How Did We Get Here?
A brief review of the law will help explain why this is so significant. The much-heralded 2001 tax act, signed into law by President George W. Bush, gradually reduced the maximum rate of the federal estate tax (and the equally onerous generation-skipping transfer tax on transfers to grandchildren) from 55% to 45%. It also gradually increased the amount of property that you could pass free of federal estate tax from $675,000 per person in 2001 to $3.5 million per person in 2009. That means that with basic estate planning, a married couple could pass up to $7 million free of federal estate tax, if they both died in 2009.
Then, in 2010 only, the 2001 tax act repeals the estate tax. But like a horror film character who just won't die, under the existing law the estate tax returns again on January 1, 2011 - only at a much lower $1 million exemption and a higher maximum 55% tax rate! This strange "now it's gone, no it isn't" effect is the result of a rule in Congress that attempts to limit budget deficits.
A New Tax Replaces the Estate Tax
To pay for this one-year vacation from the estate tax, Congress replaced the estate tax with an increased income tax. Before 2010, any assets that pass to someone when you die would be valued at fair market value at the date of death. Thus after death, when a surviving spouse or heirs sold any assets (like securities or a home) that had increased in value, they would not have to pay income tax on any of that growth that occurred during your life. (This is referred to as a "step-up in basis.") For many heirs this means huge income tax savings, oftentimes tens of thousands of dollars or more.
But in 2010 property that passes at death does not automatically receive this step-up in basis. Instead, each individual has a limited amount of property that can be "stepped-up" in value at the time of death. Property that does not receive this step-up value will be subject to tax on the total increase in value from the date you first acquired the property. This means that the property could be exposed to tens of thousands of dollars of income tax liability for your heirs!
Not surprisingly, these rules are convoluted and in many cases very different from the old law. In fact, Congress attempted to institute a similar tax structure in the 1980s and it was repealed retroactively, because it was too difficult to administer. Because of past experience as well as the anticipated difficulties in calculating such a tax, the common belief was that Congress would change the law before January 1, 2010. But it didn't.
What Should We Expect from Congress Now?
No one knows what Congress will do next; everyone assumed that Congress would act before December 31, 2009. But Congress was preoccupied by the health-care debate then, and it is very possible that Congress will continue to focus on health care and other pressing matters up to the time of the mid-term elections in early November. In fact, some cynics have suggested that Congress will not act until the end of 2010 or later because Congressional members up for re-election will make repeal of the death tax a campaign issue. These same cynics argue that both Republicans and Democrats will blame the other for this mess, with neither wanting to fix it. If that happens, we may not see anything from Congress regarding the estate tax until 2011, at the earliest.
How Are You Affected?
This law can affect you in several ways. For married couples as well as single clients, we need to first make sure that your estate plan divides and distributes your property according to your desires, and not by the provisions dictated by Congress. For more than 50 years it has been common to use a written mathematical formula to divide the assets of a married couple when the first spouse dies to maximize estate tax savings. Similar formulas have been used to provide funds for charitable causes and to benefit family and friends. But in 2010, when there is no estate tax, these formulas will not work. If a spouse is not your sole beneficiary (for example, if you have children from a prior marriage), the existing formula could result in the disinheritance or substantial reduction of resources provided for the surviving spouse.
What Should You Do?
We encourage you to meet with us as soon as possible to review your estate plan and make any changes that are necessary for this law. We need to ensure that your property is positioned to receive the maximum step-up in basis increase available under current law. This is a time that demands a new approach to your planning with new thinking and building in flexibility to see that your wishes are fulfilled no matter what Congress will throw at us this year or next. We have solutions that will meet your planning objectives with the least amount of tax impact.
See Estate-Tax Repeal Means Some Spouses Are Left Out, January 2, 2010 Wall Street Journal, and A Bizarre Year for the Estate Tax Will Require Extra Planning, January 8, 2010 New York Times