Some of us remember a catchy theme tune from the days of t.v. westerns – ―Whistle a tune that will carry me to Tombstone Territory. It conjures up thoughts of lawless days gone by. I wonder if it might not be appropriate background as we review the current status of federal estate tax law.
No Federal Estate Tax in 2010
The repeal of the federal estate tax that was initiated as part of President Bush's economic development program has now become reality. For individuals dying in 2010, there is no federal estate tax. (There does remain, however, a separate Connecticut tax on estates of more than $3.5 million, and all estates—regardless of size—still pay a probate court fee based on what is reported for estate tax purposes, even if they pay no estate tax). Although Congress indicated that it would restore the federal tax for 2010, there has been little discernible progress.
Federal Estate Tax Scheduled to Take Effect January 1, 2011
The National Federation of Independent Businesses has been a key special-interest group in the tax law discussions, insisting on neither a $3.5 million nor a $5 million exemption, but a complete, permanent repeal of the estate tax. But, Congress's continuing attention to health insurance reform and the legislative gridlock that it has generated have been the largest obstacles to addressing the federal estate tax. Unless something is done, the repeal of the estate tax will ―sunset on December 31 of 2010, due to a required balanced-budget amendment that had been tacked on to the initial repeal legislation in 2001 by Senator Byrd. The sunset of the repeal means that the federal estate tax would come back to life on January 1, 2011—but with only a $1,000,000 exemption, as had been allowed by the law in 2001.
Efforts to Change the Scheduled Estate Tax Law
There have been efforts in Congress to restore the estate tax, retroactively for 2010, with a continuation of the $3.5 million exemption that was available previously for individuals dying in 2009. A bill did pass the House of Representatives as late as December 2009. That bill would have maintained the federal estate tax with an exemption of $3,500,000 and a 45% tax rate, effectively exempting 99.25% of Americans from federal estate tax. But, the Senate failed to act on the bill, holding out instead for a $5,000,000 exemption and a 35% rate. The Congressional Budget Office estimated that the Senate bill would have cost $350 billion in lost revenue. There were reports that a compromise might be attached to a ―jobs bill in the Senate, in order to attract Republican support. That compromise, discussed by Senate Majority Leader Harry Reid (D-Nev.) and Senate Minority Leader Mitch McConnell (R-Ky.), fell through, however, and became unnecessary when enough Republicans signed on to the jobs bill without the estate tax compromise. Subsequently, an agreement was said to have been reached in the Senate Finance Committee to present a bill that provides for a $5 million dollar exemption. That effort apparently failed, too, when Senators Kyl and Baucus could not agree upon the need for a majority of Democratic votes before proceeding.
More recently, the Senate Budget Committee passed a resolution on the federal budget for fiscal year 2011. The resolution does not present formal language for legislation, but does indicate guidelines, which the Finance Committee customarily considers when it drafts tax legislation. Among those guidelines is a call for reinstatement of the 2009 estate tax exemption levels for 2010 and 2011—thereby, confirming a $3.5 million exemption and a maximum 45% estate tax rate. The Budget Committee Chair indicated anticipation that the President's bi-partisan fiscal commission will recommend more permanent reform.
Any estate planning attorney or accountant will tell you that people having property approaching $1,000,000 in value, or more, are confused, worried, upset, even angry. Many have paid significant amounts for estate planning services and are sometimes being advised that they should go back to their attorneys and expend even more for a ―temporary amendment to what they understood would be documents effective for the long-term.
Carryover Basis of Property to Heirs Now in Effect
One of the most significant issues associated with the debate over the estate tax is that of determining the tax basis of inherited assets. Traditionally, when someone dies, the heirs receive that decedent's property with a value, or -tax basis for income tax purposes, that is "stepped-up" to the date of the decedent's death-which means that, when the heirs sell the inherited property, they do not have to pay capital gains tax on any of the appreciation or increase in value of the property that occurred prior to the time of the decedent's death. That step-up in basis was an income tax trade-off. (In other words, since you had to pay a hefty estate tax on the current value of property passing at date of death, the government agreed not to impose double taxation by forcing the heirs to pay an income tax on the capital gain inherent in that property's value).
