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2010 estate tax repeal, basis rules, and reporting requirements.

In the midst of Congress passing sweeping laws in support of unprecedented federal financial bailouts and approving major national healthcare reform. Congress surprisingly did not act to prevent this year's repeal of the federal estate tax and generation skipping transfer tax (GST). As a result, pursuant to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), these taxes have been repealed for decedents dying after December 31, 2009, and through December 31, 2010. While this interim repeal may sound tax free, it is trickier than its face value suggests due to the new related modified carryover basis rules under Internal Revenue Code section 1022. These new basis rules replace the historical stepped-up (or stepped-down) basis rules with carryover basis rules, as modified for certain permissible basis increase allocations. Also, as part of the repeal, there is no longer the need to file estate tax returns with the IRS; however, new reporting rules may require executors to file a new type of return under' revised IRC section 6018.

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Accountants have always been essential to proper estate, gifting, and tax planning; trust administration; and probate. Today's carryover basis rules and reporting requirements make the role of accountants all the more significant. This article focuses on: 1) the 2010 estate tax and GST repeal; 2) the new modified carryover basis rules; 3) the new reporting requirements and related penalties; 4) challenges for fiduciaries; and 5) live things accountants can do today to advise and assist their clients and colleagues during these uncertain times.

2010 Estate Tax and GST Repeal

The EGTRRA provided for a gradual phase-out of the estate tax and GST from 2001 through 2009, with a complete repeal of these taxes for decedents dying after December 31, 2009. Few practitioners expected that the repeal would actually take effect. Many felt certain that Congress would, before the end of 2009, pass a proposed law such as H.R. 4154, which, among other things, proposed permanent maximum estate tax and GST tax rates of 45% and applicable exemption amounts of $3.5 million (S7 million for married couples). While the House passed the bill on December 3, 2009, the Senate did not vote on it. Accordingly, just as President George W. Bush had pledged during his term, the nation entered 2010 without any so-called death taxes. During the first quarter of 2010, there were speculations, which continue today, that Congress would or still will enact legislation imposing an estate tax and GST and repealing the modified carryover basis rules retroactive to January 1, which raises some complicated constitutional law questions.

At the date of publication of this article, it appeared possible that new legislation will not be enacted for 2010. To make matters more confusing, if Congress does not act, then, due to a Senate parliamentary rule (Congressional Budget Act of 1974 section 313, informally referred to as the "Byrd Rule"), the laws repealing the estate tax and GST for 2010 will automatically sunset and the entire act will be repealed as of December 31, 2010. If this occurs, the law will revert back to the pre-EGTRRA law in effect in 2001, which, in essence, would constitute a repeal of the repeal. Thus, if Congress does not act, the 2011 law will include, among other things--

* an estate tax on estates with gross assets valued over $1 million;

* a GST on skip transfers in excess of $1 million, as indexed for inflation from 1997;

* a continued lifetime exemption from the gift tax of $1 million;

* top marginal estate tax, GST, and gift tax rates of 55%, with a 5% estate and gift tax surcharge on estates or gifts above $10 million;

* a stepped-up (or stepped-down) basis for inherited assets;

* the requirement to file an estate tax return for estates with gross assets in excess of $1 million; and

* the return of the state death tax credit allowed against the federal estate tax.

Of course, Congress may still enact retroactive law for 2010, enact new law for 2011-or, it may again do nothing.

New Modified Carryover Basis Rules

The EGTRRA repealed the prior stepped-up (or stepped-down) basis rules under IRC section 1014 and replaced them with the new modified carryover basis rules under IRC section 1022. Not only are these rules complicated; they effectively convert the previously imposed estate tax and GST to the decedent's estate into a potential future income tax to the decedent's beneficiaries or heirs. The magnitude of the result of this new law will be based upon how many deaths occur in 2010 and the adjusted basis of those decedents' estates. Conceivably though, the potential future income tax could have an unfortunate negative effect for families whose wealth would otherwise not have been subject to an estate tax.

Under prior IRC section 1014, the basis of certain property in the hands of a beneficiary or heir was stepped-up (or stepped-down) to the fair market value of the property as of the date of the decedent's death, and the passing holding period was considered to be long-term. Thus, any appreciation of a property's value during the decedent's lifetime would have escaped income taxation permanently. To illustrate, for a decedent who had died during 2009 owning appreciated property valued as of the decedent's date of death at $2.5 million with an adjusted basis of $200,000, such property would have passed to the decedent's beneficiary or heir with a stepped-up basis of $2.5 million. Provided that the decedent's total gross assets did not exceed $3.5 million, the estate would not have been subject to an estate tax. If the property was thereafter sold by the decedent's beneficiary or heir for the lair market value of $2.5 million, there would not have been any taxable income as a result of such sale.

