Federal Estate Taxes

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On January 1, 2010, an unprecedented event occurred: Congress allowed the federal estate tax and generation-skipping transfer tax to completely disappear. Will Congress reinstate the federal estate tax in 2010 or will they do nothing and simply allow the estate tax to reappear in 2011?

The United States estate tax is a tax imposed on the transfer of the “taxable estate” of a deceased person, whether such property is transferred via 1) a Will or Trust, 2) through intestate succession, or 3) otherwise made as an incident of the death of the owner, such as the payment of life insurance benefits or paid-on-death financial accounts.  The amount that one can pass “estate tax free” depends on the tax law in place in the year of one’s death.

Gift and Estate Taxes

The following table compares current rates and exemptions with those from 2009 and those scheduled to take effect next year unless Congress changes the law.

 Year Lifetime
Gift Tax
Exemption
Total
Gift and
Estate Tax
Exemption*
Generation
Skipping
Tax (GST)
Exemption
Gift, Estate,
and GST Taxes
Top Rates
2009   $1 million $3.5 million $3.5 million 45%
2010   $1 million Unlimited Unlimited 35%
2011   $1 million $1 million $1 million 55%

*The estate tax exemption amount is reduced for lifetime taxable gifts.               

Estate Taxes in 2010

It sounds like a great deal for the children of ailing wealthy parents.  For 2010, there is no federal estate taxes levied on the estates of people who die in 2010.  Of course, this may be too good to be true.  By letting the tax lapse, Congress has created some unintended consequences and increased the chances that you may owe taxes on an inheritance. Yes, the result of the repeal of estate tax in 2010 is that some people of lesser means may owe capital gains taxes on inherited assets. What’s more, since many Wills and trusts are written on the assumption that the estate tax exists, a Will that made sense last year (or any other year, for that matter) could result in your surviving spouse getting a reduced amount of your estate.

The current repeal of the federal estate tax law may hold up for the rest of this year, but some tax experts expect legislators, at some time later this year, to reinstate the tax and make it apply retroactively for 2010. If they do, that would mean estate inheritances received in 2010 when the law is not in effect could still be taxed.  We can expect constitutional challenges to new estate laws if applied retroactively.

The Basics

The following are some of the basics related to the federal estate tax law and how to protect yourself and your heirs, at least until Congress takes action.

  • Both the estate tax and the generation-skipping transfer tax (on assets given to grandchildren) were repealed at the end of 2009.
  • Both taxes are scheduled to return in 2011 at the unfavorable rates that applied 10 years earlier. The amount that is exempt from each of these taxes will then be $1 million, and the tax on the rest will be 55 percent.
  • There is still a gift tax if you give away more than $1 million during your lifetime, but the tax rate has been reduced from 45 percent to 35 percent.
  • Heirs will now have to use the original price paid for an asset when computing their tax liability, instead of the value upon the owner’s death. This change of “cost basis” could be very expensive, and difficult, for heirs. For example, if you inherit shares of Microsoft that your parents accumulated over many years, you might be stuck hunting for all their transaction slips and adjusting for stock splits along the way (a potential nightmare). And when you sell any of the shares, you may owe capital gains tax on the appreciation. Each estate can exempt $1.3 million of gains from this carryover basis rule, as it’s called. Another $3 million exemption applies to assets inherited from a spouse.

What Might We Expect?

Many estate planners expect Congress to restore the taxes retroactively, and to put back in place the system that applied in 2009: a $3.5 million exemption for estate tax and generation-skipping transfer tax, with a 45 percent rate for these two taxes as well as the gift tax.  Given the revenue needs of the federal government, it is difficult to guess what estate tax legislation Congress may pass.

If Congress passes retroactive legislation, past court cases suggest that restoring the tax this way is legal. But people with enough at stake may bring lawsuits arguing that a retroactive tax is unconstitutional. The sooner Congress acts, of course, the fewer the number of people with an incentive to bring such cases.

Possible Steps to Take

The following are some issues to consider:

1)         Locate records of assets that are subject to capital gain taxes

You will do your loved ones a favor by organizing your records to show the cost basis of assets they might ultimately inherit.  It might be worth gently asking your parents if they happen to have kept transaction slips for stock shares they still hold.  Many people who were not wealthy enough to put them in the estate tax danger zone could be affected by the carryover basis rule. It is such a bookkeeping headache that it is unlikely to stick, but you should prepare just in case it does.

2)         Are there “tax formula clauses” in your estate planning documents?

Review your Wills and revocable living trusts to see if they include phrases such as “that portion”, “that fraction”, or “that amount” (without saying what it is). These are signs of attorneys trying to take maximum advantage of the estate tax exemption, which kept increasing. In 1999, it was $650,000 and by 2009 it had reached $3.5 million.

Instead of naming a specific sum that will go into a trust, many documents refer to an amount up to the exemption amount or express the sum as a percentage of whatever the limit happens to be when the person dies. This is good standard practice, but in a year without an estate tax, make certain the document reflects your intent. It is possible that under your current arrangement, less money would go to your spouse than you would like or too much may go to grandchildren. Consult your attorney about whether amendments may be necessary.