Now, without federal estate taxes, that "stepped-up basis" rule no longer applies-the trade-off is no longer necessary. Without the step-up in basis, the estate must go back and figure out what the decedent's purchase price was for every inherited item, and carry that basis forward to the heirs. As one estate planner put it, with a building this is not so hard; with an art collection it is harder; with a stamp collection it's nearly impossible. In any event, it is time-consuming and is likely to increase the expense involved in settling an estate. But, unless the heirs can prove that the decedent paid more than zero for the property, they are responsible for paying capital gains tax on the property's entire value as if it were all appreciation that occurred from the date the decedent acquired the property.
Sure, there is some relief. The repeal of the estate tax law includes a provision allowing an estate to step up the basis on up to $1.3 million dollars worth of property. Perhaps, in theory, the imposition of a capital gains tax on all property in excess of $1.3 million transferred by all individuals will generate more revenue for the government than would be raised by an estate tax at a much higher rate on only property exceeding $3.5 million passing from only the nation's wealthiest individuals in the year 2010. But, from a policy perspective, to implement such a change for a period of only one year, and then to revert to the rules of prior law, seems rather short-sighted and costly.
The turmoil this poses for those who deal with decedents' estates is, needless to say, mind-boggling. What do you mean you don't know how much your grandfather paid for that Proctor and Gamble stock? What do you mean there are no records? Congress learned this lesson the hard way in the 1970's when it previously tried to impose -carry-over basis. The law was repealed retroactively within a year after its effective date, for no one could or would comply with it. Has the onset of the information era or the proliferation of computers and electronic recordkeeping done anything to change people's recordkeeping habits? Does any member of Congress know what's at stake for his or her own heirs?
It now becomes the job of the Executor of the Will (the Administrator of the Estate, if there is no Will) to allocate a step-up in basis to upto $1.3 million of each decedent's assets (like a house or stock, for example), and therefore, to specific heirs. It is likely that neither the decedent's Will nor local probate law contemplates the role the Executor must play in this regard. Should an attorney advise clients to revise their Wills for 2010? The IRS is expected to develop forms for estates of decedents dying in 2010 so that the basis of assets passing through an estate can be reported to the IRS and to the heirs. Although such a form is anticipated by August, will it become unnecessary if the carryover basis law is repealed retroactively?
Perhaps, Congress is presuming that the heirs of wealthier families will all see eye-to-eye on who gets the step-up and who does not. The allowable adjustment to basis is subject to certain limitations: For example, the increase in basis can be to an amount which is no greater than fair market value at the decedent's date of death, and no adjustment is allowable for the basis of assets that are ordinarily subject to income (not capital gains) tax, such as IRAs and qualified retirement benefit accounts. There is also a $3 million step-up in basis available to spouses for appreciated assets. But all other assets are to be valued at their original value. The additional $3 million step-up available for appreciated assets passing to a surviving spouse is subject to the rules that have been traditionally applicable to the marital deduction for estate tax purposes. It seems likely that technical corrections to the law and the imposition of burdens upon financial institutions with respect to reporting of basis to executors and heirs.
No Relief for Transfers in Trust
Another issue that comes with the advent of carryover basis is the following statement from Section 2511(c) of the Internal Revenue Code, effective on January 1, 2010: ―Notwithstanding any other provision of this section and except as provided in regulations, a transfer in trust shall be treated as a transfer of property by gift, unless the trust is treated as wholly owned by the donor or the donor's spouse under subpart E of part I of subchapter J of chapter I. Some people thought that the second portion of that sentence might mean that a gift to a wholly-owned grantor trust would not be complete for gift tax purposes in 2010 and, so, would not be taxable. Not so, the IRS has announced. In fact, the Service says, the new language ―broadens the types of transfers subject to the transfer tax under Chapter 12 to include certain transfers to trusts that, before 2010, would have been considered incomplete and, thus, not subject to the gift tax. The Service plans to clarify the issue further with new regulations.
I reckon we've seen complications like this before, haven't we? ―Whistle me up a memory. Whistle me back where I want to be. Whistle a tune that will carry me to Tombstone Territory.