Yikes! In spite of the heat put on Congress from the Obama Administration to pass legislation to continue federal estate tax on post-death transfers of property by Americans into 2010 and beyond, amazingly, Congress failed to do so. The surprise (to many) to this point (although new estate tax legislation may or may not be enacted soon), is that for the 2010 tax year no federal estate tax or generation skipping tax will apply on the transfer at death of property in the estates of individuals dying in 2010 specifically.

 

Like most seemingly taxpayer-favoring laws, this possibly short-lived estate tax repeal carries a noteworthy trade-off. However, the trade-off manifests on income tax rather than on estate tax itself. Under pre-2010 law, estates of wealthier individuals enjoyed a “step-up” in the basis of unlimited amounts of property. To determine capital gains when a legatee sells certain inherited assets, stepped-up basis generally values property as of the transferor’s date of death. So, if Earl only paid $20 per share for the ABC stock that he left to his son, Alex , under his will, if ABC was valued at $100 per share on the day Earl died and Alex sold the shares at that same price within a year of his father’s death he would not realize any (potentially taxable) capital gain. However, with the ostensible repeal of Federal Estate Tax, stepped up basis becomes available only  for the first  $1.3 million in assets transferred by single decedents with the availability of stepped-up basis on an additional $3 million in property that is transferred to the decedent’s spouse or a trust under which the surviving spouse is sole beneficiary. (That means $4.3 million in stepped up property would be available for married individuals dying in 2010.)  

 

Further, under the 2010 regime, federal gift tax remains, but the top bracket drops from 45% to 35% with the first $1 million in property transferred during lifetime exempt from the tax.

 

Given that the elimination of tax on property transferred at death reduces Treasury revenues in a deficit economy, many legislators urge restoring both the estate and generation skipping taxes retroactively to January 1, 2010 deaths. While many in both Congress and the Tax Community expected that newer legislation  would mirror 2009 estate tax rules under which up to $3.5 million worth of property could be transferred at death with no transfer tax, and with amounts beyond this limit taxed at 45%, the precise nature of any law yet to be enacted remains unknown.  Certain Republican legislators propose that the exemption amount be indexed for annual inflation.  Simultaneously, certain legal pundits argue that retroactive taxation is unconstitutional . (Little, if any, history of retroactive taxation operates; most tax law is enacted with months or years before it takes effect.) Taxpayers may see a higher or lower exemption and higher or lower marginal estate tax rates.Even so, the Congressional gridlock in 2009 may continue with an (unexpected by many)estate tax holiday for property transfers by individuals dying in 2010. 

 

Unless Congress acts, estates of those dying in 2011 face the harsher rules operating before more rules took effect that raised exemptions and lowered rates under a 2001 Tax Act. The property exemption drops to a relatively puny $1 million and the top estate tax (and gift and generation skipping tax) rates jump to an unpleasant 55%.

 

Many estate planning choices that could result in either significant tax savings or big mistakes are in flux. For example, not all assets are eligible for the stepped-up basis (retirement plans and cash come to mind), and thus a married individual should carefully consider which assets to leave to a spouse under the (additional) $3 million permissible amount of stepped-up property to be left to a spouse.  Consider intergenerational wealth transfer: If the generation-skipping transfer tax is eliminated for 2010, transfers to grandchildren are attractive for those dying in 2010, but possibly not in 2011 and later. Wealthier Americans planning to make lifetime gifts to family members and other non-spouse recipients may want to gift more in 2010 while the top gift tax bracket is lower. Even the low interest rate environment enhances certain planning opportunities for taxpayers having assets of $10 million and more. With the permissible interest rate factor down to 3% in January of 2010, taxable distributions from tax advantaged mechanisms to transfer property such as charitable lead trusts and grantor retained annuity trusts may be lower than older versions of those types of trusts.

 

 If there was ever a situation that supports the notion of monitoring in the financial planning process, this is textbook example.  Given the current uncertainty, the need for expert advice by professionals who are carefully watching the estate tax environment is a must.