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The estate tax mess and what you should do about it

Scott Gunderson

Well, the unthinkable has happened to estate taxes they have been eliminated. At least for 2010, you can die and not owe Uncle Sam any estate taxes, no matter how large your estate. Several super wealthy people have died this year including George Steinbrenner, Art Linkletter, and Texas oil billionaire Dan Duncan (worth a reported $9 billion). No doubt, there are and will be others who will die this year and not owe any estate tax with much smaller, and potentially larger, estates. Had these folks died in 2009 when the estate tax was imposed on estates in excess of $3.5 million, the Treasury would have collected over $5 billion just on the large estates mentioned above. If they would have waited until 2011 to die, their entire estates above $1 million would have been exposed to the estate tax.

The irony of the super wealthy escaping estate tax is that it is being financed by increased taxes on smaller estates in the form of capital gain taxes. Under 2009 law, if an asset was included in your estate for estate tax purposes, your heirs would receive a “stepped-up basis” in the asset to its fair market value on the date of your death. So, if the heir wished to sell the asset, he or she could do so without being subject to capital gain taxes. Under 2010 law, since there is no estate tax, there is also no “stepped-up basis.” An estate is allowed to add $1.3 million of basis to assets to mitigate some of the tax.

To illustrate, let’s say George had died in 2009 and his interest in the Yankees was included in his estate. If he left those interests to his sons, they would receive a step-up in basis to the fair market value of the Yankees as of George’s date of death. If they wanted to sell the Yankees the next day, they could do so and not pay any capital gain tax. But, since George died in 2010, when there is no step-up in basis, his sons could still sell the Yankees but would pay capital gain tax on the potential $1 billion sale price, less of course, the additional $1.3 million of basis allowed by law.

A more down-to-earth example illustrates how this change impacts a smaller estate. Let’s say Bill died in 2009 with an estate of $2.5 million consisting of his home and investments. His estate would have been exempted from the estate tax because it was less than the exemption amount for 2009 of $3.5 million. His assets would, however, receive a step-up in basis to fair market value. If Bill left his estate to his two kids and they wanted to sell the house and cash in the stocks, they could do so without paying any taxes at all. If Bill dies in 2010 his estate is not subject to the estate tax, but there is no step-up in basis. So if Bill’s basis in his assets is $500,000, then after an allowance of $1.3 million in basis step-up is applied, his kids will pay capital gain tax on $700,000 of gain if they sold all of the assets a tax they never would have been exposed to in any other year. The estate tax does not just affect the rich. It affects everybody.

So far, Congress has failed to address this issue. In a clear case of Congressional malpractice, they have allowed this state of affairs to exist. There have been proposals to re-instate the estate tax and the basis step-up and make it retroactive to Jan. 1, 2010. Many scholars believe that such a retroactive imposition of a tax would violate constitutional limits on ex post facto laws and that the courts would likely strike down such a law.

There is discussion and rumor about a lame duck Congress addressing this issue by giving individual estates the ability to choose between paying the estate tax in 2010 and receiving a basis step up, or choosing the carry-over basis and not paying any estate tax in an attempt to survive a constitutional challenge.

In any event, in 2011 the estate tax exemption drops to $1 million and the tax rates go back to 45 percent of every dollar over $1 million. Congress may modify this scheme, but it will take bipartisan effort and agreement to achieve any change. Whether this is possible in today’s political climate is questionable. It figures to be a battle between deficit hawks and anti-tax folks, and your guess is as good as anyone’s on the outcome.

What should you be doing to deal with this issue? You should have your attorney review any estate planning documents you might have which use formulas or other language to create separate trusts when the first of you or your spouse dies (commonly known as A-B trusts). These clauses are tied to an estate tax regime which no longer exists and could result in your estate being distributed in a manner you didn’t intend if you die in 2010.

If your estate exceeds $1 million, be prepared to go back to your attorney for additional planning. If you were “safe” from the estate tax in 2009, you won’t be in 2011 and thereafter, under current law. It is likely that your attorney will recommend additional steps you can take to minimize your estate tax burden and to allow you to pass the bulk of your estate to your loved ones or charity. The estate tax, no matter what the exemption amount, is still the only voluntary tax in America and can be avoided with proper planning.

Scott Gunderson an attorney in Reno who works in estate planning, trusts and probate law. Contact him at 354-3593 or scott@scottgunderson.com.