2010 Estate Tax Repeal – Is it real?

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Caution: These are preliminary
thoughts on the current status of the estate tax as of January 1, 2010
and have not been thoroughly analyzed and proofread in an effort to
disseminate this information quickly. Therefore, this information
should not be relied upon to make any estate planning or related
decision without first verifying the sources and accuracy of the
discussion.

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whom this communication is not expressly addressed should seek advice based on
their particular circumstances from their tax advisor.

Introduction

Cabbage PATCH Kids ‘n Congress

Welcome to the Theater of the Absurd! Congress, by failing
to do what everyone assumed they would, has created one of the biggest tax
messes in history. That’s quite a statement in light of a tax law that gives
new meaning to the term “complexity”. Everyone expected Congress to “patch” the
estate tax so that in 2010 we’d have the same $3.5 million exclusion and 45%
tax rate as in 2009 until they decided what to do for the long term. But alas,
Congress, opted to do nada and left us all holding the cabbage waiting for the
patch! The potential damage to families from failed bequests, the toll of
potentially ugly litigation, and more, is simply inexcusable.

Probably 100% of the tax experts all believe that some
time in 2010 Congress will put that same proposed patch into law, and if
legally permissible (the pundits differ a bit on this one) make that patch
retroactive back to January 1. There are arguments on all three sides:

• Retroactive reinstatement should be viable under the
  concepts of U.S. v. Hemme, 58 AFTR 2d 86-6320 (106 S.Ct. 2071) and Estate
  of Allgood, 52 TCM 576 (1986). The court held that it was reasonable for
  Congress to reduce the unified estate tax credit to prevent taxpayers from
  deliberately taking double tax benefits. The court, however, reasoned that
  since the estate paid less tax under the new law, it wasn’t deprived of
  anything to which it could properly take constitutional exception. This
  rationale may not apply in the current situation.
• Retroactive reinstatement should not be permitted
  under the concepts of Untermyer v. Anderson, 6 AFTR 7789, 276 US 440, 1
  USTC 297 (US) Citator 2nd (RIA) which refused to sanction retroactive
  reinstatement of the gift tax. This position is that it is not a
  retroactive change in existing rules, but a retroactive enactment of a law
  that presently doesn’t exist. An important point in this issue might be
  that there has been so much discussion on retroactivity in even the general
  media that taxpayers may be argued to have had notice of this possibility,
  lots of notice.
• Repeal carry over basis rules retroactively and make
  estate and GST reinstatement effective prospectively. If this occurs there
  may be a golden window of planning available prior to Congress acting. It
  would also mean that the detailed analysis of the carryover basis rules
  below will be so much wallpaper.

If the estate tax reinstatement is not retroactive, or
Congress doesn’t act, 2010 will be an even bigger tax mess. This article will
summarize some of the issues, but the bottom line is you need to update your
will, revocable trust, and estate plan NOW! Depending on the language in your
will, revocable trust and other documents, your entire plan may be in jeopardy.
Even better yet, if you heed this important advice and Congress retroactively
changes the law, the revisions you make may have to be revisited!

As the World Turns (or if you prefer, “Developments Unfold”)

Possible developments and potential resolution of the
estate tax “gap” continue to swirl around Washington. Perhaps resolution of
some sort will have occurred by the time you read this, although issues, and
permanent lessons for estate planners in every profession, will remain.

From the AALU Washington Report:

The estate tax remains in flux as key Congressional
tax-writers have indicated that an estate tax resolution will not occur in the
near future. However, recent developments around the Senate debate to increase
the federal debt limit are pointing to a two-year extension of 2009 estate tax
law ($3.5M, 45% rate) as a likely outcome.

In accordance with a deal struck by Senate Democrats and
the Obama Administration, the Senate will likely adopt a pay-as-you-go budget
measure under which the estate tax would receive a two-year exemption, meaning
that revenue offsets would not be required for costs associated with an estate
tax fix in that window. This leads to the scenario highlighted above – a
two-year patch of ’09 law most likely passed later this year as part of a
larger tax package, perhaps under reconciliation instructions requiring only 51
votes.

It remains unclear whether the law will be reinstated
retroactively – Senate Finance Chairman Max Baucus (D-MT) agrees with
retroactivity, but House Ways and Means Chairman Charlie Rangel (D-NY)
continues to stand in opposition against retroactive tax increases. Many
scenarios for the estate tax remain on the table and are complicated by other
legislative and political matters such as a health care compromise, a
job-creation bill, and this year’s midterm elections.

George’s Smoke and Mirrors Come Home to Roost

The Bush tax breaks enacted in 2001 as part of the
Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Tax Act”
although it was also affectionately known by the acronym “ERGTRRA”) played the
oft used political games to make government budget numbers work (outside
Washington folks call it smoke and mirrors). In 2010 the estate tax was
repealed, but it roars back with a vengeance in 2011. That way George could
tell all that he repealed the evil death tax. But he never really did because
2011 assured its return at a costly level in order to make the budget numbers
“work.” No one believes that the estate tax can ever be repealed with budget
deficits multiplying like Tribbles (if you don’t know how Tribbles multiply
then you missed a classic Star Trek episode).

Overview of the Estate Tax System 2009, 2010 and 2011

2009 Estate Tax Rules

The estate and generation skipping transfer (GST) tax
apply with a $3.5 million exclusion and maximum 45% rate. The gift tax has a $1
million lifetime exclusion and maximum 45% rate.

2010 Estate Tax Rules (as of December 31, 2009)

2010 with Repeal Real

No estate or generation skipping transfer (GST) tax will
exist in 2010, unless Congress acts. The gift tax remains with a 35% rate, and
the same $1M exclusion, as a backstop to the income tax. Thus, estate tax
repeal is effective January 1, 2010. Should you plan or is this just a tempest
in a teapot? If you immediately revise all of your estate planning documents to
conform to the estate tax repeal landscape, and then Congress reinstates the
estate tax, will you have to revise all your planning and documents yet again?
Is it worth the effort and cost to revise your documents to endeavor to
anticipate all the following scenarios?

• Repeal stays effective for 2010 and thereafter.
• Repeal stays effective for 2010 and, thereafter, the
  laws presently scheduled to take effect in 2011 actually do ($1 million
  exclusion and 55% tax rate).
• Repeal stays effective for a short initial portion of
  2010, but then Congress reinstates the estate tax using the 2009 rules of a
  $3.5 million exclusion and 45% rate pending further Congressional
  action.
• The estate tax is reinstated retroactive to January
  1, 2010, using the 2009 rules.

Throw Momma from the Train – Redux

Hey, it was only a movie title now, but will people push
mom from the train in 2010? Probably. Ugly but true. Will kids who too often
ignore mom’s wishes not to have heroic measures dust off those old living wills
and pull the plug on mom? Will suddenly caring children take mom home from the
nursing home to provide a “different” level of care at home?

State Estate Tax Rules Post-2010 Repeal

Many states decoupled from the federal estate tax system
and enacted their own estate tax laws, often with a lower exclusion then the
federal estate tax exclusion (e.g., 2009 – $3.5 million). It does not appear
that state estate tax systems are repealed to track the federal estate tax
repeal in 2010 absent express action by the states. However, depending on the
wording of the various state laws, this conclusion may prove incorrect.

If state estate taxes will remain, which is likely in
light of the significant deficits many states face, a host of issues are
raised. The state estate tax systems still generally tracked the federal estate
tax. If the federal estate tax really is repealed, then the interpretation and
application of state estate tax systems will become increasingly difficult and
outdated as time progresses. Most significantly, as explained in discussions
below, the presence or absence of a state estate tax will create substantial
issues with the application of the new federal rules, and widely different
results could occur as a result of the different state estate tax laws (or
absence of them).

Carry Over Basis Rules

Yeah, But They Also Said We’d Never Have Repeal Limbo!

Why bother discussing carry over basis rules? Most pundits
are convinced that Congress will reinstate the estate tax, and most likely
retroactively (although the actual results of all this may be resolved before
you read this). But the same experts never imagined American taxpayers in the
bizarre wormhole (for those of you who aren’t Trekkies a wormhole is a tunnel
connecting two different points in space-tax-time). So, knowing full well that
the following discussion is likely to be as useful as a buggy whip on the new
electronic cars, we plow onward. If carry over basis has fallen to the status
of the buggy whip (as every accountant and estate planner hopes) skip the next
section and move onward.

New 2010 Income Tax Basis Rules – Overview

The general rule is that the heir’s basis will be the
lower of the fair market value of the asset or the decedent’s tax basis.

