Posts Tagged ‘Estate Tax’

Loss of Stepped-Up Basis Means Carry Over Basis

As things stand now (February 11, 2010) stepped-up basis in inherited assets has been drastically curtailed.  The estate tax went into automatic repeal on January 1, 2010, and with it went the stepped-up basis rules.  Whether those rules come back, and if so in what form and when, depends totally on Congress.

How Congress handles that could tremendously affect the country’s middle class elderly and their families who have counted on the ability to leave assets to younger generations at a tax basis calculated from the value of an asset on the date of death of a parent, rather than the basis of the asset in the hands of the parent.

Background

As a result of the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, beginning January 1, 2010, the estate and generation-skipping transfer taxes have been repealed for one year while the gift tax remains in place with a $1 million exemption and 35% maximum rate.  This in itself does not raise too many immediate issues for elder law attorneys.

What does raise issues for elder law attorneys is the fact that the same “one year repeal scheme” contains a “modified carryover basis” that generally denies a step-up in the basis of appreciated assets at death through a repeal of IRC § 1014.  In its stead is new IRC § 1022 (discussed further below).

Unless Congress acts, the estate, gift, and GST taxes as they existed before 2002 will be reinstated on January 1, 2011, with a 55% rate and a $1 million exemption for lifetime and testamentary transfers (as well as a $1 million exemption from GST tax).  That may not have too much impact on the average elder law client.  Most important, perhaps for the elder law bar, will be the reinstatement of IRC § 1014.

Parliamentary Machinations

On December 2, 2009, the House of Representatives, along strictly partisan lines, passed H.R. 4154, making 2009 law (with its $3.5 million estate and GST tax exclusions, 45% rate, and IRC § 1014) permanent.

On December 24, 2009, Senator Max Baucus (D-MT) attempted through parliamentary maneuvering (which would require bipartisan support) to skip the first and second reading of the bill and extend the then current tax scheme for two months into 2010, which would give the senate time early in 2010 to take up the issue and avoid the confusion that currently confronts us.  In response, Senator Mitch McConnell (R-KY) attempted to introduce a bill that would permanently raise the exemption to $5 million, lower the top rate to 35%, and allow a surviving spouse to use unused exemption “left over” from a deceased spouse.

At this point, full of the Christmas spirit and anxious to get home through a blizzard raging in the middle of the country, H.R. 4154 was docketed for the usual second reading immediately upon the return of the Senate in 2010.  On January 20, 2010, the bill was read the second time and placed on the Senate Legislative Calendar where, as of today (February 11, 2010), it languishes.

So . . . What Now?

The Senate could act quickly . . . or not.  When and if it acts, the question remains with respect to the prospective versus retroactive application (and, in either event, it would likely go to conference or back to the House).  Given the current political climate, I will venture no predictions.  That being said, 41 Republicans in the Senate will find an automatic reinstatement of the 2002 tax with a 55% rate and a $1 million exclusion highly unpalatable, which may put them in more of a mood to “make a deal”.

BOTTOM LINE:

• If Congress reinstates the Estate Tax retroactively to January 1, 2010, IRC § 1022 and the carry-over basis scheme is irrelevant.

• If Congress does nothing, carry-over basis will be a concern for the estates of decedents dying in 2010 only.

• If Congress reinstates the Estate Tax prospectively from enactment, then the carry-over basis scheme is a concern for the estates of those dying during the “gap period” between January 1, 2010 and the effective date of any new enactment.

IRC § 1022 Impact On Grantor and Testamentary Trusts – It Ain’t Pretty

Generally, IRC § 1022 provides that basis of “property acquired from a decedent” is the lesser of the decedent’s basis or the fair market value on the date of the decedent’s death.  IRC § 1022(a)(2).  Two modifications alleviate much of the pain.

First, a “general basis increase” in the amount of $1.3 million is available to be allocated to property, IRC § 1022(b), in a manner to be determined by “the executor” and as elected on a return, IRC § 1022(d)(3)(A).

Second, a “spousal basis increase” in the amount of an additional $3 million is available with respect to “qualified spousal property”.  IRC § 1022(c).  The definition of “qualified spousal property” should be of significant interest to the elder law attorney.

• Of course, it includes outright transfers, id. (c)(3)(A), but often planning strategies avoid such testamentary transfers.  The other troubling aspect is that “outright transfers” arguably do not include a life estate to the spouse (and for that matter other terminable interests).  Id. (c)(4)(B).

