There has been much made of the fact that the House was recently successful in passing an extension of the 2009 estate tax for 2010 and later years.  BUT the Senate was unable to obtain enough votes to pass similar legislation to extend the current estate tax provisions.  This means that the federal estate tax has disappeared for deaths occurring after December 31^st; however, in 2011, the estate tax will return with a $1 million per estate exemption from tax and a Clinton-era 55 percent top rate.  By contrast, for those dying in 2009, the first $3.5 million of each estate was exempt from federal tax, and the top estate rate was 45 percent.  But there is more… In addition, and few people are talking about this: For the time that there is no federal estate tax, the heirs are not allowed to obtain a "stepped-up basis" in the property they inherit.  The resulting "carry-over basis" usually results in higher income taxes for the heirs should they sell the inherited property.

For those who need an explanation in English, here it is: Generally, when property (stocks, certain other equity interests, real estate, machinery) is inherited, the property is valued (for capital gains tax purposes) at the value on the day of the death of the person leaving the property.  This is called the “basis” and, in this example, is a “stepped-up-basis” because it was not the original “basis” that the person who died had in the property.  Why is this important?  Well, if (when) the heir sells the property, the capital gains tax owed by the heir is computed by taking the sale price, subtracting the basis, and using the result (the capital gain) to compute the tax owed.  By removing the opportunity to have a stepped-up basis, if the heir sells the property the capital gains tax is now computed using the dying person’s original basis, generally the purchase price of the asset (also called “carry-over basis” because it is carried over from the original purchaser).  Generally speaking this carry-over basis will be much lower than the stepped-up basis would have been, resulting in far greater capital gain and thus more capital gains tax owed.  To "soften the blow" to the middle-class who would otherwise arguably be paying higher capital gains tax to help subsidize the wealthy in passing their estates tax-free, Congress did enact some modifications to the carry-over basis provisions.  These adjustments are found in IRC §1022(b) and (c).

It is the general consensus that Congress will reinstate the tax sometime in 2010, but with all that is on the table—not to mention the mood in Washington—who really knows what will actually get accomplished.  Even if the tax is reinstated, the questions that remain are when, what will be the rate, and what will be the exemption amount.  Democrats have supported maintaining the current rate of 45 percent with the $3.5 million exemption, while Republicans are pushing for a 35 percent tax rate and an exemption of $5 million.

Further complicating matters, if Congress waits too long the question of whether a retroactive enactment of estate tax back to January 1^st is constitutional becomes larger. In the early 1990's, a retroactive tax increase was affirmed in the courts with respect to closing an unintentional loophole, as well as a retroactive change in rates; however, the retroactive imposition of a tax when none exists as opposed to a retroactive tax rate increase, or a correction of an unintentional error in the law, is arguably different

Needless to say, through planning and assessment of one’s circumstances and options are critical elements of estate planning, now more than ever.  At Sorrell Law Firm we take the time to thoroughly review your situation and your goals.