How One Mistake Can Cost You Millions

Congress has created great confusion for people seeking to minimize the possible tax burden on their heirs for 2010 and beyond. As this year began, the federal estate tax simply vanished — no matter how big the estate — while a new capital gains tax on inherited stocks, property, businesses and collectibles suddenly applied to thousands of additional estates. And the rules are set to change drastically again in 2011.

That’s all the result of legislation enacted in 2001 that Congress was ­expected to revise last year but failed to do so.

All that could change if Congress passes new legislation this year, which Democrats vowed would happen in early 2010 and take effect retroactive to January 1, 2010.

You can do intelligent estate planning even amid such uncertainty and flux. Here’s how…


Here’s what I expect to happen (although you can’t tell for sure, given the heated political atmosphere) and how it could affect your planning…

The federal estate tax won’t really disappear. The government is running a huge budget deficit, and it’s doubtful that Congress will let a 94-year-old tax that provides about $25 billion in annual revenue skip a year. However, Democrats would have to fight Republicans who call it a “death tax” and would love to see it disappear permanently.

If any law enacted this year is retroactive to January 1, some heirs are likely to try to take advantage of the current “no-estate-tax gap” by challenging the retroactive law in court on constitutional and/or other grounds.

A new law enacted in 2010 would probably exempt up to $3.5 million in assets from estate tax. Above that amount, assets might be taxed at a rate as high as 45%. Those were the rules that in late 2009 the House (but not the Senate) voted to extend.

New rules that are currently set to go into effect in 2011 will not go into effect. Under those rules, $1 million would be exempt from estate tax and amounts above that would be taxed at 55%. Republicans likely will not allow the estate tax to become so costly to taxpayers, and Democrats likely would use the possibility that it could happen as a negotiating tool to try to resurrect some level of estate tax for 2010.

Rules currently imposing a capital gains tax on inherited assets in 2010 will likely not remain in effect. Under those rules, a tax of between 15% and 28% is imposed on inherited assets that have gained in value by a total of more than $1.3 million (or as much as $4.3 million if the heir is a spouse who is a US citizen). That gain is measured from the time that the person who dies acquired the assets until the time of his/her death, but the tax is paid ­after the heir sells the assets, on top of any additional tax on gains since the person died. Such measures have proved difficult to comply with and to monitor, and they would affect tens of thousands of estates this year.

Instead, expect the old rule, which is due to return in 2011, to be restored for 2010 as well. Under that old rule, the “cost basis” of inherited assets is “stepped up,” or reset, to its value at the time of death. That usually reduces the amount of tax an heir has to pay when selling those assets.


If you expect your estate to be worth less than $3.5 million, your estate probably will not owe federal estate tax under the legislation that Congress is likely to pass this year. Nevertheless, you should document the value of any estate assets regardless of the size of the estate. That means that you should record the values of stocks on the date that the person dies and get appraisals for assets such as a home soon after the person dies.

Caution: Some states have estate tax exemptions that are different from federal exemptions, while others follow federal estate tax rules. Examples: New York’s exemption is $1 million, and New Jersey’s is $675,000. In response to this year’s and next year’s changes, some states may adjust their rules. Check with your tax professional.

In case the estate tax is resurrected, here are wise steps to take if your estate would exceed $3.5 million in 2010…

Make gifts. In 2010, you and your spouse (if you have one) each can give away up to $13,000 worth of assets as gifts to any number of recipients without incurring any gift tax consequences.

Example: William Adams gives $13,000 to his son, $13,000 to his daughter, $13,000 apiece to the son’s spouse and the daughter’s spouse, and $13,000 to each of his four grandchildren. Thus, William can reduce his taxable estate by as much as $104,000 (eight times $13,000) this year, free of gift tax. If William is married, his wife can do the same amount of gifting, doubling the couple’s total to $208,000.

In addition, you can directly pay tuition and medical expenses.

Divide your assets. Assuming that the exemption is $3.5 million, a shrewd married couple may be able to double that exemption and eventually pass on up to $7 million to heirs, free of estate tax. However, that requires a tricky strategy.

Example: Bob Simmons owns $5 million in assets, and his wife, Edna, owns $2 million worth. For each spouse, that includes half of shared properties, such as a house. Because bequests from one spouse to another aren’t taxed (if the inheriting spouse is a US citizen), even if Bob dies first and leaves all of his $5 million to Edna through the estate, there will be no estate tax at that time.

However, that would leave Edna with a $7 million estate. If she dies with that much and the federal estate tax exemption is $3.5 million at that time, Edna’s estate would be $3.5 million over the ceiling and would owe $1.575 million in tax when she dies if the 45% rate is still in effect. Instead, if their marriage is strong, Bob could give $1.5 million to Edna outright before he dies and not leave her any additional assets when he dies. Then each spouse could pass $3.5 million to other heirs without generating estate tax.

Revisit your will. Many wills call for an amount equal to the estate tax exemption to go to heirs other than the spouse or to a trust for those beneficiaries. However, that procedure may leave the spouse short of what the spouse needs to live on, especially if the value of stocks and real estate has dropped sharply. For instance, if you die with, say, $4 million, and $3.5 million (the exemption amount) of that goes to your kids, the $500,000 may not be enough for your spouse to live on.

Instead, make sure that your will is drafted so that your spouse receives an adequate amount to live on, outright or in trust. This is especially important if your state has an estate tax exemption that is lower than whatever the federal exemption ends up being. You might want to reduce the amount that you leave to a nonspouse to no more than the state exemption level or lower.

If Congress Doesn’t Act

In case the rules don’t get revised this year…

Make sure that your will does not leave assets to anyone based on a formula that refers to whatever amount does not trigger the federal estate tax. If you do use that language and the estate tax is zero, courts may interpret that language to mean that you are leaving an unlimited amount to an heir other than your spouse.

Amend your will to specify how much of the $1.3 million capital gains tax break should be granted to each of your heirs if you have more than one heir other than your spouse. Otherwise, your executor will have to decide how to apportion that tax break.

Estate Tax Rules

Unless Congress changes the law as it stood on January 1, 2010, the estate tax will swing wildly over the next few years.

2009 Rules…

Estates are taxed at 45% on amounts greater than $3.5 million.

The value of assets is reset at the time of death. That new value serves as the cost basis for figuring capital gains when heirs eventually sell the assets and pay taxes on those gains.

2010 Rules…

Estates are not taxed.

The value of assets is based on prices at which they were acquired by the person who dies. That value then serves as the cost basis for figuring capital gains when heirs sell the assets and pay taxes (with an exclusion of $1.3 million or up to $4.3 million if the heir is a spouse who is a US citizen).

2011 Rules…

Estates are taxed at rates ranging from 41% on amounts greater than $1 million to 55% on amounts greater than $3 million.

2009 rules on capital gains return.

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