Estate Tax Repeal: Good News or Bad News?

3/23/2010

Congress very unexpectedly let the federal estate tax die for 2010. The public and the experts are confused about what it all means, but it may have implications for how your estate is distributed. The current situation is a huge mess which creates uncertainty for those with large estates. In 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was designed to provide significant tax relief, including “permanent” relief from the federal estate tax (with its then $675,000 exemption and maximum 55% tax rate). The new law steadily lowered the maximum estate tax and generation-skipping tax (“GSTT”) rate to 45%, while increasing the exemption amounts to $3.5 million in 2009 and eliminating federal estate tax and GSTT altogether in 2010. If Congress takes no further action this year, the federal estate tax returns again on January 1, 2011 - only a much lower $1 million exemption and a higher maximum 55% tax rate.

Paying for Estate Tax Repeal

To pay for the one-year exemption from federal estate tax, Congress replaced estate tax with an increased income tax. Before 2010, any assets that passed to someone when you die would be valued at fair market value at the date of death. Thus after death, when a surviving spouse or heirs sold any assets (like securities or a home) that had increased in value, they would not have to pay income tax on any of that growth that occurred during your lifetime. (This is referred to as a “step-up in basis.”) For many heirs this meant huge income tax savings.

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” in value at the time of death. Property that does not receive this step-up will be subject to tax on all increase in value from the date you first acquired the property. Not surprisingly, these rules are convoluted and in many cases are very different from the old law. In fact, Congress attempted to institute a similar tax structure in the 1980s, and it was repealed retroactively because it was too difficult to administer.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 didn’t.

State Tax Laws

Nineteen states and the District of Columbia, like Minnesota, have continued to impose a separate estate or inheritance tax. In Minnesota, the estate tax is assessed on the value of the estate in excess of $1 million, and it starts at 39%, declining as the value of the estate increases (a “regressive” tax).

How Are you Affected?

This law may affect you in several ways. For married couples as well as single clients, you need to first make sure that your property will be divided according to your desires, and not 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 may 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.

What Should You Do?

We encourage you to meet with us if you have concerns regarding your estate plan, and make any changes that are necessary for this law. You should ensure that your property is positioned to receive the maximum step-up in basis increase available under current law. This is a time that may demand a new approach to your planning, with new thinking and building in flexibility to see that your wishes are fulfilled no matter what Congress will throw at us this year or next. We have solutions that will meet your planning objectives with the least amount of tax impact.

Please contact any of the professionals in our Estate Planning Department if you would like further information or have questions regarding this issue: