The Federal Esate Tax was eliminated by "The Economic Growth and Tax Relief Reconciliation Act of 2001" passed by Congress. The elimination of the Federal Estate Tax was accomplished by a phase-out of the Federal Estate Tax over a period of several years. Under the 2001 legislation, the Federal Estate Tax was completely eliminated by the year ending December 31, 2009. This was achieved by gradually lowering the tax rates and raising the Exemption Equivalent (the amount of the estate that is not subject to taxation) between the years of 2002 through 2009.
Thus, for the year of 2010, the Federal Estate Tax has been completely repealed. However, due to the Sunset Provision of the United States Senate, the Federal Estate Tax is to be revived beginning January 1, 2011 and beyond.
All efforts to revive the Federal Estate Tax for the year of 2010 simply did not get done to the amazement and astonishment of many. Most observers expected Congress to act in some way to prevent the full repeal of the Federal Estate Tax for the year of 2010 to simply allow it to return on January 1, 2011 with vengeance.
Under the current law, the Federal Estate Tax will return on January 1, 2011 at the 2002 Exemption Equivalent Amount of $1,000,000 per taxpayer ($2,000,000 for couples) and the 2001 maximum tax rate of 55%. To go from the 2009 Exemption Equivalent Amount of $3,500,000 per taxpayer ($7,000,000 for couples) and a maximum tax rate of 45% to the much lower Exemption Equivalent Amount and higher 55% maximum tax rate scheduled for 2011 will be dramatic for many taxpayers.
Options to Address the Expiration
There were and still are options available to address the expiration of the Federal Estate Tax for the year of 2010. Any of these options will require retroactive tax legislation making such legislation effective retroactively to January 1, 2010. Retroactive legislation in the area of federal taxation is very uncommon but has occurred on occasion (the last time being the Jobs And Growth Tax Relief Reconciliation Tax Act Of 2003 which was passed on May 23, 2003 and signed into law by the President of The United States on May 28, 2003 and made retroactive for the entire year of 2003).
Excluding often unpopular retroactive tax legislation, Congress’ inability to address the expiration of the Federal Estate Tax for the year of 2010 with more moderate tax legislation will cause estates to be subject to higher tax rates and a lower Unified Transfer Tax Credit (Exemption Equivalent Amounts) for the year of 2011 and beyond.
Tax Planning Opportunities
In order for tax professionals and taxpayers to properly engage in tax planning, the status of tax legislation must be known (or be fairly predictable). Retroactively changing the current status of the Federal Estate Tax greatly hampers this opportunity.
Moreover, tax planning generally involves making certain investments, purchases, sales or other transactions or actions based on projected tax consequences of such transactions or actions. In the event that legislative action is not taken and enacted to change the current status of the Federal Estate Tax for the year of 2010, the tax consequences for decedents dying during the year of 2010 are quite different from decedents with the same Taxable Estates dying during the years of 2009 or 2011.
To highlight these differences, the chart below illustrates various tax consequences for the estate of decedents dying during the year of 2009 and contrasts those results for a decedent with the same Taxable Estate who deceased in the year of 2010 and the year of 2011.
The Federal Estate Liability computed under the various scenarios demonstrates the dramatic changes in the federal taxation of estates for the years of 2009, 2010 and 2011 under the current Federal Estate Tax provisions. As shown in Example 4 and Example 6, the Federal Estate Tax Liability more than doubled in the year of 2011 as compared to the year of 2009 on the same Taxable Estate.
Impact on Heirs
Another significant consequence of the expiration of the Federal Estate Tax for the year of 2010 is the change in the law for the basis of the person who inherits property from a decedent who died during the year of 2010. For the year of 2010 only, such basis to the heir will not be the long standing fair market value on the date of death of the decedent (step-up basis when fair market value on the date of death is more than the adjusted basis) but rather will be the carryover basis rule that applies to gifts of property.
Thus, if the property is appreciated property where the fair market value on the date of death is more than the adjusted basis to the decedent, the heir inherits property that is likely to result in income tax gain to the heir if such property is subsequently disposed of by the heir in a taxable event. The carryover basis rule basically means that the basis of the inherited property will be the same to the heir as it was to the decedent (or fair market value on the date of death if it is lower than the basis to the decedent on the date of death).
However, some adjustment is allowed for the heir (as allocated by the executor of the estate). The heir can choose to take a step-up basis in the inherited property for a maximum amount of $1,300,000 ($60,000 for decedent nonresidents who are not citizens of the United States). For any amount inherited in excess of $1,300,000, the heir’s basis in such property will be the smaller of the decedent’s adjusted basis or the fair market value on the date of death. The step-up basis adjustment for property inherited by the surviving spouse of the decedent is $3,000,000. All of these amounts are to be adjusted for inflation.
Thus, for the illustrations highlighted in the chart on page 12, the heirs of the property of the decedents dying in the year of 2010 will receive carryover basis on the inherited property (with the limited step-up basis adjustment provisions described above.) Under the current law, the long standing step-up basis adjustment returns for property inherited from decedent dying after December 31, 2010.
The Federal Estate Tax has gone through significant changes in recent years. The efforts to completely eliminate it have not been successful but a one-year hiatus of the Federal Estate Tax has been achieved. Tax planners, to the extent possible, can utilize the benefits of the no Federal Estate Tax for estates of taxpayers that decease in the year of 2010. However, the high tax rates of pre-2002 and low Exemption Equivalent amount of 2002 return in 2011 causing estates to be subject to a higher Federal Estate Tax that has not applied for several years.
This change in the amount of Federal Estate Tax for the year of 2011 suggests an imbalance and inconsistency in the application of the Federal Estate Tax. This shift in the Federal Estate Tax beckons Congress to implement a more fair, consistent and stable Transfer Tax System. Hopefully, Congress carefully and fairly addresses this dilemma soon and provides a more permanent solution in this area of Federal Taxation.
Marvin J. Williams, MBA, JD, CPA, CMA, CFM, is a professor of Accounting and Taxation at the University of Houston-Downtown.