In 2001, Congress passed a law that gradually increased the federal estate tax exemption from $675,000 in 2001 to $3.5 million in 2009. The law also repealed the federal estate tax for one year in 2010. Most practitioners thought Congress would amend the repeal before it took effect in 2010. That did not happen.
BASIS OF INHERITED PROPERTY
To offset the lost estate tax revenue, Congress adopted a “carryover basis” regime on certain property inherited in 2010. Under the carryover basis rules, a beneficiary of a 2010 estate would inherit the property of the estate at the basis, or tax cost, of the decedent. Congress granted each estate a $1.3 million basis adjustment that the executor may allocate among the assets of the estate to the extent of the unrealized gain, if any. For those assets passing to the surviving spouse, the executor may allocate an additional $3 million of basis to the amount of the unrealized gain, if any. Estates with unrealized gain in excess of the available basis adjustment will be subject to a capital gains tax on such gain at the time of sale, assuming that the property retains its value or appreciates in value.
For example, an individual purchased stock for $10 per share in 2005. If the same individual dies in 2010, when the stock was valued at $50 per share, under the carryover basis rules, the beneficiary of the stock would receive the property with a $10 basis. When the beneficiary eventually sells the stock, the gain would be the difference between the sale price and the $10 basis, assuming that such property did not receive a basis adjustment.
There is an exception to the carryover basis rule. If the subject property decreased in value and was worth less than the purchase price at the time of the decedent’s death, the basis of the inherited property would be the fair market value of the property as of the decedent’s date of death. Upon sale, the gain (or loss) would be determined based on the difference between the sale price and the fair market value of the asset determined at the decedent’s date of death.
Carryover basis is contrasted with “steppedup basis,” which was the law prior to 2010. Assets inherited from individuals who died prior to 2010 received a step up in basis equal to the unrealized gain on the asset as of the decedent’s date of death. With the step up in basis, the beneficiary would have a basis in the inherited property equal to its fair market value on the date of the decedent’s death.
To illustrate, had the individual from our prior example died in 2009, when the stock was valued at $50 per share, the beneficiary would have received a “step up” in basis equal to the date of death value, increasing the basis of the inherited shares to $50. When the beneficiary eventually sells the shares, the gain would be based on the difference between the $50 basis and the sale price.
Under the step up basis rules, there is an exception for estates that declined in value following the death of the decedent. The executor of such estate can elect to use an alternate valuation based on the fair market value of the estate assets as of the six month anniversary of the decedent’s death. If the alternate valuation is elected, all estate assets must be valued as of the alternate valuation date. The election may only be made if it results in a decrease in the estate’s overall federal estate tax. Otherwise, the executor is precluded from using the alternate valuation. If an asset were subject to the alternate valuation and subsequently sold, the gain (or loss) would be based on the difference between the fair market value of the property on the alternate valuation date and the sale price.
At this point, it is unclear whether carryover basis will be implemented. The Internal Revenue Service has not released any forms to report the basis of property belonging to a decedent dying in 2010, and the Department of Treasury has not issued any guidance on the matter. The government inaction is not dispositive, since those estates subject to the carryover basis regime (i.e. those with more than $1.3 million of unrealized capital gain) have until April 15, 2011 to file an informational return reporting the carryover basis of the estate assets.
ESTATE TAX EXEMPTION
Without Congressional action, repeal of the federal estate tax will sunset and the pre-2001 tax regime will apply. All estates in excess of $1 million will be subject to the federal estate tax, and the maximum estate tax rate will increase from 45% in 2009 to 55% in 2011 and thereafter.
Several bills were introduced in Congress to address the effect of the 2001 law. All of these bills propose a retroactive reinstatement of the estate tax. One such bill would impose a retroactive reinstatement of the estate tax with a $3.5 million exemption and a repeal of the carryover basis regime for the estates of decedents dying after December 31, 2009. Another bill proposes a hybrid, whereby estates of individuals dying after December 31, 2009 and before January 1, 2011 would be able to choose between the carryover basis regime or an estate tax at 2009 tax rates. This same bill would incrementally increase the federal estate tax exemption to $5 million, which would be indexed for inflation, and would reduce the maximum federal estate tax rate to 35%.
Some of the bills propose the creation of a progressive estate tax. One bill proposes a tax whereby estates valued at more than $10 million would be subject to a higher rate of tax. Under this proposal, the federal estate tax rates would range between 45% to 55% depending on the value of the estate. In addition, estates in excess of $500 million would be subject to a “billionaire” surtax of 10%. These bills would also provide additional estate tax relief to family farmers and those with conservation easements on their land.
The details of the future estate tax laws are difficult to predict, but they will likely reflect some of the terms of these proposed bills.
GENERATION-SKIPPING TRANSFER TAX
The 2001 legislation also increased the generation-skipping transfer tax exemption and repealed this tax for transfers made in 2010. The generation-skipping transfer tax is a tax imposed on gifts or bequests to a “skipped” generation. A generation-skip occurs when the donor makes a gift to her grandchild or any subsequent generation. This is called a generation-skip, because the gift bypasses the intermediate generation (i.e. the donor’s child).
Some of the proposed bills would reinstate the generation-skipping transfer tax for all transfers to a skipped generation occurring after December 31, 2009.
GIFT TAX
The gift tax laws were not dramatically altered by the 2001 law. However, the law did decrease the maximum gift tax rate in 2010 to 35% and increase the maximum gift tax rate to 55% for gifts made in 2011 and thereafter. Currently, Congress is focusing its attention on curtailing the effectiveness of various gifting strategies.
To reduce the number of gifts passing free of gift tax, a bill has been introduced that would undermine the effectiveness of a gifting technique called a grantor retained annuity trust, known generally as a “GRAT.” A GRAT is a trust in which the donor retains an annuity interest for a fixed term of years. The annuity is based on the value of the trust assets using the IRS annuity tables. At the end of the annuity period, any remaining trust assets are transferred to the beneficiaries of the trust. It is possible to structure a GRAT so that the transfer occurs free of gift taxes.
Under current law, a GRAT is not required to have a minimum annuity term, though most GRATs have a term of at least two years to allow the GRAT assets to appreciate over time. With an effective GRAT, it is possible to transfer large sums of money without paying a gift tax on the transfer. The proposed legislation would reduce the effectiveness of a GRAT by requiring a GRAT to have a minimum ten year (10) term and by requiring a taxable gift upon creation of the GRAT.
The same bill also proposed changing the rules regarding the use of valuations and discounts to reduce the gift or estate taxes on inter-familial transfers.
CONCLUSION
Currently, the transfer taxation scheme is in a period of uncertainty which makes long-term planning challenging. We are closely monitoring the situation, and we welcome you to contact your estate planning attorney at Hinckley, Allen & Snyder LLP should you wish to discuss any of these issues in greater detail.