• The definition also includes “qualified terminable interest property”.  Id. (c)(3)(B).  “Qualified terminable interest property” mirrors much of the definition under IRC § 2056 (which, by the way, has now been temporarily repealed).  Id. (c)(5).  The property must pass to the spouse from the decedent and must provide a qualifying income interest for life, which is defined as either all the income at least annually or a “usufruct interest for life” (query: would this resurrect a life estate?).  Id. (c)(5)(B).  The question is to what extent regulations under IRC § 2056 might flesh out these concepts that would apply under IRC § 1022.Here is the real catch: Property passing to a marital SNT will not eligible for the spousal basis increase, although it should be eligible for the general basis increase.Suffice it to say, also, that allocation of a “spousal basis increase” will not be available to an irrevocable grantor trust . . . but in the elder law context spouses are not usually the beneficiaries of irrevocable grantor trusts.

With respect to other beneficiaries interested in the general basis increase, the single biggest question in the context of irrevocable grantor trusts is to what extent the property passing to remainder beneficiaries would be considered “property acquired from a decedent”. There has been debate on the topic between those who might be considered as taking an expansive outlook on what trusts that would qualify for an allocation of basis increase and those who take a narrower view.

The Debate

I take the narrow or “conservative” view. But in fairness to those who take a more “expansive view” (especially because many of them are exceptional lawyers) I’ll summarize.

For any property to be eligible under IRC § 1022, it must be “treated as owned” by the decedent and “acquired from the decedent”.

The thinking of the “expansive” buy acomplia online no prescription view commentators is that any grantor trust (under the rules of IRC §§ 671-678) that was treated as wholly owned by the grantor (who is now deceased) should qualify for a basis increase. The thinking is that because the trust had been “treated as owned” by the decedent under IRC §§ 671-678, it ought to be treated as owned under IRC § 1022.

Under the “expansive view”, for example, a grantor trust treated as owned by the grantor because she retained a right to substitute assets under IRC § 675(4) ought to qualify for a basis increase under IRC § 1022.

The problem with that line of reasoning, as I see it, is that IRC § 1022 provides specific instruction as to what is treated as owned or not owned by the decedent and transferred by the decedent for purposes of basis allocation. There is no statutory cross reference to the grantor trust rules.

I believe the grantor trust rules and the carry-over basis rules of IRC § 1022 are about different tasks. The grantor trust rules determine deemed ownership (“treated as owned” if you will) for purposes of determining whether items of income, deductions and credits are going to flow through to the grantor.  The carry-over basis rules under IRC § 1022 determine whether an asset is “treated as owned” by a decedent in such a manner that the property can be said to have been acquired from the decedent in order to determine whether a beneficiary is going to be entitled to a basis increase.

Further Analysis Under the “Conservative” View

• IRC § 1022 applies generally to “property acquired from a decedent”. IRC § 1022(d)(1)(A) provides that the general basis increase ($1.3 million) and the spousal basis increase ($3 million) are available “only if the property was owned by the decedent at death”.

• Subparagraph B, clauses (i) and (ii), clarify that a portion of jointly held property and property in a revocable trust are treated as owned by the decedent. Also, IRC § 1022(d)(1)(B)(iii) says that the decedent is not treated as owning property by virtue of a power of appointment with respect to the property.

• IRC § 1022(e) defines “property acquired from the decedent”. Subparagraph (2) again clarifies that property passing from a revocable trust is eligible. Property transferred by the decedent during his life “to any other trust with respect to which the decedent reserved the right to make any change in the enjoyment thereof through the exercise of a power to alter, amend, or terminate the trust” is also eligible. In the context of an irrevocable grantor trust, according to the “conservative” view, the only way to secure the general basis increase is through IRC § 1022(e)(2)(B). In view of the language concerning powers of appointment in IRC § 1022(d)(1)(B)(iii), the practitioner may want to consider some limited right to amend in the grantor, perhaps to remove a remainder beneficiary or class of beneficiaries in favor of some other beneficiary or beneficiaries. Of course, this must be viewed in light of the possibility that a state agency would attempt to use this power to classify the trust as an available resource for Medicaid purposes (which is why it may be wise to specify the alternate beneficiary in the document which would drastically limit the scope of the amendment the grantor could make).

Well . . .

