01/13/2010

So – the estate tax is gone for 2010. But before we all rejoice, we need to ask the question – what does this mean? And more importantly, who WILL pay the tax if the estate does not? No estate tax does not mean no tax. And the corollary could be, where there is chaos , could there be opportunity?

Before outlining the “highlights” of 2010’s non-estate tax year, let me say that if you have an estate that is valued at less than a million dollars, you probably don’t have to be concerned. If you have an estate that is valued at more than a million dollars (or you have parents who have an estate valued at more than a million dollars), you need to see your estate planner soon. We will all hope that Congress repairs the damages in the next couple of weeks, but if that doesn’t happen, you really ought to have your estate plan (wills) visited by a specialist who can give you some guidance – even though he/she will have no more certainty than I have in this blog.

Here is what we know will happen IF the “no estate tax” year continues:

Unlimited step up in basis of spousal transfer – now limited to an additional $3M increase in basis.
Unlimited step up in basis to non spousal heirs – now adjusted to an additional $1.3M increase in basis.
What does this mean? The surviving spouse and the heirs will probably pay tax when they sell inherited assets. Where there was no tax for estates valued at $3M or less…now there is tax, probably.

Under old estate law (as in, three weeks ago), a husband could leave a wife his estate with a basis of $5M and a fair market value of $10M and she would instantly have assets worth $10M for tax purposes. That is called a step up in basis and she gets the whole enchilada tax deferred as part of unlimited spousal transfer. If she sold those assets a week later for $10M, there would be no estate tax and no capital gains. Now, enter “no estate tax” year: same facts — $5M basis, $10M fair market value. The wife’s new basis would be $5M plus $3M plus possibly $1.3M, so $9.3M. She sells a week later for $10M and has a capital gain of $700,000 with a tax of $105,000. Hmmm. Whose idea was this??

Now, worse, let’s say the same husband has an estate with a basis of $10M but because of the real estate crash, it is now only worth $5M. Are you ready for this? The wife’s new basis is $5M. It is the lower of cost or market. She holds on for a couple of years and the market recovers a little. She sells for $6M. She has a $1M capital gain and will pay $150K in taxes. Remember, in 2009, there would have been NO tax.

Another example: your mother leaves you assets with a basis of $700,000, but miracle of miracle, the assets have a fair market value of $1.5M. You are probably OK. You get to add $1.3M to the $700K which equals $2M. The assets you are receiving are less than $2M, so you get the full step up in basis to the fair market value of $1.5M. You sell the assets for $1.5M and pay no tax. But if the assets are worth $3M, you will only get a step up to $2M ($700K plus $1.3M). If you sell the assets and get full fair market value, you will have $1M of capital gains and $150K of taxes. Under the rules of estate tax in 2009, there would not have been any estate tax and you would not have paid any tax, either. So…how is “no estate tax” working for you? Are you beginning to see why it needs to be fixed, and why it may be a Middle Class problem? Remember, the poor don’t pay estate taxes and the very wealthy have sophisticated (and expensive) estate plans that are designed to be “tax efficient.”

Another nasty surprise waits for those of us whose estate plans in our wills read that our marital trusts get some amount based on a formula to maximize the estate tax credit and that all else goes to our spouse, thus sheltering a certain sum for the use of our children some day. That is virtually ALL OF US! Under “no estate tax,” there would be NO money flowing to fund the marital trust and ALL money going to the spouse. If there is never an estate tax ever again, I guess this isn’t an issue. But if Congress reinstates the estate tax, it could be too late for some people to fund that marital trust for the children. This is a real problem in second marriages, but also a tax issue for heirs in a first marriage. TALK TO YOUR ESTATE ADVISOR about this issue.

Perhaps the worst problem is just that we don’t know what to do for ourselves or how to advise you…because we don’t know what Congress is going to do. It could decide to bring back the 2009 estate tax short term or initiate a new estate tax regime. It could decide to do it as of the date of legislation or retroactively or even prospectively. It leaves all of us hanging out here with no sure way to plan. And with extreme complexities – like, this strange basis adjustment – we may or may not have to continue with the basis adjustment on some assets for the life of an estate. Who knows? Did I mention the uncertainty?

I did mention a possibility of opportunity. For those of you who are have larger estates, in the several millions of dollars, IF you were already thinking about doing some substantial gifting in 2010, you might be in a position to “hedge your bets” by making those gifts while the gift tax rate is lower than it has been for years — 35%. We know if Congress does nothing, we will get a 55% gift tax rate for 2011. That makes 35% a heckuva deal. Unless of course, Congress passes a fix retroactively. SEEK GUIDANCE SOON.

Remember, if Congress does not act, on January 1, 2011, POOF! We time travel back to 2001 with estate tax exemption set at $1M, step up in basis restored (because the whole estate is exposed to estate taxation), 55-60% estate tax and gift tax rates. Is this all whacky? Or is it just me?

In the meantime, consider joting an email to our Senators (that is Udall and Bennett in Colorado) and our local Congressional Representatives to let them know that a nonpolitical solution would be a nice gesture. Wouldn’t it? Certainly.