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Estate Tax Purgatory: How To Extricate Yourself

Although most tax experts predicted it would never come to pass, we now find ourselves in a unique place for estate planning—somewhere between heaven and hell. It’s a little slice of heaven because there’s no federal estate tax liability, at least now, for families of anyone who dies in 2010. Yet even that temporary reprieve comes with complications—and a great deal of uncertainty—that can make wise planning devilishly difficult.

The current state of affairs results from the “sunset” provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which instituted several favorable estate tax changes during the past decade and culminated with an outright repeal of the estate tax in 2010. Consider these key features.

  • The estate tax exemption has gradually increased from $675,000 in 2001 to a high-water mark of $3.5 million in 2009.
  • The exemption from the generation-skipping tax (GST) also crested at $3.5 million in 2009. Both the estate tax and the GST are repealed for 2010 only.
  • During the past decade, the top estate tax rate was reduced from 55% to 45% in 2009. (Due to an anomaly in the law, the top effective rate before EGTRRA was actually 60% for estates valued at more than $10 million).
  • The “unified” estate and gift tax system was divided after 2004. While the estate tax exemption has gradually increased, the lifetime gift tax exemption for individuals has remained locked at $1 million. Beginning this year, the gift tax rate is linked to the top individual income tax rate—currently 35%, but scheduled to rise to 39.6% in 2011.
  • The state inheritance tax credit allowed against the federal estate tax was phased out during the four years after EGTRRA was enacted. Some states have adjusted their laws to conform to federal changes, while others have implemented new legislation.
  •  During 2010, heirs don’t get a “step-up” in the cost basis of assets; future capital gains have to be based on the assets’ original cost, rather than on their market value at the death of the person providing the inheritance. But another provision may blunt the impact of that change. An heir may increase the cost basis of qualified assets by $1.3 million, and the basis for assets inherited by a surviving spouse may be bumped up by $3 million.
  • Both the federal estate tax and the GST are scheduled to come roaring back in 2011, with the top tax rates reinstated and an exemption of only $1 million. (The GST exemption will be indexed for inflation.)

What happens next isn’t clear. The EGTRRA changes could be allowed to stand, a compromise may be worked out in Congress, or (least likely) legislators could vote to make the repeal permanent. If a new law is made retroactive to the start of 2010, that might prompt a constitutional challenge that could take years to resolve.

In the meantime, it’s important to have all of your estate planning documents reviewed. If your will was established several years ago, or if you’ve set up a trust that uses a formula tied to federal estate law, crucial changes could be needed. For example, one popular estate planning tool, the “bypass” trust, often uses the federal exemption amount to divide assets between the trust and a surviving spouse. This year, with no tax or exemption, that could leave trust unfunded and direct everything to the spouse; in 2011, if the exemption drops back to $1 million, that, too, could shift the intended balance between spouse and trust. Pre-EGTRRA documents based on a percentage formula also could distort distributions. Other complications may arise when there’s a second marriage, particularly if there are multiple sets of children involved. Charitable bequests, state inheritance taxes and other issues may also pose problems. 

Keep in mind that the wording in estate planning documents is crucial and subject to legal interpretation. You may need to work with your attorney to revise language to accommodate the estate tax rules for 2010 and beyond. Your attorney can also help you structure wills and trusts for optimal flexibility. Documenting your intentions in writing may help resolve future disputes.

The only real certainty now is that more legal changes will be coming soon. A resolution about the estate tax exemption level, in particular, could have far-reaching consequences; there’s a vast difference between the exemption of $1 million that’s scheduled to apply in 2011 and the $3.5 million that has been discussed as part of a potential compromise on a permanent tax. We can work with your attorney to help you devise a strategy that makes sense for your family.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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