We are now nearly 50 days into the new year and the failure of Congress to deal with estate taxes has moved from an oversight and embarrassment to a growing real-world problem. To recap: the estate tax was reduced over the past decade in a 2001 law that said estate taxes would disappear totally in 2010, and then return in 2011 in a very punitive form. Congress repeatedly said it would deal with the matter before the tax disappeared. Most people expected a new law making the 2009 treatment of estates permanent. This would have excluded the first $3.5 million of an estate from taxation ($7 million for a couple) and taxed the excess at 45 percent.
[See Best Affordable Places to Retire.] While the House did enact this change, the Senate did not. Sound familiar? So, today, we have no federal estate tax in this country. But we do have a related change that is causing havoc with people who are far from super rich. People who receive assets in an estate have been able to have the value of their bequests "stepped up" to the assets' market value when the estate-holder died. This increases the value of the assets for estate-tax purposes but avoids any current taxes on the appreciated value of the assets being transferred. It also helps minimize future taxes; when the recipient sells the assets, they pay capital gains only on the appreciation since their inheritance.
But as part of the end of the estate tax this year, this treatment of assets also was ended. Now, the value of the estate is subject to tax on the difference between its current market value and the value when it was originally obtained by the estate holder. And while there is no estate tax this year, there is a capital gains tax on these appreciated assets. It kicks in after the initial $1.3 million of an estate, with an additional exclusion of $3 million available for the surviving spouse of the estate holder. Now, that may seem like a lot of money, but it's not, particularly if the asset being valued is land (as in farm land) or a closely held business that has been in the family for a long time. Those assets may have very modest initial valuations, and their conveyance easily could trigger enough of a tax bite to force the sale of part or all of the asset that is inherited. This, of course, assumes the estate can even locate all the decades-old paperwork that would establish that initial valuation.
Even worse, it's just not clear whether estate executors, and their legal and financial advisers, should proceed as if the 2010 situation will remain in place. Congress has indicated it will enact a retroactive fix. So, which rules should you follow? If you pay the step-up taxes and they are later repealed, what would you as an executor say to the beneficiary? If you don't pay the taxes and it turns out Congress does not act in a timely fashion, are you on the hook for penalties? And what about the legally binding duties that executors have to act in the best interests of the heir? What if now is absolutely the right time to sell an inherited asset? If you don't make the sale because of uncertainty over estate taxes, are you exposed to legal action should the value of the asset decline? But if you make the sale, which you can't undo, and the rules do change, are you then also subject to legal action?
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Jack Nuckolls, national director of private client tax services at BDO Seidman, says this is no longer an academic question. Executors could be on the hook to pay funds from their own pocket to remedy poor decisions, he says. "If the government comes along and finds that an executor has failed to pay any tax obligation," he says, "the executor can be held personally liable."
Nuckolls and other estate experts have been flocking to estate tax seminars and continuing education programs so they can learn details of the 2010 estate laws. "I have to go learn these rules, and I think it's a total waste of time" because of the likelihood of Congressional action, he says. "In the meantime, people are really dying, and you have to do all these things."
A client in Oklahoma died in January, Nuckolls says, and had actually changed his will to anticipate the 2010 elimination of the estate tax. In many large estates, the traditional way of minimizing estate taxes has been to create a trust and place $3.5 million of assets -- the decedent's exclusion -- into that trust. That trust would not be taxed. The rest of the estate would go into a family trust and avoid taxation until the death of the surviving spouse. With no estate taxes, the Oklahoma person didn't need to shelter that initial $3.5 million because there is no estate tax. But in providing all his money in a single family trust, Nuckolls says, it looks like his estate will be exposed to higher Oklahoma state estate taxes than if the second trust had been established. Further, by not leaving anything to the spouse directly, this estate may not be able to qualify for the $3 million spousal exclusion on capital gains taxes. "It seems like we could be wasting $3 million," Nuckolls says.
Does your head hurt yet? Nuckolls' does. And there are other meaningful differences between the 2009 and 2010 rules, which may or may not go away, to be possibly replaced by new rules, which may be retroactive to the first of the year. Or, maybe not? All of which leads him to issue this lament to Congress:
"Why didn't you guys just take care of business?"