Now, under IRC section 1022, for decedents dying after December 31, 2009, the property is treated as if acquired by gift and the basis in the hand of the decedent's beneficiary or heir is the lesser of: tire decedent's adjusted basis or the fair market value of the property at the date of the decedent's death. The holding period is also no longer automatically considered to be long-term. Accordingly, for a decedent who dies during 2010 owning appreciated property valued as of the decedent's date of death at $2.5 million with an adjusted basis of $200,000, such property will pass to the decedent's beneficiary or heir with a carryover basis of $200,000. There would not be any estate tax or GST to the decedent's estate, regardless of the value of the decedent's gross assets. However, if the property is thereafter sold by the decedent's beneficiary or heir at the fair market value of $2.5 million, such sale could result in taxable income of $2.3 million; at a capital tax rate of 15%, this would result in a capital gain tax of $345,000 to the beneficiary or heir. In some instances, especially for smaller estates or if higher capital gain tax rates are applicable, the 2010 rules could result in a greater income tax to the beneficiary or heir than the estate tax to the decedent's estate would have been under the prior estate tax regime.

To provide some relief, there are two basis increase rules that modify the general carryover basis rule. However, while providing relief, they also add confusion. The first basis increase rule, commonly referred to as the general basis increase, permits the carryover basis amount of certain assets to be increased by a total of $1.3 million. This basis increase may be allocated by the executor to any property the that the executor chooses and may even be allocated to a portion of the property held by the decedent. For instance, the rules permit the executor to allocate some of this basis increase to 1 out of 10 shares of the same stock that was held by the decedent. Using the prior example, if the property is distributed to anyone other than the surviving spouse, the executor could increase the $200,000 adjusted basis of the property by $1.3 million, for a resulting increased basis of $1.5 million. If the beneficiary or heir then sold the property at the fair market value of $2.5 million, such sale could constitute taxable income of $1 million to the beneficiary or heir which, at a capital tax rate of 15%, would result in a capital gain tax of $150,000.

The second basis increase rule, commonly referred to as the spousal basis increase, permits the carryover basis amount to be further increased by an additional $3 million for property passing to the decedent's spouse. This basis increase applies to qualified spousal property that is defined as either outright transfer property or as qualified terminable interest property. (Note that qualified spousal property does not encompass a life estate or other terminable interests granted to a surviving spouse or property left to a surviving spouse in a power-of-appointment trust or irrevocable grantor trusts.) For a surviving spouse who acquires property with a fair market value of $2.5 million and an adjusted basis of $200,000, the executor could elect to increase the basis by $1.3 million (general basis increase) plus an additional $1 million (of the $3 million available spousal basis increase), for a resulting increased adjusted basis of $2.5 million. If the surviving spouse then sold the property at the fair market value of $2.5 million, there would not be any taxable income on such sale.

There are several other related basis rules:

* The adjusted basis may be further increased by the certain losses.

* For decedents who are not citizens of the United States at the time of death, the general basis increase is reduced from $1.3 million to $60,000; and the property, spousal basis increase, and adjustments for losses are unavailable.

* In community property states, the surviving spouse's one-half share of community property is treated as owned by the decedent for purposes of the basis allocation rules.

* The two basis increase rules do not apply to: 1) any property acquired by the decedent by gift or inter vivos transfer for less than adequate and full consideration within three years of the decedent's death, unless such property was gifted, or so transferred, by the decedent's spouse; 2) any property that constitutes a right to receive an item of income in respect of a decedent under IRC section 691; or 3) the stock or securities of certain foreign entities.

* Liabilities in excess of the basis of property are disregarded in determining the adjusted basis of such property and whether gain is recognized on the acquisition of subject property.

