2010 Tax Act

Prepared February 4, 2010

There have been a number of unexpected changes for the federal estate tax for the year 2010 and thereafter. As a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“Tax Act”), the federal estate tax exemption was increased progressively from 2001 through 2009, and the federal estate tax was repealed for the calendar year 2010. However, the Tax Act expires on December 31, 2010 and the estate tax is reinstated for 2011, under the laws in effect prior to the Tax Act in 2001, which means a maximum federal estate tax exemption of $1 million and a maximum federal estate tax rate of 55%. The federal gift tax has not been repealed and remains in effect with a $1 million dollar exemption. However, the gift tax rate in 2010 has been reduced to 35%. In 2011 the maximum rate is increased to 55%. The temporary rate reduction, as well as today’s low interest rate environment, creates current planning opportunities for many clients.

In order to fully understand the effect of these changes, we need to describe the rules for the different periods. In 2009, the federal estate tax law provided that each individual dying in 2009 would have a $3.5 million federal estate tax exemption and a maximum federal estate tax rate of 45%. The concept of “cost basis” relates to capital gains. Generally, one’s “cost basis” is what you pay for something. When you go to sell the item, you would pay tax on the difference between what your cost basis was and the price you sold it for (assuming the value went up). Prior to 2010, there was also an automatic full “basis step-up” for assets held at death. This resulted in an increase in basis and an elimination of capital gains on pre death appreciation. In 2010 there is no federal estate tax, but the Tax Act also eliminates the automatic “basis step-up” and provides that the individual(s) inheriting property will receive the lower of the decedent’s carryover basis or the fair market value of the property. This may result in many estates actually owing more tax overall (upon the sale of the assets) than they had with an actual estate tax. It also may result in the loss of basis. To partially offset the elimination of the basis step up, the Tax Act provides that an executor can increase and allocate a $1.3 million “basis” with an additional $3 million of “basis” for assets left to a spouse. In 2011, the federal estate tax is reinstated as noted above, with the return of the automatic basis step up.

Confusing to be sure, but here is the real problem. The failure by Congress to act with respect to the repeal of the estate tax will potentially produce a number of unintended consequences in one’s estate plan. Bequests to spouses that are based on the estate tax exemption or bequests to grandchildren based on the generation skipping tax (“GST”) exemption may be entirely distorted. For example, this may be of particular concern if one’s estate plan provides that one’s children or other relatives “receive the maximum amount that can pass free of estate tax and for the surviving spouse to receive the balance.” That simple formula would leave your spouse with nothing! The reverse may be the case if one’s instruments provide that the estate tax exemption (which does not exist for 2010) amount passes to one’s children and the balance to your surviving spouse, in which case the children would receive nothing! Another problem would occur if one’s Will has a provision devising the GST exemption, because in 2010 there is no GST exemption. Furthermore, one’s estate planning instruments may not allocate your assets in a way that can take advantage of the change in the basis step-up rules to allow for both the general and spousal step-ups in basis. This could have a significant impact on your heirs when it comes time to sell inherited assets, such as a home.

Everyone expected Congress to avoid the problems by simply extending the 2009 estate and gift tax laws into 2010, and then in 2010 focus on a more permanent resolution of the estate and gift taxes. However, Congress in its distraction with health care reform, failed to extend the 2009 estate and gift tax laws into 2010.

Congress may try to reinstate the estate tax for 2010 and may or may not make it retroactive to January 1st. If Congress does choose to do something retroactively, it may be fraught with constitutional challenges. Whether Congress will try to change the estate tax in 2010 and the changes they are expected to make for 2011 cannot be predicted with certainty.

In addition to the above, please be advised that there is discussion in Congress about eliminating some of the popular estate planning tools used in sophisticated estate planning. More specifically, there is discussion about eliminating certain discounts used in valuation, and eliminating short term grantor retained annuity trusts (“GRATs”), where the remainderman’s interest (i.e. children and grandchildren) is “zeroed out” to avoid gift taxes.

There are a number of options available to provide the necessary flexibility and provisions that can be added to estate planning instruments to take into account the current tax laws and the anticipated changes.  Experienced tax and estate counsel can discuss the impact to you and your estate caused by the significant changes in the tax laws .

Some additional changes which you should be aware of are summarized below:

1. IRA Roth Conversions: Commencing January 1, 2010, taxpayers can convert traditional IRAs to Roth IRAs, regardless of income. Converted amounts are included within income in the year of the conversion, except for conversions taking place in 2010, where a taxpayer may elect to include 50% of the income in each of 2011 and 2012. A taxpayer who makes a conversion may reconvert back to a traditional IRA. A taxpayer will generally want to reconvert if the assets held in the IRA have declined in value. Your Will should contain language allowing your personal representative to engage in a reconversion and should provide guidance and standards to assist your agent in the decision making. If you would like assistance in determining whether a conversion or reconversion is appropriate for you, then please feel free to give us a call.

2. Capital Gain Rate and QDI: The 15% capital gain tax rate (0% for taxpayers below the 15% tax bracket) will increase to 20% in 2011. Qualifying Dividend Income (“QDI”) taxed at reduced capital gain tax rates, will be taxed at ordinary income tax rates beginning in 2011.If you would like to schedule an appointment to discuss the potential problems and issues set forth above, and how they may affect you, then please feel free to contact us. We look forward to hearing from you.