For anyone who missed it, Dan Duncan, a Houston, Texas, oil billionaire passed away earlier this year. Because he died in 2010, with no federal estate tax in place, his entire $9 billion estate will pass tax free. Had he died in 2009, his estate would have owed Uncle Sam approximately $4 billion. Of course, had Mr. Duncan been a resident of Washington State, an estate tax would be due on all assets valued over $2 million.
Recent reports indicate the Senate may be close to an estate tax compromise. The compromise, which needs 60 votes to pass, would set the federal estate tax exemption at $5 million and impose a top tax rate of 35%. If passed it would mean many families will be able to pass their estates free from federal tax. Estate Planning in Washington, however, would still be essential. We still have an estate tax with a $2 million exemption limit, families have businesses and real estate that require planning to effectively pass such assets to the next generation, and many people now find that long term care issues can be a greater threat to leaving a legacy than estate taxes.
With the estate tax in flux this year, you may want to revise your wills to make sure your bases are covered. If you have a will that leaves assets to a person based on an estate tax formula it may need revision. For instance, some wills leave assets to children based on an amount that can pass free of federal estate tax. If this is the case, in 2010, presumably all assets would pass to those children under this language. Such a scenario may leave little or nothing for a surviving spouse. Often this is not a person’s intent. Additionally, you may want to have language included to address an estate tax with a $1 million exemption limit or a higher limit, depending on what Congress does or does not do later this year.
You should also consider to whom your assets will pass and how they will be affected by the capital gains tax. If you are leaving more than $1.3 million to someone other than your spouse, you may want to make sure your executor knows how to allocate the step-up in basis, applicable to estates of persons dying in 2010. If the basis step-up won’t cover all such assets (so as to minimize future capital gains taxes on an asset’s sale), it may be wise to include language guiding the executor to allocate the basis step-up in a manner that minimizes the tax burden on all beneficiaries. Hopefully such language will reduce the potential for strife among family members.
The evening of Tuesday, April 20, 2010, I will present an estate planning seminar at the Bellevue, Washington offices of Waddell & Reed. This presentation starts at 6:00 p.m. and is scheduled to run until 7:30 p.m. Also, on Friday, April 23, 2010, financial planner David Harry and I will conduct an estate and financial planning seminar beginning at 11:30 a.m. at the Northshore YMCA in Bothell, Washington. Each presentation will focus on estate planning in a world with and without the federal estate tax.
The Washington state legislature has recently proposed to double the estate tax rate. The current estate tax rates start at 10 percent and rise to 19 percent. The proposed increase doubles the current rate with a top rate reaching 38 percent. If signed into law the increase will take effect on April 1, 2010.
On January 1, 2010, the federal estate tax was repealed. Currently, there is no federal estate tax. So, what does this mean for people in the State of Washington? It means several things. First, it means that if you die today, you may not owe any estate tax to the federal government; second, there is still an estate tax in Washington State that may apply; and, third your heirs may have to pay a substantial capital gains tax on property that is sold. Let’s look at each of these issues.
Federal Estate Tax
I say you may not owe federal estate tax because toward the end of 2009, Congress made a lot of noise about how they would simply bring the estate tax back in early 2010 and have it applied retroactively to January 1. So in actuality, if you die today and Congress creates a retroactive tax in May, you could still owe federal estate taxes.
If, however, Congress does nothing on the estate tax issue in 2010, the estate tax is automatically set to come roaring back in 2011. At that point, the estate tax exemption will be $1,000,000 per person as opposed to the $3,500,000 exemption in 2009. This means a lot more estates will owe taxes in 2011 than in 2009.
Washington State Estate Tax
Regardless of what happens with the federal estate tax, Washington still has its own estate tax. Here, the estate tax exemption is $2 million per person. So anyone with an estate in excess of that amount would owe estate tax to Washington State. Proper planning can minimize or even eliminate this tax in certain situations.
Capital Gains Tax
There is another wrinkle with estate tax repeal. This year, without the estate tax, you can only receive an increased tax basis on $1,300,000 worth of your property. What does that mean? Well, under the old estate tax laws, when a person died the tax basis in his or her property would increase from the amount paid for the item to the market value of the item at the time of death. But this is not the case in 2010. Now only $1.3 million of your property will qualify (with an additional $3 million exemption for property passing from one spouse to the other). If you have property worth more than that, a capital gain will be incurred on the sale of the asset, and that gain will be based on the original cost of the item.