For those dying in 2010 there will be a limited basis step
up. Congress effectively created an income tax cost to replace the estate tax.
If you die owning a stock you paid $1 for and it is worth $1M under 2009 law,
you would pay an estate tax (if your estate exceeded $3.5M) but then the
“investment” or “tax basis” in that stock would be increased to $1M value at
your death. IRC Sec. 1014. If your kids sold it for $1M they would not pay
capital gains tax. Under the new 2010 law the basis step up is limited under an
arcane set of new rules that ever tax geek hopes they don’t have to learn.
These rules are called “carryover basis”. Every estate will get to increase the
tax basis in assets owned at death by $1.3M (only $60,000 for non-resident
aliens, sorry Sigourney). $3M more can be allocated to increase basis of
property received from a deceased spouse. These rules will require substantial
recordkeeping by everyone, regardless of the size of your estate, because
everyone is potentially subject to income and capital gains taxes. The rules
are arcane, even for tax laws!

This new rule is similar to what a donee of property
received as a gift during the donor’s lifetime, must do — determine the
donor’s income tax basis. IRC Sec. 1015. More specifically, the basis of
property received as a gift is the adjusted basis of the donor, subject to a
few special rules. If the donor’s tax basis is greater than the fair value of
the property at the date of the gift, the basis for determining a loss is
limited to the fair value of the property on the date of the gift. This is to
prevent the donee from recognizing a tax loss for income tax purposes on
property received as a gift. The second special rule is that if the donor
giving you the property had to pay gift tax on the gift, the adjusted basis of
the property is increased by the amount of gift tax paid, so long as the
increase is not to an amount more than the fair value of the property.

Application of Carryover Basis Rules

Example of Carry Over Basis

Carry over basis is simple to explain (although very tough
to implement). Consider the example above used to explain step up in basis.

Example: You own a building which has an adjusted tax
basis (investment, less depreciation, plus improvements) of $200,000 and a fair
market value on the date of your death of $1,000,000. Had you sold the building
just prior to death you would have realized a taxable gain of $800,000
[$1,000,000 – $200,000] and paid an approximate federal and state income tax of
about $200,000. If you die in 2010 or later owning the building your heirs will
inherit it with the same $200,000 tax basis you had, not a tax basis of the
$1,000,000 fair value at death (subject to the optional basis adjustment
rules). If your heirs sell the building the next day, they will have a taxable
gain of $800,000, the same gain you would have had. The real difficulty for
your heirs will be to locate the records you have of improvements to the
building, depreciation deductions, closing costs, etc., to demonstrate your tax
basis.

While a pure carry over basis rule would have met the
objective of replacing an estate tax with a capital gains tax, Congress sought
to minimize the impact of these rules on “smaller” estates. Thus, Congress
enacted a “modified” carry over basis rule which permits some amount of basis
adjustment. For “smaller” estates, some 98% of decedents, this means that the
net tax effect will be similar under the new law (if in fact carryover basis
remains the law which is unlikely according to most), as it had been under
prior (i.e., the current rules which existed until 2010) — no federal estate
tax and a step up in income tax basis. As will be explained below, every estate
will be allowed to step up $1.3 million in assets. Thus, if the appreciation of
assets in your estate is sufficiently under $1.3 million that you don’t
reasonably anticipate it exceeding that amount by your death, all assets in
your estate will receive a step-up in basis. This means that every executor
should create records showing the basis of all assets held by the estate. These
records should show a description of the asset, decedent’s adjusted tax basis,
the fair value at death, and then finally the tax basis to the heirs. This is
almost akin in many instances to the work necessary to file an estate tax
return.

Rules Similar To Gift Assets Under Prior Law

Property acquired from any decedents who die after
December 31, 2009 is to be treated as if transferred by the decedent to the
heir as a gift. Assets received as gift transfers will have the same tax basis
to the donee (heir) as they did to the donor (decedent), namely carry over
basis (subject to several exceptions). This gift rule is the same under the
post 2010 law as under old law. This means that not only will the tax basis of
the decedent generally carry over to the heirs, but the character of the
property, as ordinary income or capital gain property, will also carry over to
the heirs. This is important since the characterization of property as capital
gains property can have substantial income tax benefits on sale. Similarly, if
the property inherited was depreciated, and hence subject to depreciation
recapture on sale (i.e., some portion of the gain that would otherwise be
treated as capital gains must be characterized as ordinary income and taxed at
a higher rate) that taint will also carry over to the heirs.

Character of Property

The carry over basis rules enacted as part of the 2001 Tax
Act also provide that the character of property in the hands of the decedent
carries over to the hands of the heir. There are exceptions.

Example: If land was inventory, and hence ordinary income
property to the decedent who subdivided land and sold building lots as a
livelihood, then the land inherited by his heirs would have not only the same
tax basis as it did to him, but it would also be characterized as ordinary
income property.

Property Must Be “Acquired From” The Decedent To Be Subject to New Basis
Rules

The general rule noted in the preceding paragraph applies
to property “acquired from” the decedent. This term must be defined to
understand when the new rules will apply. Property acquired by devise (real
property received from a decedent), bequest (personal property received from a
decedent), or inheritance, or by the decedent’s estate, will be deemed
“acquired from”. Property transferred by the decedent as a gift during his
lifetime is deemed “acquired from” the decedent for purposes of the new rules.
Any other property which passes from the decedent by reason of the decedent’s
death if passed without consideration (i.e., not paid for by the recipient).
This includes property the decedent owned as a joint tenant with the right of
survivorship or as a tenant by the entirety. For jointly held property between
spouses the property is deemed 1/2 owned by each spouse. This means only 1/2
the value of jointly held property can be stepped up in value.

Property transferred by the decedent to certain trusts,
will similarly be subject to the new basis rules. Property transferred to a
“qualified revocable trust” or “QRT will be subject to the new carry over basis
rules. Finally any other trust with respect to which the decedent reserved a
right to change the beneficial enjoyment of the trust property by exercising a
right reserved to the decedent to alter, amend or revoke the trust, will be
treated as property “acquired from” the decedent and subject to the new
rules.

Exceptions to the General Carry Over Basis Rules

The decedent’s basis will not always be the exact tax
basis to the heir. The basis will actually be the lesser of the adjusted basis
of the decedent in the property, or the fair market value of the property at
the date of the decedent’s death. This means the lesser of basis or fair value,
not a pure carry over basis. Executors will thus have to create records more
complex than those under prior (i.e., pre-2010) law. The executor will have to
determine your adjusted tax basis in each asset and still identify current fair
market value information for each asset as of the date of your death (although
the complexity of a second calculation at the alternate valuation date won’t be
necessary). But this is not the entire picture, more complexity is yet to come
in the form of two modified increases to basis, explained below.

Example: Decedent dies on January 21, 2010 (and Congress
has not retroactively reinstated the estate tax under a 2009 structure).
Decedent owned a rental property with an adjusted income tax basis of $575,000,
and worth $650,000. Assume neither of the special basis adjustments explained
below are allocated to the property. The adjusted tax basis in the hands of the
heirs, on which they will determine their capital gain when they sell it, is
$575,000.

Example: Decedent dies on March 1, 2010, (and Congress has
not retroactively reinstated the estate tax under a 2009 structure), owning a
rental property with an adjusted income tax basis of $575,000, and worth
$450,000. The adjusted tax basis in the hands of the heirs, on which they will
determine their capital gain when they sell it, is the lesser of Decedent’s
adjusted tax basis or the fair value at his death, or $450,000.

The implications of the above is that the executor will
have to determine the fair value of every asset in the estate, just as under
prior law. This may require an appraisal for non-marketable assets such as real
estate and closely held business interests.

General Increase $1.3 Million in Tax Basis

One of the major exceptions the new law provides to the
general carry over basis concept is that every decedent can increase the basis
of assets to eliminate $1.3 million of taxable appreciation.

Example: Your estate consists of a house worth $600,000
for which you paid only $300,000 (your tax basis) and stocks worth $2.5 million
which you only paid $1.5 million (your tax basis). You can allocate $300,000 of
special basis adjustment to increase the basis in your house to its $600,000
fair value, effectively eliminating any gain. You can allocate $1 million of
special basis adjustment to your securities, thus effectively eliminating any
gain. When your estate utilizes this special “modified” carry over basis rule,
your heirs will not have to pay capital gains tax on the pre-death appreciation
when they sell the assets. Without this special tax break the $1.3 million in
appreciation could have ultimately cost your heirs $260,000 in capital gains
tax (depending on future increases in capital gains rates).

The purpose of the above rule is to prevent the majority
of estates from bearing the burden of passing on capital gains tax to their
heirs. Just as the applicable exclusion amount under prior law kept estates of
under $3.5 million from paying estate tax, the $1.3 million basis step up,
modifies the carry over basis rules to enable most estates to avoid the cost of
capital gains on later sales of inherited assets. Unfortunately, it does not
permit smaller estates to avoid significant paperwork and complexity. When this
is combined with the $3 million special basis adjustment on transfers of assets
to a spouse, only a very tiny percentage of estates will face the carry over
basis complexity.

It is not estates of $1.3 million and under that will be
able to avoid the impact of the carry over basis rules, rather, its estates of
any value that do not have more than $1.3 million in pre-death appreciation
that will receive this benefit. Thus, even an estate of $10 million or more may
avoid the tax consequences of carry over basis if the appreciation on its
assets is less than the permissible basis adjustments.

The actual mechanics of this special basis adjustment are
somewhat more complicated and involve a bit of jargon. The basis increase
allocated to a particular asset is the “aggregate basis increase” allocated
under the new allocation rules, to that asset. IRC §1022(b)(2)(A). The
aggregate basis increase in 2010 is:

a. $1.3 million, as explained above.

b. Plus, any increase in the $1.3 million for
inflation.

c. Plus, any capital loss carryovers.

d. Plus, any net operating loss carryovers under Code
§172. These are taken into account to the extent that these losses would have
been permitted to be carried over from the decedent’s last income tax return to
the next year’s income tax return had the decedent lived.

e. Plus, any loss deductions for built in losses which
would have been permitted as deductions under Code §165 as if the property
inherited from the decedent had instead been sold for its fair value prior to
the decedent’s death.

The rules apply to all property acquired from the
decedent. Thus, joint assets, assets held in qualifying revocable trusts
(“QRTs”), etc. will all be subject to these new allocation rules. However, the
executor of an estate only has the legal right to make decisions concerning
probate assets. Non-probate assets will thus present a particular
challenge.

Special $3 Million Increase for Property Passing to a Spouse –
Overview

If married, you may qualify for an additional $3 million
basis adjustment. Similar to the $1.3 million basis step, there is another
major modification of the general carry over basis rules. This is an additional
basis increase, unrelated to the $1.3 million basis increase, for property
acquired by a surviving spouse. This rule would effectively makes the carry
over basis rule (other than the allocation of basis) irrelevant for almost all
married taxpayers.

Example: The amount of pre-death appreciation that can
receive a step up in basis if you leave everything to a surviving spouse is
$4.3 million ($1.3 million and $3 million). This amount can be increased
further if you factor in the special home sale exclusion rules discussed
below.

This increase is only available if there is a surviving
spouse. Thus, the estate tax laws will continue the substantial favoritism
historically shown to married couples.

If the entire estate is funded to a family trust, similar
to a bypass trust used under prior law, then the trust may not meet the
requirements of Qualified Spousal Property (“QSP”) if there are other
beneficiaries and the spouse is not receiving the appropriate income interest.
Consideration should be given to funding a family trust not to exceed $1.3
million in appreciation and the balance to a QTIP that qualifies as a QSP.
Another approach is to bequeath all to a QTIP and permit a portion to be
disclaimed into a bypass or family trust, but that disclaimer would have to
have a similar limitation.

Requirements to Qualify for $3 Million Spousal Basis Adjustment

In order for assets to qualify for the basis step up, they
must be “qualified spousal property” (“QSP”). Congress knew instinctively that
taxpayers needed more estate tax acronyms to keep the rules confusing! QSPs
include QTIPs or out right transfers of property to a surviving spouse.

Qualified terminable interest property (“QTIP”) qualifies
as a QSP, and thus for the $3 million spousal basis adjustment. This is a trust
from which the surviving spouse will receive income for life and which is
funded with property which passes from the decedent. This requires that the
surviving spouse be entitled to receive all of the income from the assets in
this trust, payable to her at least annually. Alternatively, the surviving
spouse may have an interest for life in the property. No person can be given a
power to appoint any part of the QTIP assets to anyone other than the surviving
spouse during the surviving spouse’s lifetime. This means giving a power to
someone to appoint the QTIP property after the death of the surviving spouse
will not disqualify those assets from the $3 million basis step up.

Example: Husband wishes to bequeath $5 million of assets
with a $2 million tax basis, and hence $3 million of pre-death appreciation, to
a QTIP trust for his third wife. On her later death Husband wants the assets
distributed to the children from his first marriage, but he is not certain in
what proportions or how (i.e., in trust or not). He gives his brother a limited
power of appointment to designate the proportions and when the class of persons
consisting of his children from is first marriage may receive these assets. If
this power is exercisable during his third wife’s lifetime, the assets
bequeathed to the QTIP will not qualify for the $3 million basis step up. If
this power is only exercisable after the third wife dies, the assets so
bequeathed should qualify. The definitions of different types of powers of
appointment will no longer appear in the tax laws once the estate tax is
eliminated.

In determining whether payments to the surviving spouse
will qualify as constituting all the income payable at least annually, the new
law directs the IRS to issue regulations governing how an annuity will qualify
as the appropriate type of income interest. In determining whether a transfer
of property qualifies for QTIP treatment an interest in property, such as a
fractional or percentage share, will qualify.

Out Right Transfer Property to Surviving Spouse Qualifies for Basis Step
Up

An out right transfer property to the surviving spouse
qualifies as QSP. This is basically property which is transferred outright to
the surviving spouse. More technically, this is any property “acquired from”
the decedent as that term was defined in the preceding discussions. Property
will not qualify for the $3 million basis adjustment as “out right transfer
property” if the interests passing to the surviving spouse will lapse on the
occurrence of an event or contingency, the failure of an event or contingency
to occur, or the lapse of time.

Example: Husband dies leaving assets with $1.3 million of
pre-death appreciation to his son, and a house worth $4 million, with $3
million of pre-death appreciation, to his surviving wife. However, because
Husband was concerned about his surviving wife’s remarrying he had the bequest
to her limited to a life estate. She had full use of the residence for her
life, but upon her death the house would be transferred to his son. The
surviving wife’s ownership interest in the house will lapse on the occurrence
of an event, her death, so it will not qualify for any of the $3 million basis
adjustment under these rules.

If the termination is because of the death of the
surviving spouse under a simultaneous death clause (a provision which states
which spouse should be presumed to have died first in the event both spouse’s
die from a common disaster or at approximately the same time), or if the
surviving spouse dies within six months of the date of the first spouse’s
death, the asset is passed elsewhere, this condition will not prevent the
benefit of the $3 million basis adjustment.

Property Must be Owned by Decedent to Qualify for Basis Increase

To qualify for the spousal basis increase the assets
involved had to be owned by the deceased spouse on his death. If property was
owned jointly by the deceased spouse and the surviving spouse, the decedent
will be presumed to have owned one-half of the property. If the property is
owned by the decedent and a joint tenant who is not the decedent’s spouse then
the property will be treated as owned by the decedent based on the proportion
of the value contributed to the property’s acquisition by the decedent.

Example: Husband and Friend purchased land for $500,000,
with Husband contributing $300,000 and Friend contributing $200,000. Husband
will be treated as owning 3/5ths of the property.

The decedent will be treated as owning property held in a
qualified revocable trust (“QRT”) which decedent funded during his lifetime
with assets. This is in general terms the popular revocable living trust.

The decedent will not be deemed the owner of assets
because of his possessing a power of appointment over those assets.

The actual mechanics of this spousal basis adjustment are
that a portion of the “aggregate spousal basis increase” is to be allocated
under the new allocation rules, to each qualifying asset. The aggregate spousal
basis increase in 2010 is $3 million, plus, any increase in the $3 million for
inflation.

Maximum Basis Increase

The maximum basis increase, when the $1.3 million general
increase and the $3 million spousal increase are both used in full is still
limited to the fair market value of the property involved.

Example: Husband dies with an $8 million estate consisting
of an interest in a closely held business. His tax basis (investment) in the
family limited partnership (“FLP”) operating the business is $4.5 million. The
theoretical maximum basis increase on his bequest of the FLP interests to his
surviving wife is $5.3 million [$1.3 million + $4 million], but the FLP
interests cannot be increased by more than their fair value of $8 million so
the maximum basis increase permitted is only $3.5 million [$8 million – $4.5
million].

Planning For the New Spousal Basis Adjustment

Since no one can know who will be the surviving spouse, a
planning objective under the new post-estate tax system, similar to the
objective under the old law, will be to divide assets between spouses. This is
meant to assure the greatest likelihood of maximizing the basis increase
regardless of who is the first to die. But the task of dividing assets is
actually somewhat different, and more complex, than planning under prior law
(i.e., the estate tax system in place through 2009). Under pre-2010 law the
planning is based on dividing the value of assets between spouses. Under the
post 2009 modified carry over basis system you will need to divide assets based
on appreciation. This is not only more complex but will require more careful
monitoring. Thus, taxpayers who divided assets to maximize funding of bypass
trusts under prior law will have to re-evaluate that planning.

Example: Husband and Wife have a combined estate of $6.5
million consisting of a house valued at $2 million, purchased for $500,000,
stock purchased at $1,000,000 valued at $1,000,000, and real estate worth $3.5
million, purchased for $500,000. The total estate has appreciation of $4.5
million [$1.5 million on the house and $3,000,000 on the real estate]. Under
2009 law Husband and Wife could divide assets by giving the Husband the house
and stock, and Wife the real estate so each owns sufficient value of assets to
take maximum advantage of the applicable exclusion and the graduated estate tax
rates. Under the new system, however, this approach won’t suffice. The assets
will have to be divided so that the appreciation on assets is equally divided.
The stock could be owned by either and would not be relevant since there is no
appreciation (this could obviously change as time goes on and the stock
appreciates or depreciates in value). The house and real estate would have to
be divided equally, or alternatively the house owned by one spouse and the real
estate divided in a manner that equalizes the appreciation between spouses.

Inflation Adjustment Increases $1.3/$3 Million Figures

The basis adjustment or increases for $1.3 million
general, and $3 million spousal, are subject to increases for inflation. The
inflation increase will be based on the increase in the cost of living
adjustment for a particular calendar year, using 2009 (the last year before the
modified basis adjustment rules become operative) as the base year. The amounts
of inflation increases will be rounded down as follows:

a. $100,000 for the $1.3 million adjustment applicable to
all taxpayers.

b. $250,000 for the $3 million spousal basis
adjustment.

c. $5,000 for the $60,000 adjustment for non-resident
aliens.

Community Property Law and the New Carry Over Basis Rules

Generally all property acquired by a husband and wife
during their marriage, while they are domiciled in one of the community
property states belongs to each of the marriage partners, share and share
alike. They share not only in the physical property acquired but also in the
income from the property and their salaries, wages, and other compensation for
services. At the same time, each may have separate property. They may also hold
property between them in joint tenancy and generally may adjust between
themselves their community and separate property (i.e. use a transmutation
agreement). Couples can state prior to marriage via a prenuptial agreement that
they will not be bound by the community property laws of their state of
domicile.

Generally, community property assets retain that character
even after the parties have moved to a non community property state, unless the
parties themselves are able to adjust their rights between themselves. This is
important with respect to your actions with respect to the assets held. For
example, your restructuring of title to any assets presently owned individually
or in joint name could affect this characteristic.

Property acquired before marriage retains the form of
ownership it had when acquired – separate, joint or other. Property acquired
during the marriage by gift or inheritance by one of the parties retains the
character in which it was acquired. Property purchased with community property
is community property, and property purchased with separate property is
separate property. Property purchased with commingled community and separate
property, so that the two cannot be separated, is community property.

For community property a special rule applies which may
provide for a full basis step up. This is a significant benefit for community
property. A surviving spouse’s one-half share of community property assets will
be treated as if “acquired from” the decedent and subject to the carry over
basis rules. To obtain this benefit at least one-half of the interests in the
asset, under the decedent’s state’s community property law, must be treated as
if owned by the decedent.

3 Year Rule – Restricting Death Bed Planning Techniques

The purpose of this rule is to protect income tax
revenues. Since there is no estate tax after 2009, unless or until Congress
changes the law, and there will still be a $1 million gift tax exclusion, what
will stop taxpayers from shifting assets between high and low income tax
bracket taxpayers to obtain basis step up?

Example: A terminally ill patient, Tom, has an estate
consisting of modest assets. The patient, however, has a close friend, Ida, who
owns a particular internet stock she purchased for $1 that is now worth $1
million. The friend, Ida, sees the benefits of obtaining a basis step up so his
heirs can avoid capital gains tax. Ida transfers the stock to the close friend
who is terminally ill, Tom. When Tom dies, he can bequeath the stock, with
basis step up, back to Ida. Ida can now sell the stock and avoid capital gains
tax because the tax basis in the internet stock received a free basis step from
Tom. This is an obvious abuse which has to be controlled to protect the
integrity of the new tax system.

Congress sought to limit this abuse by preventing basis
step up on transfers within three years of death. This rule provides that the
basis of assets transferred within three years of death cannot be increased
under the modified carry over basis rules for the $1.3 million adjustment if
acquired by the decedent within the three year period ending on the date of
death. This restriction applies to property acquired by gift. A spouse can
transfer property within three years of death to obtain a basis step up under
the $3 million spousal basis step up unless the transferor spouse received the
assets as a gift.

If the above interpretation is correct then clients should
consider inter-spousal transfers prior to death. There is a 3 year rule but it
provides for an exception for intra-spousal transfers. Thus, if one spouse is
on his or her death bed, consider transfers to the healthy spouse before death
to obtain a full basis step up. Durable powers of attorney should be amended to
address this. See sample clauses below.

Allocating the Basis Adjustment

The basis adjustment, for the $1.3 million and $3 million
are to be made by the executor appointed under the decedent’s will. The
executor’s determination will be governed by state law unless except as changed
by the decedent’s will, revocable living trust, or other governing instruments.
The executor will report the allocations as made on a tax return. Once made,
the allocations will be binding except as the IRS may indicate in future
regulations.

Many taxpayers assume that if the estate tax is eliminated
the requirements to file an estate tax return will be eliminated. The
requirements will continue, and in many respects will be more complex and
difficult to make, and will likely affect more, not fewer, taxpayers. Further,
since the rules will be new and different, for larger estates the cost and time
involved under the new post-estate tax repeal law, may actually be greater than
before. Even for smaller estates that do not need to file a return, equivalent
records will have to be maintained to establish the tax basis for property.

The allocation of basis adjustments may be made on an
asset by asset basis. The template used in the past for a Code Section 754
basis adjustment for a partnership may present a useful template for this
analysis.

The basis allocation will be quite simple for most estates
in that the amount of basis increase permitted will exceed the pre-death
appreciation in the assets.

Example: You die with $2 million in assets, which have a
tax basis of $1 million. The $1.3 million basis adjustment alone (i.e., without
consideration of the spousal $3 million adjustment) enables your executor to
step up the basis of every assets so that no pre-death appreciation will ever
be taxed. This is relatively simply in that there is no conflict, as
illustrated in the next example, below.

Although there is no conflicts between heirs in the above
example, simple may still not be an appropriate description of what the
executor will face. The executor will have to obtain the tax basis and fair
market value of all assets, including joint assets and revocable living trust
assets over which the executor may have no control. Also, for decedents
domiciled in states with no estate tax (or when they are under the state estate
tax thresholds) heirs won’t pressure executors to undervalue assets, but rather
to value them as high as feasible to maximize the basis step up to minimize
future capital gains.

The real issue under the new modified basis adjustment
rules will arise when the aggregate basis increase is not sufficient to assure
every heir of the elimination of capital gains tax.

Example: You die, unmarried, with $3 million in assets,
which have a tax basis of $1 million. The $1.3 million basis adjustment cannot
enable your executor to step up the basis of every assets so that no pre-death
appreciation will ever be taxed. Some assets will have a built in tax cost,
others may not. The decisions as to how the executor should make such an
allocation are quite complicated, and could create considerable disputes
between beneficiaries.

Example: Assume the same facts as in the preceding
example, and that there are three children. The $3 million estate consists of
the following assets:

o House – value $1 million, basis $250,000.

o Business – value $1 million, basis -0-.

o Stock – value $1 million, basis $750,000.

How should the basis increase of $1.3 million be
allocated? It could be done proportionately to relative appreciation. The house
has $750,000 of the total $2 million of appreciation so that $487,500 [$1.3
million x $750,000/$2,000,000] of the basis adjustment could be allocated to
the house. But what if your son plans on living in the house indefinitely so
that it won’t be sold? What if your son will qualify for the home sale
exclusion rule on a portion of the gain? What if your son is the executor? What
if you left each child 1/3 of each assets versus giving the house to child 1,
the business to child 2 and the stock to child 3? The factors to consider, and
the risks and issues that can arise are almost endless.

Income In Respect of a Decedent (“IRD”) and The New Modified Carry Over
Basis Rules

You cannot use basis increase on property which is income
in respect of a decedent (“IRD”) property (this is sometimes called Code §691
property). For example, the assets in your IRA accounts cannot be allocated any
portion of the basis step up under the modified carryover basis system.

Liabilities and the New Modified Carry Over Basis Rules

If you sell property that is subject to a liability, that
liability is treated as part of the amount you realize on the sale, and can
thus contribute to the determination of the taxable gain. These rules are not
changed by the 2001 Tax Act. However, the repeal of the step up in basis rules
which gave property a tax basis equal to its fair value on death, there is a
greater opportunity for taxpayers to unexpectedly face a tax cost.

Liabilities in excess of your adjusted tax basis will not
be considered for determining whether gain is recognized on acquisition of
property from a decedent by the decedent’s estate or any beneficiary which is
not a tax exempt entity. The purpose of this rule is to prevent the repeal of
the estate tax stepped up basis from triggering gain on assets held with
liabilities in excess of basis.

Example: You purchased real estate for $100,000. It
appreciated to $2,000,000 and you mortgaged the property for $1,500,000. The
mortgage liability exceeds your basis in the real estate by $1,400,000. On your
death, your estate will not recognize gain on the property. Further, when your
estate distributes the real estate to your heirs (assuming that the $1.3
million or $3 million basis adjustments are not applied to this property) your
heirs will also not recognize gain on the receipt of the property.

Example: Assume that your executor applies the $1.3
million and a portion of the $3 million basis adjustments to the real estate.
The basis of the real estate can thus be increased by $1.9 million to its $2
million fair value which exceeds the $1.5 million mortgage.

The new carry over basis rules could have provide an
opportunity for taxpayers to circumvent the tax consequences of carry over
basis using charity. Congress wanted to prevent taxpayers from financing a
property, giving the money received from the financing to their heirs, and then
donating the property subject to the mortgage (or other financing arrangement),
If permitted, this would enable you to circumvent the carry over basis rules.
Your heirs would have cash with a basis equal to its value (i.e., the cash from
the financing) and the encumbered property would be donated to a charity and
“disappear” from your balance sheet, including the financing. The charity could
then sell the property and not report any gain. This is because a charity,
under the general rules would not have to report gain on such a transaction. If
permitted this would enable you to avoid the income tax consequences of the new
Code §1022(g). To prevent this type of planning your heirs will end up
inheriting the property with the liability. Gain won’t be recognized as a
result of the heir receiving an asset with a liability in excess of your tax
basis in the asset. But, the heir will inherit the same tax problem you had.
Namely, if the heir disposes of this encumbered asset he will have to recognize
taxable gain.

Gain on Distributions from Estates and Trusts

A common drafting technique for wills has been to state
that a specific dollar amount rather than a percentage (in tax jargon a
pecuniary bequest) would be given to fund (transfer the requisite assets to) a
state level bypass trust to preserve the maximum state estate tax exclusion
(e.g., $675,000 in New Jersey, or $1 million in New York), or simply to give a
desired dollar amount to a specified heir. Generally, no gain or loss results
from a transfer of property from an estate to a trust or from a trust to a
beneficiary under the terms of the governing instrument. There are several
exceptions. When the distribution is of appreciated property distributed in
satisfaction of a right to receive a specific dollar (pecuniary) amount, gain
may be recognized for income tax purposes.

Example: On your death you have a particular mutual fund
worth $250,000. When your estate is settled eight months later and your state
bypass trust is funded in the amount of $675,000, the mutual fund is worth
$600,000. Your will bequeaths an amount up to $600,000 to the bypass trust for
the benefit of your surviving children. The executor funds this bypass trust
with the mutual fund. The tax basis to the estate in the mutual fund is
$250,000. Gain of $350,000 [$600,000 – $250,000] must be recognized.

Example: Grandparent transfers various assets to a trust
for the benefit of several grandchildren. When each grandchild reaches age 35
he or she is to receive $35,000. When the first grandchild reaches age 35 the
trustee transfers stock with a tax basis of $24,000 and a fair market value of
$35,000. The trust must report a gain of $11,000 [$35,000 – $24,000].

If the estate can allocate a portion of the $1.3 million
or $3 million spousal basis adjustment to the property some portion or all of
the gain could be eliminated. It is not clear whether post-death appreciation
can be so eliminated. But in many cases the valuation of a non-marketable
assets is not precise so that the effect may be to eliminate all gain.

Special Use Valuation Rules and Income Recognition

To minimize the estate tax burden on estates including
certain interests in closely held business or real estate assets Code §2032A
provide special valuation rules. These rules are an exception from the general
valuation rules of valuing assets at their fair market value under the standard
of a hypothetical willing buyer and a willing seller. For example, if you use
land as a parking lot for your business, but a developer could build an office
building on the land, the price a developer would pay for the best use of the
property, not a price a purchaser would pay for parking lot land, is used. This
general valuation rule can create a tremendous hardship for farm or family
businesses where assets are used in the business at a lesser value than fair
value. The special valuation provisions of Code Section 2032A are intended to
mitigate this hardship. A major drawback of taking advantage of the special use
valuation is that the basis step-up which assets receive on death is limited to
the special use valuation amount (increased by any gain recognized, as
explained below). This lower basis could trigger an unintended future income
tax cost, so a special income tax rule was provided for.

The special rule provides that if an estate had to
recognize taxable income as a result of a distribution of special use valuation
property to a qualified heir the amount would be limited to the excess of the
fair value (not the special use value) of the property on the date it was
transferred exceeds the value of the property on the date of death. This rule
eliminated any taxable gain to the extent that the value of the property on the
date of death exceeded the special use valuation of the property.

If your executor distributes appreciated assets to satisfy
a beneficiary’s right to a pecuniary bequest your estate will recognize gain
only to the extent that the fair value of the property on the date of
distribution exceed the value of the property on the date of the decedent’s
death. This new rule is necessary after 2009 when the modified carry over basis
rules come into play. Prior to 2010 this special rule for determining gain only
applied to distributions of special use valuation property, not any other
property, because it was only in that context that the unfairness would
arise.

Example: Reconsider the example above. On your death you
have a particular mutual fund worth $250,000. You purchased the mutual fund for
$50,000 years earlier. When your estate is settled eight months after your
death, the mutual fund is worth $600,000. Your will bequeaths an amount up to
$600,000 to a trust (it is no longer a bypass trust since there is no longer,
after 2009, an estate tax assuming you were domiciled in a state without an
estate tax) for the benefit of your surviving spouse and children. The executor
funds this by pass trust with the mutual fund. The tax basis to the estate in
the mutual fund is $50,000, carry over basis, not the $250,000 fair value at
death, as it would have been under the old law. Note, that if your executor
allocated some portion of the $1.3 million or $3 million spousal, basis
step-ups permitted under the post-2009 laws, the $250,000 basis could be
achieved under the new law. However, for this example, assume that no such
allocation is made (i.e., the basis adjustments are allocated to other assets).
Gain of $550,000 [$600,000 – $50,000] must be recognized if no special rule is
provided for. This new special rule states that the gain cannot exceed the
amount of appreciation from the date of death value, or the $250,000. Thus the
gain under the post-2009 law should be the same as under prior law of
$350,000.

The result of the special rule is that even if your
executor doesn’t make an allocation of basis to an asset with pre-death
appreciation, the gain the estate will realize for income tax purposes will not
be greater under the post-2001 Tax Act than it was under prior law. Similar
rules will be provided by the IRS to address the comparable income tax problem
by trusts. IRC §1040(b).

This special rule is yet another instance where an estate
will have to determine and document the fair market value of assets at death,
the decedent tax basis in assets, and other data. Record keeping under the new
rules will continue.

What happens to your estate’s tax basis in the property if
this special rule applies? The basis of property to an heir (i.e., what the
heir will use to calculate income tax when later selling the property) is the
basis before the exchange, which is your tax basis on purchasing the property
during your lifetime, increased by the amount of gain your estate must
report.

Example: Your heirs (the trust’s) tax basis should be your
tax basis of $50,000 increased by the $350,000 gain recognized, or $400,000.
The difference between the $400,000 basis and the $600,000 date of death value,
or $200,000 is exactly the amount of gain not recognized by your estate because
of this special rule. The result is that if your heir (trust) sells the mutual
fund it will then realize the gain. Thus, this special rule defers the timing
of recognizing gain, it does not eliminate it.

It appears that losses will continue, as under prior law,
to be deducted when an estate distributes property with post-death depreciation
to satisfy a pecuniary obligation.

Example: Your will states that $50,000 should be
distributed to your favorite college friend. Your executor distributes stock
that you paid $80,000 to purchase. Your estate should be entitled to a $30,000
loss deduction.

Special Rules for Inherited Art and Creative Property After 2009

The general rule under the 2001 Tax Act is that not only
will your tax basis in property carry over to (i.e., become the tax basis for)
your heirs, but the character of property as a capital asset (the gain on which
would be taxed at more favorable capital gains rates) and the holding period
(the time of ownership which can affect the capital gains tax rates affecting
assets on sale) also carry forward and apply to your heirs.

