
There are other changes that have taken place for the 2010 tax year.

First, under the now-repealed estate tax laws, property passing from a decedent used to receive a step-up in cost basis equal to the property’s fair market value as of the decedent’s date of death. That tax benefit has been eliminated for persons who die in 2010, and instead, the basis of property acquired from a decedent will be the lesser of the decedent’s adjusted basis or the property’s fair market value on the decedent’s date of death.

Under this rule, it is possible that the cost basis of property will be stepped down. These new carryover basis rules will not only cause the imposition of capital gains taxes that previously were avoided following a person’s death, but the beneficiaries who inherit an estate now need to know what the decedent’s cost basis was in the properties they receive. For many people who inherit property in 2010, records will not exist or will be incomplete, thus making it difficult or impossible for them to determine a particular property’s cost basis. There are two important exceptions, though, to the carryover basis rules. A decedent’s executor or personal representative is allowed to allocate up to $1,300,000 to various assets owned by a decedent, thereby increasing the cost basis of those assets.

Also, an additional $3,000,000 of basis increase can be allocated to properties passing to a spouse or to a special “qualified terminable interest property” trust for the spouse (often called a “QTIP” trust or a “marital” trust). Under the tax laws in 2010, just like the laws which existed prior to estate tax repeal, any person may give an unlimited amount of property to his or her spouse or to a QTIP trust (the “Marital Deduction”) without generating any gift or estate taxes.

Second, the Federal gift tax, while not repealed, now has a lower 35% rate of tax, down from the 45% rate in 2009. Under current law, each person may give away during lifetime as much as $1 million in cash or other property without generating any gift taxes. Any gifts which exceed this amount will be taxed at 35%. The annual exclusion remains at $13,000.

Third, the Federal generation skipping transfer tax has been repealed as well for the 2010 tax year. Under the old law which existed prior to repeal, each person could give away during lifetime or at death up to $3.5 million (the “GST exemption”) without imposition of the generation skipping transfer tax. Any gifts to grandchildren or great-grandchildren (and to certain other persons two or more generations younger than the person making the gift) in excess of the GST exemption would have been subject to the GST tax which was equal to the highest marginal estate tax bracket (45% in 2009). Although the GST tax has been eliminated for 2010, it will be reinstated in 2011, and the available GST exemption will be reduced to its former level of only $1,000,000 (although this amount will be indexed for inflation) and with a 55% rate of tax.

It is unknown what will happen to the estate, gift and generation skipping tax laws in 2010. It is possible that Congress will reinstate these taxes and make them retroactive back to January 1, 2010. (It is not clear, though, if retroactive reinstatement of the estate, gift and generation skipping tax laws is constitutional, and this is an issue that may one day be decided by the United States Supreme Court.) It is also possible that Congress will do nothing in 2010, and let the laws revert to how they were prior to the 2001 tax act. It is possible as well that Congress will pass new legislation creating new exemptions and rates of tax.

The new tax laws make it difficult to plan a married couple’s estate. Under the former tax laws, the typical plan was for a married couple (first marriage with children all from that marriage) to leave as much property as possible to a bypass trust for the benefit of the surviving spouse and/or children. (In second marriage situations, when children from different marriages or relationships existed, different types of plans were often used.) Now though, if this same type of trust is used, it will be possible to place the deceased spouse’s entire estate in the trust since there is no longer a limit to the amount of property that can pass free of estate taxes.

Considerations for Your Clients
Putting as much property as possible into this type of trust is beneficial because if the estate tax is later reinstated, the trust will have been funded with as much property as possible when the first spouse died, thereby saving even more estate taxes than would otherwise have been possible under the former law. The trust also provides protection from the claims of creditors and future spouses, and the trust earmarks the trust property for the beneficiaries chosen by the spouse who dies first. Other benefits are available as well.
But if your clients place all of their assets in a trust of that nature, then the $3,000,000 step up in cost basis that can be allocated to property passing to a spouse or to a QTIP trust for a spouse will not ever be used.

Essentially, the decision that must be made today is whether to focus on (i) minimizing capital gains taxes by providing for the maximum step up in cost basis at the first spouse’s death, (ii) minimizing estate and generation skipping taxes that may one day get reinstated; (iii) minimizing state death taxes if they apply for your client, or (iv) putting in place the non-tax protections of a trust. For many married couples, it is not possible to achieve all of these objectives.

Source: ProDoc (2010)

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This site has been prepared by Richard G. Mills, Attorney at Law of Duncanville, Texas, and
Timothy Schultz, Attorney at Law of San Antonio, Texas, for informational purposes only. View Legal Notice