The estate tax is gone, but don’t celebrate yet

We are seven weeks into the new year and there is still no clear roadmap for the estate tax.  It’s probably not too early to think about what might happen in 2011 — a 55% estate tax with a $1 million exemption.

But what about 2010?  Should we all be celebrating the (at least temporary) demise of the estate tax?

Not so fast…

The estate tax hasn’t been removed, it has been replaced with another tax.  The new tax is the capital gains tax.

Thousands of estates will be impacted.  In fact, the chief tax counsel for the House Ways and Means Committee (the committee responsible for writing tax bills) estimates that an additional 65,400 estates will have to pay taxes in 2010 because of the elimination of the estate tax.

If that doesn’t make any sense, then let me explain the concepts of “basis” and “step up” and how they were affected by the change in laws on January 1.

If you buy an asset (for example: a house, shares of stock) and sell it later for a profit, you have to pay capital gains taxes on the profit.  The price that you paid for the asset is called the basis.

Sometimes the basis changes.  For someone dying last year, the basis of each of their assets would change (step up) to the value of the asset on the day that person passed away.

An example might make that more clear:

Appreciated Assets in 2009 (With An Estate Tax)

  • Steve buys 100 shares of Apple, Inc. stock for $5 in 1997.  His basis for each share is $5 (the total basis is $500).
  • Steve passes away in 2008.  At the time, the shares of Apple stock are valued at $100.
  • Steve’s trust leaves the shares to his daughter Kate.  Kate’s basis in the shares steps up (changes) to their value at Steve’s death — $100 (for a total basis of $10,000).
  • Kate sells the shares in 2010 for $200 each.
  • Kate has to pay capital gains taxes on a $10,000 gain (100 shares times the difference between the sale price of $200 and the basis of $100).

Here’s how that would have looked had Steve passed away under the laws as they currently stand for 2010:

Appreciated Assets in 2010 (With No Estate Tax)

  • Steve buys 100 shares of Apple, Inc. stock for $5 in 1997.  His basis for each share is $5 (the total basis is $500).
  • Steve passes away in 2010.  At the time, the shares of Apple stock are valued at $100.
  • Steve’s trust leaves the shares to his daughter Kate.  Kate’s basis in the shares does not change, but remains at $5 (for a total basis of $500).
  • Kate sells the shares in 2010 for $200 each.
  • Kate has to pay capital gains taxes on a $19,500 gain (100 shares times the difference between the sale price of $200 and the basis of $5).

Under the old estate tax system, a person could pass on assets worth $3.5 million (and for which the basis would be $3.5 million) without paying any federal taxes. Now, much smaller estates are exposed to taxes.

Congress hasn’t left us completely out in the cold, though.  In 2010 you can increase the basis of property you pass on by up to $1.3 million.  Again, let’s take a look at an example:

Using Your IRC § 1022 Basis Increase

  • An entrepreneur, Julie, starts a business with just $100,000 in seed money.
  • Julie’s business has grown to be worth $3 million when Julie passes away.
  • Julie trust leaves her business to her son, Mark.
  • Mark’s basis in the business, if he chooses to later sell his shares, can be increased to $1.4 million.  This would use the entire $1.3 million increase available to Julie.

The situation is even worse for couples.  Under the 2009 estate tax laws, all property left by the decedent to their spouse would get the setup up in basis.  Someone passing away in 2010 can only increase the basis of property left to a spouse by up to $3 million (in addition to the general basis increase of $1.3 million).

So who is at risk of additional taxes now that the estate tax is gone?  Many people could be swept up into these new taxes.  But two groups in particular should carefully consider their planning in light of the changes in the law in 2010:

  • Married couples or individuals with substantially appreciated assets or a closely-held business
  • Anyone with a net worth between about $1.5 million and $3.5 million that includes appreciated assets

If that sounds like you and your family — you’re not alone.  We could see a 1000% increase in the number of estates that owe taxes this year.  And then it’s all supposed to reset in 2011, with an estate tax at the antiquated limit of $1 million.

So this story is almost certainly not over.  Stay tuned!

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One Response to The estate tax is gone, but don’t celebrate yet

  1. Tom Merson March 1, 2010 at 1:51 pm #

    I appreciated the information in your Feb 19, 2010 blog. Can you direct me to the IRS regulation or interim rule that states the $1.3M general basis increase allowed for persons passing away in January, 2010? Also with regard to the stepped up valuation for listed stocks, is the closing price on the date of death the correct value or is there another preferred valuation method? I will not have to file a form 706 because the total estate is under $1.1 M.

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