Prior law provided that creative property, such as music,
art, copyrights, etc.) which you received as a gift (more technically, art when
your tax basis was determined in part or whole by reference to the tax basis of
an earlier holder, such as the donor who created and gave you a sculpture)
would not be characterized as a capital asset. Such property will no longer be
characterized as not constituting a capital asset. This new rule is a special
exception to the general modified carry over basis rules.

Example: Craftsman buys clay for $10 and makes a sculpture
worth $20,000 and bequeaths it to you. Under prior and current law your tax
basis is $10. Under prior law the sculpture would be an ordinary (non-capital)
asset to you because it was not a capital asset to Craftsman. Under this new
special rule it can be characterized as a capital asset to you (unless another
exception applies).

Special Rules for Donations of Certain Capital Assets

The amount which can be deducted for a charitable
contribution purposes is limited. Specifically, the new law reduces the
contribution deduction by two items. The first is the gain which would not
qualify as long term capital gain. This is determined as if the property were
sold for its fair value on the date it was donated. The second reduction
applies if either a gift is made to certain private foundations, or a donation
is made of tangible personal property the use of which is not related to the
charitable purpose of the charity (e.g., art donated to a hospital). In these
two situations, the amount of the gain which would have been characterized as
long term capital gain is applied to reduce the charitable contribution
deduction.

The special rule characterizing certain inherited art,
copyrights and other property as capital gain property will not apply to
charitable contributions of such property.

The new carry over basis rules change the character of
inherited art and other property for purposes of determining your income tax on
the sale or exchange of that property. It does not change the rules for
purposes of determining the deduction available if you donate that type of
property to a charity.

Personal Residence Interplay of Home Sale Exclusion and Carry Over Basis
Rules

The new 2010 carry over basis rules liberalize the home
sale exclusion rules for estates and heirs. To understand the changes, an
overview of the home sale exclusion rules is necessary.

The house sold must have qualified as your principal
residence for at least two of the five years prior to the sale. To add some
flexibility, if your client doesn’t meet the full two year test, your client
may qualify to benefit from a portion of the $250,000 maximum exclusion if you
had to move because of a job change, health problem or other qualifying
excuse.

If the residence was partially used for personal purposes
as a principal residence and partially used as for business purposes (rental or
house office) the full exclusion may not be available. To the extent that
depreciation was claimed on the property after May 6, 1997, the exclusion will
not be available. This means that depreciation prior to such date will not have
an adverse impact. Depreciation from a home office or rental use after that
date will.

The maximum gain which can be excluded is $250,000 for a
single client, or $500,000 for a couple filing a joint tax return. To use the
higher $500,000 exclusion one of the spouse’s had to have owned the house for
at least two of the preceding five years. Both spouse’s had to have used the
house as a principal residence during at least two of five years preceding the
sale. There was some leniency in the event you fail some of the above
requirements for reasons beyond your control. If you fail the two of five year
ownership and use rule, or the once every two year sale rule, as a result of a
change in your employment, health, or certain circumstances to be specified in
future regulations, you may qualify for a partial exclusion.

However, the home sale exclusion rules did not provide for
any leniency on the death of a taxpayer. This is even more problematic when the
step up in basis rules are eliminated, such leniency might be necessary. Under
current law (i.e., the law which will exist through 2009 when the modified
carry over basis rules become effective) if you purchase a house that
appreciated prior to your death, the appreciation would qualify for a basis
step up on your death and the capital gains would disappear.

Example: You purchased a home for $40,000. It appreciated
to $290,000, or a $250,000 increase. If you sold the home prior to your death
the gain could be excluded from taxation under the home sale exclusion rules.
If however, you died owning the home, the exclusion would not apply but your
heirs would obtain a step-up in basis in the home they inherited from you. Thus
the basis would be increased from $40,000 to the fair value of the home on your
death, or $290,000. Thus, if your heirs sold the home, no capital gains tax
would be due.

Post 2009 the modified carry over basis rules will not
always guarantee a step up in the tax basis of your home. Thus, unless this
issue were specifically addressed, your heirs could face a capital gains tax
they may have avoided under prior law.

Example: You purchased a home for $40,000. It appreciated
to $290,000, or a $250,000 increase. If you died owning the home, and the $1.3
million/$3 million spousal basis adjustments were not allocated by your
executor to the home, your heirs would obtain a carry over in basis in the home
they inherited from you, or $40,000. Thus, if your heirs sold the home, a
$250,000 capital gains tax would be due. The new rule described below seeks to
address this.

An estate or trust may qualify to exclude the gain
realized on the sale of the decedent’s personal residence. Your estate could
qualify for this benefit, an heir who inherited the property from you (e.g.,
your child) could qualify, and a special trust referred to as a Qualified
Revocable Trust (“QRT”) can qualify. The QRT is explained more fully,
below.

Example: You purchased a home on July 1, 1997 for $100,000
and lived in it until you died June 30, 2003 when the home was worth $500,000,
an appreciation of $400,000. Assume that your executor did not elect to
allocate any of the $1.3 million/$3 million spousal basis adjustments to the
home. Your estate sold the home after your death for $500,000. Your executor
could use the $250,000 home sale exclusion to eliminated $250,000 of the
$400,000 capital gain.

When an executor considers which assets should receive an
allocation of the $1.3 million/$3 million spousal basis adjustments
consideration should be given to maximizing the use of the home sale exclusion
available to estates. This can increase the maximum capital gains which can be
avoided under the post-2009 laws to $4,550,000 [$1.3 million general basis step
up + $3 million spousal basis step up + $250,000 home sale exclusion].
Remember, this is not value of assets which can be increased, but rather
appreciation.

A QRT, Qualified Revocable Trust is not the same as a
QPRT, or Qualified Personal Residence Trust. Confusion will abound. Good for
accountants and lawyers, but not easy for regular folk. A QRT is a trust which
is a grantor trust which is treated as owned by you. The income earned by a
grantor trust is taxable to you as the grantor (i.e., the person who set up the
trust) during your lifetime. The common revocable living trust is a QRT. A
trust will not qualify as a QRT if it is a foreign trust. If you could only
exercise power over the trust with the consent of another person, the trust
will not qualify as a QRT. IRC Sec. 684.

Example: A trust can be characterized as a grantor trust
if a related non-adverse trustee can be given the right to distribute income
and principal among a class of trust beneficiaries without an ascertainable
standard in order to achieve grantor trust status. See PLR 8103074 and Carson
v. Comr., 92 TC 1134 (1989). Such a trust would not appear to qualify as a QRT
under the new law.

You heir, say your child inheriting your home, can count
the time periods for which you owned the house, or used it as your residence,
in determining if the heir qualifies for the home sale exclusion. Specifically,
a home has to be used, as explained above, for two of the five years before
sale, as a principal residence. Your use and ownership can be combined with
that of your heir.

Example: You purchased a home on January 1, 2003 for
$100,000 and lived in it until you died December 31, 2003 when the home was
worth $340,000. You only lived in and owned the home for one year and thus do
not meet the requirements for the home sale exclusion. You bequeath your home
to your partner who is in need of additional cash. If he sales the home
immediately he will have a capital gains tax to pay. Your partner resides in
the home as his principal residence for one year and then sells it for
$360,000. Your partner can add your ownership and use of the home to his and
thus qualify to exclude up to $250,000 of the gain when he sells the home. He
need not wait to qualify for the two year use period based solely on his
use.

It appears that the heir can count his use of the property
and the decedent’s ownership. Thus, if the decedent owned the house but the
heir used it, the exclusion may be available. Under pre-2010 law a surviving
spouse can add the deceased spouse’s use and ownership to determine if the
exclusion is available. Thus, the post-2009 modified carry over basis law
appears to extend this benefit.

Special Rules Applicable To Foreign Taxpayers and Transactions

The basis adjustment available to most estates which
permits assets’ basis to be increased by up to $1.3 million is reduced to a
nominal $60,000 for non-resident aliens. Further, the adjustment for capital
loss carryovers, net operating loss carryovers under Code §172 and any loss
deductions for built in losses which would have been permitted as deductions
under Code §165 to a resident taxpayer, will not be permitted to a non-resident
alien.

You will have to evaluate any estate tax treaty between
the United States and the country in which the particular non-resident taxpayer
is a citizen. There may be benefits to offset this harsh limitation.

No basis increase is permitted on stock in a: foreign
personal holding company (“FPHC”), a domestic international sales corporation
(“DISC”), a foreign investment company (“FSC”), or a passive foreign investment
company.

