What is Congress Doing About the Estate Tax?

This document is not a substitute for professional legal advice.

You need to review  your personal circumstances, financial and your goals.

Always review your estate plan on a regular basis.

Federal Estate tax laws change frequently.  From 2001 through 2009, the law in this area changed in two ways, both for the better.

First, the number of individuals subject to an estate tax fell gradually each year, as only estates of an increasing size were subject to the tax. Second, the top tax rate dropped from 55% in 2001 to 45% in 2009.  Then came January 1, 2010. On that day, the federal estate tax disappeared. If a person dies in 2010 — no matter how much he or she owns at the time of death, and no matter who the beneficiaries are — there will be no federal estate tax. While this sounds like an unqualified benefit, under current law the estate tax will be reinstated on January 1, 2011. Although Congress has failed to act thus far, many observers expect that Congress will eventually change the estate tax law in a significant way.  In short, anything is possible. Until we know more for sure, all of us should consider the following warnings and determine whether we need to revise our estate plan sooner rather than later.

BEWARE January 1, 2011.

For those who died in 2009, the federal estate tax applied only to estates valued at more than $3.5 million, and only if those estates did not pass to a spouse or to charity. Under the current law, there will be no federal estate tax for those who die in 2010 — but the estate tax will return for those who die in 2011, and on terms that are less favorable than in 2009:

(a) the tax will apply to estates of $1 million or more (not $3.5 million), and

(b) the tax rate will be 55% (not 45%).

This is the law today. It could easily change before — or after — January 1, 2011. While most knowledgeable observers expect a change, it’s not at all clear what the outcome will be. This lack of clarity makes estate planning a challenge.

More people will pay capital gains taxes.

Through 2009, the beneficiaries of all estates received a significant bonus when they received a bequest from a decedent. How so? You may know that your “basis” in an asset is the purchase price you paid for it. If you sell the asset during your lifetime, you pay capital gains tax on the difference between your basis and the new sales price. Through 2009, the beneficiary of inherited property received a “stepped-up” basis in that property. This means beneficiaries paid no capital gains tax on appreciation earned before they received the property — that is, before the person who left it to them died. There was no limit on the amount of property that received this stepped-up basis.

Example: In 1960, your favorite aunt bought 1,000 shares of stock for $1 a share, or $1,000 total. When she died, it was valued at $72 per share, or $72,000 total. After you received the stock as a beneficiary, you decided to sell it for $75 per share. Because your total basis for the sale was increased from $1,000 to $72,000, you only had to pay capital gains on the difference between the $75,000 you received and your new $72,000 basis, rather than the original $1,000 purchase price.

The law now limits this “stepped-up” basis to $1.3 million, with an additional $3 million available if estate assets go to a surviving spouse. Sounds complicated? It is — especially because the IRS has issued no rules describing how this limited stepped-up basis will work.

Example: If the stock described in the above example didn’t fall under the revised stepped-up basis limit of $1.3 million, you would have had to pay capital gains tax on the difference between $1,000 (the original basis) and $75,000 (your sale price), which is $74,000. For valuable assets, this is obviously can represent a significant increase over the estate tax that would have been generated in 2009 or before. It is estimated that this part of the current law could affect the beneficiaries of 70,000 estates in 2010, compared with only 5,500 households affected by the estate tax in 2009.

Therefore: When calculating capital gain income, it can be difficult to find information about our basis in the assets we’ve sold — and even more difficult when they’re inherited assets. Do your beneficiaries a favor: keep good records of the purchase price of your investments. Without that information, the IRS will probably assume the non-stepped-up basis in an asset will be zero, and the entire sales price will be subject to tax.

Pay attention to your estate plan if it includes a “bypass trust.”

A “bypass trust” is designed primarily to maximize estate tax savings. Does your estate plan include a bypass trust, which has been a standard estate planning tool for decades?

If you don’t know, ask this question: will you create any trust under your estate plan other than one that was designed solely to manage property for the beneficiary (like young children or grandchildren)? If so, you should review your will or revocable living trust with your attorney. The simple example that follows cites a large estate of $10 million — but I know of many comparable trusts that were drafted when the law exempted only $600,000. (If you are one of those people who have not changed their estate plan since 1997, when the law exempted only $600,000, get in and review it)

Example: Husband and Wife each own assets worth $5 million. In early 2009, Husband died and his will directed all of his estate to go directly to Wife if she survived him, and if not to his children. Wife survived, and there was no estate tax on Husband’s estate because the entire bequest qualified for the unlimited marital deduction. Wife then died suddenly at the end of 2009, owning a $10 million estate. The first $3.5 million was distributed free of estate tax to the children, but the remaining $6.5 million was subject to the tax, at 45%.

