What a mess Congress has created! We are now in a year where there is no federal estate tax – but hold the cheers. Congress has substituted another method of taxation that will collect more taxes from many of our clients and families than the estate tax. Additionally, as has been reported in the local and national press, these changes will, for some, greatly alter the planned-for and anticipated distributions among family members and heirs.
A brief review of the law will help explain why this is so significant. The 2001 tax act, signed into law by President George W. Bush, gradually reduced the maximum rate of the federal estate tax (and the equally onerous generation-skipping transfer tax on transfers to grandchildren) from 55% to 45%. It also gradually increased the amount of property that you could pass free of federal estate tax from $675,000 per person in 2001 to $3.5 million per person in 2009. That means that, with basic estate planning, a married couple could pass up to $7 million free of federal estate tax, if they both died in 2009.
Then, in 2010 only, the 2001 tax act repeals the estate tax. But like a horror film character that just won’t die, under the existing law the estate tax returns again on January 1, 2011 – only at a much lower $1 million exemption and a higher maximum 55% tax rate! This strange “now it’s gone, now it isn’t” effect is the result of a rule in Congress that attempts to limit budget deficits.
Paying for Estate Tax Repeal
To pay for this one-year vacation from the estate tax, Congress replaced the estate tax with an increased income tax. Before 2010, assets that passed at death were valued at fair market value at the date of death. Thus after death, when a surviving spouse or heirs sold assets (like securities or a home) that had increased in value, they would not have to pay income tax on any of the increase in value that occurred before death. (This is referred to as a “step-up in basis.”) For many heirs this meant huge income tax savings, oftentimes tens of thousands of dollars or more.
But in 2010, property that passes at death does not automatically receive this “step-up” in basis. Instead, each individual has a limited amount of property that can be “stepped-up” at the time of death. Property that does not receive this stepped-up value will be subject to tax on the entire increase in value from the date it was first acquired. This means that the property could be exposed to tens of thousands of dollars of income tax liability for heirs!
Not surprisingly, these rules are convoluted and in many cases very different from the old law. In fact, Congress attempted to institute a similar tax structure in the 1980s but it was repealed, retroactively, because it was too difficult to administer. Because of past experience as well as the anticipated difficulties in calculating such a tax, the common belief was that Congress would change the law before January 1, 2010. But it did not.
How Are You Affected?
This law can affect you in several ways. For married couples as well as single clients, we need to first make sure that your property will be divided according to your desires, and not as dictated by Congress. For more than 50 years it has been common to use a written mathematical formula to divide the assets of a married couple when the first spouse dies to maximize estate tax savings. Likewise formulas have been used to provide funds for charitable causes and to benefit family and friends. Now, in 2010, when there is no estate tax, these formulas will not work. If a spouse is not your sole beneficiary (for example, if you have children from a prior marriage), the existing formula could result in the disinheritance or substantial reduction of resources provided for the surviving spouse. Likewise, if you have a formula plan intended to divide assets between individual beneficiaries and charities, it could result in one group or the other being completely disinherited. For a more detailed discussion, see No Estate Tax in 2010: Good News or Bad?
The effect on charitable giving is also being felt as an unintended consequence of estate tax repeal. The decision to let the estate tax expire has removed the incentive by the very wealthy to include charities in their estate plans, and may have a negative effect on lifetime charitable giving, as well.
There are a number of proposals circulating in Congress to address the estate tax situation. Congress is also debating a jobs bill, and there had been some indication that a compromise between Democrats and Republicans was possible involving both pieces of legislation. It appears now, however, that partisanship may prevent a compromise, and may threaten quick action on estate tax legislation.
What Should You Do?
According to Financial Planning Magazine, the “biggest lesson from this estate tax mess is for clients to have their wills revised and make sure their intent is stated clearly.” At Huck Bouma, we encourage our clients to meet with us as soon as possible to review their estate plans and make any changes that are necessary. Everyone needs now to ensure that their property is positioned to receive the maximum step-up in basis increase available under current law. This is a time that demands a new approach to planning with new thinking and flexibility to see that your wishes are fulfilled, no matter what Congress throws at us this year or next.
Going forward, with the uncertainties inherent in potential future legislation, an annual review is warranted for anyone with a taxable, or potentially taxable estate, according to Financial Planning Magazine. We could not agree more.