On December 17, the President signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. This law prevented the increase in tax rates for all taxpayers, as well as create some new and interesting tax law changes for both individuals and businesses. This post will focus on the radical changes to the estate tax.
Notable changes to the estate tax include:
- A $5 million exemption ($10 million for spouses)
- The estate tax exemption would have been $1 million in 2011
- A 35% tax rate (down from 45% in 2009)
- The estate tax rate would have maxed out at 55% in 2011
- Estate tax exemption portability
- For 2010 the choice of either:
- being subject to the estate tax and receiving a step up in basis
- not being subject to the estate tax and following the carryover basis rules
A Very Brief History of the Estate Tax
Over the past ten years, Congress had phased the estate tax out of existence. In 2009, the estate tax exemption amount was $3.5 million dollars and the estate tax rate was 45%. In 2010, the estate tax was completely abolished; although the gift tax remained with an exemption of $1 million and a 35% tax rate. When the estate tax is in effect, assets receive a “step up” in basis in the hands of the inheritors. This means that the basis of assets equals the fair market value at the date of death, and the inheritors can then sell the assets tax free (if sold promptly after death).
Example: John bought stock for $20,000 in 1960. John died in 2009 while the value of the stock was $200,000. John’s son Tim inherits the stock. If there was no step up in basis, Tim would sell the stock for $200,000 and would have a gain of $180,000 ($200,000 sales price less $20,000 basis). Since John died while the estate tax was in effect, the stock gets a step up in basis to $200,000. Tim can now sell the stock for $200,000 without a gain ($200,000 sales price less $200,000 basis). Tim will have gain or loss if he sells the stock over or under $200,000.
In 2010, since there was no estate tax, there was no step up in basis. The basis of assets in the hands of the inheritors would be equal to the lesser of market value or the original cost (plus improvements) of the assets. However, even under the carryover basis rules, taxpayers could still step up the basis of assets up to $1.3 million (a surviving spouse could increase the basis of assets by an additional $3 million).
Higher Exemption Amounts and Lower Tax Rate
The current exemption amount is $5 million per taxpayer, and $10 million for a married couple. A flat tax rate of 35% applies to amounts over these exemptions.
Estate Tax Exemption Portability
This tax change is very substantial. But first, some background info: Each taxpayer has a $5 million exemption. Taxpayers can transfer assets at their deaths to their spouses free of estate tax. Under old law, transferring assets to a surviving spouse wasted the exemption of the first spouse to die.
Example: John and Tina are married. John has a $10 million estate. Tina is destitute. When John dies, Tina inherits all of John’s assets. There is no estate tax because the surviving spouse inherited all the assets. However, when Tina dies, her estate is $10 million. Her estate tax exemption is $5 million, which makes her estate subject to estate tax of $1,750,000 ($10 million estate less $5 million exemption = $5 million estate subject to a tax rate of 35%). Since John bequested all of his assets to his spouse, he never used his own estate tax exemption.
Exemption portability means that the surviving spouse can now utilize the unused estate tax exemption of her deceased spouse.
Example: Same as above, except now exemption portability applies. Tina can still use her own $5 million tax exemption. Under portability, she can now use her husband’s unused tax exemption of $5 million. Since her total exemption of $10 million equals her assets at her death, she will have no estate tax.
To use the exemption portability, the first spouse to die must elect to use portability on his/her estate tax return. An estate tax return must be filed by the first spouse to die to use portability even if the return is not otherwise required to be filed.
To Be (Subject to the Estate) or Not to Be (Subject to the Estate Tax)
For 2010 only, the choice is between:
- being subject to the estate tax and receiving a step up in basis
- not being subject to the estate tax and following the carryover basis rules (an election is required for this choice)
Why would someone want to be subject to the estate tax? For most people it won’t make sense to be subject to the estate tax. Even under the carryover basis rules, you can increase the basis of your assets up to $1.3 million (up to $3 million for spouses). Therefore as long as you want to step up the basis of your assets under $1.3 million or $3 million, it probably doesn’t make sense to be subject to the estate tax. Where it does make sense is if you want to step up the basis of your assets over these amounts and won’t be subject to the estate tax (or would be subject to very little estate tax).
Example: Jane has assets of $1.5 million. Her basis in her assets is $500,000. Since the potential step up in basis is the difference of $1 million between the market value and basis, and this amount is less than the maximum step up of $1.3 million, Jane can simply step up the basis of her assets by $1 million under the carry over basis rules.
Example 2: Jane has assets of $4.5 million and a basis in those assets of $1 million. Here, the potential step up is $3.5 million. Under the carryover basis rules, the most that Jane could step up the basis of her assets is $1.3 million. Under these circumstances it makes sense for Jane to be subject to the estate tax (which would be zero because her estate is under the exemption amount of $5 million), and receive a full step up in basis of $3.5 million.
If Jane has an estate over the exemption amount and would be subject to the estate tax, her advisor would have to do some number crunching to see if it is better to pay estate tax and receive a full basis step up, or avoid the estate tax and end up paying higher income taxes on gains from sales of assets that didn’t receive a basis step up.
Other items to take note:
- The gift tax exemption is increased to $5 million (up from $1 million) and gift tax is at a 35% rate
- The generation skipping tax (GST) exemption is $5 million.
- The GST tax rate in 2010 is 0%, then 35% in 2011 and 2012
- There are extensions of filing deadlines for those who died before the enactment of these tax law changes
Oh, and by the way, all these tax rules change on January 1, 2013.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.