Total federal tax: approximately $2,925,000

A bypass trust could have saved significant taxes. When Husband died, he could have put $3.5 million in a bypass trust to be held for the benefit of Wife for the remainder of her lifetime, with the money to go to their children upon Wife’s death. He could also have given the remaining $1.5 million to Wife. When she died in December 2009, her estate would only have had $6.5 million. After sheltering the allowed $3.5 million from tax from Wife’s estate as well, only $3 million would have been subject to federal estate tax.

Total federal tax: approximately $1,575,000

Savings by creating a bypass trust: $1,350,000

So, where is the problem? In most wills and trusts, the amount going into a bypass trust is defined in a way that essentially sets it at the maximum amount that can be sheltered from the estate tax. If you still have the same provision in your will, your entire estate will go into the bypass trust. Is this what you intended? What are the terms of the bypass trust? Do they provide enough protection for your surviving spouse — or did you want your surviving spouse or other beneficiary to receive more assets free of trust? This is especially important if your estate has grown significantly since you signed your last estate planning documents.

Therefore: Look at your documents to see if you have any kind of trust that might be a bypass trust. If so, call us and ask if you need to revise your will or trust now.

There is still a federal gift tax.

Even though there is no longer a federal estate tax (at least for now), the federal gift tax is still in force.  Each time you give more than $13,000 to any person in one year, you make a “taxable gift.” Once the sum of taxable gifts made over the course of your lifetime reaches $1 million, you must pay a gift tax on any subsequent taxable gifts, at the gift tax rate of 35% in 2010. Note that this comes out of your pocket, and not the pocket of those who received the gifts.

Example: You give $100,000 a year to each of your five grandchildren. That means that each year you are making taxable gifts of $435,000 ($100,000 gift - $13,000 exemption = $87,000 x 5 = $435,000). For two years, you are fine. By the third year, you will have made taxable gifts of $1,305,000, which is over the $1 million lifetime exemption amount. In the third year, then, you would pay a gift tax (on $305,000) of $106,750.

The lesson: Although there may be times that making large gifts is a smart idea, remember that the federal gift tax did not go the way of the federal estate tax.

Don’t forget about state estate taxes.

Even though the federal estate tax has been repealed (for now), 18 states continue to impose their own estate and/or inheritance tax on their residents. Do you know whether your state of residence imposes a state estate tax or a state inheritance tax — or both? And what’s the difference between the two?

An estate tax is imposed on the right to transfer property to someone else, and it is paid by the estate of a decedent. Although usually no tax is imposed on assets passing to a spouse or charity, bequests to all other beneficiaries are taxed at the same rate.

An inheritance tax, in contrast, is imposed on the right to receive property from someone else. Again, property that passes to a spouse or charity is usually free from tax, but anyone else inheriting taxable property must pay the inheritance tax before they receive their bequest. The amount of the tax often varies depending how closely the beneficiary is related to the decedent. A decedent’s children, for example, might pay tax at one rate, while siblings and other relatives might pay at a higher rate, and unrelated beneficiaries might pay at a still higher rate.

In New York State, for example, there is a 16% estate tax on all assets above $1 million that pass to someone other than a spouse or charity. Please note that the $1 million exemption applied even when the federal exemption was significantly higher.

Therefore: Even though there is no federal estate tax (for now), if your estate is more than $1,000,000 it will be subject to Minnesota state taxes, if you are a resident.

While gifts from IRAs make excellent bequests, the value of lifetime gifts from IRAs is up in the air.

For the last four years, Congress allowed individuals over age 70½ to make direct distributions of as much as $100,000 from their IRAs to qualified charities without having to report such money as gross income, even though it was counted as a part of their minimum required IRA distribution. This was a terrific way to save income taxes, especially for people who had overfunded IRAs, but the law was not extended into 2010. We hope that Congress soon will extend the law into 2010 and beyond.

Therefore: If you are older than 70½, you might want to wait until later in the year to make significant decide about distributions from your IRA.