Congress left Washington in December without extending the federal estate tax (FET).
There is no FET in 2010, at least perhaps not until Congress tackles this politically charged hot potato this year. And the talk is that when they do, they will make the law retroactive to January 1 to capture taxes from all those who died and who would have been affected.
The retroactive application is not a simple issue and is fraught with constitutional pitfalls. Indeed, the Supreme Court upheld the retroactive application of an increase in the FET rate in 1994. But the issue Congress is expected to adopt this year is the retroactive application of a new law, not a mere rate change. This may be too much of a stretch for the Court.
If Congress Enacts a New Law to Apply Prospectively in 2010
If Congress enacts a new law and makes it prospective only, the estates of those who die prior to its enactment, regardless of the sizes of the estates, will escape the FET. Of course, if Congress fails to act at all in 2010, all those who die this year will escape the FET.
Unfortunately, that is not the end of the story. If either of the above scenarios were to unfold, one of the most important tax breaks in the tax code will exit the scene. That tax break, the so-called step-up in basis, provides heirs with a new and higher basis in inherited property. If, for example, a person buys an asset for $10,000 (cost basis) and at the time of his or her death the asset is valued at $50,000, the heir will assume the date of death value of $50,000 for basis. Thus, the $40,000 appreciation during the decedent’s life will escape capital-gain tax. Under the 2001 Tax Act, the step-up tax break is not available in 2010 (or, for that matter, if the FET is permanently abolished).
The heir’s basis in the inherited asset is the decedent’s cost basis of $10,000. And, when the heir sells the asset, there will be a capital-gain tax on the $40,000 plus any appreciation occurring while the heir owns the property.
Imagine the practical complications created by the elimination of step up. Without the proper verification documents, tracking the cost basis of assets acquired decades ago can be a frustrating exercise in futility. Further, without the proof of the cost basis of an asset the IRS can require that zero basis be applied.
The law allows the executor of an estate to allocate up to $1,300,000 to increase the basis of assets in the estate and an additional $3,000,000 to increase the basis of assets passing to the surviving spouse for a total of $4,300,000. (This could all go to the spouse if decedent so directs.)
Nevertheless, many nonspousal heirs who inherit more than $1,300,000 as well as spouses who inherit more than $3,000,000 or $4,300,000 can be snared by the application of carryover basis, whereas they would not have been touched by FET with a $3,500,000 exemption per taxpayer and an unlimited marital deduction.
If Congress enacts a new law to apply retroactively in 2010, expect a flurry of law suits challenging the constitutionality of the law. This should take several years to resolve, leaving the affected estates in limbo for the duration.
If Congress fails to act in 2010, the provisions of the 2001 Tax Act would kick in for 2011 and beyond. This means we go back to the way it was in 2001: $1,000,000 FET exemption with a top rate of 55%.
Also, the carryover-basis law applies only in 2010. Step up will take effect again in 2011.
The repeal of the FET in 2010 does not extend to the federal gift tax, which will continue in 2010 with a $1,000,000 exemption and a top rate of 35%. A 55% top rate will kick in for 2011 and beyond.
The repeal of the FET, however, also repeals the generation-skipping tax, which affects transfers to generations two below the transferor (e.g., grandchildren). This tax will kick in with a $1,100,000 exemption and 55% tax rate in 2011 and beyond.
What to Expect
The consensus opinion is that eventually Congress will make permanent the FET law as it was in 2009: A $3,500,000 exemption per person and a top rate of 45%.
There is some talk of increasing the exemption amount to $5,000,000, indexing it for inflation, and reducing the top rate of 45% to 35% over a 10-year period.
It should be noted that under this FET tax and schedule in 2009 about 5,500 decedents were subject to the FET. That is out of 2,500,000 deaths in the U.S. for 2009—an average of about 15 decedents per day. The total tax raised was about $14,000,000,000.
Predictions, anyone? Predictions?