Although we have known since 2001 that the federal estate tax was scheduled for a one-year repeal beginning on January 1, 2010, it’s hard to believe that the repeal has actually taken effect. Many experts were confident that Congress would have acted to prevent this from happening, perhaps by permanently extending the 2009 federal estate tax level and rates. Although the House had approved such a bill on December 3, 2009, the Senate failed to take similar action.
A brief review of the law will explain why this is so significant. The 2001 tax act signed into law by President George W. Bush was designed to provide significant tax relief. It gradually reduced the maximum federal estate tax (and generation-skipping transfer tax on transfers to grandchildren) from 55% to 45%. It also gradually increased the amount of property that could be passed free of federal estate tax (the “applicable exclusion amount”) from $675,000 per person in 2001 to $3.5 million per person in 2009. That means that a married couple who planned correctly could have passed up to $7 million free of federal estate tax had they both died in 2009.
Although there is no estate tax this year, in 2011, under the existing law, the estate tax rates are scheduled to revert to a top rate of 55% and the applicable exclusion amount will revert to $1 million. New York will continue to impose an estate tax on estates exceeding $1 million. It’s unclear whether Congress will take action this year and it’s uncertain what the laws will provide or whether they will be enacted retroactively. At least Senator Max Bauchus, Chairman of the Senate Finance Committee, recognizes that swift action is necessary to prevent “massive confusion.”
To compensate for the loss of estate tax revenue, the 2001 tax act increased the income tax by substantially changing the law with respect to capital gains on property included in a decedent’s estate. Before this year, a decedent’s assets received a step-up in basis to their fair market value at the date of death. Upon a subsequent sale of assets (such as real property or securities), the surviving spouse or heirs would not have to pay income tax on any of the growth that occurred during the decedent’s life. This resulted in an enormous tax savings for many heirs. However, in 2010, there is a limitation on the amount of property that can be “stepped up” in value at the time of death. Property that does not receive the step-up will be subject to tax on all increases in value from the date the decedent first acquired the property.
As you can imagine, this can affect many more people than even the change in the estate tax rates.
The repeal of the estate tax this year may significantly impact some married couples whose will or trust includes a formula to divide the decedent’s property into a credit shelter trust (also referred to as a “bypass” or “family” trust) and a marital trust, so as to maximize the amount that will pass free of estate tax. The trustee may be forced to fund more assets into the credit shelter trust than necessary, leaving the marital trust relatively empty. However, it is unclear how such formula clauses would be interpreted and how the credit shelter trust would be funded.
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