New Jersey Estate Planning & Elder Law Blog : New Jersey Estate Planning Lawyer & Attorney : Deirdre Wheatley-Liss : Fein Such Kahn & Shepard Law Firm : Elder Law, Tax Planning

USA Today has two stories running today - one Our view on death and taxes: Loopy estate tax policy highlights D.C. dysfunction, and the other Opposing view on death and taxes: End the 'death tax'.  Both totally miss the point that there is a tax as a result of death no matter which way you lean - an estate tax would be assessed immediately, or there will be capital gains taxes to pay for decades to come.

In the first article, they quote a US Senator: "Sen. Jim Bunning, R-Ky., bluntly put it, [George] Steinbrenner "was smart enough to die in 2010."  Really?   Smart enough to die this year?  I am sure Mr. Steinbrenner's family and friends appreciate your comments on their loss.  USA Today then describes why there is no estate tax in 2010, including the recent political battles, and supports an estate tax by saying:

It makes sense to tax inherited wealth, derived simply by having the right parents, at a higher rate than money acquired through hard work or investment. Advocates of repeal rarely say where else they'd get the money to make up the lost revenue, because the inevitable answer is it would come from taxpayers of lesser means.

Ahh, the famous "he who has more must share" argument.

On the flip side, in the second article Rep. Louie Gohmert, R-Texas, takes the position "[t]ime to end the death tax permanently.":

For anyone to reach his hand into a deceased person's pocket and steal is despicable. But, when someone dies and the government steals from the deceased, our laws legalize the theft.

He goes on to tell the story of the family farm that had to be sold to pay taxes.  

Ahh, the famous "how dare they" argument.

How how about a few actual facts to consider.

• The estate tax impacts around 2% or less of the entire US population (for in depth factual information about who pays the estate tax and how generated look at  the Tax Policy Center "Tax Policy Briefing Book" chapter on Wealth Transfer Taxes).  So for the other 98% of US taxpayers, consider the estate tax  a source of revenue to the federal government that you don't actually have to contribute to. 
• In 2009, an estimated less than 100 estates with family farms and small businesses were subject to tax - just 1.9% of all taxable estates.  There are current laws to defer taxation of farms and better ones have been proposed (see Family Farms to be Exempted from Estate Tax?)
• Estate taxes were estimate to generate $13.8 billion in 2009.  The federal government spends $x each year - if estate taxes don't generate part of the income, other taxes will.
• For more facts, look at Truths about the Estate Tax - Debunking the Popular Myths

And the most important, and most glaringly overlooked fact of all in BOTH USA Today articles - if there is no estate tax there is STILL a tax on inherited wealth.  That tax is the capital gains tax. Let's thing - if there is no estate tax all that appreciation on assets that has disappeared for 98% US taxpayers on a person's death will now potentially be subject to tax on the sale of assets.  An while an estate tax may seem harsh in light of the death of a loved one, consider the nightmare of finding proof of cost basis for assets purchased decades earlier.  For more information about the real realities of no federal estate tax, look at Federal Estate Tax "Death" in 2010 Creates Capital Gains Trap.

A thought - let's abandon rhetoric and look at creating good tax policy.

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Now that May of 2010 is upon us and there is still no federal estate tax finality, we can begin to look at the situations that families are facing where loved ones have passed since January 1.  A key issue is that their estate planning documents (wills or trusts) may not make sense in 2010 where there is no estate tax.

For example, a common provision in a Will if a person has a taxable estate is  "I leave my trust an amount equal to my applicable exclusion amount" - what does that mean?  Well, in 2009 "applicable exclusion amount" was loosely translated to $3.5 million. In 2011 "applicable exclusion amount" will loosely translate to $1 million.  In 2010 "applicable exclusion amount" has no meaning - it is a defined term under section 2010 of the Tax Code   which section does not exist this year (OK -  I am just now seeing the irony that a tax section that has no meaning in the year 2010 is section 2010).  The best was this was explained to me was "What if you had a Will that said it should be interpreted under the laws of the Soviet Union - there is no Soviet Union anymore, so what does that mean?"

Some states have come to the rescue and passed laws that say that where there is ambiguity in how to interpret a Will due to the 2010 repeal of the Federal Estate Tax, that the terms should be interpreted as if the person died on December 31, 2009 (when the estate tax was still in effect, so all the tax "terms of art" have meaning).    Julie Garber at About.com reports:

To date it appears that at least four states have actually passed laws designed to put the estate plans of people who die in 2010 in the same position as if they had died on December 31, 2009: Indiana, Maryland, Virginia, and Wisconsin. Note that all of these laws have been written to become void if Congress acts to bring the federal estate tax back in 2010.

