This is the third article in a series discussing various tax planning opportunities that should be considered in the wake of the recent elections.  For the prior articles see:

Postponing Sales Until 2017; and

Should you Accelerate Charitable Gifts to 2016?

President-Elect Trump has made it clear that he intends to repeal federal estate taxes.  In light of the Republican majorities in the House and Senate, prognosticators believe that estate tax repeal will occur in the near future.  Assuming that estate taxes are repealed, there are numerous questions.

First, when will the repeal occur?  The last time that estate taxes were repealed in 2001, the repeal did not actually occur until 2010.  If there is a repeal with a delayed effective date, you will still owe taxes if you are unfortunate enough to die before the repeal becomes effective.

The second issue is whether repeal will be permanent.  Federal estate or inheritance taxes have been repealed four times in the past (1802, 1870, 1895, and 2010).  Each time the tax was repealed, it was later reenacted in a different form.  The most recent reenactment actually occurred in 2001, by the same Congress that repealed the tax for 2010.  They actually voted for the tax to reappear in 2011!  Based on history, I do not expect that repeal will be permanent.  It is easy to imagine a day when the 99.9% who will not have to pay the tax again decide that it is fair for our wealthiest taxpayers to pay a tax upon death.  Of course, this is grossly unfair to the 0.1%, but it was unfair every other time that estate taxes were enacted.

The third issue is whether the revenue loss from estate tax repeal will be replaced, in whole or in part, by a loss of stepped-up basis, or, even worse, capital gains tax upon death.  Under current law, the income tax basis of assets gets changed to the fair market value of the assets owned upon death.  The asset can be sold by one’s heirs soon after death without paying capital gains tax.  If stepped-up basis is removed, the tax will need to be paid when assets are sold after death.  When the tax was repealed in 2010, stepped-up basis was removed, though there was a limited amount of basis step-up granted.  Unlike estate taxes, which currently only are paid by 0.1% of decedents, stepped-up basis benefits the families of all decedents who own appreciated assets.

A more troubling possibility is a capital gains at death tax system, which is used in Canada.  This system would impose a capital gains tax on the built-in gains on assets owned at death.  If you lose stepped-up basis, at least you can postpone the date upon which the tax will be incurred.  If taxes are imposed at the time of death, the ability to postpone the tax will be lost.

Several clients have asked us whether they should alter their estate planning in light of the proposed repeal of estate taxes.  In my opinion, it is premature to alter your estate planning based upon the assumption that you will die in a year in which estate taxes do not exist.  As a general rule, if there are sensible strategies to remove assets from your taxable estate, I recommend that you implement these strategies.  As always, you should favor strategies that are flexible so that you can take advantage of future opportunities.

I just finished a project for a husband and wife who own commercial real estate with a fair market value of $10 million and a cost basis of $2 million. The husband is in poor health; his wife is 15 years younger and enjoys good health. The real estate was owned jointly by the couple when I met them in March.

I recommended that they transfer all of their real estate and other assets to a Tennessee Community Property Trust. Assuming the husband dies first, the real estate will obtain an income tax basis of $10 million upon his death. This will allow his wife to take significantly higher depreciation deductions with respect to the property following her husband’s death. Furthermore, in the event that she chooses to sell the property after her husband dies, there will be no capital gains taxes or depreciation recapture (except for appreciation and depreciation that occurs after her husband’s death).

If the husband had died before the trust was established, only one-half of the property would have received a stepped-up basis, resulting in an overall basis of $6 million rather than $10 million. Thus, transferring the property from joint ownership to a community property trust will result in an additional $4 million of basis upon the husband’s death.

In addition to the income tax benefit, there are two ancillary benefits of the community property trust. First, the husband will have $5.12 million of assets to fund his federal estate tax exemption if he dies this year. Second, probate will be avoided for both spouses.

Last week, the attorneys in our firm gave a presentation to the Nashville Society of Financial Service Professionals titled "The New Estate & Gift Tax Laws – The 2-Year Window of Opportunity.” The presentation was a joint effort by Bryan Howard, Jeff Mobley, Stephanie Edwards, and our two newest members, Paul Hayes and Paul Gontarek, who joined us at the beginning of the year.

Paul Hayes is an experienced estate planner like the rest of us, and is also a CPA and a Certified Financial Planner.

Paul Gontarek specializes in trust and estate litigation, which seems to be a growth industry due to  increased life expectancies and other societal changes.

This is the second article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first article, see: Part 1 – Charitable IRA Rollovers

The Act retroactively reinstated estate taxes to apply to decedents who died in 2010. However, the Act provided two relief provisions. First, the federal estate tax exemption for 2010 decedents was $5 million. Second, the Act allows executors to elect the carryover basis regime for 2010 decedents if that regime is preferable to the estate tax regime.

We represent several estates that plan to elect the carryover basis regime. The carryover basis regime may result in future income taxes; however income taxes are less than estate taxes. Most estates of $10 million or more will elect the carryover basis regime. This is because the estate tax regime would result in estate taxes, either now or upon the death of the surviving spouse. Estates of unmarried decedents with more than $5 million will generally elect the carryover basis regime.

