Tax and Financial News for February, 2011

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The Return of Estate Taxes – Should You Elect Out?

One great concern for many tax planners at the end of 2010 was how to adjust for the reversion of estate tax provisions to pre-Bush levels. Congress and the President solved that problem with the passage and enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 – at least for a few years. This law reinstated the estate tax for 2010, 2011 and 2012; but it also allowed executors of estates for those who died in 2010 to elect out of estate tax. It’s important to understand which option for settling an estate is best for you.

Basis step-up

Prior law repealed the estate tax for 2010. Along with that repeal, the basis step-up rules were also eliminated. Those rules allowed heirs to increase their basis in inherited assets to the fair market value at the date of death. Here’s how it worked:

Assume John died holding two stocks – Stock A valued at $4.5 million and Stock B valued at $500,000. Now, assume that both stocks were originally bought by John for $1 million each.

Under the old rules, the tax basis of the heirs for the assets would be the fair market value at the date of death or an optional valuation date six months later. If the stocks were subsequently sold for $5 million, the heirs would pay no income tax. In essence, the gain on Stock A would escape income taxation while the loss on Stock B would provide no income tax benefit.

Instead of the basis step-up rules, Congress allowed for a modified carryover basis regime that provided some relief to taxpayers. Under the rules in effect for most of 2010 (i.e. no estate tax), the basis of the heirs would be:

  Non-Spouse Heirs Spouse
Carry-over basis of Stock A $1,000,000 $1,000,000
Basis adjustment under carry-over basis rules 1,300,000 3,000,000
Unrealized net loss on Stock B 500,000 500,000
  Basis in Stock A 2,800,000 4,500,000
Fair market value of Stock B 500,000 500,000
Income tax basis to heirs $3,300,000 $5,000,000

As you can see, the non-spouse heirs would receive significantly less in basis if the executor elected out of estate tax. This means that, upon sale of the stock, they would pay $340,000 in income taxes on the sale at the date-of-death value (assuming a combined 20 percent federal/state tax rate).

Since the new law reinstates the basis step-up rules and increases the estate tax exemption to $5 million, many estates and heirs will benefit under the law. In the preceding example, while the spouse would not benefit from the step-up basis rules, non-spouse heirs would value estate assets at $5 million (the actual fair market value) and escape income and estate taxes.

The preceding example is simplistic in nature and does not take into account all potential scenarios. Some issues you should also be aware of include:

  • The new law retroactively reinstated the estate tax. What this means is that an executor can elect to use the old law, but that election must be made on the estate tax return. Otherwise, the assumption is that the estate is subject to the estate tax.
  • The new law assumes that any property inherited from a descendant was long-term in nature. This meant that any capital gain would be treated at the lower, more favorable capital gains rates. This is not so if the executor elects out of the estate tax for descendants who pass away in 2010.
  •  It is highly possible that an election out of estate taxes for 2010 will have the effect of transferring the tax burden from one beneficiary to another, depending on the types of assets distributed to each. As such, care must be exercised to ensure all beneficiaries are treated equitably.

These points represent only a few considerations in settling the estate of a person who died after 2009 and before December 17, 2010. Depending on the size of the estate, the decision will require complex analysis and calculations before choosing whether to use the law as it was enacted in late 2010 or elect out of the estate tax for descendants dying in 2010. Because the due date of any estate tax return is no earlier than nine months after December 17, 2010, give us a call and let’s be certain that any decision you make is the best one for you.


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