For those of us in New Jersey where there is no legislative solution, a quick fix is to have an amendment done to your documents to address how they should be interpreted if there is a death in 2010.

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The New York Times ran an article this week "Saying ‘No Thanks’ to a Bequest".  In the article, Deborah L. Jacobs explores how a disclaimer provision either included in an estate plan, or created after death, can achieve some estate tax savings in this environment of uncertainty about the federal estate tax this year or next.

In an estate plan a "Disclaimer" is when a beneficiary says "No, I don't want that part of my inheritance."  Now, why would a person not want an inheritance?  Well, for a spouse, a disclaimer is used more accurately to say "I don't want to take my inheritance outright, and therefore it should pass to a trust where I am a beneficiary." This trust could capture the exemption amount from federal estate taxes if and when the federal estate tax comes back.  A disclaimer creates flexibility in a period of uncertainty as the spouse doesn't have to decide now if it makes sense to fund the trust, they can wait and see what the tax laws are at the time the first spouse dies.

The article outlines how a disclaimer works, the benefits of disclaimers (flexibility being key) and some of the drawbacks (what if the spouse doesn't disclaim, or accepts the assets so they can't disclaim).  However, I think the article misses one key point about how using disclaimers to create trust can create inflexibility.  If a person sets up a trust in their Will and directs that it be funded (i.e.: put $1 million is this trust) instead of allowing it to be funded through a disclaimer (i.e.: I spouse disclaim $1 million which will now pass to a trust), then the trust can give a person a "Power of Appointment" over the trust.  

A "Power of Appointment" essentially allows a person to change who gets the trust funds and how after the death of the decedent.  This is incredibly powerful in using a trust.  A trust will last for years or decades after your death.  Unless you have a crystal ball, you don't know what will happen to your beneficiaries, or what the tax laws will be in the future.  By setting up a trust for your spouse and children, and giving your spouse a Power of Appointment, your spouse has the ability to change how your children eventually get your assets after your spouses' death.  For example, if a child has a health issue, your spouse can change the trust to leave more to that child, or to leave it to the child in trust instead of outright.  Without the Power of Appointment the child might get money that would negate other benefits he was receiving.

So how to balance the flexibility of a disclaimer with the flexibility of a Power of Appointment? In New Jersey, where we have a state level estate tax of $675,000, we recommend a "3-Part Will".

• Part 1 - An amount equal to $675,000 goes to a family trust with a power of appointment in favor of the surviving spouse
• Part 2 - An amount equal to the difference between (1) the federal estate tax exemption amount (if any) and $675,000 go to the spouse - the spouse can disclaim this amount to a family trust if it makes sense from an estate tax perspective
• Part 3 - The balance to the spouse  

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 My two prior posts have been about the  federal tax impact for single individuals who die in 2010, and the federal tax impact for married individuals.  In summary the results for singles were not good, and for marrieds were worse – the "death" of the estate tax creates a capital gains "trap" for survivors.  While all this will be moot if Congress does as they have promised and create an estate tax retroactive to January 1, 2010, they haven’t acted yet, and as of January 1, this is the law.

What planning can be done in this environment?

Can you just say “whoo-hoo”; I’ll give everything to my children.  Hold on there – the federal estate tax is repealed in 2010, not the federal gift tax.  Each person still has a lifetime exemption of $1,000,000 – if you make gifts in excess of that in 2010, you will be subject to the federal gift tax at a rate of 35%.

However, the generation skipping tax (“GST tax”) is repealed in 2010.  The GST Tax essentially says that you can only leave up to $3.5 million to grandchildren without paying a separate tax of 55%.  The theory behind the GST Tax is that the government should share in the wealth at each generation.  If grandma leaves everything to granddaughter, the IRS might need to wait 75 years until tax can be collected again.  If assets go the children, the IRS might only have to wait 30 years to tax again.  So, in 2009 you could leave up to $3.5 million to grandchildren without GST tax. In 2010, you can leave everything to grandchildren without an additional tax.  For wealthy families, this could mean a huge amount passing to lineal descendants with the only tax cost(s) being capital gains (click here for an explanation of the 2010 capital gains tax trap for estates).

The estate plan you had in 2009 and will need again in 2011 won’t really make sense in 2010 unless they make the estate tax retroactive.  Do you need to go out and totally revise your plan? Not necessarily.  If you have a terminal situation however, it definitely bears looking at your current plan to make sure it addresses how to plan to minimize capital gains taxes instead of estate taxes.

Gifts to grandchildren may be a winning strategy in early 2010.  Also, for anyone who is terminally ill, a change of an estate plan to leave assets to grandchildren may be a winner as well (although if the estate plan isn’t changed, disclaimers may be able to be employed by the children to a similar effect).  And it will bear looking at the estate plan of anyone who is terminally ill.

