May 5th, 2011

In January 2010 we were faced with a world without an estate tax. Most “experts” expected Congress to re-enact the federal estate tax as it applied in 2009.

The world without an estate tax involved “carryover basis” of property inherited from a decedent who passed away in 2010. In simple terms, the basis of inherited property would be the lesser of the fair market value at the date of death or the decedent’s cost basis.

To make this more palatable, the executor could allocate an additional $1.3 million to assets valued at the decedent’s basis, provided that the allocation would not push the basis over the property’s fair market value. For property left to a surviving spouse, $3 million of basis could be allocated in the same way.

More complications were added. The $1.3 million would be increased by the unrecognized loss on any property worth less than basis on the date of death, plus unused capital loss carryovers of the decedent, plus unused net operating losses of the decedent.  If you think this still seems simple, you haven’t considered what happens when there are assets not under the control of the executor, property held in a trust or various trusts in separate tax jurisdictions, or property held jointly with someone other than the surviving spouse.

How is the amount of basis determined and allocated under those circumstances?

The Economic Growth and Tax Relief Reconciliation Act of 2001 that developed this situation indicated that a tax form would be available to report the basis allocation and a hefty fine would be handed out for those who do not comply. A draft of the form was circulated unofficially in early November, but pulled within days. A second draft of Form 8939—without instructions—was released Dec. 16, 2010, and comments were requested within 30 days of the release. The Tax Relief Act of 2010, which reinstated the federal estate tax with a $5 million exemption and a 35 percent maximum tax rate, was not expected at the time the draft was designed.

Under the 2010 act, executors of 2010 estates can elect out of the estate tax and back into carryover basis. The election shall be irrevocable and made on Form 8939. On March 31 the IRS announced that the form is not yet available, is not due April 18, 2011, and should not be attached to the decedent’s final Form 1040. Stay tuned.

The following examples are estates that will need to be reviewed separately:

• Gross estate is $4 million: Executor would not want to elect out of the system.
• Gross estate is $15 million; expenses, debts and deductions are $10 million: Executor would not want to elect out of the system.
• Gross estate is $6 million; expenses, debts and deductions are $100,000: Executor would want to elect out of the system.

And we’ve heard of the death of George Steinbrenner. His estate will probably elect out because they’re not worried about additional basis. They are unlikely to sell the Yankees.

A Temporary Solution
The $5 million exemption will be in place for 2010 and 2011. It can be adjusted for inflation in 2012, but then the estate tax reverts to the law that was in place in 2001. Congress needs to act again or, come 2013, we will be back to the harsh scenario predicted for 2010.

Generation Skipping Transfer Tax
The generation skipping transfer tax (GST) was reinstated retroactively for decedents dying and transfers made after Dec. 31, 2009. The GST exemption is equal to the estate tax exemption ($5 million per year for 2010–12). However, the 2010 tax rate is 0 percent. For deaths and transfers after 2010, the GST tax rate is equal to the highest estate and gift tax rate in effect for the year—35 percent for 2011 and 2012.

Portability
Spouses can “share” the combined applicable exclusion amount beginning in 2011. This provision is only available for deaths in 2011 and 2012. If one spouse were to pass away in 2011 with a taxable estate of less than the $5 million applicable exclusion, the difference between the applicable exclusion and the taxable estate is added to the exclusion amount for the surviving spouse.

This figure (called the “deceased spousal unused exclusion amount”) is only available if an election is made on a timely filed estate tax return for the deceased spouse. If more than one spouse predeceases an individual while this provision is available, the individual can only benefit from the “unused exclusion amount” from the last spouse to die.

Serial marriages cannot accumulate extra exemption amounts.

The portability provisions apply to estate tax only. The unused GST tax exemption is not portable.

The bypass trust was the mechanism previously used to make sure that the full exemption available to a married couple was used. With such a trust, however, portability is unnecessary. The portability provisions will help those who fail to plan to get the same advantage in utilizing the
full exemption.

However, there are other reasons to use a bypass trust:

• Appreciation on the assets, as well as the current value of the trust’s assets, is removed from the survivor’s estate.
• The trust can preserve the GST exemption, which is not portable.
• The trust has greater creditor protection than a survivor’s or Qualified Terminable Interest Property trust.
• The trust protects the desires of the first spouse to die in determining ultimate beneficiaries of his/her assets.
• The trust eliminates any disincentive to remarriage occurring with portability.
• Portability is temporary; the trust is not.

Trust agreements that provide for disclaimer trusts can create a bypass trust by a timely disclaimer or use the portability provisions.

State Death Tax
The state death tax credit went away after 2004 pursuant to 2001’s Economic Growth and Tax Relief Reconciliation Act. This was a very bad deal for California because the only estate tax due was based on the federal death tax credit. This is called a “pick up” tax. The credit was to have been reinstated for 2011 and forward.
The state death tax deduction, which replaced the credit, is extended through 2012.

Due Dates
Form 706 has historically been due nine months after the date of death, with a possible automatic six-month extension of time. An estate tax return due as a result of this legislation is not due until nine months after enactment—that is Sept. 17, 2011, if that date is later than the normal due date. Disclaimers normally due nine months after the date of death are also extended. The election to use carryover basis rather than file an estate tax return is also extended until September 2011, but many people believe Oct. 18, 2011, will be the revised due date.

Gift Taxes
Before enactment of the Tax Relief Act of 2010, gift tax was determined with a 35 percent maximum rate and a $1 million applicable exclusion. For gifts in 2011 and 2012, the applicable exclusion amount will be $5 million with a top tax rate of 35 percent. The applicable exclusion is applied after the annual exclusion(s) of $13,000 per donee. The annual exclusion is increased in $1,000 increments due to inflation and could possibly increase for 2012.

The Act re-integrates the estate tax, gift tax and GST exemptions at $5 million. This is an opportunity to leverage additional gift tax and GST exemptions for taxpayers. Individuals may be able to eliminate estate, gift and GST tax costs from their estates with proper planning.

Today’s low interest rates and asset valuations make the use of gifts very attractive. If this is a temporary situation, instead of the “new normal,” gifts are a major consideration.

Charitable IRA Rollover Gift(s)
Individuals age 70.5 and older can donate $100,000 per year directly from their IRAs. A similar provision was available in 2006–09. The donation can satisfy the owner’s IRA required minimum distribution. The law change was retroactive to Jan. 1, 2010. Individuals had until Jan. 31, 2011, to make a 2010 charitable IRA rollover gift. Some requirements:

• Donor must be owner or beneficiary over age 70.5.
• A public charity must receive the donated funds.
• The gifts must be made from traditional or Roth IRAs only.
• After-tax basis in IRAs cannot be used for these gifts.

Individuals who failed to take their 2010 required minimum distribution in 2010 could satisfy the requirement with a January 2011 charitable rollover that they requested to be allocated to 2010.

The contribution made this way is equivalent to a 100 percent charitable deduction. It benefits those who don’t itemize deductions, have charitable contribution carryovers and want to pay the minimum rate on social security payments received.