On December 17th, President Obama signed the Tax Relief Act of 2010, bringing to a close almost ten years of uncertainty about the estate tax and replacing it with . . . two years of uncertainty about the estate tax. Thus ends perhaps the most interesting and tumultuous period in the 95 year history of the modern U.S. estate tax.
First, a little history.
Prior to 1997, the estate tax exemption was $600,000—and it had been stuck at that level for a number of years. At that time—which in retrospect seems like boom times for estate tax planning—it seemed like every client who came in the door needed estate tax protection. A combination of a relatively low estate tax exemption and a booming economy and stock market made for a perfect storm, estate-tax wise.
However, it was not to last. The Taxpayer Relief Act (“TRA”) of 1997 was to raise the estate tax exemption in several steps from $625,000 in 1998 to $1,000,000 in 2006. However, before we could even get to the $1,000,000 in 2006, Congress struck again, this time with the so-called estate tax repeal. Like 1997’s TRA, The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) raised the estate tax exemption in several steps from $600,000 to $3,500,00 over the 8 year period from 2002 to 2009. The surprise at the end of EGTRRA’s ladder was the much-vaunted repeal of the estate tax. Of course the one little detail that your Congressperson may have failed to mention in the self-congratulating newsletter back in 2001 was the fact that the repeal only lasted for one year, 2010. Oh, that, and the fact that in 2010 the estate tax was replaced by a creature not seen since 1980: carryover basis.
The reason the repeal was only temporary was because most of the 2001 estate and gift tax law changes were scheduled to sunset (or end) on December 31, 2010. At that point we were to go back to current law, or rather what current law would have been had EGTRRA not been enacted and the scheduled increases of the 1997 Act had taken place. Thus, the estate tax exemption was scheduled to drop back to $1 million per person. Although obviously we never made it all the way through TRA 1997’s scheduled exemption increases, the highest amount it was to have reached in 2006, $1,000,000, would have been the exemption if no changes had been made to the estate tax prior to 2011.
The other sneaky thing about the 2001 act (other than the sunset provision) was that it essentially replaced the estate tax with the capital gains tax. Replacing one tax with another is not exactly what comes to mind when someone says that they have “repealed” a tax. When we had an estate tax (in other words, prior to 2010) the basis of property acquired from a decedent was the fair market value at the time of the decedent’s death. This is known as a “step up” in basis. The 2001 Act did away with this step up basis (in 2010) and instead said that the basis of property acquired from Decedent would be lesser of: a) the adjusted basis of decedent, or b) fair market value of the property at date of the decedent’s death. Under this modified carryover basis regime the heirs did have a $1,300,000 basis increase which could be allocated to any assets.
For nine years the estate tax pundits predicted imminent change. In fact, back in 2001 they predicted that this would be fixed within months, not years, and certainly well before 2010. Surely Congress would not allow the estate to actually disappear in 2010. And surely Congress would not allow the estate tax to come back in 2011 with “only” a $1 million exemption. Well, the pundits were right on one count. Though as January 1, 2010, loomed closer and closer and then finally passed, the non-pundits who practice in this area had long ago lost faith that Congress would ever fix the estate-tax aspects of the 2001 tax act.
Which brings us back to today. . .
In the waning days of 2010, just before the estate tax was set to return with a $1 million exemption, Congress and the President agreed to a slate of tax cuts that included estate tax “reform” as a compromise. This was perhaps one scenario the pundits had not expected: the Republican leadership in Congress creating a compromise with the Democratic President. The President wanted those tax cuts and the Republican members of Congress wanted the increase in the estate tax exemption. In order to make the deal work both sides had to swallow a bitter pill.
Estate Tax Exemption. The most important change in the new estate tax law, is that the estate tax exemption for 2011 and 2012 is up to $5,000,000. That means, no matter who someone leaves their assets to, if they all add up to less than $5,000,000 at the time of death, there is no estate tax at all. This is also now indexed for inflation. . . but since there will be only one “new” year, 2012, for which this will be applicable, it may not be of great concern.
