Estate planning attorneys are in a tricky situation in 2010. Clients’ needs haven’t changed. They are asking the same question they always have: How do I best structure my estate plan to meet my non-tax objectives in the most tax efficient manner? But in the current estate planning environment, formulating a long-term answer is a challenge.
To understand how we ended up in this predicament, a little background is needed. Specifically, we need to understand both the historical and current rules affecting the federal estate tax and asset basis. This article will take a look at these two components and how they have changed in recent years.
Historic Estate Planning for Estate Taxes
Bread-and-butter estate planning has traditionally involved making maximum use of the tools available to get the estate tax as close to zero as possible. The most universal tool is the unified credit (also known as the applicable exclusion amount), a federal tax credit that offsets gift and estate tax liability. The unified credit can be thought of as the amount a person can pass tax-free to heirs.
While the amount of the unified credit has fluctuated over time, the basic planning concept remained the same: Combine the unified credit with other available deductions or credits to save as much estate tax as possible.
Historic Estate Planning for Income Taxes (Basis)
The second component—asset basis—has been easy. As long as a person holds a parcel of property until death (or has certain “incidents of ownership”), the property gets a “step up” in basis at death. This effectively exempts all appreciation in assets that are held until death.
To illustrate the importance of basis, suppose a taxpayer acquires a piece of investment property for $25 and sells it two years later for $100, without having taking any depreciation on the property. In this case, the taxpayer will have a basis in the property of $25 (cost basis). On the sale, he will have $75 of taxable gain ($100 amount realized from the sale less his $25 cost basis).
Now let’s suppose that, instead of selling the property, the taxpayer dies in two years (when the property is worth $100) and leaves it to his nephew. The nephew sells it immediately for $100. Under the historic estate tax laws, the nephew will generally take a basis that is “stepped up” to the fair market value of the decedent. So the nephew now has a $100 basis in the property, resulting in $0 in taxable gain ($100 amount realized less $100 stepped up basis).
So we can see that this “step up” in basis is a very taxpayer-friendly rule. If the taxpayer holds the property until death, all appreciation in the property escapes taxation.
Estate Planning Under The Taxpayer Relief Act of 1997
At the time the Taxpayer Relief Act of 1997 was enacted, the unified credit was set at $600,000 and estate tax rates were as high as 55 percent. This meant that many people with fairly modest estates were subject to estate tax (keep in mind that your taxable estate includes life insurance). And the high tax rates meant that taxpayers could lose over one-half of their estate in estate taxes.
As it’s name suggests, the Taxpayer Relief Act was taxpayer-friendly. It raised the unified credit from $600,000 in 1997 to $1 million by 2006. This provision would have substantially reduced the number of estates that would be subject to estate tax. But the due to another piece of legislation, discussed next, the Taxpayer Relief Act was placed on the shelf for several years.
Estate Planning Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)
President George W. Bush’s first piece of major legislation was the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA was touted as the “death of death taxes” because it prescribed for the gradual phase out of the federal estate tax. But on the eve of its enactment, EGTRRA was in danger due to a Congressional rule known as the Byrd Rule. The Byrd Rule allows Senators to block a piece of legislation if it purports to significantly increase the federal deficit beyond a ten-year term. And in the then-current political environment, there were enough votes in the Senate to do just that.
To sidestep the Byrd Rule, Congress included a sunset provision in EGTRRA. Under this provision, EGTRRA was set to expire on January 1, 2011, unless Congress took further action to make EGRRA’s changes permanent. As a result, EGTRRA did not increase the federal deficit beyond a ten-year term and was at risk of being blocked under the Byrd rule. We can only assume the Congressional intent was to get something in place and hope that Congress would make the changes permanent sometime before January 1, 2011. So far, that hasn’t happened.
While it lasts, EGTRRA is very favorable for taxpayers with taxable estates. When EGTRRA was enacted in 2001, the unified credit was immediately increased to $1 million. It was set to increase to $3.5 million by 2009. The maximum tax rate was immediately reduces to 50 percent and set to decrease to 45 percent by 2007. And in 2010, EGTRRA would usher in a one-year era of no estate taxes!
But EGTRRA was not all good news. While it repealed the estate tax (good), it replaced the “stepped up” basis regime with a modified carryover basis regime (not good). Effective January 1, 2010, taxpayers no longer have an unlimited step-up in basis in property inherited from a decedent. Instead, the general rule is that the taxpayer takes a “carryover” basis equal to the lesser of the decedent’s adjusted basis or the fair market value on decedent’s date of death.
Let’s go back to our previous example to illustrate the current basis rule for 2010. A person buys a piece of investment property for $25 and dies in two years (when the property is worth $100) and leaves it to his nephew. The nephew sells it immediately for $100. As we saw in the example above, the nephew would have owed no taxes under prior law. But the new general rule does away with that basis step up. The nephew will take a basis equal to that of his uncle ($25). This means that the nephew will be in the same situation that his uncle would have been in when the property is sold. He will pay tax on the full $75 in appreciation.
EGTRRA does provide “coupons” that will benefit most estates in 2010. First, it provides each taxpayer with $1.3 million ($60,000 for non-resident non-citizens) of basis increase that can be allocated among his or her assets at death. Anyone can receive the basis allocation as long as they acquire the property from the decedent. This puts a person with less than $1.3 million of asset appreciation in roughly the same position as under prior law.
EGTRRA also provides a $3 million coupon for “qualified spousal property,” which includes outright transfers to a spouse or QTIP trust. This provides an additional $3 million of appreciation that can be exempted from the estate of a married individual.
But … remember the sunset provision? All of this goes away on January 1, 2011, unless Congress acts before then. This means that on January 1, 2011, we are back under the Taxpayer Relief Act of 1997. The estate tax will be resurrected. The applicable exclusion amount will be $1 million and the tax rates will range from 41 to 55 percent. And the modified carryover basis regime introduced by EGTRRA will be repealed.
So here we are between two worlds. Yesterday (in 2009) we had both estate taxes and a basis step-up. Today (in 2010) we have no estate taxes or basis step-up. And tomorrow (in 2011) we will once again have estate taxes and a basis step up. On top of that, most practitioners believe that something will happen between now and January 1, 2011. What that something may be is subject to debate. But it is fairly certain that current law is not the permanent situation.
Estate Planning in the Current Environment
So how do we plan in this changing environment? Flexibility is key. Estate plans should be drafted with enough flexibility to allow for basis allocation and asset disposition in 2010 while anticipating the reinstatement of the estate tax in 2011. This requires custom drafting and attention to detail.
The estate plan must also be reviewed to be sure that there are no formula clauses or other references to prior law that would have undesirable consequences in the current environment. For example, a clause that left an amount equal to the federal unified credit to a certain beneficiary or trust would no longer have meaning in 2010 since there is no federal unified credit in 2010.
Finally, in the midst of all this change and uncertainty in the tax laws, it is easy to lose track of non-tax objectives. Too often estate planning attorneys let the tax tail wag the dog. We must always pay close attention to the estate plan to be sure that it meets the client’s non-tax needs.