“This is a good year to die.” I’m sorry for the bluntness, but if you’ve heard about the changes in the estate tax law for this year of 2010, you’ve probably stumbled upon this phrase as well. After all, the gist of the estate tax law is that for anyone who dies this year, regardless of the amount of wealth he or she leaves behind, his or her estate will not be charged the normally-dreaded estate tax. But I’m here to argue that actually, in terms of paying for estate taxes, it’s really not such a good year to pass away. In theory, a repeal of the estate tax sounds like it would be a good thing, but I believe that because the legislation was so poorly drafted, the estate tax repeal just ends up creating a lot of confusion and problems.
First, an overview of what the estate tax law is, and what changes were made to it this year. Normally when people pass away, the IRS will tax whatever assets they leave behind (the estate tax). However, the estate tax only applies to people whose wealth, at the time of their death, exceeds a certain amount. This amount varies year by year. In some years it’s as low as one million dollars, in other years, you have to leave behind 3.5 million dollars or more in order for your estate to be taxed. Additionally, the tax percentage varies year by year as well, although on average it can be around 50% of your total estate.
For this year only, Congress has eliminated the estate tax altogether. You can see why, for tax reasons, this seems like an enticing year to die. Especially for someone who leaves behind a large estate, saving 50% of it from taxes can mean A LOT to beneficiaries and heirs. However, that’s not the only change to the estate tax law this year. In order to offset this loss in revenue for the IRS, Congress changed the step-up in basis rules too.
Basically the step-up in basis is relevant to a tax that you must pay when you sell an asset and its value has appreciated from the time you bought it (the capital gains tax). The amount that is taxed is determined by the difference between what you received for the asset when you sold it, minus what you paid for initially. The initial amount you paid for the asset is called the “basis,” and it’s good to have a high basis so that eventually the capital gains tax will be less for you.
Normally when a beneficiary receives an asset from a deceased person, the beneficiary’s basis for the asset will be “stepped up” to the value of the asset at the time the beneficiary received the asset. The alternative would be that the basis of the asset would remain the same for the beneficiary as it was for the deceased (ie, the amount the deceased paid for the asset). But the IRS chooses to wipe the slate clean, and presumably the value of the asset at the time the beneficiary receives it will be higher than the amount the deceased paid for it, hence the basis is “stepped up.”
But this year if a beneficiary sells an asset he inherited, the basis for that asset will remain the same as the deceased’s basis for the asset (subject to a few exceptions, described here and here). Thus, the basis is not “stepped up” and presumably the beneficiary will be paying a higher capital gains tax on the sold asset.
Still though, up to this point, the estate tax repeal sounds generally beneficial to taxpayers. So what was I talking about in the beginning? Well, I believe there
1. Problems with the language in your existing trust documents.
Many trust plans try to avoid the estate tax as much as possible. To that extent, trust documents often use language referring to the estate tax when deciding how to allocate assets upon death. For example, language in trust documents often have the trust creator leaving behind to one entity the “maximum amount that can be given free of the estate tax.” In a normal year, this would mean that the trust creator intends to give an amount equal to the amount exempt from the estate tax (so typically, amounts varying from one million dollars to 3.5 million dollars).
However, under this year when there is no estate tax, that amount is essentially limitless! With this language, the trust creator is essentially giving away his entire estate, when he probably thought he was only giving away up to a certain dollar limit. This then creates the unintended consequence of all of the deceased’s assets being left to potentially only one person, and nothing left at all to other persons named in the trust document.
Therefore, if you have an estate plan already in place, it’s probably a good idea this year to have your attorney take another look at your documents to make sure they still reflect your original intent. Any language reflecting something different (such as in the example given above), can be patched up by your attorney writing up a simple amendment or codicil.
2. Do I have a stepped-up basis or not?
Another problem with the changes in the estate tax law this year is that it actually isn’t very clear how the basis rules will apply. For example, let’s take a beneficiary who receives an asset this year from the deceased’s estate. The beneficiary will want to sell the asset at a time that minimizes the capital gains tax. The question is, if the beneficiary sells the asset in 2011, do the basis rules of 2010 or 2011 apply? As it is written, the law is ambiguous on this matter and most estate planning attorneys will not have a clear answer to this question until 2011 finally rolls around.
3. Retroactivity issues…finding out that you really weren’t home-free after all.
Finally, for all the changes in estate tax law we’ve been through this year, and the amount of time we’ve spent trying to make sense of them, it could very well turn out that Congress decides to add a retroactive estate tax anyway. The problem is that we don’t know if: 1) it is even constitutional for Congress to enact a retroactive tax such as this, and 2) even if it is legal, we don’t know if Congress will ever get around to it. If Congress does try to enact a retroactive estate tax, one thing that is almost certain is that beneficiaries who inherited from large estates this year will put up a fight in the courts, which will delay the resolution of this question for that much longer. Since we are already well into September, and 2011 is just around the corner, the thinking now in most circles is that Congress will probably not enact a retroactive estate tax (see article here). But since no one really thought Congress would allow the repeal of the estate tax to go forward this year, who can really predict the actions of Congress anymore?
In Conclusion
I don’t mean to be a downer, but I believe that a closer look at the estate tax law in 2010 shows that this is a case of something sounding too good to be true. In the end, it’s the clients who suffer when attorneys can’t provide them with clear guidance or in the worst case scenarios, when their assets are distributed in ways they had never intended. How did this come about though? For one thing, it’s just too radical of a change to completely get rid of the estate tax for one year. As a result, most people did not think Congress would seriously go through with these changes, and I’m sure there are many estate planners out there who did not plan for this contingency. Furthermore, even if Congress was content with allowing these changes to go forward, the legislation could have been much better drafted to avoid the ambiguities that we are now faced with. In any cases, the nightmare (as I believe it to be) is hopefully almost over. 2011 will be an interesting year to watch to see if things in the estate planning world can finally go back to “normal.”