The Bush era tax cuts slowly phased out the federal estate tax and abolished it altogether for decedents dying in 2010, and replaced it with a rather complicated modified carryover basis regime. Just about everyone assumed Congress would reinstate the estate tax for 2010. As the year wore on, opinions began to change to where just about everyone predicted Congress would not reinstate the estate tax for 2010. Then out of the blue, mixed in with the GOP/Obama Administration compromise agreement tax provisions, was a proposal to retroactively reinstate the estate tax with a $5 million per person exemption and a tax rate of 35%.
Because the reinstatement occurred so late in the year, Congress is allowing a choice for 2010, providing the following two options:
1. Tax Option - Subject the estate to the estate tax provisions for 2010 and provide the beneficiaries with an inherited basis equal to the fair market value (FMV) of assets inherited from the decedent.
2. Modified Carryover Basis Option - Not pay the retroactive estate tax and instead utilize the modified carryover basis regime for determining the basis of inherited items.
For estates worth $5 million or less, the obvious choice would be the tax option of filing an estate tax return and taking advantage of the $5 million exemption, resulting in no tax and providing beneficiaries with an inherited basis of items equal to the items’ FMV at date of death. For larger estates, the question becomes more complex: pay the tax now and provide the beneficiaries with a FMV basis and perhaps a lesser tax in the future when the asset is sold, or avoid the tax now and possibly saddle the beneficiaries with a larger tax when they dispose of an asset in the future? These decisions will have to be made after considering the beneficiaries’ financial and tax circumstances, the intended use of the inherited property, and the makeup of the estate and the ability to pay the estate tax.
Another twist is a new provision that permits the executor of a deceased spouse’s estate to transfer any unused exemption to the surviving spouse, thus eliminating the need by most couples for complicated estate planning such as certain trust arrangements; this provision would take effect for decedents dying after 2010. But don’t get rid of that trust just yet! This extension is only through 2012, and based on prior performance, can we really trust Congress to develop a permanent solution to the estate tax by then? They had eight years to devise a permanent fix last go-around and waited until the 11th hour, only to come up with a two-year, temporary fix.
The $5 million per person exemption and top tax rate of 35% applies to estate, gift and generation skipping taxes through 2012, except the exemption amount will be inflation adjusted beginning in 2012, and the increase from $1 million to $5 million for the lifetime exemption for gifts applies for 2011 and 2012, but not 2010.
Modified Carryover Basis - The modified carryover basis essentially passes the decedent’s tax basis, with some adjustments, on to the beneficiaries so that the beneficiaries will be responsible for the tax on any appreciation over and above the decedent’s basis.
Example: A decedent owned 1,000 shares of Bank of America that were purchased for $2 a share and at the date of death were valued at $20 per share. Under the modified carryover basis regime the beneficiary’s basis would be $2 a share plus any allowable adjustment (discussed next) to that basis, not to exceed the FMV at date of death. Had the estate been taxed, the beneficiaries’ basis would have been $20 per share.
The allowable aggregate increases to basis (not to exceed the FMV at date of death) and allocated to specific inherited assets by the executor of the estate include:
- $1.3 million ($60,000 for a non-resident alien), plus
- The decedent’s unused capital loss carryovers, plus
- The sum of the decedent’s built-in losses (generally losses from the sale of the decedent’s investment or business property if it had been sold at FMV immediately before the decedent's death), plus
- The decedent’s unused net operating loss carryovers, and,
- If applicable, a spousal property basis increase of $3 million.
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