Estate Tax Abyss

For more than 32 years, I have counseled clients on planning for federal estate tax and Oregon inheritance tax. Throughout that time, numerous legislative changes have occurred: taxes have increased and decreased; effective dates have come and gone; and clients have changed their strategies to fit the evolving landscape in our tax laws. Never, however, have we been confronted with the lack of certainty over estate tax laws that we now face, due to the ineptitude and irresponsibility of the United States Congress.

Back in 2001, as part of the initial Bush administration tax plan, the federal estate tax exemption was scheduled to gradually increase over a nine year span. In the tenth year (2010), the federal estate tax exemption became unlimited. In other words, for those dying in 2010, there is currently no federal estate tax.

In addition, the tax benefit commonly known as “step-up in tax basis” was repealed for the year 2010. Under the old rules, the tax basis in assets inherited by beneficiaries became the fair market value of the assets as of the decedent’s date of death. In 2010, tax basis in inherited assets is called “modified carryover basis,” which is the lower of the date of death value or the decedent’s tax basis, meaning that no step-up to date of death value is achieved.

There are two significant exceptions to this rule. First, a decedent’s estate is entitled to increase the basis in assets owned by the decedent at death by an amount equal to $1.3 million. Second, with respect to assets passing to a surviving spouse or to a trust for the surviving spouse that qualifies as a QTIP Trust, an additional $3 million step-up is available.

In 2011, the entire house of cards falls. Because of a sunset provision enacted as part of the original law, deaths in 2011 and thereafter are treated as though the 2001 law had never been enacted. In other words, inherited assets receive a full step-up in basis, but decedents are only entitled to a $1 million federal estate tax exemption.

Basically, this means anyone dying in 2010 would completely avoid federal estate tax, but carryover basis (subject to the exceptions discussed above) would apply. If, however, that person survived until 2011 or thereafter, he or she would only be entitled to a $1 million estate tax exemption, with the remainder being taxed at significant rates.

During the past 10 years, we all thought Congress would act responsibly and change these laws so that “estate tax Armageddon” would never occur. Indeed, when the 2001 law was passed, it was anticipated that changes would occur well before the year 2010. Yet the year 2010 is now upon us with no foreseeable change in the law, and we find ourselves scratching our heads in anticipation of what Congress will or will not do.

As recently as last December, there were as many as nine separate bills, either in the drafting stage or pending before Congress, intended to fix the estate tax law and avoid the current quagmire. None of those bills passed both Houses.

So here we are with no relief in sight. There is conjecture that Congress will act during the first quarter of this year to correct this problem, most likely through establishing an estate tax exemption somewhere between $3.5 million and $5 million per individual, with the reinstatement of stepped-up basis. However, there is a growing probability that this will not occur.

Given the recent election results in Massachusetts, it may be more difficult for Congress to pass comprehensive estate tax legislation. Many pundits have agreed that if legislation does not occur quickly, then it may not occur at all this year. Some Democrats, who see the situation in 2011 as a tremendous opportunity to increase taxes without new legislation, may be willing to simply let the Bush 2001 tax cuts die a quiet death and reinstate the law as it existed in the year 2000. The pundits go on to argue that if people complain because the estate tax exemption would then only be $1 million and the tax would increase to a maximum 55 percent rate, the Democrats could simply say, “Blame it on the Republicans – it’s their law.”

But let’s presume Congress does something soon. In fact, Congress may have already acted by the time this article is published. Many legal scholars argue, however, that any legislation, if made retroactive to January 1, 2010, will be subject to scrutiny because of the potential unconstitutionality of a retroactive increase in estate taxes.

If indeed that is the case, and Congress avoids retroactivity by passing a law that is effective only for deaths occurring after enactment, then what happens to those who died between December 31, 2009 and the new effective date? Do they have no step-up in basis other than the amounts identified for 2010? Do they avoid federal estate tax? Do they have the right to choose which set of laws they want to follow? These questions, together with a host of others, remain unanswered.

Exacerbating the entire situation is the Oregon inheritance tax, which currently provides for a fixed $1 million exemption, a maximum rate of 16 percent, and the presumption of a full increase in basis. The Department of Revenue has recently taken the position force, but Oregon will follow the federal rule in 2010 and move to carryover basis.

If the feds act to change the law and Oregon does not reconnect to the federal income tax changes, then we could have stepped-up basis for federal purposes and carryover basis for Oregon purposes. So beneficiaries would have to keep two depreciation schedules-one for Oregon and one for federal purposes. This issue has not yet been resolved.

There are a myriad of other problems that are much more technical, going well beyond the scope of this article.

The real question, however, concerns how our clients deal with this problem now. In many typical estate plans for our married clients, we have prepared wills and revocable living trusts which fund a marital share and a bypass amount (normally the amount of the unused estate tax exemption). If the bypass share equals the unused exemption, then under the 2010 “Armageddon law,” this could result in the entire estate going to the bypass share. If the will provides, for instance, that the bypass share goes to children of the first marriage, then the 2010 law would result in the surviving spouse being disinherited.

After thorough investigation and analysis of the problems presented by the current federal estate tax law and how those problems interface with the Oregon inheritance tax, the Firm’s estate planning group has developed a number of different options available for clients who are concerned that their estate plans may be affected. Although these rules affect married couples most profoundly, they also have a significant impact on single individuals.

It is impossible for us to review the thousands of wills we have prepared over the last 30-40 years to determine which clients may or may not be affected by these unanticipated changes in the law. As a result, if you are concerned about how the law may affect your estate planning documents, we urge you to call the office, make an appointment, and evaluate whether and to what extent any changes might be required in your estate plan.

Please understand that Congress has the ability to enact legislation to fix this problem retroactively, assuming that is constitutional. If this is the case, then your estate plan is probably unaffected. However, there is no guarantee this will happen.

If you have questions regarding how this law affects your estate planning documents, please call our office and we will analyze your documents and provide recommendations. As always, we will do everything we can to ensure that your interests are protected.