Image: Danilo Rizzuti / FreeDigitalPhotos.net

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My prior post was about the federal tax impact for single individuals who die in 2010 (unless Congress does as they have promised and create an estate tax retroactive to January 1, 2010 – we will have to wait and see if that happens and how it is constructed).

The news for single folks was not good. Mom dying with a $3.5 million estate in 2009 could leave it to son tax free. Mom dying with that same $3.5 million dollar estate, assuming the basis of her assets is $350,000, now creates a  federal capital gains tax of $277,500 for son (or $416,250 if he is in NJ).

The news for married folks is worse. In 2009 mom could leave $100 million (or whatever amount) to dad with no taxes whatsoever – there is an unlimited marital deduction from estate taxes (so long as your spouse is a US citizen). In 2010 only $4,300,000 will pass tax free to the surviving spouse.

The "death" of the estate tax creates a capital gains "trap" - and the “trap" catches assets passing to a surviving spouse that were never subject to tax under the estate tax.

What??? you say. How is it possible that by eliminating the estate tax you are creating a tax for widows and widowers? As I noted, due to the magic of Internal Revenue Code Section 1014, capital gains taxes disappear at death under the 2009 law. Section 1014 creates a “step-up in basis” by stating that when an estate is subject to estate taxes, the cost basis of inherited assets is the date of death value.  For example, mom bought stock for $10, and when she dies it is worth $100.  Dad  inherits stock and sells for $100.  His capital gains is $0 ($100 of value - $100 of basis =0).

However, in 2010 there will be no estate tax, and therefore no “step-up in basis”.  Instead, per Section 1022, Dad can apply $1,300,000 million plus $3,000,000 to add basis to the assets that mom has. How might this work? Let’s say mom has a $6 million estate, made up mostly of the family business she and dad still work in and some real estate. Assume mom has a $500,000 basis in the assets – all that appreciation has been due to increases in value over the years. If mom died in 2009, dad would get $6 million tax free. If mom dies in 2010, and dad sells everything since he doesn’t want to work without his life partner, he only has a basis of $4,800,000  ($500,000 of mom’s basis + $4,300,000 of allocated basis). Since he sold for $6 million, he has $1,200,000 of capital gains. He will owe the federal government $180,000, and if he lives in New Jersey, he will also owe the Garden State $90,000, for a total of $270,000. Remember, had mom died in 2009 when there was an estate tax in place, dad would have owed $0.

It bears repeating that all other concerns aside, this new tax regime where you need to track cost basis over a life time is a nightmare. How do you prove mom’s basis before she died was $500,000? Was every improvement tracked? What documentation will the IRS accept as proof? Will you have that documentation 30, 40, 50 years later?

My next post will address some planning opportunities (every cloud has a silver lining after all) that might exist in this new tax environment.

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Sigh ... I was really, really hoping I would not have to post about what happens to those who die in 2010 from a federal tax perspective.  However, since Congress couldn't seem to get its act together, here is the current 2010 landscape (with the caveat that Congress can act in 2010 and have a retroactive estate tax - but, we will have to see what happens when it happens).

Did you know that the "death" of the estate tax creates a capital gains "trap"?  And that "trap" catches the smaller estates, the ones that under current tax laws have no federal tax consequences on death. 

Assume you are single person with a $3.5 million estate (I will post separately about married couples).  Had you died in 2009, there would have been no federal tax consequences to your death.  If you die in 2010,  there will no federal estate taxes (same as 2009).  However, your heirs will have to pay capital gains taxes (see, there is always a catch).

What??? you say.  I thought death was tax free in 2010.  It is estate tax free, there won't be a federal estate tax.  There will, however, be federal and state capital gains taxes for deaths in 2010. Why??? you ask.  Well, there is a pesky little section of the Internal Revenue Code (1014) that says, essentially - when an estate is subject to estate taxes, the cost basis of inherited assets is the date of death value.  For example, mom bought stock for $10, when she dies it is worth $100.  Son inherits stock and sells for $100.  His capital gains is $0 ($100 of value - $100 of basis =0).  Section 1014 is a neat magic trick - it makes capital gains taxes disappear.  In tax parlance we call this a "step-up in basis".

However, in 2010 there will be no estate tax, and therefore no step-up in basis.  Let's take the same example where mom bought stock for $10, and when she dies it is worth $100.  Son inherits stock and sells for $100.  He now has a capital gain of $90 subject to tax ($100 of value - $10 of basis = $90).  He must pay federal capital gains tax on this amount (15%) and state capital gains tax (7.5% in New Jersey) for a total tax of $20.25 if he is in NJ - or $15 if he is in FL or another state without a state estate tax.  

