As of January 1, 2010, the federal estate tax system is in a state of disarray. Under current law (passed in 2000), the estate tax exemptions increased gradually until 2009 at which time it was $3.5 million. If a person dies in 2010, there is no estate tax, but there is carryover basis instead of a basis step-up. On January 1, 2011, the estate tax returns with a 1.0 million exemption and a graduated tax rate schedule from 37% to 55%. There are several bills pending before Congress to make the federal estate tax applicable in 2010 as well (retroactive to January 1, 2010), but so far none of them have passed. So, here is how things currently stand:
1. If death occurred in 2009:
The estate tax is in effect with the following exemption and tax rate:
|Net Estate Above||But Not Above||Tax||Plus||Marginal Tax Rate||On Amount Above||Applicable Credit Against Tax|
Also, the basis of assets included in the decedent’s estate receive a basis step-up to the fair market value on the date of death.
Example. Suppose the decedent’s gross estate is $4,000,000 and there was $100,000 of liabilities and costs of settling his or her estate. The estate tax is computed as follows:
|Less Liabilities and Expenses:||- $ 100,000|
|Net Taxable Estate||$3,900,000|
|Tax Due on $3,900,00||$1,635,800||<—total tax liability|
|Less Applicable Credit:||- $1,455,800||<—tax on first $2.0 million of estate|
|Net Tax Payable||$ 180,000||<—tax on last $400,000 of estate at 45%|
2. If death occurs in 2010 and Congress does not reenact the estate tax retroactive to January 1, 2010:
There is no estate tax. However, there are two limited step-up-in-basis rules. The “Aggregate Basis Increase” is $1.3 million and may be applied to any of the assets in the decedent’s estate. The “Spousal Basis Increase” is $3.0 million and applies only to property passing to the decedent’s spouse. Assets in excess of these amounts will take a “carryover basis” (that is, the same basis that the decedent had). The effect of carryover basis is to cause the beneficiaries of the estate to recognize capital gains taxes when the assets are sold.
Example: Suppose the decedent is married and the estate consists of the following assets on the date of death and the decedent’s trust provides that an amount of assets with a basis equal to the Aggregate Basis Increase goes to Trust “B” and the balance of the estate goes to Trust “A” for the benefit of the decedent’s spouse:
|Identity of Asset||Value on Date of Death||Mortgage||Basis||Unrealized Gain|
|Real Estate||$3,100,000||0||$ 100,000||$3,000,000|
|Bonds||$ 400,000||n/a||$ 200,000||$ 200,000|
If the assets were sold on the day before death, there would be a taxable gain of $4.5 million, upon which income tax would be owed at capital gains rates.
Now as a result of the decedent’s death, suppose that the trustee allocates the Stocks to Trust “B” and the rest of the assets to Trust “A”. The results would be as follows:
|Identity of Asset||Value on Date of Death||Old Basis||Basis Increase||New Basis||Unrealized Gain||Trust Allocation|
|Real Estate||$3,100,000||$ 100,000||$3,000,000*||$3,100,000||$ 0.00||Trust “A”|
|Stocks||$2,500,000||$1,200,000||$1,300,000**||$2,500,000||$ 0.00||Trust “B”|
|Bonds||$ 400,000||$ 200,000||$ 0||$ 200,000||$200,000||Trust “A”|
* = Spousal Basis Increase
** = Aggregate Basis Increase
If the trustee of Trust “A” sells the Bonds the day after the date of death there will be a profit of $200,000 ($400,000 value minus $200,000 carryover basis) which will be subject to income taxes at capital gains rates.
3. If death occurs in 2011 and Congress does not change current law:
Returning to the previous example, there would be no estate tax on the decedent’s death computed as follows:
|Less Marital Deduction:||-$5,000,000||
<— assets allocated to Trust “A” meeting requirements for estate tax marital deduction
|Less Tax Exemption Amount||- $1,000,000
||<— Assets allocated to Trust "B"|
|Estate Tax Due||$ 0|
The basis of all of the assets would step up to fair market value on the date of death. So, if an asset were sold the day after the date of death, for example, there would be no taxable gain for income tax purposes.
When the surviving spouse dies, assuming no change in the value of the assets of the estate, the estate tax consequences are as follows:
<— Assets allocated to Trust “A”; Trust “B” assets are not taxable on survivor’s death
|Less Marital Deduction:||– ______ 0||<— No marital deduction because spouse predeceased|
Less Tax Exemption Amount:
Net Tax Payable
|Tax Rate:||50%||<— Approximate|
The basis of the assets in Trust “A” (but not the assets of Trust “B”) would step up to fair market value on the date of the survivor’s death.