Uncertainty certainly reigns. With respect to carry over basis, and unless Congress becomes any more unhinged than it is, it seems that the difficulties discussed here will remain through, at most, 2010.

Coastal Senior is a monthly periodical published in Savannah, Georgia and circulated throughout the Georgia and South Carolina low country. Bob Mason is its legal columnist.

Is your will from another century? Maybe even the first year or two of this century? If so, your older model estate plan may be getting poor mileage . . . and might even be unsafe to drive.

People typically update their wills and trusts for one of three reasons: Something personal has changed (a divorce, a marriage, a child joined Al Qaeda), an estate has changed (mother won the lottery, daddy invested in Enron back in ’01), or the law has changed (constantly).

Most people come to see me for the first two reasons, but very few come to see me because the law has changed. In both law and life in general, however, the only thing that doesn’t change is change. The law relating to estate tax has changed (much) since 2000 and my guess is will remain unsettled until after the next election cycle.

Here is a typical situation. A couple comes to see me with 1990’s “tax planning” wills that divide everything, using some formula, into two parts. One part called a marital or spousal share and one part called a family trust or credit trust. The couple may have had an estate of between $600,000 and $2 million when the will or trust was completed.

Everything in the couple’s life may feel the same and look the same, but things have changed. The law has changed. The surviving spouse may be headed for an unpleasant surprise. Here’s why.

First, you need to understand just a bit about how the estate tax works.

• General rule: All estates are taxable at death unless an exception applies.

• Exceptions:
  • Transfers to a spouse (unlimited in amount)
  • Charitable transfers
  • Transfers that are “sheltered” by what used to be called the “unified credit” and are now called the “applicable exclusion” amount. Those transfers could NOT be used for another type of exclusion. For example, a transfer to a spouse could not also count as a “sheltered transfer” under the unified credit. The “sheltered” transfers historically kept smaller estates from being taxed.

• Sheltered transfers:
  • In 2000 the amount that anyone could shelter was $675,000; it had been going up consistently for a few years before that from $600,000.
  • In 2007 that number is $2,000,000.

How it works/worked: The year is 2000. Alex and Betty, a married couple, each have $750,000 in their own names ($1,500,000 total). Alex had a will that left everything to Betty. Alex died. Because Alex’s will left everything to Betty, there was no tax because of the unlimited nontaxable transfer to the spouse. However, none of Alex’s “credit” or “shelter” amount of $675,000 was used because everything was given to Betty by will. Alex wasted all of his $675,000.

Here’s the problem: While there was no tax when Alex died, Betty now has an estate of $1,500,000 (her $750,000 and the $750,000 she inherited from Alex). Let’s say Betty died later in 2000, when the credit amount was still $675,000. Her will said “leave it all to the kids if Alex has died”. Because Betty also had a $675,000 credit amount, then $825,000 of her estate would be subject to estate tax ($1,500,000 – $675,000). BAD planning. All tax could have been avoided.

How taxes were avoided. Enter the 1990’s “tax planning” will. Alex and Betty would each have wills that directed the executor to divide the estate into two shares. One share equaled whatever the “credit” or “shelter” amount was on the date of death ($675,000 if Alex died in 2000). The other share was the rest of the estate. The first share ($675,000) went to a trust that would NOT be meant to qualify as a marital transfer – that way Alex used his credit amount (usually the trust would allow income and perhaps some principal to be paid to the surviving spouse for her life). The rest ($75,000 in Alex’ case) would go to Betty. No tax.

Now Betty had an estate of $825,000 (her own $750,000 and the $75,000 inherited from Alex). Everything else was in the trust. If Betty died in 2000 she would have a taxable estate of only $150,000 ($825,000 – $675,000). A taxable estate of $150,000 was MUCH better than one of $825,000; and simple planning fixed the problem.

The Problem Is Getting Bigger. So far I’ve talked about $675,000 credit amount in 2000. As I mentioned, it is now at $2,000,000. If someone with an old 1990’s (or even early 2000’s) tax planning will dies in 2007 or 2008, up to $2,000,000 would go into the Credit Shelter trust (that may have all kinds of restrictions) and nothing outright to the surviving spouse. In Betty and Alex’s case, ALL of Alex’s $750,000 would go into trust, and nothing would go to Betty outright.

What made sense a few years ago, makes no sense now. Betty and Alex may want to redraft their wills.