Testamentary transfers starting from 2010 by a U.S. estate
to a nonresident alien will be treated as a sale or exchange of those assets at
their fair value.

Gain from the sale or exchange of a foreign mutual fund or
investment company stock is treated as ordinary income, and not capital gain,
under special rules. The basis of such stock becomes its fair market value on
death. This special rule is repealed after 2009 when the estate tax is repealed
and the new modified carry over basis regimen begins.

Reporting Requirements Under the New Modified Carry Over Basis Rules

The new modified carry over basis rules require
substantial compliance. The new reporting requirements must address the
complexity of advising heirs of their tax basis in inherited assets. IRC Sec.
6018.

Your executor must file a tax return with the IRS
reporting specified information. Although the new reporting requirements will
only apply to estates over $1.3 million. This is the amount below which no
appreciation will be taxed under the modified carry over basis rules. For
estates of $1.3 million or less the tax basis of all assets will be stepped up
so the IRS need not worry about reporting. The above rule is limited to the
$1.3 million figure, as inflation indexed. It is not increased by the amounts
for losses and loss carryovers.

For estates with under $1.3 million in assets (not
appreciation) even if an IRS tax filing is not necessary executors should
compile the same information since this information will be necessary for heirs
to determine the tax basis if assets they sell. Further, if an heir, say your
child, has a large estate, it is possible that the heir’s executor will have to
file a tax return on his death. The information from your estate will be
necessary for your heir’s executor to file a tax return.

These rules are a bit confusing in that the modified carry
over basis rules refer to $1.3 million of appreciation, not $1.3 million of
assets. However, the reporting requirements are based on $1.3 million of
assets. The rationale for the difference is simple. The IRS will assume that
for assets of estates under $1.3 million in total value all assets will have a
tax basis equal to their value at the date of the decedent’s death (similar to
the step-up in basis rules under current law). The issue of whether the $1.3
million in basis step up protects all assets cannot apply for estates with less
than $1.3 million even if all assets have a zero tax basis. Over this amount,
taxpayers will have to prove tax basis.

Estates of under $1.3 million will presumably not be
required to file any type of tax return. As noted above, executors of such
estates should still collect and organize similar information since each heir
will still have to have documentation of the tax basis in assets inherited.
What this also means, which is the same as under current law, for estates not
required to file, the incentive will be do justify the highest value possible
for any assets in the estate since these assets will become the tax basis of
the assets to the heirs.

Example: Father died and his entire estate is valued at
$850,000. His estate is left to his only heir, his son. The estate consists of
a house which the son, as executor, believes to be worth about $350,000 and
$500,000 of mutual funds. Well the value of the mutual funds is fixed and
clear, but what about the house. Under prior law in say 2001 with a $675,000
exclusion, the son would make every effort to have the house appraised at the
lowest value possible in order to minimize the value of the estate and hence
minimize estate taxes on the value in excess of $675,000. After 2009, under the
new modified carry over basis rules, son would endeavor to do just the
opposite, up to a point. The higher the son could have the house appraised, but
not in excess of $800,000 (the amount which when combined with the $500,000 of
mutual funds would trigger the requirement for the estate to file with the
IRS), the better. Why? So long as the estate is under $1.3 million in value
there is no reporting requirement. Under this threshold the incentive will be
to value any asset with an uncertain value (real estate, closely held business,
art, etc.) as high as possible since that value will be the value to the heir
and determine the income tax the heir will have to pay on selling the
property.

For non-resident aliens (non-citizens) estates over
$60,000 will be subject to reporting requirements. The only assets considered
are those potentially subject to U.S. taxation, generally tangible property
located in the U.S. Tax treaties may affect this. These are bi-lateral
conventions (agreements) between the U.S. and the non-resident alien’s country
of citizenship.

In many instances the executor may not have complete
information to file the required tax return with the IRS. For example, a trust
may own assets included in your “taxable” estate, you may have owned assets
jointly with someone so that they assets pass by operation of law outside your
estate, etc. In these instances the new reporting rules direct your executor to
describe the property and list anyone who has a beneficial interest in the
property, such as a joint owner, trustee, etc. These rules could be extremely
burdensome and difficult to implement. For many estates several different
people will have to collaborate to complete the return. For example, if before
you died to transferred some but not all of your assets to a revocable living
trust, the trustee and you executor would each have information necessary to
the completion of this return. For most taxpayers this should not be an issue
because the trustees and executors are often the same people. Where they are
not, coordination will be necessary. For some taxpayer’s this could prove
problematic. In addition, co-owners of any joint assets will presumably have
information and be required to cooperate as well.

The information which will have to be reported is similar,
but more comprehensive than, what had to be reported on an estate tax return
under pre-2010 law. The reason for the detailed reporting requirements is that
heirs must know the tax basis they have in assets they inherit so that they can
determine their income tax consequences when they sell property. You must
advise the IRS of:

• The name and tax identification number (e.g., Social
  Security number for an individual) of each beneficiary (recipient).
• An accurate description of the property involved. For
  publicly traded stock this will be quite simple. Likely, more complex
  requirements and details will be required of a closely held business or
  other harder to value assets.
• The adjusted income tax basis of the property to the
  decedent. This requirement was not relevant under prior law when most
  assets (except IRD, etc., an IRA account as an example) received a step up
  in tax basis to the fair value at death (or at the alternate valuation date
  six months following death).
• The fair market value of each asset to the decedent.
  This is similar to the current law. Although the new law post 2009 is based
  on a carry over basis concept, the existence of the “modified” carry over
  basis approach actually adapted (i.e., which permits you to adjust basis
  for the $1.3 million general and the $3 million spousal amounts) requires
  both tax basis and fair market value data. When this is compounded by the
  issue of how to allocate these adjustments, the complexity is truly
  remarkable.
• The decedent’s holding period for the property. As
  explained above, the time the decedent held the property, which is
  necessary for determining the capital gains consequences on the sale of
  property, carries from the decedent to the heirs.
• Any information necessary to determine if any of the
  gain an heir would realize on the sale of the property would be taxed as
  ordinary income (i.e., at the maximum individual income tax rates) rather
  than as capital gain income (potentially taxed at the lower capital gains
  tax rates) must be provided. This could include information as to dealer
  status. For example, if the decedent purchased land, subdivided, and sold
  many lots as inventory, any remaining lots could generate ordinary income
  and not capital gains to the heirs. Similarly, depreciation deductions
  claimed on a property could cause the recharacterization of some portion of
  the gain as ordinary income instead of more favorable capital gains.
• If carry over basis remains law, which is unlikely,
  but hey, who knows, the IRS will define the phrase “sufficient information”
  which your executor will have to provide, in a broad, complex and difficult
  to comply with manner. But when they do, forgive them, for it was Congress
  that came up with this mess. The IRS will only be trying to implement
  it.
• Any other information that the IRS may require in
  regulations. Hey, if they are requiring all “sufficient” information in the
  preceding paragraph, what else might they want?

Once your executor makes the determinations above, he will
then have to report to your heirs the information necessary for them to
determine their tax basis, holding period,, etc. in the property. Specifically,
the new law will require that for decedent’s dying after 2009 the following
information will have to be provided to heirs:

• Name, address, telephone number of the person filing
  the return. This will generally, but not always, be your executor.
• All of the information required to be furnished to
  the IRS, as explained in the preceding section, for the assets bequeathed
  to the particular heir.

Your executor will have to provide this information to
each heir within 30 days of filing with the IRS. Perhaps the typical receipt
and release used for probate and estate administration will include an
acknowledgement of the data attached as an exhibit so that the executor has
proof of meeting these requirements.

To assure that your executor complies with these rules,
substantial penalties are provided for in the event that the reporting
requirements to the IRS and heirs are not met. The penalty is generally $10,000
for failing to furnish the required information to the IRS. However, for
failing to provide the IRS the information required concerning appreciated
assets which the decedent received as a gift within three years of death is
only $500. If an executor fails to provide beneficiaries with the information
required under the Code then the penalty is $50 for each failure.

Impact of Repeal on your Existing Estate Planning Documents

Your Will Could be Really Wrong

If your will leaves an amount to a trust or children based
on the amount that doesn’t create a federal estate tax (a common way to write
will language because of the many changes the law has taken over the years)
what happens if there is no estate tax? Your dispositive scheme may just go
haywire! You need to revise your will to contemplate a world without an estate
tax. Tax advisers never had this scenario in mind on their radar screen.

