History Lesson on the Estate Tax

Dear Mr. Premack: I don’t understand what Congress has done with the estate tax. I’ve read that there are special rules that apply only in 2010, and that the tax is going to go up drastically in 2011. Why can’t this administration get its act together so that regular people know how to make plans for the future? – A.N.

(This column was posted in 2010. Search “estate tax” for newer columns that discuss more recent changes to estate tax law.)

The current estate tax law was passed by Congress in 2001 and signed into law by President Bush. At that time, they celebrated the “repeal” of the federal estate tax, which they had decided to phase-out over a nine year period. At that time, few people realized that the new law contained an expiration provision, essentially repealing itself at the end of ten years and leaving us with today’s mess.

Specifically, the 2001 law increased the exemption from estate tax from $675 thousand to $1 million in 2001 and up to $3.5 million in 2009. In 2010 the exemption is unlimited, meaning that the estate of anyone who dies in 2010 will pay no estate tax.

Though the estate tax does not exist in 2010, it is not repealed. The 2001 law states that on January 1, 2011 the old system will be reinstated. Under the old system, the exemption would have reached $1 million by 2011. This creates a huge dichotomy: if you have an estate of $5 million and die on December 31, 2010 the estate tax is $0, but if you die the next day the estate tax is about $2 million.

Shift to current events. On December 3, 2009 the US House of Representatives passed HR 4154. This bill (if it becomes law) would reinstated the $3.5 million exemption for years 2010, 2011 and beyond. The US Senate received the bill and referred it to committee. The Senate is also considering another bill (S 2784) to keep the $3.5 million exemption and to allow a surviving spouse to use any portion of the deceased spouse’s exemption that was not used at the first death. We may see action on these bills in the next few months.

The 2001 tax act also imposed a tax increase for 2010 that has not been covered widely in the media. Some history is needed to put this into perspective. Prior to 2010, an asset was given a “free step-up in basis” at the time its owner died. For example, assume you bought a share of stock many years ago and paid $10. Today the share is worth $30. If you sell the share you’ll owe capital gain tax on the profit of $20. However, if you still own the share when you die, its basis is increased to its value on the date of death. If the heir sells the share, she’ll only be taxed on gains after the date of death. So if that same share goes up in value to $40 one year after the date of death, when the heir sells it tax is due on the difference between $30 and $40 instead of the difference between $10 and $40. This step up in basis could cover any amount of assets.

Contrast that to the system that exists today under the 2001 law. If the heir is the surviving spouse, the step up in basis is limited to $3 million. Any other heirs (like the children) are limited to a step up in basis of $1.3 million.

What is the impact of the new limits? Assume a wealthy family has a portfolio valued at $5 million on the date husband dies, with a basis of $1 million. Wife needs to liquidate. She can step up the basis from $1 million to $4 million, and will owe capital gain tax on the $1 million remaining profit. The tax on that $1 million gain will be about $150,000.

Perhaps that would be considered fair by many taxpayers. But the point I want to make is that in 2009 that same family (with a proper legal estate plan) would have paid $0 in federal estate tax and $0 in capital gain tax. In 2010 that family pays $0 in federal estate tax and $150,000 in capital gain tax. Some families will pay higher taxes under the 2010 rules compared to their tax situation before “repeal” of the estate tax. This tax increase was contained in the 2001 tax act.

The tax increase is higher if the assets are left to the children after both parents have died. The children get a $1.3 million step up in basis, so if they must liquidate their parents’ $5 million portfolio, their basis can only be increased to $2.3 million. They owe capital gain tax on the remaining $2.7 million profit, about $405,000 which they would have saved if their parents died with a proper legal estate plan in 2009.

If Congress passes either HB 4154 or S 2784, these new capital gain taxes will be eliminated. But we don’t know if a law change will be retroactive to January 1 or will be only be applied from the date of passage forward. Congress should have solved this in 2009 to avoid sticky legal issues. Whatever your position on the estate tax exemption, contact your Senators now to voice your opinion on the pending bills.

Paul Premack is a Certified Elder Law Attorney and a Five Star Wealth Manager (Texas Monthly Magazine 2009-2013) practicing estate planning and probate law in San Antonio.

Original Publication: San Antonio Express News, January 29, 2010

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