Submitted by Arthur J. Dykes, CPA, and Donald Paris, CPA

Is the Estate Tax Dead? And, if so, will it be re-born?

As you are probably aware, dealing with the uncertainty of the Estate and Generation Skipping Transfer (GST) Tax, has made tax planning very difficult.

When Congress passed the 2001 Tax Act, the Federal Estate and Generation Skipping Transfer tax were scheduled to be repealed in 2010, but few ever expected it to actually occur. But, it has happened, because Congress has been unable to pass a bill to re-enact it. Without new legislation, the Federal Estate, Gift, and GST taxes will, in 2011, revert back to 2001 levels, with substantially higher rates and lower exemption amounts.

Consider the case of Mrs. Smith, a widow, with a gross estate of $5 million, principally of stocks and bonds, and some retirement accounts inherited from her spouse. Mrs. Smith passed away in February 2010 and the executor of her estate tells the surviving children and grandchildren, that they will inherit the entire $5 million, since the estate tax has been repealed. Or will they?

Mrs. Smith’s executor must consider a number of issues, including the possible increase in income taxes. Prior to repeal, the income tax cost basis of assets included in a decedent’s gross estate would be "stepped-up" to the fair market value at the date of death. However, in 2010, a modified carryover cost basis was adopted. Thus, Mrs. Smith’s children would inherit her stocks and bonds with a cost basis of what Mrs. Smith originally paid.

If the children have "already spent" Mom’s inheritance and have to sell the securities, the children are most likely going to incur a capital gains tax, which may not have been anticipated. There are additional complex technical rules relating to basis adjustments available to property acquired from the decedents’ assets or from qualified spousal property, so it is highly recommended you consult a tax advisor to take advantage of these special rules. Maybe your executor should be instructed not to sell any assets in 2010 until the estate tax laws are more clear. If this carryover cost basis survives, maintaining accurate and detailed records will be required. Can you imagine inheriting stocks from Grandma acquired 30, 40, or even 50 years ago, and determining what her cost basis was in those stocks? This would entail researching the original cost, subsequent sales, stock dividends, stock splits, and spinoffs. How likely is it that Grandma kept all these documents in a safe place?

Another possible dilemma for Mrs. Smith’s executor is whether Congress will pass new "retroactive" legislation back to January 1, 2010, thus reinstating the estate tax. What would happen in that circumstance, nobody knows; although we are certain someone will litigate the legality of a retroactive reinstatement of an estate tax for a decedent who died in 2010 prior to the date the new law is enacted. If Congress chooses to act, resulting legislation may or may not be retroactive. It is noteworthy that the U.S. Supreme Court’s historical experience in the tax area has been more favorable to the government than to taxpayers.

Another consideration for Mrs. Smith is whether a state estate tax will be incurred. Each state is different, and the state may still impose an estate tax in 2010, even though the Federal estate tax was repealed.

Since most of us are not planning to die in 2010, are there any planning opportunities regarding lifetime wealth transfers? In light of all this uncertainty, we suggest meeting with your financial advisors and estate attorneys to discuss (1) gifting, since the federal gift tax rate in 2010 is reduced to 35%; (2) making GST transfers; (3) charitable giving options; (4) planning for use of the spousal cost basis adjustment for qualified property; (5) making sure you have good records for determining the proper cost basis; (6) using more sophisticated wealth transfers, such as qualified personal residence trusts, family limited partnerships, or family loans since there has been no legislation changing the taxation of these techniques, and they all transfer wealth but minimize or eliminate the gift tax; (7) planning for the use of life insurance proceeds for payment of state death taxes, or providing funds for paying income taxes on carryover cost basis property; or (8) funding a life insurance trust with annual exempt gifts.

Stay tuned for further developments in the estate and gift tax law area. The uncertainty surrounding these issues makes planning very difficult, necessitating the use of experts as early as possible.