Congress’ failure to address the federal estate tax law allowed the estate tax to expire at the end of 2009. While the elimination of a tax would typically be seen as a good thing, this one-year repeal creates headaches for clients and planners and may actually increase the tax burden on families of individuals who die in 2010.

Past, Present and Future

In 2009 an unmarried individual could pass $3.5 million of assets free of federal estate tax, and a married couple with proper planning could pass $7 million free of tax. Any assets over the exemption amount were taxed at a flat rate of 45%. Lifetime gifts over the $1 million gift tax exemption were subject to a 45% gift tax. As a trade off for the estate and gift tax, inherited assets received a “step-up” in basis. More about the step-up in basis issues later.

In 2010 there is no federal estate tax. However, the federal gift tax remains, with a reduced tax rate of 35% and a lifetime exemption of $1 million. With the repeal of the estate tax came the repeal of the stepped-up basis rules. In its place is a modified carry-over basis system that allows an executor to increase the basis of assets owned by the decedent at death by up to $1.3 million, not to exceed the fair market value of the asset. In addition, the basis of property transferred to a spouse can be increased by up to an additional $3 million.

In 2011 the federal estate tax is scheduled to return – with a vengeance. The exemption is reduced to $1 million per individual, and the tax rate is graduated up to 55%. However, with the return of the estate tax comes the return of the step-up in basis rules.

Potential Funding Troubles

Many estate plans divide assets between a “credit shelter trust” and the surviving spouse (either outright or in a “marital trust”) at the death of the first spouse to die. The intent is to pass the maximum amount exempt from estate tax into the credit shelter trust and the balance to the surviving spouse. This avoids estate tax at the first death and prevents assets in the credit shelter trust from being included in the surviving spouse’s estate. The result is that a couple can maximize their combined estate tax exclusion.

The amount directed into the credit shelter trust is usually defined by a formula, or a reference to “the largest amount that can pass free of federal estate tax.” Because there is no estate tax in 2010, wills and trusts with this type of funding clause will direct all assets into the credit shelter trust, and no assets will be directed toward the surviving spouse. This could cause problems for a couple reasons.

Suppose a client with a $5 million estate wanted assets equal to the exemption amount of $3.5 million to go into a credit shelter trust for the benefit of children from a prior marriage and the remaining $1.5 million to go into a trust for the benefit of a second spouse. A funding clause that would have worked in 2009 may now direct everything to the trust for the children, leaving the spouse with nothing.

In addition, residents of states that have a separate state estate tax may find that funding only the credit shelter trust may result in additional estate taxes due to the inability to take advantage of state marital deductions. Further, under the new carry-over basis rules, discussed below, if assets are placed in the credit shelter trust they will not qualify to receive the additional $3 million spousal basis adjustment.

Problems with Basis

The implementation of a modified carry-over basis system may cost heirs more than the estate tax it replaced. If Dad buys Stock A for $100 and sells it later for $1,000, Dad will have recognized a gain of $900 which is subject to capital gains tax, currently at 15% (assuming long term gain). Now assume Dad had purchased Stock A for $100 and died in 2009, at which time the fair market value of Stock A was $1,000. Son would have inherited Stock A with the basis stepped up to the value at the date of death -- $1,000. If Son sells Stock A for $1,000 there will be no gain recognized and no capital gain tax, and Son has essentially inherited $1,000. Had Son received the stock with a carry-over basis of $100, when Son sold the stock he would have paid $135 in capital gain tax and netted only $865.

Consider how the carry-over basis will affect a hypothetical estate. Suppose Mom has purchased various assets for $200,000, which have increased in value over the years to $2,000,000. Most would consider this a significant estate – but by no means huge. Had Mom died in 2009, her entire estate would have been covered by the $3.5 million exemption, and no federal estate tax would have been due. If Mom dies in 2010, there is no estate tax due, but the kids take the assets with Mom’s basis of $200,000. The executor can increase the basis by $1.3 million resulting in a total basis of $1.5 million. If the kids sell the assets, the $500,000 gain (difference between the $1.5 million basis and the $2 million fair market value) will be subject to a 15% capital gains tax, costing the kids $75,000! If the kids wait and sell in 2011, when the capital gains rate is scheduled to increase to 20%, the tax bill will be even more.

In addition to the headache of paying more tax, the kids must somehow have had the foresight to keep track of the basis of all of Mom’s assets. Trying to calculate the basis of assets acquired over a lifetime of stock splits and reinvested dividends can be real trouble.

If Dad were still alive, Mom could leave assets to him and qualify for an additional $3 million spousal basis adjustment. But to qualify for the spousal basis adjustment the assets must be left outright to Dad or in a marital trust solely for Dad’s benefit. If the funding clause of the trust puts all the assets in a credit shelter trust, the spousal basis adjustment will be lost.

What to Do?

Few think that Congress will allow the estate tax to come back with only a $1 million exemption. (Of course no one thought Congress would allow the estate tax to be repealed in 2010!) There has been some talk that the 2009 estate tax rules may be retroactively extended for 2010 and beyond. However, it is unclear if such a retroactive extension could survive a legal challenge that it would probably face.

The shifting estate tax landscape makes it difficult to know what to do or how to plan. If you have no estate plan in place, do not let Congress’s inaction prevent you from getting started. There are several issues – planning for your disability, naming guardians of your children, planning for a business, asset protection – that need to be addressed regardless of the estate tax situation. If you have an estate plan in place, now would be a good time to review it with your attorney to make sure any funding issues are addressed and to ensure that your plan still accomplishes your goals.  Feel free to call us at Great Plains and we can discuss your estate planning goals with you and assist you with putting a plan in place or getting your existing plan up to date.