Estates worth $5 million or less will stay with the estate tax regime. They will not owe any federal estate taxes and all assets owned by the estate will receive a stepped-up basis.

The Executors for married decedents whose estates were between $5 and $10 million will have to analyze the two regimes. When the available basis step-up of $4.3 million is enough to increase the basis of all assets to date of death value, the estate should elect the carryover basis regime. When the basis step-up is not enough to eliminate all pre-death gains, the executor will need to analyze whether future income taxes to be incurred on pre-mortem appreciation will be more than future estate taxes to be incurred upon the death of the surviving spouse.

The analysis of future income taxes and future estate taxes requires a crystal ball. Income taxes might be avoided if the surviving spouse gives appreciated assets to charity or holds them until death. Estate taxes might be avoided if the surviving spouse makes sufficient gifts or if the $5 million federal estate tax exemption is extended until the year of the spouse’s death.

The Act did not specify how or when to make the election to be subject to the carryover basis regime. The Act specified that the Form 706 for decedents subject to the estate tax regime does not need to be filed until September 17, 2011. I expect guidance from the IRS clarifying that the carryover basis election can also be made as late as September 17, 2011.

Short-term capital gains are taxed at a significantly higher rate than long-term capital gains. In 2010, the maximum rates are 35% for short-term capital gains and 15% for long-term capital gains. In 2011, the maximum rates will increase to 39.6% and 20%.

Prior to 2010, gains from sales of assets by an estate were automatically treated as long-term capital gains, regardless of when the decedent bought the asset. For decedents dying in 2010, this rule does not apply. It is now necessary to determine when the decedent bought the asset. If the asset is sold within a year after it was acquired, the gain will be short-term.

Tax on pre-mortem gain can be eliminated by allocating the decedent’s basis increase to the property. Every decedent has $1.3 million of basis increase that may be allocated by the Executor. Married decedents potentially have an additional $3 million of basis increase that can be allocated.

The basis increase can not be used to eliminate post-mortem gains. Assume the decedent bought a stock for $200,000 on November 1, 2009. The decedent died on March 31, 2010 when the stock was worth $260,000. If the Executor sells the stock for $300,000 on October 15, 2010, there will be a short-term capital gain of $100,000. The pre-mortem gain of $60,000 can potentially be eliminated if the Executor chooses to allocate a portion of the decedent’s basis increase to this particular asset. The basis increase cannot be used to wipe out the $40,000 post-mortem gain.

The gain could be converted from short-term capital gain to long-term capital gain if the Executor waits to sell until November 1, 2010.

Our firm is assisting Executors and Trustees with the administration of several estates and revocable trusts of decedents who have died during 2010. Administering these estates has presented numerous challenges.

The first problem is that we do not know whether federal estate taxes will be reinstated retroactively. We are advising the Executors that there are two different sets of laws that could apply, either the law that is currently on the books, or another law that has not yet been written. We are guessing that a retroactive law, if one is enacted, will be similar to the law that existed as of December 31, 2009; however, there are no guarantees.

If there is no federal estate tax, this is great news for most of our estates. However, the price to be paid for having no federal estate taxes is carryover basis. I was not practicing law in the late 1970’s when the prior version of carryover basis was the law, but have been forewarned by various practitioners who were practicing during that time period. Carryover basis is even worse than I had imagined.

We are advising Executors to assume that carryover basis is the law. This means that the Executor needs to ascertain the cost basis of the decedent’s assets unless the total value of the assets is less than $1.3 million, or is less than $4.3 million if the decedent was married and leaves at least $3 million of assets to the spouse or a qualified marital trust. Fortunately, most publicly traded securities held in brokerage accounts now list the cost basis. Determining the cost basis of various other assets such as furniture, artwork, real estate and interests in closely held businesses is not so easy.

One revocable trust has a large holding in a single stock. The stock has performed well since the time of the decedent’s death and the Trustee would like to sell a substantial portion of this position. However, the decedent’s basis in the stock was very low and the beneficiaries do not want the Trustee to sell and incur a large capital gains tax. If carryover basis is repealed and stepped-up basis is restored, everyone will be delighted to sell the stock. By the time the law is settled, the value of the stock may have declined precipitously.

Another revocable trust makes a large charitable bequest that will only occur if federal estate taxes are reinstated retroactively. Neither the charity nor the alternate takers can make plans until the law is settled.

Another estate holds significant real estate holdings. The Executor would prefer not to sell the real estate in the current market. Sales are not necessary if there are no federal estate taxes, but sales will be necessary if federal estate taxes are reinstated retroactively. Waiting until the law is settled may be too late to raise money in time to pay taxes if that becomes necessary.

There are numerous income tax planning issues that must be addressed due to carryover basis and all of its complicated rules. There are also carryover basis strategies that should be considered prior to death when you know that death is imminent but have at least a few days to make changes. I plan to discuss these strategies in a future article.

Because of the Tennessee inheritance tax, Executors still have to obtain date of death values, and perhaps alternate valuation date values, for all assets owned by the decedent. This means that Executors for estates of 2010 decedents have more to do than ever before.