Introduction:  Despite conventional wisdom that the estate tax exemption of $3.5 million would be extended into 2010, Congress has now allowed the estate tax to be repealed on schedule for the duration of 2010.  The estate tax will be replaced in 2010 by an unusual capital gains tax that heirs would have to pay on inherited property. Strangely, in 2011, the estate tax will return back to 2001 numbers with a 55% tax rate and an exemption of slightly more than $1 million.

 

Example - before 2010: Before 2010, heirs could compute their taxes based on the value of their inherited assets at the time of the decedent's death. So, if Mary inherited a piece of property worth $200,000 from her father that he bought in 1975 for $10,000, no capital gains tax would be due on the $190,000  increase in value.  Mary would receive a "step up in basis" on her father's death as if she bought it herself for $200,000.
 
Example - 2010: However, if Mary's father died in 2010, and Mary immediately sold this same piece of property, Mary would potentially have to pay capital gains taxes on a gain of $190,000 ($200,000 less $10,000 original basis), because her  basis in the property will no longer be "stepped-up" to the date of death value. This will not only cause a burdensome tax hit to heirs, but will also create a nightmare for families who have to dig up old records for everything from real estate to stocks purchased years ago.

 

Shocking Lack of Clarity: The lack of clarity on this issue for the last several years has made it very difficult for estate planners to properly plan for their high net worth clients, who have been led to believe that the $3.5 million exemption would be here to stay and have done their planning accordingly.

 

To make matters worse, even with the current repeal, Congress may still retroactively reinstate the tax back to January 1, 2010!  The constitutionality of this would be questioned, however, adding the courts to the mix of uncertainty.

 

Summary of the confusion:   If any person dies at any time in 2010, his heirs will not know 1) if he owes estate taxes at all 2) if so, how much he owes, 3) how much can be sheltered from taxes or 4) how much they will need retain to pay the taxes. Because of this uncertainty, trustees and personal representatives are going to be holding back moneys from very demanding surviving spouses and other heirs in order to avoid the risk of over-distribution in the event of a retroactive tax.

 

What to do now:   We strongly recommend that anyone who has done estate tax planning or has a taxable estate of $1m or more, revisit our office to address this unbelievable uncertainty in the tax law.  In addition, any professionals who work with clients on estate planning issues must learn the ramifications of this surprising turn of events.  Please feel free to contact us on this very important issue.