New Reporting Requirements and Related Penalties

Prior law required the estate to file an estate tax return, Form 706, with the IRS if the gross assets of the decedent's estate exceeded the then-applicable exclusion amount ($3.5 million in 2009). As of January 1, 2010, the law requires the executor to file a return with the IRS providing information on each property (other than cash and cash equivalents) owned by, and acquired from, a decedent when the aggregate fair market value of the assets distributed to the decedent's beneficiaries or heirs exceeds the statutory general basis increase amount ($1.3 million for citizens and $60,000 for foreign citizens without regard to built-in losses and loss carryovers). Additionally, a similar return is also required to be filed with the IRS for any property acquired by the decedent, other than from a spouse, within three years of the decedent's death if such transfer was required to be reported on a gift tax return.

This return is required to be filed with the income tax return for the decedent's last tax year which, generally, is due on April 15 of the year following the year of death. Absent any extension, this could result in a very short to impossible time frame to file such return. The return must contain the following information:

* The name and tax identification number of the recipient of the property;

* An accurate description of such property;

* The adjusted basis of such property in the hands of the decedent and its fair market value at the time of death;

* The decedent's holding period for such property;

* Sufficient information to determine whether any gain on the sale of the property would be treated as ordinary income;

* The amount of any basis increase allocated to the property; and

* Any other information prescribed by the secretary.

The executor must also furnish such information in writing to each beneficiary within 30 days of filing such return with the IRS.

Significant penalties may be imposed for failure to timely file. Any person who is required to timely file, but fails to do so when the decedent's basis in the noncash or cash equivalent property exceeds the applicable general basis increase amount, may be subject to a penalty of $10,000. Also, any person who is required to file, but fails to do so when the decedent had acquired property by gift within three years of the decedent's death from someone other than decedent's spouse, may be subject to a penalty of $500. Furthermore, any person who is required to provide beneficiaries with the written informational statement, but fails to do so, may be subject to a $50 penalty for each such failure. Such penalties will not be imposed if it is shown that any such failure is due to reasonable cause. Conversely, if such failure is determined to be due to intentional disregard, a penalty equal to 5% of the fair market value of the decedent's property may be assessed.

Just as the new basis rules could have negative income tax results for families that would not have otherwise been subject to an estate tax, the new reporting rules also may require reporting by some families that would not have previously been required to file an estate tax return. Studies estimate that 5,000 estate tax returns were, or will be, required to be filed for deaths occurring in 2009; whereas, now 60,000 up to 100,000 returns are estimated to be required to be filed under the new reporting regime.

Challenges for Fiduciaries

Funding formulas. Many trusts or wills may have funding clauses that were drafted in contemplation of an estate tax and GST. For 50 years, trusts have used funding provisions based upon certain mathematical formulas that distribute a portion of the decedent's estate to the decedent's bypass trust to be distributed to the decedent's selected beneficiaries upon the second death, with the remaining portion to be distributed to the surviving spouse's martial trust. Common formulas pass the decedent's estate to the bypass trust in an amount equal to the applicable estate tax exemption amount, or in an amount that will generate the largest taxable estate for estate tax purposes without the estate paying any federal estate tax ($3.5 million for 2009), with the remaining portion of the estate to be distributed to the surviving spouse's marital trust. Without an estate tax, such a funding formula essentially instructs the trustee to fund the bypass trust with all of decedent's property. During this estate tax repeal phase, such a formula could result in an unintended disinheritance or a significant reduction in the distribution to the surviving spouse. To avoid this result, nine states have enacted laws to construe trust formula funding clauses and GST provisions to be administered as if the 2009 estate tax were still in effect.

Adjusted basis information. It may be difficult for some individuals to compile the required information to determine the adjusted basis of some or all of their assets. Under prior law, the basis of property transferred to a beneficiary or heir could be based upon an appraisal issued as of the decedent's death. A current appraisal will no longer be useful to determine the adjusted basis of transferred property. Without such information, executors will have difficulty ascertaining which assets to allocate the basis increases and whether a return is required to be filed with the IRS.

Trust administration and probate. In addition to the difficulty of administering or probating the estate, fiduciaries now have the responsibility to allocate the available basis increases. It may be difficult for fiduciaries to fulfill their fiduciary duty to treat beneficiaries fairly and equally in the absence of basis increase allocation instructions. Basis allocation challenges further arise for fiduciaries in light of possible retroactive legislation.

Reporting. The return, if required, must be filed by April 15 after the decedent's death if the aggregate basis of the assets passing to the decedent's beneficiaries or heirs exceeds $1.3 million; however, the IRS has not yet issued the required form. Even when the IRS publishes a new form, it may be difficult for executors to determine whether a return needs to be filed, and if so, how to accurately complete it on their own.

