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Wednesday, January 13, 2010

No Estate Tax in 2010 Could Mean Major Problem for Surviving Spouse

When the law was passed in 2001, almost no one believed that Congress would actually allow the Estate Tax to end in 2010, even for just one year.  When the Senate failed to act this past December, the unthinkable happened – the Estate Tax was repealed!  There is no Estate Tax for individuals dying in 2010!  You might think that is good news but you might be wrong!  The repeal of the Estate Tax may be a major problem for the surviving spouse and it could cost the beneficiaries of the estate significant tax dollars as well!  Here’s why.

Most affluent tax payers utilize some form of a trust in their estate plans to accomplish a multitude of important goals.  With the Estate Tax in the 45% range, avoiding the imposition of the Estate Tax has been one of the most significant goals for many taxpayers.  For the past several years, Congress allowed some amount of a decedant’s estate to pass to beneficiaries without the imposition of the Estate Tax.  Last year the amount that could pass free of Estate Tax was $3,500,000.  Now that there is no estate tax, why is that a problem?

Many taxpayers took advantage of an aspect of the former Estate Tax law by using what is called a “Bypass Trust”.  The way the Bypass Trust works is simple -  the decedant’s trust provides that upon death of the first to die (either the husband or the wife), a certain amount of the decedant’s assets pass to the Bypass Trust, usually to benefit the family of the decedent (children & grandchildren) with the balance of the decedant’s assets passing to the Marital Trust.  And THAT is the problem.  Can you see why?  Read on, this is where things get interesting!

The problem is that when the most recent version of the Estate Tax was passed (back in 2001 by President Bush) the amount of assets that a decedant could pass free of Estate Tax was changing each year (at first we were working with $675,000, then $1,000,000, eventually it got up to $3,500,000).  The way most estate planning attorneys dealt with that moving target was to utilize “formula language” to set the amount of assets that would flow to the Bypass and the Marital trusts.  And that is where the problem starts – “formula language.”

Most estate planning documents call for something along the lines of the following; “Take the maximum amount that can pass free of estate tax and use that to fund the Bypass Trust, then take the balance to fund the Marital Trust.”  Did you see it?  Did you see the problem?  If there is no Estate Tax, the decedant’s entire estate will go into the Bypass Trust and NOTHING will go into the Marital Trust.  If you are a spouse of someone with wealth, I’m sure you understand where this is going.  It gets better (or worse, depending on your perspective) read on.

Here is a simple example: suppose Husband & Wife have a combined net worth of $6,000,000.  Suppose they have the typical estate plan that utilizes a Bypass and a Marital trust.  Husband has $3,000,000 in his trust and Wife has $3,000,000 in her trust.  Suppose Husband predeceases Wife and in the unlucky year of 2010.  Wife may have just lost $3,000,000!  Here’s why.

Husband’s trust has $3,000,000 in assets.  Husband’s trust directs the Trustee to fund “…the maximum amount that can pass free of estate tax into the Bypass Trust…”  Since there is no estate tax, that’s ALL the trust assets.  Just about every trust agreement is different from the next, but it is safe to say that many trusts provide that the surviving spouse has little or no interest in the Bypass Trust.  Why?  Because back when there was an Estate Tax, the assets that flowed to the Bypass escaped Estate Tax.  In order to take maximum advantage of that fact, the estate plan tried to keep those assets from being taxed in the surviving spouse’s estate.  How do you accomplish that?  One way is to give the surviving spouse little or no interest in the Bypass Trust.  In 2010, that could mean DISASTER!

Now, just for fun, consider families with second marriage situations.  Can you imagine the surviving spouse asking the children of her husband from the first marriage to “share” some of the windfall they received due to the end of the Estate Tax.  Good luck with that!  But wait, it gets better (or worse)!  No more automatic stepped-up basis adjustment!

Under current law, there is no more “Stepped-up Basis”.  What is Stepped-up Basis, simply explained, prior to 2010, when a decedant left property to a beneficiary, the beneficiary received a basis in the inherited property equal to the value of the property at the time of the decedant’s death (I’m simplifying this concept – but essentially this is the rule).  So if you inherited $100,000 worth of IBM stock from your dad, then you sold it for $100,000 you didn’t have to pay any tax.  Under the current law, if you inherit that same $100,000 in IBM stock from your dad, and if your dad bought it 30 years ago for $10,000, you now have to pay a tax on the difference between your dad’s basis ($10,000) and the Fair Market Value at death ($100,000).  Therefore you have a $90,000 capital gain!  So much for “repeal of the taxes on assets passing from a decedant to a beneficiary.  What could be worse than that?  Keep reading.

Congress must have known that this would create huge taxes even on smaller or medium sized estates, so they put a provision in the 2010 Estate Tax Law that allows the executor of the estate to “adjust” the basis upwards to a full amount of $3,000,000.  So even if a beneficary inherited $4,000,000 with a basis of only $1,000,000, there would be no capital gain tax due.  Wow, that’s pretty generous of Congress!  Here’s the bad news, the $3,000,000 exemption amount is ONLY available to property passing to the Surviving Spouse of the decedant!  Again, problem is, under most “formula language” trusts, all the decedant’s assets are going to fund the Bypass Trust and assets in that trust DO NOT QUALIFY for the $3,000,000 stepped-up basis under the 2010 Estate Tax Law.

It is true that there is another way for the Executor to increase basis in property passing even under the Bypass Trust but that amount is limited to $1,300,000.  So any way you slice it, if your documents are not “fixed” you could end up with money being taken away from the spouse(despite the intention of the decedant prior to his death) and you will also end up giving away a $3,000,000 adjustment in basis.  Now for the only GOOD NEWS – these problems can be fixed!

But they can only be fixed if you have your estate planning documents reviewed by an attorney.  The documents can be amended under most circumstances, but TIME IS OF THE ESSENCE!!!  Call your estate planning attorney, set up a meeting and review your documents.  Otherwise, 2010 may be the worst year of all for clients with medium to large estates!

In accordance with Internal Revenue Service Circular 230, we advise you that unless otherwise expressly stated, any discussion of a federal tax issue in this communication or in any attachment is not intended to be used, and it cannot be used, for the purpose of avoiding federal tax penalties.


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