Estate Taxes, Crystal Balls and What Might Happen This Year

MAY 24, 2010  VOLUME 17, NUMBER 17
There is no estate tax in 2010. But there might be. When will we know? What should you do?

Estate planning attorneys have joked darkly (as a group, we often have slightly off-kilter senses of humor) that 2010 is the year to die. Because of Congressional plans first adopted a decade ago, the federal estate tax has long been scheduled to disappear this year, but to return in 2011 with a sort of taxman’s vengeance. Although estates of less than $3.5 million were exempted from estate tax last year, next year the limit is scheduled to drop to $1 million.

For years we estate planners have all reassured our clients that Congress would not — could not — let that happen. Many of us even confidently predicted what Congress would do. Most of us agreed that it was likely Congress would leave the estate tax in place, with the $3.5 million exemption figure or maybe a slightly higher number, and tinker with some of the mechanics. Don’t worry, we all said, there is no way the estate tax will return to the $1 million level — nor will it disappear altogether in 2010, even just for a year.

We were all wrong. Congress has been unable to reach any agreement about how to act, it is now 2010 and there is no estate tax.

But there might be. Speculation has swirled for months about whether Congress has the power to reinstate the estate tax now and make it retroactive to the first of the year. Even if it is legal (and it is not completely clear that it is), every passing day makes it politically less palatable. One idea now being discussed: could Congress reinstate the estate tax but let the executor of each estate decide whether to apply the “new” estate tax or the eliminated estate tax rules?

Why would anyone want to be subject to the estate tax? Because of something called “carryover basis.” As the rules now stand for the estate of someone dying in 2010, there is no estate tax but accumulated capital gains can be taxable if and when heirs sell the property they inherit — though there is $1.3 million of capital gains avoidance given to the estate of each decedent.

Let’s imagine a scenario: because you are a market genius, you bought $1 million worth of McDonald’s stock in early 2003. It is now worth about $5 million. That is the only thing you own, and you are not feeling very healthy. Now assume Congress adopts a new estate tax for 2010, sets a $5 million exemption amount, and allows your heirs to decide whether to apply it or the current, no-estate-tax system.

Your heirs actually do better with the imaginary new estate tax in place. They could inherit your entire estate with no tax consequences; under the current 2010 rules, they will eventually owe income tax on about $2.7 million of gain. Need the math? Here it is: your imaginary estate has $4 million of capital gains that would be untaxed under either 2009 or 2011 rules, but do not escape taxation in 2010. You do get a $1.3 million exemption, which leaves $1.7 million of gain that your heirs receive along with their McDonald’s shares. So if they ever sell their inherited stock, they will owe a significant (but uncertain) income tax on the capital gain.

The truth is, of course, that you didn’t buy a million dollars worth of McDonald’s stock in 2003. In fact, there is a slim likelihood that you are worth more than a million dollars at all. That is not because of recent market reverses — that is because only about one percent of Americans have that kind of net worth, according to the most common estimates. And if you are not worth a million dollars on the day you die, neither the current nor any proposed federal estate tax regimen will make the slightest difference to your estate or heirs. State estate tax rules vary somewhat, but Arizona imposes no estate tax at all, and most of the states that do would also exempt assets of less than $1 million.

But what if you are worth more than a million? What are you supposed to do? The best answer for now might be to keep an eye on what Congress is doing, expect to pay to have your estate plan updated before the end of this year, and in the meantime try to avoid heavy traffic or unhealthy eating. Yes, we know — that wasn’t very helpful advice.

How about this advice: if you are worth more than a million dollars, you should probably have your estate plan reviewed now and expect to have it reviewed again next year, or after we know what Congress is going to do. Depending on your net worth, the types of assets you own and your intended beneficiaries, it might turn out that you don’t need the 2011 return visit — but we won’t know until Congess acts.

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