In 2001, a Congressional struggle over the fate of the federal estate tax ended in a classic bad result. Republicans, anxious to say they’d driven a stake through the heart of the “death tax,” passed a bill repealing the estate tax, effective January 2010. Democrats used the threat of a filibuster to keep the repeal law from becoming permanent. So as it emerged from the Washington sausage factory, the “repeal” lasts only this one calendar year, 2010.
From the time the 2001 estate tax “repeal” was passed, until recently, almost all of my estate planning colleagues insisted the “repeal” in 2010 would never actually occur. In 2006, Republicans, who still controlled Congress, sought to make the repeal permanent. Democrats, feeling election trends were moving in their direction, had enough seats in the Senate to prevent that from happening.
At the start of 2009, with Democrats in control of both House and Senate, my colleagues said surely Congress would promptly reestablish the estate tax on a permanent basis, with something like the then-current $3.5 million exemption and 45 percent maximum tax rate. As the year wore on without effective action, the conventional wisdom became that Congress would pass a one-year “patch” to keep the 2009 system in place to avoid the “repeal.” Indeed, the House passed such a bill, but the Senate, marching off a political cliff with its massive health care bill, took no action.
Here we are in 2010, and the “repeal” is now fact. Of course, there’s plenty of talk about how Congress will now quickly take up this important issue, reestablishing the estate tax retroactively to January 1, 2010. I say don’t bet on it.
As in 2001, 2006 and 2009, the opponents and proponents of the estate tax are engaged in a Mexican standoff. Congress places no value on rationality and simplicity. The Democrats want more tax revenues and love taxing wealth transfers; the Republicans perceive the electoral winds blowing in their direction come November, much as the Democrats did in 2006, and smell the estate tax as an issue they can milk for political gain.
Those of us trying to help clients plan for estate and gift taxes must tell them we can only guess what the laws will be, not only next year, but even tomorrow. Perhaps our discipline should now be renamed “estate guessing.”
Kidding aside, estate planners must now create more complex estate plans with contingencies based on what might happen to the estate and gift tax laws. And many advisers are encouraging clients to review existing plans to avoid unintended results.
Worse yet, the current “repeal” brings with it a pernicious feature called “carryover basis.” Through the end of 2009, assets held by a dying person received what’s known as a “stepped-up basis,” meaning those assets are passed to heirs with a cost basis equal to their value at the date of death.
Suppose your benefactor, shrewd Uncle Ernie, purchased 100 shares of Microsoft stock at $80 a share, for a total of $8,000. Twenty years and eight stock splits later, Ernie held 14,400 shares worth $438,000 when he died in 2009. Under the system in place until December 31, 2009 (and assuming Uncle Ernie’s total estate was less than the $3.5 million estate tax exclusion), you would have inherited those 14,400 shares of Microsoft with a new basis of $438,000 and with no estate tax. If you now sell those shares, you would report a gain on your Schedule D only to the extent you received more than $438,000 for them; if you received less, you would report a loss.
Now suppose Uncle Ernie held on until January 1, 2010. Unlucky you, for now you’ve inherited those 14,400 Microsoft shares at Uncle Ernie’s cost basis of $8,000. If you sell them for $438,000, you must declare a gain of $430,000 on your federal and state income tax returns. Uncle Sam will help himself to $64,500 in capital gains tax, while Uncle Arnold will grab another $43,000 in state income tax. In other words, estate tax “repeal” is going to cost you $107,500.
It gets worse. Unlike many investors, Uncle Ernie kept a record of what he paid for his Microsoft shares. With individual stocks, it’s not too difficult to reconstruct the historic cost basis. But with mutual funds, reconstructing cost basis can be a challenge, particularly where the investor reinvests dividends, as is frequently the case. Each dividend reinvestment increases the cost basis, regardless of whether the source of those reinvestments is ordinary income dividends or capital gains distributions.
Because the IRS takes the position that the cost basis of an asset is zero unless the taxpayer can prove otherwise, if you don’t have records of all those reinvestments, you may be stuck paying far more in capital gains and income taxes than you would otherwise owe. Don’t count on the mutual fund company being able to provide you with records of Uncle Ernie’s investments and reinvestments. Ernie may have transferred his shares from the fund company to a custodian such as Schwab or Fidelity, after which the fund company may have discarded some or all of the investment history.
But wait; there’s more! One inheriting an asset must now claim the lower of the decedent’s historic cost basis or its value at the date of death. So if Uncle Ernie had also bought some share of Citigroup for which he paid $100,000, but which was worth only $10,000 at his death, you’re stuck with the latter for your cost basis. You can’t even offset Uncle Ernie’s $90,000 loss on Citigroup against the gain on the Microsoft stock.
Once again, my Pollyanna colleagues say Congress will quickly remedy these problems by reinstating the estate tax and stepped-up basis, retroactive to January 1, 2010. I’m not a betting man, but I know where I’d put my money on that proposition.
