A Bizarre Year for the Estate Tax Will Require Extra Planning
DEATH and taxes, the adage goes, are the only certainties in life. But when it comes to the combination of the two, the estate tax, there is only uncertainty for 2010.
Most tax advisers thought that Congress would extend the estate tax before it was due to expire at the end of last year. But while the House did act, the Senate did not. So what few predicted would happen did happen: the tax is gone for one year but set to be revived in 2011 at a higher rate and a lower exemption, unless Congress acts. It’s the first time since 1916 that rich Americans can contemplate dying without one last tax.
While many ghoulish jokes have been made about hastening the demise of an old, rich relative, the reality is far more chilling: people who never thought they would pay an estate tax could end up paying capital gains tax instead. The reason is that previous iterations of the estate tax valued the assets at their price on the owner’s date of death and exempted estates up to a certain size from all taxes. In 2009, that level was $3.5 million a person.
But when the estate tax disappeared so, too, did the Internal Revenue Service provision for date-of-death valuations. That means heirs may be responsible for capital gains taxes on any appreciated property when they sell it, forcing them to go back through decades of brokerage statements to calculate the difference between the value of something today and its original price.
Mindful of this, Congress authorized the I.R.S. to issue a stopgap measure exempting the first $1.3 million in capital gains and an additional $3 million for a spouse. This may seem pretty high, but it is not hard to imagine a comfortable widow or widower leaving a Brooklyn brownstone, a Florida condo and a portfolio of securities topping that amount.
“We are in uncharted territory right now,” said R. Scott Johnston, partner in the private wealth services group at the law firm Holland & Knight. “Killing off grandma is an overly simplistic view.”
The conventional wisdom is that Congress will revive the estate tax and make it retroactive to Jan. 1. But, of course, no one was predicting at this time last year that the estate tax would expire. The situation has thrown a wrench into the core tenet of estate planning: set up everything as if you would die tomorrow. What happens if the law changes by then?
Let’s assume we don’t know what will happen. Here’s a look instead at several of the unintended consequences of not having an estate tax.
REVIEW YOUR WILL Because estate exemptions rose and tax rates decreased in predictable steps — from $675,000 a person and a tax rate of 55 percent in 2001 to $3.5 million and a 45 percent rate last year — lawyers often wrote provisions into wills that put the maximum amount into trusts that could be transferred tax-free. What was left usually passed to the surviving spouse. Now, those exemption limits are gone.
“Someone with $20 million thought the balance was going to the surviving spouse, after the $3.5 million exemption,” said Christopher Zander, a partner at Evercore Wealth Management. “Now there’s a mismatch. It’s the same formula, but it’s based on a different tax law regime.”
He added: “This impacts a lot of people. It’s not just the super-rich.”
Many states have provisions that a certain percentage of an estate has to go to a surviving spouse but there may be children from a previous marriage who will contest giving back any of their inheritance. The crucial point is that formulas put into wills to keep from redoing a will every couple of years may not work as expected. Fixing this is simple: redo that portion of the will.
CHOICES FOR THE AFFLUENT Proponents of the estate tax argue that it affects very few people, and even now that is true. Still, many upper middle-class people who had been covered under the $3.5 million exemption may no longer be, even with the stopgap provision from the I.R.S. One estimate puts the number of people affected this year at 70,000, up from the 5,500 who annually paid the old estate tax.
A long-held house, for example, could easily exceed the current limits. The Corcoran Group is marketing a townhouse on East 65th Street in Manhattan that is part of an estate sale. The property, in the family since 1960, is listed at $6.95 million. The heirs, however, do not know what the original purchase price was, though they do know the appreciation in that area has been immense. Jonathan Miller, a certified real estate appraiser in Manhattan, noted that a similar townhouse on East 71st Street sold for $7 million in October, more than 10 times what the seller paid for it in 1982.
Figuring out whether tax is owed on homes is not simple either, said Daniel L. Kesten, a partner in the private client services group at law firm Davis & Gilbert. There are certain exemptions if it was a primary home and others for capital improvements done to it. If it was a second home, the equation changes. Deciphering all these permutations comes at a cost of time and legal fees.
The more difficult issue is determining the original price of securities. Generally, there are public records for a house. But a person could have owned a stock for decades and no longer have a record of its original price. And in that time, the stock price could have risen, the shares could have split and the broker changed several times.
“You can find it, but it’s going to be a chore to come up with the correct basis,” said Bernard Rappaport, a tax partner at Anchin, Block & Anchin. “This is going to make matters worse for a lot of people.”
RISKS FOR THE WEALTHY The big question for people who were subject to the estate tax before it disappeared is what happens if Congress re-enacts the tax and makes it retroactive to the beginning of the year.
The simple answer is that the matter will probably end up in the courts. There is Supreme Court precedent for Congress’s making an estate tax increase retroactive, in a 1994 ruling. But this time, Congress would retroactively be imposing a tax that no longer exists.
“I could see where the executor says he died when there was no estate tax and I’m not going to pay it,” Mr. Rappaport said, predicting that such a case would go to the Supreme Court. “The conservative judges could say you can’t do this retroactively. It’s a risk, but who knows?” Further, any legal fees would pale in comparison to what a large estate would owe at last year’s 45 percent tax rate.
Still, for financial advisers, the pressing questions are in terms of estate planning. The gift tax is down to 35 percent, from 45 percent, and the generation-skipping tax on assets passed to grandchildren is gone. In 2009, if a wealthy businessman wanted to give his granddaughter a gift above the exemption, he would have paid an effective tax of 74 percent on that amount, according to data from the J. P. Morgan Advice Lab. This year, the grandparent would pay only the 35 percent gift tax.
The risk is that Congress could also reinstitute the generation-skipping tax retroactively. “You have to be somewhat hesitant,” Mr. Johnston of Holland & Knight said. “In estate planning, you don’t typically want to be the test case if you’re trying to pass big bucks down through the ages.”