Estate Tax Rate. The highest estate tax rate used to be 55%. It was down to 45% in 2009, but under the new law, the highest estate tax rate will be reduced to 35%. This is where the wealthiest families will significantly reduce their potential tax liability.
Portability. This concept, which might also be described as, “Let’s not make couples set up Credit Shelter Trusts”, is intended to give the survivor of a husband and wife the ability to carry forward any unused estate tax exemption from the first spouse’s death. This is the basic concept behind the “A-B” arrangement that creates the Irrevocable Trust B/Family Trust/Credit Shelter/Bypass Trust is a bread-and-butter estate planning technique.
For example, if there is a $5,000,000 estate tax exemption and a husband and wife have $10,000,000, under all our prior law, the planning would be to have the husband and wife establish an A-B Trust, so that when husband died, his $5,000,000 share would go into a Trust B/Family Trust/Credit Shelter/Bypass Trust for wife, and wife would have her own assets in the Trust A/Survivor’s Trust. Assuming no change in value, when the wife died she only had $5,000,000 subject to tax, the amount of the exemption, the Trust B/Family Trust/Credit Shelter/Bypass Trust was not taxed, and there was no estate tax at all. Until the brand new law, if the husband and wife hadn’t set up that arrangement, and left all the money outright to the survivor, when wife died, she would have owned $10,000,000 subject to estate tax, much more than the exemption, and there would be a significant tax of about $1,750,000!
Now, under the new “portability” provisions in the estate tax law, even without the trust arrangement, it may be possible for the surviving wife to use her husband’s unused exemption. However, it requires that the first spouse’s estate file a timely estate tax return making an election that this exemption can be used by the survivor.
Return of the Step-up in Cost Basis. The new law brings back one of the tax benefits to dying, a full step up in the income tax cost basis of most assets, to the new date of death value, so that the estate or the beneficiaries could sell highly appreciated assets without paying capital gains income tax. Under the short estate tax repeal of 2010, this step-up did not uniformly apply, though it did apply to the first $1.3 million of appreciation in an estate, with an additional $3,000,000 “step-up” available for property that went to a spouse. In other words, for anyone worth less than $1.3 million at death, they got a step-up in basis as before, but for larger estates, old cost basis had to be determined and they had to figure out how to apply their limited amount of “step-up.”
What Happens for 2010 Estates? The law also clarifies (or complicates) what happens for a decedent who died in 2010. The default application is the “new” law, a $5,000,000 estate tax exemption, with a full-step up in cost basis. So, for an individual who died with $3,000,000 in highly appreciated assets in 2010, the new law will apply, there will still be no estate tax, but all those assets will get a step-up in the cost basis.
However, for the Steinbrenners of the world, an estate can still elect to have the ORIGINAL 2010, no-estate-tax, no-step-up-in-cost-basis apply. This must be an affirmative election. Therefore, for estates UNDER $5,000,000, there is little likely reason to opt out of the new law, as it offers the full step-up in cost basis (or step-down) and the full allocation of the GST exemption. For estates under $5,000,000, without offsetting marital or charitable deductions, it may be advantageous to opt back in to full estate tax repeal. HOWEVER, looking at the overall capital gains/estate tax issues to determine the best result would be necessary.
For those in that above-$5,000,000 mark, the law requires this election be made “at such time and in such manner as the Secretary of the Treasury or the Secretary’s delegate shall provide.” The law also provides that, for someone dying in 2010 (before the new law went into effect) the due date for the estate tax return and any elections is nine months from the date of the new law.
2012. Ah, here we get a return to form. After all of this, this new law will again expire on December 31, this time December 31, 2012, meaning that, if nothing is done (again!) prior to that time, we will again revert back to the old-old estate tax law, with a $1,000,000 estate tax exemption. It is telling to note that the estate-tax portion of the 2010 tax act is entitled “TEMPORARY Estate Tax Relief.”
