Did the Death Tax Really Die?

The Estate Tax, or “Death Tax,” is a federal tax on inheritance.  Over the last ten years, the Death Tax rate has ranged from 45% to 55%.  However, there is also a “Death Tax Exemption,” meaning that if the total value of your Estate at death is below the Exemption, your heirs do not have to pay any Death Tax; if the total value of your Estate at death is above the Exemption, your heirs only have to pay Death Tax on the amount over the Exemption.  In 2009 the Exemption was $3.5M.  In 2010, the Death Tax – under current rules – is completely eliminated: Bill Gates could die in 2010 and there would be no Estate Tax.  But in 2011, the Estate Tax returns with only a $1M Exemption and a top tax rate of 55%.

Although it sounds like good news that the Death Tax vanishes in 2010, along with the elimination of the Death Tax is a dramatic limitation of the “Step-Up” in Basis which prevented many heirs from having to pay Capital Gains Taxes on the sale of certain inherited assets.  While the Death Tax applied to roughly 6,000 taxpayers per year, the limitation on the “Step-Up” in Basis is estimated to affect approximately 70,000 taxpayers per year.

You may wonder whether these changes will affect your Estate Plan as currently written.  Married couples should check to see whether their Trusts divide the estate of the first spouse to die into a Bypass Trust (sometimes called a “Family Trust,” an “Exemption Trust,” a “Credit Shelter Trust,” or a “B Trust”) and a QTIP Trust (sometimes called a “Marital Trust,” or a “C Trust).  If the terms of the Bypass Trust and QTIP Trust differ – such as different beneficiaries, different trustees, or different distribution standards – it would be a good idea to have an attorney review your Trust as the elimination of the Death Tax in 2010 might affect the allocation of assets to such Trusts and thus adversely affect your intent.

Furthermore, if you have highly appreciated assets, you may want to discuss with an attorney the possible need to amend the formula that allocates assets between the Bypass Trust and the QTIP Trust to take advantage of a limited additional “Step-Up” in Basis for spousal property.

In addition, the 2010 law brings new reporting requirements for estates of individuals dying in 2010.  Whereas in the past you only needed to file an Estate Tax return if the decedent’s estate exceeded the Estate Tax Exemption, now you need to report non-cash transfers at death of assets in excess of $1.3 million and certain appreciated assets received by the decedent within three years of death. 

Although this 2010 elimination of the Estate Tax combined with the limitation in the “Step-Up” in Basis was written into the Internal Revenue Code in 2002, no observer believed that Congress would actually let this happen.  Over the years, Congress has attempted to make a permanent change to the Estate Tax law but never was able to get enough votes to do so.  In December 2009, the House passed a law to keep the Estate Tax Exemption permanent at $3.5 million but the Senate never even got it out of committee.  When Congress went on holiday break, most observers fully expected Congress to “repeal the repeal” in January by reinstating the Death Tax with a $3.5M Exemption and having in retroactively apply to January 1, 2010.  However, it is already the end of January and there has been no sign that Congress is even thinking about the Estate Tax issue.  As a result, there are three likely possibilities: (1) Congress “repeals the repeal” by passing a temporary or permanent Exemption of $3.5 million and applying it retroactively to January 1, 2010; (2) Congress “repeals the repeal” by passing a temporary or permanent Exemption of $3.5 million and applying to prospectively to the date the bill passes; (3) Congress doesn’t do anything, allowing these unique rules for 2010 and returning to the old rules with a $1 million Exemption in 2011.

As a result of this uncertainty, it may be wise to amend your Estate Plan to make it flexible.  Furthermore, for decedents dying in 2010, it is not clear whether Trustees and Executors should follow the reporting requirements under the old rules or follow the reporting requirements under the new rules, making Trust Administration and Probate very tricky this year.

This is a messy situation that nobody thought would actually happen and makes planning difficult for clients, attorneys, and accountants.  Hopefully, Congress will give us some guidance soon though hope is diminishing with every passing day.