These new rules impose burdens on fiduciaries, who are required to carry out a decedent's wishes that were created under prior law but will be carried out under current law. These challenges create the need for the expertise of accountants to determine the adjusted basis of property, allocate the basis increase allocations, and administer or probate the estate in compliance with current law.

Five Things Accountants Can Do Today

Inform clients and colleagues. Accountants can inform their clients of the status of the current estate tax, GST, and gift tax, and the potential upcoming legislative changes. There are many misperceptions that the general public has about the estate tax repeal, and many people may not be aware of the related new basis rules and reporting requirements. CPAs should encourage clients to have their trusts reviewed by an attorney. An attorney may consider, based upon the clients' asset portfolio and goals, amending the formulas to be more flexible in contemplating both an estate tax repeal and an estate tax. Disclaimer trusts or other wait-and-see provisions may be appropriate, and even required, for individuals to achieve their desired distributions. In addition, some may want to consider adding basis increase allocation instructions or guidance for the trustee. Furthermore, advisors should inform colleagues to help them to inform their clients, as well as create better teamwork among clients' professionals in order to develop complete plans.

Determine adjusted basis. Consider reviewing clients' asset portfolios, especially those with assets that have been held for years or have experienced several basis adjustment events, and help clients determine the current adjusted basis of each asset. If there is missing information, encourage clients to track down the information. The adjusted basis information will be essential for individuals to do proper planning. Such information is also crucial for beneficiaries or heirs. Basis information is also necessary for a fiduciary to perform proper trust administration.

Plan ahead. Once the adjusted basis of each asset is determined, consider analyzing clients' asset portfolios and discussing their goals to determine if any gifting or selling would be appropriate, especially if a client is elderly or ill. For example, it may be appropriate for a client holding an asset with an adjusted basis significantly higher than the fair market value to sell the property and offset other income with the loss because the beneficiary or heir will take an adjusted basis that is the lesser of the decedent's adjusted basis or the fair market value of the property. Thus, the beneficiary or heir will not be able to sell the depreciated property at a loss. There may be other instances where gifting may be appropriate to consider now that the gift tax rate is imposed at a low 35%. Identifying these issues and helping the client plan accordingly with the client's attorney could result in significant tax savings for a family. Further, consider if some GST planning for some clients is appropriate.

Know the reporting requirements. Inform executors and fiduciaries of the new reporting requirements, which require that the form be filed by April 15 of the year following the year of death. As before, the final income tax return. Form 1040, for the decedent must also be filed by April 15 of the year following the year of death, and any fiduciary income tax return, Form 1041, for the estate during administration also needs to be timely filed. Visit the IRS website for any updates on the issuance of the form of the required report.

Remain informed on new developments. While the estate tax and GST are repealed as of today, the future of these taxes remains unsettled. If Congress does not act, the pre-act laws will come back into effect on January 1, 2011. Follow any pending bills and the actions of certain professional groups. The AICPA has been actively involved in urging Congress to make a number of reforms through written requests submitted to the House Committee on Ways and Means and me Senate Finance Committee, including: 1) maintain the 2009 estate tax and GST exemptions amounts; 2) retain the 2009 step-up (or step-down) to fair market value basis rules; and 3) reinstate the full state estate tax credit.

Many observers were surprised when Congress did not act before the estate tax and GST repeal became effective. For a period before the repeal became certain, many planners were taking a wait-and-see approach due to the uncertainty. Some are still taking this approach, waiting to see whether Congress will enact legislation retroactive to January 1, 2010, or to take effect before the act's 2011 repeal of the repeal. However, the current repeal and basis rules means that adjusted basis information and tax analysis may be pivotal for planning, as well as for administration or probate. With such importance, accountants can be an integral, and even necessary, part of their clients' estate, generation skipping transfer, and gift planning. In addition, accountants' advice will likely be necessary to assist fiduciaries in fulfilling their duties. The lack of congressional action to reinstate the estate tax and GST and prior stepped-up (or stepped-down) basis rules has created confusion and complexity for many professionals and their clients. However, not taking a proactive approach can leave clients in situations that may result in unintended consequences, poor planning, and fiduciary blunders.

Kristin Yokomoto, JD, LLM, MBA, is an estate and business planning attorney with Balanced Legal Planning, APLC, in Newport Beach, Calif.
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Title Annotation:estate planning
Author:Yokomoto, Kristin L.
Publication:The CPA Journal
Date:Dec 1, 2010
Words:3734
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