In some instances the manner in which assets are owned or
a will or trust is structured it might be feasible to correct the problem after
death through post-mortem planning. For example, it might be feasible for a
surviving spouse or children to disclaim assets they receive, even in trust,
and have those assets then pass to the beneficiary who was really intended to
receive them. If a will or revocable trusts establishes a trust for many
beneficiaries (called a “sprinkle” or “pot” trust). If some assets pass to
persons that were not intended but sufficient assets remain in a pot trust it
might be feasible with appropriately directed distributions from that trust to
equalize or offset unintended consequences created by the repeal of the estate
tax.

Unfortunately, in many situations the consequences of
estate tax repeal, possibly even if the estate tax is reinstated retroactively,
litigation may ensue. Many courts would adopt a construction that would
minimize taxes which has historically been significant, but if this impacts the
actual beneficiaries inheriting will they?

Word formulas that leave a specified calculated amount
based on tax law to a particular beneficiary or trust may no longer be
effective or worse may completely contradict the testator’s intent. These have
been used to fund bypass trusts, state bypass trusts, to divide bequests as
between bypass and QTIP, funding the marital or bypass, funding trusts for
grandchildren or other exempt persons, etc. The elimination of the estate and
GST tax can result in all or nothing passing to one of the intended recipients
of a formula clause.

Example of Bypass Funding

Your will was written when the estate tax exclusion was
$600,000 and bequeathed the largest amount that would not trigger a federal
estate tax to your children from a prior marriage. The balance, which was the
bulk of your estate, was to pass to your new spouse.

Sample Pre-2010 Will Clause Funding Federal Bypass

“I give, devise and bequeath the pecuniary sum which is
the largest dollar amount which will not create a federal estate tax on my
death, to the Trustee of my Applicable Exclusion Trust, in trust, (“Applicable
Exclusion Trust”) to be disposed of in accordance with the provision below
“Application of Applicable Exclusion Trust.”

Note that similar issues are raised by a martial (QTIP)
trust funding clause approach that states that “I give, devise and bequeath the
pecuniary sum which is necessary to avoid the creation of a federal estate tax
on my death, to the Trustee of my Qualified Terminable Interest Property Trust,
in trust, (“QTIP Trust”) to be disposed of in accordance with the provision
below “QTIP Trust.”

This common scenario raises a myriad of issues:

• How will the language in your will “the largest
  amount that will not trigger federal estate tax” be interpreted if there is
  no estate tax? Will the simplistic literal interpretation apply? If there
  is no federal estate tax than an infinite amount can pass free of estate
  tax.
• Does the application of the literal interpretation of
  the provision result in your entire estate pass to your children and
  nothing to your surviving spouse? Does it matter if that was clearly not
  the intent of the testator?
• Will courts recognize the intent at the time the will
  was drafted to pass a portion of the estate to the spouse and only a
  portion not all to the children? This would be a strained interpretation if
  the will had been in place for many years. As the federal estate tax
  exclusion has increased from $600,000 to $3.5 million everyone has had
  plenty of time and notice to revise their documents to readjust the amount
  passing to the children under a will similar to that above. So why on this
  final step of repeal would the courts recognize something different? At
  which point of the spectrum from $600,000 to $3.5 million to the entire
  estate was the testator’s “intent?” The counter argument is that if no
  change was made to the will language as the exclusion increased, that
  perhaps that was the intent. What if there were projections prepared by the
  estate or financial planner or CPA that reflected what would occur under
  the formula and those projections clearly illustrated that a limited dollar
  figure would pass to the children? If the presumption of the testator when
  the will was signed was that there would be an estate tax, how should that
  presumption be factored into the analysis?
• If Congress retroactively reinstates the estate tax
  to January 1, 2010 but you die before the reinstatement is passed what
  happens? Will a retroactive estate tax change survive a constitutional
  challenge? It is pretty likely that someone with substantial wealth will
  die between January 1, 2010 and the date Congress eventually reinstates the
  estate tax (if Congress in fact does so) whose heirs will have a tremendous
  incentive to challenge any reinstatement. But even if such a challenge was
  successful as to the estate tax what will the implications be for state law
  interpretations of the will as to how property will be distributed? Will a
  state court be bound to the new retroactive definition of the estate tax
  exclusion?

State Estate Tax Roulette

The state in which you are domiciled on death can make the
planning implications more obtuse to figure out. Variations in state estate tax
can result in a vastly different scenario. Consider the same sample will clause
illustrated above with a twist (additional phrase highlighted):

Sample Pre-2010 Alternative Will Clause Funding Bypass Trust

“I give, devise and bequeath the pecuniary sum which is
the largest dollar amount which will not create a federal or state estate tax
on my death, to the Trustee of my Applicable Exclusion Trust, in trust,
(“Applicable Exclusion Trust”) to be disposed of in accordance with the
provision below “Application of Applicable Exclusion Trust.”

Well, if you were domiciled in the Garden State (that’s
New Jersey for you non-Springsteen fans) if those magic words “or state estate
tax” appear in your will, New Jersey has only a $675,000 exclusion so the
initial dispositive scheme of more than a decade ago in the old will would
still be carried out.

If, however, you headed South to the sunny climes of the
land of Miami Vice where there is no state estate tax, then the issue is
identical to that of the federal exclusion amount. Since the federal estate tax
does not exist then your entire estate would arguably pass in Florida by the
above bequest. The remainder provision in your will would be academic. This
could result in your designated bypass trust heirs, perhaps children from a
prior marriage, receiving your entire estate and your surviving spouse nothing
(or vice versa depending on the structure of your will).

Two different states, two completely different
results.

Now the fun can really begin. Let’s play 2010’s estate tax
version of Where’s Waldo?

Example Bypass Funding and State Estate Tax Formula

You were domiciled in a high tax state, New Jersey.
Worried over the substantial estate tax you began filing income tax returns as
a Florida resident and used your Florida beach condominium as your address.
Since you know the best tax advice is obtained on the golf course, you heeded
the recommendations of your gold buddies and took out a library card in
Florida, registered to vote in Florida, and opened a bank account in Florida.
Following your death, the State of New Jersey audits your estate and
aggressively argues that you never severed your ties sufficiently to shift your
domicile from New Jersey to Florida. You still retained the bulk of your
financial contacts, investment accounts and accountant in New Jersey and a
large and primary home. Were you domiciled in New Jersey or in Florida on
death. This argument has heretofore taken the form of executor and heirs versus
the high tax state. But alas, in the Alice in Wonderland world of estate tax
repeal, the executor, or perhaps the beneficiaries, might actually encourage
the New Jersey Division of Taxation to pursue the domicile claim. How so?

Example Encouraging State Estate Tax Audit

The will contains the following clause: “”I give, devise
and bequeath the pecuniary sum which is the largest dollar amount which will
not create a federal or state estate tax on my death, to the Trustee of my
Applicable Exclusion Trust, in trust, (“Applicable Exclusion Trust”) to be
disposed of in accordance with the provision below “Application of Applicable
Exclusion Trust. The remainder of my estate shall be distributed out right and
free of trust to my surviving spouse.” The children from the first marriage are
the sole beneficiaries of the bypass trust. The recently wed 3^rd
spouse is the beneficiary of the remainder. The children might advocate for
Florida domicile so that the entire estate inures to their benefit. The new
spouse will advocate for New Jersey domicile so that the bulk of the estate
inures to his benefit. The executor will probably hire independent counsel and
pray not to be shot in the cross-fire. If Congress reinstates the estate tax
the children and new spouse may each continue their battles in separate state
courts.

More Issues For Existing Will Bypass Funding Clauses and State Estate
Tax

Alas, there are yet more issues, complications and
confusion relating to the interplay of federal estate tax repeal and state
estate taxes and the funding of bypass trusts. Consider the following:

• The calculus prior to 2010 for a testator living in a
  high estate tax state was whether it was worth funding a bypass trust for
  the difference between the state estate tax exclusion and the federal
  exclusion amount. Example: Decedent resided in a state with a $1 million
  exclusion. In 2009 depending on the age and health of the surviving spouse
  it might be advantageous to fully fund the bypass trust up to the larger
  federal exclusion of $3.5 Million even at the cost of incurring a state
  estate tax. The avoidable state estate tax on the incremental $2.5 million
  funding to a bypass trust for a New York domiciliary in 2009 would have
  been approximately $230,000. This might well have been worthwhile to avoid
  a later and more substantial federal estate tax. But if repeal is real then
  why incur any state estate tax on the first death if there cannot be a
  future greater federal estate tax savings. Wills and revocable living
  trusts containing maximum federal funding clauses need to be re-examined.
  As with the discussions above the impact on the dispositive scheme, not
  just the tax costs, must be evaluated.
• Under pre-2010 law clients might have funded a family
  trust in the form of a bypass trust that would benefit the surviving spouse
  and all children, with an independent trustee, perhaps an institution,
  having a sprinkle powe