Attorney Robert J. Kolasa – Estate Planner, CPA & Former IRS Attorney

ESTATE AND GIFT TAXES

The price to pay for estate tax repeal in 2010 was implementation of the complex “carryover basis” rules. By way of explanation, when a taxpayer sells an asset, there is generally an income tax on the difference between the sales proceeds and ‘cost basis’ (what was paid for the asset). Under the pre-2010 rules, when a person died, the cost basis was generally increased (‘stepped up’) to its value on date of death. When the asset is later sold, only the difference between the sales proceeds and date of death value would generally be taxed. Although estate taxes could be generated by the inclusion of the asset in the estate tax base, the forgiveness of pre-death appreciation for income tax purposes constituted a major countervailing tax benefit.

While estate taxes are avoided under the 2010 carryover basis rules, income taxes in many cases may be increased when estate assets are sold. The downside of carryover basis was mitigated by the executor’s right to allocate $1.3 million (plus a possible additional $3 million adjustment for married couples) of additional “basis increases” to the decedent’s assets. Implementation of these rules required careful analysis and potentially created conflicts among estate beneficiaries, thereby greatly complicating estate and trust administration. Furthermore, the carryover basis rules were fundamentally impractical as requiring detailed inter-generational keeping of cost basis records which typically are not accurately maintained by clients. See my above cited article for an analysis of many of these complexities. Significantly, as noted below, the 2010 Tax Act permits executors of 2010 decedents to “elect” the carryover basis regimen, or be subject to federal estate taxes with a $5 million exclusion amount.

The Maddening Spectacle of “Temporary” Federal Estate Tax Measures

Sadly, the 2010 Tax Act merely extends the day of reckoning. Absent legislative change, in 2013 the law reverts to the pre-EGTRRA rules ($1 million federal estate tax exclusion and 55% top estate tax rate). Although a temporary extension may be a convenient political ploy to “let the voters decide” future tax policy (there is a Presidential election in 2012), it breeds havoc in trying to intelligently structure a client’s estate plan. The $4 million “gap” between the 2013 ($1 million) exclusion and the 2010 Tax Act’s ($5 Million) exclusion is staggering. Since the Democrats supported a $3.5 Million exclusion in the negotiations leading up to the 2010 Tax Act, it appears likely that this may set the floor as to what the exclusion may be downstroked to in 2013. Of course, anything is possible, including a series of never ending “temporary” extensions.

Under prior law, a credit shelter trust was critical to save estate taxes for married couples. Fundamental estate tax planning for a married couple revolved around funding the credit shelter trust of the first to die with assets equal to the federal estate tax exclusion amount. Full funding would prevent “wasting” the exclusion of the first deceased spouse, which could result in higher estate taxes.

The 2010 Tax Act turned the above planning on its head with the introduction of federal estate tax portability (this concept is not applicable to Illinois estate taxes or generation skipping transfer taxes). Estate tax portability permits the surviving spouse to utilize the unused exclusion amount of his or her last deceased spouse. For example, under prior law it would generally be an estate planning mistake for a married couple worth $10 Million to hold assets in joint tenancy (the first to die’s $5 Million estate exclusion could have been “wasted” as there were no assets funding a credit shelter trust). Under the regime change of the 2010 Tax Act, the “wasted” $5 Million exclusion of the deceased spouse (i.e., the “Deceased Spousal Unused Exclusion Amount” or “DSUEA”) can now be recaptured by the surviving spouse for his or her lifetime or testamentary use. Hence, in the above example, the surviving spouse would have a $10 Million exclusion amount (his or her $5 Million exclusion, plus the $5 Million DSUEA). Unfortunately, estate tax portability is also a temporary rule set to expire in 2013, although widespread bipartisan support of this concept will most likely mean that someday it will be a permanent provision.

The liberalization of the federal estate tax rules for 2011-2012 ($5 million exclusion/ 35% rate), with possible reinstatement of the pre-EGTRRA rules in 2013 ($1 million exclusion/55% rate) makes competent estate tax planning more complicated than ever.

The current situation causes significant uncertainty for both clients and advisors. Clients simply need to incorporate flexibility into their current plans while taking advantage of favorable planning opportunities. In any event, many of my clients are now revising, simplifying and improving their estate plans by:

• Adopting DISCLAIMER TRUSTS wherein the surviving spouse receives all assets outright, unless such assets are needed to be retained in trust to reduce estate taxes. Thus, the surviving spouse has the best of both worlds – simplicity and estate tax planning.
• Updating documents to take into account changed family circumstances (i.e., such as when a beneficiary receives his or her inheritance) and selecting different executors, trustees or agents under Health Care and Property Powers of attorneys;
• Updating trust funding and beneficiary designations (especially in regard to pension and IRA retirement assets following recent significant rule changes by the IRS).

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