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Part 2-Look Ma, No Basis: Estate Tax Repeal

Estate tax exemption increases, rate reductions and ultimate repeal grabbed the headlines thanks to Congress’ Memorial Day tax legislation. There are other significant changes that can affect your estate planning. Some are good and some are, well, not so good. As discussed in last month’s column, all changes expire at the end of 2011 (with a resulting return to 2001 law) absent further Congressional action.

Basis Step-Up

If you die under current law, your heirs inherit your assets with a new basis equal to fair market value at your date of death. This “basis step-up” rule frees heirs from the pain of paying income tax on any appreciation in assets held at your death. For example, that family business you capitalized with just the shirt off your back can be sold by your heirs at its gazillion dollar date-of-death value and they pay no capital gains tax.

Recently minted heirs discovered that the law works both ways. Suppose you bought stock in early 1999 and hold it until your death. Your big built-in capital loss will die along with your investment-prowess embarrassment, because the basis will be stepped down at death.

Carryover Basis

The estate tax dies at the stroke of midnight December 31, 2009, unfortunately taking basis step-up with it. At that point, a new concept will enter our lexicon - carryover basis. Carryover basis simply means that heirs inherit property with the decedent’s cost basis beginning in 2010.

A planning opportunity arises. If you have appreciated property and a spouse, you should die by December 31, 2009, and leave your estate to your spouse. There will be no estate tax thanks to the marital deduction, but your spouse will get a basis step-up. Your spouse should then plan to die during 2010, passing the property to the heirs before the estate tax returns in 2011.

Murky Basis

That’s the best of all worlds, assuming you are motivated solely by taxes. But, if either you or your spouse do not like or cannot guarantee compliance with this plan, there are some other carryover basis considerations:

  • The good news is that each decedent will have a freebie $1.3 million dollar “basis increase amount” to allocate among assets held at death. The bad news is that your heirs will be able to quarrel over who gets what asset AND who gets how much of the basis increase amount! Incidentally, no asset’s basis can be increased above date-of-death FMV.
  • At death, any unused capital loss and net operating loss carryovers increase the $1.3 million increase amount. Unrecognized losses on property worth less than basis at the date of death also add to the 1.3 million basis increase amount.
  • Under current law, a surviving spouse receives a basis step-up (or down) even though no estate tax is due. After 2009, carryover basis comes into play for bequests to spouses. However, there is a $3 million basis increase amount that may be allocated to property passing to a surviving spouse. (The $1.3 million basis increase amount also can be used for property passing to a spouse.)

Did you notice the references to “FMV?” Despite estate tax repeal, date-of-death appraisals and IRS valuation disputes will continue to play a vital role in the administration of an estate. The battle simply will shift from FMV for estate tax calculation to FMV for income tax basis determinations.

Wills in Turmoil

Currently, estate tax minimization drives how most married couples divide up assets at death. This tax-driven economic splitting of assets between spouse and descendents does not necessarily coincide with what is appropriate for the family.

The welcome increase in the estate tax exemption (discussed in my last column) could screw up your estate plan’s economics without you even being aware of it. For example, the typical will provides for a family trust to use the lifetime exemption, with the rest of the estate passing to the surviving spouse, possibly in trust. The will most likely accomplishes this by “formula” language, which automatically increases the funding of the family trust as the exemption increases.

Before the recent legislation, you may have been comfortable with the family trust receiving $675,000 (increasing to $1 million in 2006) and your spouse receiving the rest. However, the new law increases the exemption to $1 million next year and then ratchets it up to $3.5 million in 2009. Do you want to shift that much away from your spouse into the family trust? Is your spouse comfortable with that? Are the terms of your family trust consistent with this dramatic increase in its funding?

What does this have to do with carryover basis? The carryover basis regime likely will cause attorneys to develop wills that divide assets to maximize the use of the $1.3 million general basis amount and $3 million spousal basis amounts. The complexity may be mind boggling, because the will would need to consider not only the division of value among the spouse and descendents, but also the selection of specific assets to assure that the full basis increase amount can be used.

Consider that, leaving $1.3 million of asset value to your kids won’t use the entire $1.3 million basis increase amount unless those assets have zero basis. So, taxes will continue to drive testamentary plans, but the focus will shift from estate tax to income tax savings.

Murky Future

Will carryover basis ever see the light of day and, if so, will it stay with us? We older folk remember that Congress enacted carryover basis in the mid-1970s and repealed it a few years later because the complexity was overwhelming. For example, imagine the practical problems for heirs finding and proving the basis of property bought many years ago by someone who is no longer around.

One certainly could question Congress’ wisdom in failing to learn from past mistakes. But, for estate tax repeal to become and remain a reality, carryover basis probably must become a reality. Why? The simple answer is that carryover basis will raise a lot of tax dollars for the government and, therefore, is critical to reducing the overall cost of killing the death tax. A secondary reason is more of a philosophical point. Death is not a legitimate reason to allow families to avoid tax on income and gains. The current law basis step-up is accepted under this philosophy only because the estate tax rate is so high.

You Might Like It!

Now, I recognize that some family business owners will cheer carryover basis. The capital gains rate is lower than the estate tax rate. The tax on the gain isn’t due until the asset is sold and cash presumably is available.

For senior generation family members who want the business to remain in the family, carryover basis may be the best of all worlds. The estate tax goes away as an incentive for the kids to sell the business. Plus, carryover basis will act as a disincentive because a sale will trigger a big capital gains tax. Nirvana!

On the other hand, the capital gains tax disincentive might keep disgruntled or disinterested heirs from selling their business interests. The result could be one less option for releasing tensions within the family. Stay tuned next month for continued coverage of the new tax law.




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