Notice that when mom died in 2009 with an estate tax in place, son netted $100.  However, when mom dies in 2010 with no estate tax in place, son only nets $79.75. Lets add some zeros - son nets $1,000,000 if mom dies in 2009, but only $797,500 if she dies in 2010.  Now you see how no estate tax is not necessarily a good thing?!

The above is over-simplistic, but it makes the point that the "death" of the estate tax creates a capital gains trap.

One point of "relief" - your estate will be able to allocate $1.3 million to add basis to inherited assets (different rules apply for a surviving spouse) per code Section 1022.  To continue our example, mom's entire $3.5 million estate consists of stock she bought for $10 a share and is now valued at $100 a share.  Her cost basis in her estate is $350,000.  She dies, and the estate has an additional $1.3 million of basis - so the stock now has a total basis of $1,650,000.  Son sells the stock for $3.5 million, creating a capital gain of $1,850,000, which in return has son paying a federal capital gains tax of $277,500 (or $416,250 if he is in NJ).  Remember now, if mom had died in 2009 when there was a federal estate tax, son would have paid $0 in tax.

But the the so called "relief" is a trap too - how are you going to prove basis?  How do you know what mom paid for each stock share?  And if you do know, what about splits, mergers, stock dividends - what is her cost basis in all those?  Tracking basis for assets acquired over a person's lifetime, particularly when the person is now dead, is a nightmare.

Congress has "promised" to reinstate the estate tax to January 1, 2010 - and I think we all know what weight to give to Congresses promises.

My next post will address what happens if mom dies in 2010 survived by dad  (a spouse) - and the picture isn't rosy there either.

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Even though the House passed a measure for a permanent extension of the estate tax at a $3.5 million dollar exemption per person, sources are reporting that the Senate is looking to push through a one-year extension by year end.  This would mean that the estate tax exemption would be $3.5 million per person in 2010, but still come back at a $1 million exemption in 2011.

Elder Law Answers reports that "Congressional watchers are coalescing around the prediction that the Senate will likely pass a one-year extension of the estate tax before year's end -- probably as part of a defense spending bill."  It cites in in-depth discussion at OMB Watch why the Senate won't likely move for a permanent resolution in the way of the House.  OMB Watch notes "The other option is for the Democratic leadership to tack a one-year estate tax extension onto a likely omnibus appropriations bill that insiders say Congress will pass before the end of 2009."

CNN Money concurs with the one year extension, advising "The Senate is likely to rally around a short-term fix and pass a one-year extension of the tax at 2009 levels by Dec. 31."  Hani Sarji at his blog reports that the House is now even expecting a one year patch, their recent legislation notwithstanding "'According to House Majority Leader Steny Hoyer, estate state tax fix may be temporary and may be attached to defense spending bill".

Why all this pressure?  Well, besides the financial incentive in certain circles for mom and dad not to survive 2010 intact, a permanent change to a $3.5 million exemption would actually add to the deficit.  CNN Money clarifies this point:

The House bill would increase the deficit by $234 billion over 10 years, according to the Joint Committee on Taxation. That's because even though current law would repeal the tax for one year, it reinstates it by 2011 at an exemption level of just $1 million, which would mean an increasing number of estates would be subject to the tax as years went by."

 $234,000,000,000.00 - That is a lot of zeros to be giving up at a time the government is broke.  So expect a push for the real question of estate tax reform, not a patch, into 2010.

 Photo courtesy Francesco Mariano

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After a flurry of reports that Congress was going to address the estate tax this week, Derek Jenson posts this week that it is being postponed until at least after Thanksgiving.  Derek comments that this makes the one year extension of the current federal estate tax law (a $3.5 million exemption per person with a 45% rate) virtually a lock - because what else do they have time to do at this point?

Interestingly, Derek comments on how this "band aid" is only going to create more of an issue for congress.  

The 2010 extension is easy. It is a tax increase. What is difficult is raising the exemption and lower the rates for 2011. That will be a tax cut. [snip] It is not difficult to image that a year from now we will still not have a permanent estate tax bill and will be facing another one year extension or a return to the $1.0 million exemption."

Recall that under the current law, while there is no estate tax in 2010, the estate tax returns in 2011 with a $1 million exemption and 55% top rate - so the trade off for one year of no estate tax is potentially agreeing to keep the current level of $3.5 million exemption and 45% permanently (not that anything is ever truly permanent with tax and congress).  

According to the Congressional Quarterly, the cost of keeping the current rates over the next 10 years versus allow the estate tax to go away for 1 year and then come back in at lower levels (ie, if Congress does nothing) is a staggering $233.6 billion over 10 years.  We we are looking at extreme health care costs on top of an already bloated budget - perhaps a do nothing approach may net Congress more dollars in the end.

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