  • Use of Credit Trusts for Estate Tax Planning for Married Couples

The use of a Credit Trust can reduce or eliminate the payment of estate taxes at the death of the surviving spouse.

Here is how a Credit Trust works: Assume your Will includes a formula clause that would allocate up to the maximum tax-free amount to the trust if you die before your spouse.  The trust distributes your assets as you specify in the trust document — say to your spouse and family members while your spouse is alive, and then pays what is left to family upon the death of your spouse.

By placing the assets in trust, rather than leaving them to your spouse outright, you ensure that neither the assets nor any appreciation on them will be considered part of your spouse’s estate.  The assets held in the trust are, therefore, not subject to estate tax when the surviving spouse dies.

If your remaining assets go to your spouse, the tax on this portion, called the marital share, is not eliminated, but rather will be postponed until the second spouse’s death.  In most cases, no tax will be assessed when you die, because assets inherited from a spouse are entitled to an unlimited marital deduction.  Any money that remains of the marital share will be taxed when the second spouse dies.

But what happens if you pass away in 2010 and there are no estate taxes?  Depending on how a formula clause is worded, it is possible that everything will go into a Credit Trust.  This could lead to an unintended consequence.  As an example, if the trust is not set up to make payments to your spouse (for example, if it only benefits your children from a previous marriage), your spouse will receive nothing.   Another example would be even if the trust does benefit your spouse, all the money will be locked up in the trust, and your spouse will not receive anything outright.

If your estate plan now suffers from this defect, your Will can be amended to fix the problem.

3)         Watch out for state estate taxes

If you are considering moving to another state or dividing your time among two or more locations, consider the estate plan implications.  Approximately half the states have a separate estate tax, which applies not only if you live in one of these states, but also if you own real estate there.  These taxes apply whether or not there is a federal estate tax.

When you change your home state, it’s important to pull up roots and establish new ones.  Otherwise, if your former state has an income tax or estate tax, it may chase you, or your estate, for taxes.  In a worst-case scenario, you could wind up owing taxes to two states.

All states will honor a Last Will and Testament that is valid in the state where it was signed.  Specific terms drafted for one state, however, could be problematic in a new one. You do not necessarily have to have a new Will prepared if you do move, but you should have an attorney in the new state review your Will and any other estate planning documents.

4)         Do you have the resources to transfer/gift large sums of money while you are alive?

These gifts leave less for the government to tax, and if the assets increase in value after you have passed them along, the appreciation is estate-tax-free. But people in a position to do this run up against the $1 million lifetime gift tax exemption ($2 million for married couples). Most people are reluctant to make gifts so large that they will incur gift tax.  For those who are comfortable with the idea, the gift tax is now 35 percent, so in theory this is a good time to make gifts. The risk, however, is that the previous tax rate, which was 10 percent higher, could be restored retroactively. Thus, you cannot make gifts secure in the notion that the lower rate will apply.

5)         Would you like to provide a financial cushion for your grandchildren?

Normally, when you give assets directly to grandchildren or set up a trust to do so, you need to plan for the generation-skipping transfer (“GST”) tax. This tax applies on top of estate tax and gift tax. With the repeal of the GST tax for one year at the start of 2010, advisers are proposing a variety of techniques to maximize gifts to grandchildren.  How they will be affected by a law that takes effect retroactively remains unclear.  I would proceed with caution. 

Give your Estate Plan a Checkup

For all the discussion regarding the estate tax repeal, this tax affects very few people.  In 2009, less than 1 percent of the population needed to be concerned about estate taxes.  Regardless of your net worth, you still need an estate plan.  Estate planning goes far beyond taxes.

Whether or not taxes were a concern for you in 2009 or might be again — either later this year or in 2011 — make a New Year’s resolution to give your estate plan a check-up.   You should be sure that you have all the basic estate planning documents to provide for you not only at your death but also during your life.  If you have a spouse or partner, provide for him or her financially.  You should name a guardian for your children who are minors or have special needs and leave any bequest to them in trust in the event something happens to you.

Review Beneficiary Designation Forms

Retirement accounts and life insurance policies are considered as assets when calculating your estate for estate tax purposes.  Typically, it is recommended that these assets do not pass through your Will or Revocable Living Trust.  If you have life insurance, make sure you have properly completed the beneficiary designation form, naming the beneficiaries who will receive the death benefits.  Beneficiary designation forms for your retirement accounts should also be completed and coordinated with the rest of your estate plan. Make sure the forms include both primary and alternate beneficiaries.  Generally, you should not name your estate as beneficiary — that could cause your heirs to lose important income tax benefits.

Build a Legacy

Even with the uncertainties with the federal estate tax laws, there is no reason to delay thinking about the legacy you would like to leave — as examples, by providing everyone in your family with the best possible education, developing a succession plan for the family business, keeping a vacation home in the family or making meaningful gifts to charity.  Most important, estate planning is a way to take care of yourself and the people who are important to you.

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