Estate tax repeal: benefit or burden?
On Jan. 1, a one year repeal of the federal estate tax, the generation-skipping transfer (“GST”) tax, and a reduced tax rate for lifetime gifts went into effect. On Jan. 1, 2011, the federal estate tax and GST tax will be reinstated and the gift tax rates will be increased. While this temporary reprieve from the estate and GST tax may seem like a windfall for some, the change has created uncertainty, additional costs, and confusion for many.
In 2001, Congress enacted estate tax reform. The reforms gradually increased the amount individuals could pass to their heirs (beneficiaries) upon death without paying estate tax, often referred to as the “exemption amount,” and decreased the tax rate imposed on assets in excess of the exemption amount. In 2009, the exemption amount was $3.5 million per person. The highest estate tax rate imposed on assets valued in excess of $3.5 million was 45 percent.
These reforms culminated in the repeal of the estate tax in 2010. While the federal gift tax continues to apply to lifetime gifts that exceed in aggregate a $1 million lifetime exemption, the highest gift tax rate imposed on such gifts dropped to a 35 percent tax rate.
Despite the possible advantages of estate tax repeal, the reforms could have both unintended consequences and impose significant burdens on beneficiaries.
First, many estate planning documents contain language referring to laws that are no longer applicable. Estate plans commonly use formulas that divide assets by reference to the exemption amount from estate tax. Because there is no “exemption amount” under current law, the interpretation of these estate plans is uncertain and may have unintended consequences.
Second, the reforms imposed a carryover basis system for inherited assets. Under 2009 law, a decedent’s assets generally received an income tax basis equal to their fair market value at the decedent’s death. This allowed a beneficiary to easily identify the basis of an asset and generally eliminated any capital gain or loss upon sale of the asset. In 2010, however, the basis of an inherited asset will be essentially equal to, or “carried over from”, the amount at which the decedent purchased the asset. As a result, beneficiaries may have difficulty establishing the basis of an asset and may have to pay significant capital gains taxes should they choose to sell the assets.
To make matters more complicated, under the “carryover basis regime,” Congress allowed the personal representative of a decedent’s estate to increase the basis of a decedent’s assets by up to $1.3 million for assets passing to any beneficiary and by up to $3.0 million for assets passing to a spouse. This will result in additional tax filing obligations to identify the basis of the decedent’s assets and the application of the adjustments.
Third, when enacted the 2001 reforms were to “sunset” (be repealed) on Jan. 1, 2011. If the reforms sunset, the federal estate, GST, and gift tax laws will revert to what they were in 2001, an exemption amount of $1 million and an estate tax rate of 55 percent. This could result in the imposition of estate tax on significantly more estates than ever before.
Finally, Congress has indicated that it will attempt to re-enact estate and GST taxes retroactively to Jan. 1, 2010. For decedents who die in early 2010, their estates must remain in limbo until Congress decides which tax regime is applicable. In addition, many claim that retroactive imposition of the estate and GST tax laws is unconstitutional. Thus, there could be court challenges over whether the taxes are applicable to a particular estate, delaying resolution of the estate matters for many years.
Certain beneficiaries may receive a windfall from the temporary repeal of the estate tax laws. However, the drastic change in the law for such a limited period of time could lead to potentially significant income tax consequences, an inability to plan appropriately, and an increase in costs associated with reviewing and updating estate plans to accommodate the uncertainty in the law.