2010 US Estate Tax Pitfalls

Much has been said about a lapse in the United States estate tax for the year 2010. It's as though there is a legal holiday with only winners and no losers. In point of fact, I'm expecting the year 2010 to give rise to the biggest fest of professional malpractice liability on record. I’m also expecting this to be a year in which individuals who own appreciated capital assets, even if they are of relatively modest means, to get screwed in terms of tax consequences, beyond anything they might have possibly imagined. Even people with large estates, where the first spouse dies, but the surviving spouse does not, are likely to find themselves in awful postures with respect to the reintroduction of the estate tax in 2011 at 2001 estate tax rates and exclusions.

That 2011 rate is 55% and the exclusion is $1 million. This will result in an enormous increase in the number of people in the United States subject to the tax.

But even for those who are not, the year 2010, can impose serious damage to the tax posture of anyone with a net estate in excess of $1,000,000 who loses a spouse, while surviving through the balance of the year. When the estate tax has been in full force in the past, those who inherited property from a decedent enjoyed a step up (adjustment) in basis, as of the date of death. For the sake of illustration, let's assume that one owned a capital asset, which was non-depreciable (such as stocks) that has a basis of $250,000 and a fair market value, as of the date of death, of $2.5 million, as his or her separate property.

In a year other than 2010, this individual's heirs would enjoy an adjustment to the cost basis of the property from $250,000 to $2.5 million. That means that if the individual sold the property a few weeks later (ignoring the alternate valuation date for the purposes of simplification) for $3 million, the individual would pay tax on a capital gain of only $500,000, as opposed to $2.75 million without the step up in basis.

During 2010, however, the property is potentially subject to a capital gains tax on the full $2.75 million. There is the possibility of applying a $1.3 million optional upward adjustment to the basis, if there’s no other property in the estate that could better use it, and the accountant, attorney, etc., who is advising the estate administrator elects to apply this to the subject property. However, in this example, that still leaves $1.45 million subject to the tax.

Now, for those of you, who are perhaps better informed than others, including attorneys and accountants, you may say, “And, there’s a $3 million optional exclusion for surviving spouses!”

Maybe there is and maybe there isn’t! Most sizable estates, where estate planning has been done, employ a bypass trust, also called an A/B Trust, also called a credit shelter trust, which is used to exclude certain of the decedent’s property from estate taxation on the death of the second spouse to die. Partly because of the expectation that congress would never allow the estate tax to lapse and partly because of incompetence or a willingness to gamble on the part of clients—usually to save money during the Great Recession--I am confident that most of these A/B Trusts have never been amended.

Frequently, the bypass trusts contain provisions allowing the sprinkling of income among various beneficiaries, including, but not limited to, the surviving spouse. If the bypass trust would not qualify for the marital deduction by requiring that one-hundred percent of it be held for the benefit of the surviving spouse with all of the income paid out to him or her at least annually, then it does not qualify for the additional $3 million step up in basis.

I’m sure there are plenty, if not a substantial majority, of bypass trusts that fit the above description. So, if the decedent passes along more than $1.3 million in appreciated capital assets, it could present an income tax nightmare for the surviving spouse. And, if the appreciation in the decedent’s assets exceed $4.3 million, there is no relief to be had under the 2010 law.

I often hear people, sometimes arrogant, sometimes ignorant or misinformed say, “There should be no estate tax. The property was already taxed. I don’t see why I have to pay tax on this property twice. I already paid income tax on it.”

Usually, these declarations are incorrect. When did you last pay income tax on the unrealized appreciation in property, such as stocks or real estate, that you haven’t sold or exchanged? Often this unrealized gain constitutes the lion’s share of one’s estate.

Under pre-2010 estate tax law, one got a step up (favorable adjustment) in basis whenever someone died, whether or not the decedent’s estate was large enough to be taxable for U.S. Estate Tax purposes. Also, there was no limit to the amount of property that received this adjustment.

Under any system which involves the elimination of the U.S. Estate Tax, after some statutorily limited adjustments, everyone –whether or not his or her estate is large enough that it would have been taxed--is subject to the prospect of receiving no basis adjustment. This means that the income tax will inevitably be equal to or larger than what it would have been under a scenario in which an estate tax was in force.

So, be careful what you wish for. Far more people are better off with an estate tax, but no carryover basis for appreciated assets inherited from a decedent than there are people who benefit from the elimination or suspension of the estate tax altogether. There is no proposal being given serious consideration by congress that would both eliminate the estate tax and allow a step up in basis for inherited appreciable assets.

Then, there’s the issue of the estate tax exclusion. It went from $675,000 and a 55% rate in 2001 to $3.5 million and a 45% rate in 2009. In 2010 the estate tax is suspended (some say repealed, but that is not true; it’s repealed only for one year) and in 2011 it is scheduled to return to a $1,000,000 exclusion and a 55% rate. Which of these years was best for a plurality of taxpayers?

Answer: 2009.

Which is the worst? In many cases, 2010. An exception would be in instances where an otherwise taxable estate saw both spouses, or just the surviving spouse, die in 2010. Arranging this seems like too much of a sacrifice to minimize estate taxes, although I’m willing to bet that there will be extreme cases, involving unique circumstances, where this planning opportunity is used.

Where are we headed? One thing I’ve learned about the US Congress is that anyone who prefers for nothing worthwhile to happen has lots of allies in the legislature. With the burgeoning deficits facing the U.S., I don’t see the estate tax being repealed in the foreseeable future. There is some talk of increasing the exclusion, perhaps to $3 million, perhaps to $5 million. Either of these would dramatically reduce the number of estates subject to the tax.

I don’t think President Obama will give this bone to the Republicans without something of consequence in return. Whether or not this will happen is ripe for speculation. My best guess is that nothing of consequence will happen between now and the end of 2011 vis-à-vis estate taxes, leaving the rates at 55% and exclusion at $1,000,000 (different for non-US citizens) for the year 2011.

One last area of concern that I’d like to cover for 2010 is the reality that many bypass (AKA B) trusts contain formulae that may result in less than optimal, or nothing at all, from the decedent’s overall estate going into such a trust. This could be another potential source of disastrous consequences for situations where only one spouse, the first to die, dies in 2010.

What should those of us who are concerned about these developments do? A. Make sure there is special language in your estate planning documents that allows for the special circumstances that exist in 2010; B. Be sure that you’ve adequately addressed the reality that the estate tax not only returns in 2011, but that the rates and number of estates subject to the tax will increase dramatically. And C. If you are inclined to influence lawmakers, recognize that an estate tax with a large exclusion is far better for most people than one in which the estate tax is eliminated entirely, along with the reduction of availability of the step up in basis.

Disclaimer: Receiving this article from the author does not imply that you are a client of him, or his firm. It is intended to stimulate the informational curiosity of the general public and motivate those who should be concerned to get together with their own professional advisors and take whatever action, if any, is necessary to protect themselves from potential income and estate tax disasters lurking in the year 2010. 100% of all of the author’s clients have currently active, written engagement contracts, signed by him, in their possession. If you do not have such a contract, you are not presently a client and this article is offered only to stimulate your curiosity and further inquiry into the subjects broached.