When Congress left town on Christmas Eve, it failed to address a major issue – the repeal of the federal estate tax. The result of this inaction meant that after midnight on December 31, 2009 the wealthy would die knowing that their assets could pass to their heirs without the federal government receiving a penny. However, as with anything related to the federal tax code, nothing is ever that simple.
The repeal of the federal estate tax is only in effect for 2010. After this year, the estate tax is scheduled to be reinstated at levels prior to President Bush’s tax cuts becoming law. So, rather than receiving a $3.5 million exemption per person and a top tax rate of 45% as was available in 2009, 2011 estate tax law will offer only a $1 million exemption and a maximum rate of 55%. You don’t have to do the math to realize how big of a change this is.
Secondly, there are some unintended consequences that may come into play as a result of this repeal. A common estate planning strategy is to use something called a “bypass trust” with the intention of taking advantage of the maximum estate tax exemption. This strategy was used based on the federal estate tax law being in effect.
Since there is no estate tax for 2010, the wording in the legal documents that are the basis for creation of the trust could be problematic. They might say something like, “Place all of my assets that are not subject to the estate tax into a trust for my children, then leave everything else to my spouse.” In the worst case scenario, a spouse could be left with nothing as all of the assets are directed into the trust because they aren’t subject to any estate tax. Most states have some protection afforded the spouse, however, the potential litigation involved could certainly drain the assets being contested. This could get especially nasty if there were children from a previous marriage involved.
Another consequence of this repeal is the impact on the “step-up in basis” rule. This rule basically said that whatever valuation an asset had on the owner’s date of death is the value that the heirs could use as their new tax basis. For example, if Mrs. Smith died in 2009 while owning stock in IBM that she purchased thirty years ago, under the step-up rule, her heirs could use the stock price as of the day of death to calculate basis for any future sales of the stock.
For 2010, things are a little bit different. Heirs are only able to use the step-up rule for $1.3 million worth of asset appreciation. Spouses get an addition $3 million in appreciation. If Mrs. Smith dies in 2010, depending on the size of her estate, her heirs would need to know what amount Mrs. Smith purchased the IBM stock for, any dividends that were reinvested, and stock splits received in order to assign tax basis. Not only is this a costly change for heirs, but also a documentation nightmare for tax preparers. Like the estate tax, the unlimited step-up is scheduled to return in 2011.
Many observers of this mess think that Congress will retroactively impose a fix to undo the estate tax repeal. However, that is certainly not a given and even if it does happen, what new, unintended consequences will be inflicted on otherwise well-laid plans?