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So, Will there be a Federal Estate Tax in 2010?

Federal Estate Tax

On December 3, the House of Representatives passed a bill to permanently extend the Federal Estate Tax Exemption (H.R. 4154). The current exemption is $3.5 Million per person, or $7 Million for a couple, with a 45% tax on the decedent’s assets over the exemption amount.

As of yesterday though, the Senate has yet to act, which means that the law passed by President Bush in 2001 remains in effect. If Senate does not pass bill to deal with this by New Year’s, that will mean that on January 1, 2010 there will be no federal estate tax – maybe.

Why do I say maybe? Because it is still very likely that Congress will act after the new year to reinstate the tax, and make it retroactive to January 1st. They’ve done it before, with the permission of the Supreme Court. (see U.S. v. Carlton)

Even more troubling, the repeal would only be for one year, and then the exemption amount would come crashing back down to One Million Dollars (indexed for inflation) in 2011. This does not make for easy planning and will most adversely affect individuals who have children from one relationship and are now married to a different person. People who are in this situation should seek out an estate planning attorney immediately because it is likely the formulas in their Wills may cause a disastrous result. Many formulas can be read so that either the children from the prior relationship are completely cut out or the new spouse is completely cut out. There is an easy fix to this by setting caps on how much a spouse or child can get, but I reiterate – many old formulas will not work.

Most estate planning practitioners that I know still strongly believe that the government will pass a law to keep some form of estate tax – mainly because we find it hard to believe that the government will give up so much money from the people who can most easily afford to pay it. However, for those of you who have been completely ignoring the issue, it is time to start paying attention because a complete repeal of the federal estate tax will actually have a large capital gains tax consequence.

To understand this capital gains tax consequence, you must first understand and appreciate the incredible importance of “Basis“.If the federal estate tax is indeed repealed, executors will be entitled, for an individual decedent, to allocate to the decedent’s assets up to $1.3 million in basis plus the sum of the decedent’s unused capital loss carryovers, net operating loss carryovers and unrealized losses on property owned at the date of death (IRC Section 1022(b)). No asset may be increased in excess of fair market value though.

In addition to the $1.3 million basis increase available to all beneficiaries of an estate, the executor may allocate another $3 million of basis to assets passing to a surviving spouse. (This benefit only applies to heterosexual couples.)

As a practical matter, the repeal of the estate tax will most negatively affect those few individuals who have a lot of highly appreciated assets and those individuals who might not have had to file a return at all. The reason that it negatively affects the people who might not otherwise had to file a return is because I believe that a return will have to be filed to properly allocate basis to your assets. This will result in extra attorney fees for many.

The pessimist in me says that the government will wait until about August of 2010 or so and make a retroactive law, making estate planning and administration most cumbersome and costly.

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