Dealing with Repeal of the Estate Tax

The estate tax was repealed, at least temporarily, but the news is not all good.

You know the 2001 tax law phased out the estate tax so it would be eliminated for 2010. But in 2011 the old estate tax law is to be reinstated if Congress does not take action. Everyone assumed Congress would act by the end of 2009 to at least extend the 2009 estate tax exemption and tax rates. Instead, Congress did nothing and let repeal of the federal estate tax take effect in 2010. But keep these points in mind:

? Congressional leaders promise to reinstate the estate tax retroactively to Jan. 1, 2010. There is some question of whether a retroactive tax would be constitutional, but it will be enacted.

? I hope you followed our advice over the last few years on how to revise your will. Many people who did not created problems for their spouses if they pass away while the estate tax is repealed. They have standard will clauses that give their children, or a bypass trust for their children, whatever portion of the estate is exempt from the federal estate tax. Well, the entire estate is exempt from the tax now, and that means their spouses receive nothing under their wills.

That’s why we’ve recommended your will have a formula ensuring your children can’t receive the entire estate while your spouse is alive. Your will should limit the children’s share to either a percentage of the estate or a dollar amount, or the lower of the two.

? A little-known clause in the estate tax repeal is the repeal of “stepped up basis” of inherited assets. Under the federal estate tax, people who inherited assets increased the tax basis to the fair market value on the date of the prior owner’s death. No one paid capital gains taxes on appreciation during the deceased’s lifetime. Now, inheritors take the same basis the deceased owner had. When they sell, they owe capital gains taxes on all the appreciation. There are exemptions of the first $3 million inherited by spouses and $1.3 million inherited by non-spouses. Beyond the exemptions, inheritors have to go through the deceased’s records to find the tax basis of the property, or they use a tax basis of zero and pay capital gains taxes on the entire value of the property.

? The generation-skipping transfer tax also is repealed in 2010. The GSTT imposed a 45% tax on assets given directly to grandchildren in 2009 above a $1 million exemption. Right now you can give an unlimited amount directly to grandchildren and pay only a regular 35% gift tax rate. But Congress also is likely to re-impose the GSTT retroactively this year. If it does and you made large gifts to grandchildren, you’ll pay both the regular gift tax and the GSTT.

As always, we’ll keep you ahead of new developments in the estate tax and how you should react to them. For now, be sure your will is drafted according to our previous advice. This should see you through the current chaos and whatever Congress enacts in 2010.