The US Congress did not enact an extension of the estate tax before December 31, 2009. Accordingly, there is now a one-year repeal of the estate tax for 2010, subject to future Congressional action that might reinstate the tax at any time.
The 2001 Tax Act increased the federal estate tax exemption and lowered rates between 2002 and 2009. In 2009, there was a $3.5 million exemption and a 45 percent top rate for the estate tax, applicable to estates of persons dying in 2009, and for the generation-skipping transfer tax (GST). The same 2001 Tax Act provides for a one-year repeal (2010) of the estate tax and the GST — but not the gift tax — and it provides that beginning January 1, 2011, the estate tax and the GST are reinstated with a $1 million exemption and a 55 percent top rate (plus a 5 percent surtax for certain large estates).
For several years, Congress has considered a number of proposals to make better sense of the estate tax. These proposals have ranged from outright repeal of the estate tax to a broad spectrum of "reform" proposals intended to make the tax permanent but with greater certainty as to the rules. In December 2009, the House of Representatives passed a proposal to make the estate tax permanent, with rates and exemptions fixed at 2009 levels, but the Senate adjourned without taking up the House bill. Some Senators of both parties favor outright repeal, some favor extension of the 2009 law, some favor an estate tax with lower rates and a higher exemption and some would prefer higher rates and a lower exemption (that could be expected to affect more families and raise more tax revenue).
There are a number of gift and estate tax provisions that have not been in the law since 2002, but which seem to be reinstated by the 2001 Tax Act, effective either January 1, 2010, or January 1, 2011, if there is no corrective legislation on these topics in the coming months. These provisions, as drafted, may have unintended consequences.
What About Carryover Basis?
A major wildcard in the 2001 Tax Act is a provision for "carryover" basis, applicable to estates of all persons dying in 2010. Under the carryover basis rules, those who take property from a decedent will no longer receive an automatic "step-up" in income tax basis (to the fair market value of the decedent’s property at date of death). Instead, the tax basis of such property will be the lower of either the value at death or the decedent's tax basis in the property. While there are two exceptions to the carryover basis rules that will permit the allocation of some floor amounts of basis to unrealized appreciation in property inherited from a decedent (typically $1.3 million, plus an additional $3 million for amounts passing to a surviving spouse outright or in a qualifying trust), the income tax payable upon the disposition of property received from a decedent dying in 2010 may adversely impact many families that would have been exempt from the estate tax under the 2009 law.
What Happens Next?
President Obama and many members of Congress have called for a prompt extension of the 2009 estate tax law. If such an extension is enacted in 2010, and if the extension purports to be retroactive to January 1, 2010, there will almost inevitably be some decedents who die in the first days of 2010, whose families will challenge the retroactive change as unconstitutional. While we cannot predict the outcome of such a challenge, as there are precedents both ways, we can predict that the litigation will likely last several years.
There is no consensus in Congress today as to what any new estate tax law should provide. In 2010, a congressional election year, we can expect intense political infighting between those who seek repeal, and the several factions that seek a reenactment of the estate tax (factions that do not today agree among themselves as to the important details).
Planning in the Interim?
There are numerous planning ideas under consideration, but essentially every planning idea intended to take advantage of the 2010 hiatus in the estate tax and the GST involves downside risk under some legislative scenarios (that is, if there is no new legislation or under some of the legislative proposals). Remember: the federal gift tax is not repealed in the hiatus year 2010, although the maximum federal gift tax rate is lower for the moment (35 percent) than it was at the end of 2009 (45 percent).
We intend to watch the legislative developments carefully, and we will report again when there are further significant developments. In the meantime, clients who choose to move aggressively hoping to take advantage of the current confused state of the law should proceed with caution.