July 2010
Congress failed to take action on the federal estate tax in late 2009, allowing it to lapse for 2010. But beware! This so-called “death tax holiday” is just for one year. It comes back with a vengeance for 2011 and later years absent Congressional action. In the meantime, heirs may face higher capital gains taxes because of limitations on the basis step-up for inherited assets.
Congress has imposed a federal estate tax on the transfer of wealth at death since 1916. In 2009, the federal estate tax applied at a 45% rate to transfers (other than to spouses and charities) in excess of a $3.5 million exemption. In 2001, the tax rate was as high as 55% plus a 5% surcharge and the exemption was $675,000. The 2001 Tax Act gradually decreased the rate and increased the exemption over the years. The Act suspended the tax for 2010, but due to budget considerations, the suspension is for 2010 only. The 55% rate, 5% surcharge, and an exemption of only $1 million will apply for 2011 and later years unless Congress acts.
Capital gains taxes may apply when assets have appreciated
Prior to 2010, an unlimited basis “step-up” provision adjusted the income tax basis of appreciated assets to their fair market values at the date of the decedent’s death. Qualified retirement plans, IRAs, and most annuities are not eligible for the adjustment. With basis adjustment, heirs no longer refer back to what the decedent’s cost basis was for figuring gain or loss upon sale of the property by the heirs—they would instead use the fair market value at the date of the decedent’s death.
For 2010, however, heirs are only allowed a limited amount of basis adjustment for appreciated assets. Generally, they are allowed step-up of $1.3 million for non-spouse heirs and $3 million of step-up for assets passing to spouses. Assets that have gone down in value from the decedent’s cost basis would still be marked down to the date-of-death value. The result for heirs receiving assets with appreciation in excess of these amounts is exposure to increased taxes, primarily capital gains taxes, upon sale of the property. The new rules put the executor in the powerful position of determining which assets receive the limited amount of basis step-up.
It is possible that Congress may retroactively reinstate the federal estate tax and full step-up in basis of assets. While reinstatement of full basis step-up would be welcomed, the reinstatement of the federal estate tax would result in litigation. Executors of large estates would challenge the constitutionality of retroactive reinstatement of the federal estate tax. Other possibilities include raising the exemption and lowering the tax rate or allowing executors to choose between the current rules and the reinstated old rules.
Given this unusual estate tax environment, what should you do?
It is important for those with large estates to have their estate planning documents reviewed for appropriateness given the suspension of the federal estate tax. Provisions of your documents written under the presumption that federal estate taxes would continue might not work as you intend during the estate tax suspension. We can work with you and your attorney to ensure that your documents will operate as you intend, to fulfill your wishes regarding your financial assets. An estate planning document review is especially important for married couples (particularly second marriages) and those with charitable objectives. Also, for those with large estates, it would be beneficial to implement planning strategies now to reduce exposure to future federal estate taxes. Current depressed values and low interest rates make certain estate planning strategies even more powerful. Contact us to discuss how we can assist you with your estate planning objectives to capitalize on these opportunities.
Ron Altenburg works primarily in gift, estate, trust, and income taxation. An Estate and Trust Team leader, Ron helps clients to minimize death taxes and plan their retirement plan and IRA distributions.
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