Here’s an example under both the old and new systems: mom has $1.3 million in her retirement account; mom bought her house in 1980 for $50,000. Mom dies in 2009 and the house was worth $350,000. The tax basis increased from $50,000 to $350,000 and her heirs would owe no capital gains tax on the sale of the house in addition to having no estate tax to either the federal or Washington State governments.
Now let’s say mom died on January 1, 2010. If mom’s retirement account eats up her $1.3 million capital gain “exemption” then capital gain will be due on the sale of the house. The tax will be based on $300,000, the difference between the $50,000 original tax basis and $350,000, the current value of the property.
What will happen to the capital gains tax issue if the estate tax is reinstated retroactively? Presumably, it will go away. Confused? To deal with this mess I (with tongue in cheek) told one client earlier this week – “Don’t die in 2010!”
In its article Amid Debate, Business Owners Struggle with Estate-Tax Strategies, the Wall Street Journal reported that the federal estate tax is a significant concern for family business owners even though few actually wind up paying the tax. Family Businesses in Washington State should be even more concerned because the estate tax exemption in here is $2 million and not $3.5 million as with the federal estate tax exemption. However, one reason so few family business owners pay estate tax is most likely due to the use of various estate planning techniques. These techniques can include annual gifts, trusts, intra-family transactions, life insurance and even a properly drafted Will. But early planning is essential. The estate planning process can draw out for years given the many complexities facing a family business. These complexities include, among many others: selecting and grooming a successor, family dynamics and squabbles, excess cash flow to fund life insurance policies, the desire to have children earn the business rather than simply inherit it by birthright and many more. Since it’s almost certain the estate tax isn’t going away, neither will these issues for family businesses.
Executors are generally personally liable for estate taxes if they distribute property to beneficiaries before paying an estate tax obligation. And, according to at least one case, the executor may not discharge that personal liability in a later bankruptcy. Carroll v. United States, 2009-2 USTC par. 60,577 (May 6, 2009). In Carroll the estate elected to pay estate taxes on an installment basis. Over the years, the businesses inherited from the executor’s father performed poorly and the IRS installment payments stopped. During the same period, however, distributions from the companies were made to beneficiaries. The companies' poor performance ultimately lead to each of them ceasing business and personal bankruptcy for the executor. The court stated the executor’s liability could not be discharged if there was a willful attempt to evade or defeat the estate tax. Because the executor knew of the tax, was aware of his personal liability for the tax, actively transferred property out of the estate without adequate consideration and demonstrated an intentional disregard for the liability the debt could not be discharged.
In PLR 200937028, the IRS concluded that property held in an irrevocable grantor trust that was not included in the grantor’s estate at death does not receive a step-up in basis. Most individuals who own property in their own name at death receive a step-up in the tax basis of that property. For example, if you paid $200,000 for your home in 1995 and you die today with the house valued at $500,000 the tax basis increases to today’s value. Therefore, capital gain on the sale or future sale of the asset is either eliminated or minimized. However, if you transfer an asset to an irrevocable trust, even a grantor trust where the trust income is still taxed to the grantor, the asset is out of your estate and not eligible for a step-up in tax basis upon death. The beneficial trade off is that with the asset outside your estate, it is not included for estate tax purposes.
We’ve been waiting for changes to the federal estate tax for some time, however, we really have no idea what the changes will look like. Over the weekend the Wall Street Journal reported the issue is stalled in Congress with seemingly no consensus about what to do. The administration apparently wants to lock in the current exemption level of $3.5 million per person with a 45% tax rate and some Republicans are still looking for a complete repeal. Now there is a newer proposal for a $5 million dollar per person exemption with a 35% tax rate. But with so many members of Congress focused on the health care debate, this issue is decidedly low priority. Another very real possibility is that the Bush tax cuts will run their course as planned. With no action, the estate tax will be repealed for 2010 only, then return with only a $1 million federal exemption per person. Regardless of what happens at the federal level, Washington State appears wedded to its current $2 million per person exemption. If the federal exemption is rolled back to $1 million, I would expect a large number of estate plans will need to be updated.
Enter keywords:
