Winter 2009/2010

You’ve probably heard that Congress has failed to agree on an approach to estate taxes, so there’s no Federal estate tax for 2010. This doesn’t mean this is a “freebie” year, however. Other provisions still take a bite, and Congress could pass a retroactive tax.

Here’s a brief overview of the legal situation:

• We still have our Washington State estate tax (with a $2 million per estate exemption), but we don’t have a Federal estate tax in the year 2010. However, the Federal estate tax is scheduled to return in 2011, with an exemption of only $1 million per estate.
• We still have a Federal gift tax at a 35% rate, as opposed to 45% last year. You may still give $13,000 a year to anyone tax-free, and in addition the $1 million lifetime gift tax exemption remains.
• In this year of no Federal estate tax, we generally have “carryover basis” as a tradeoff. That is, we don’t have the automatic “basis step-up” that comes with an estate tax and allows you to sell assets of an estate without capital gain. There is, however, a limited step-up adjustment to basis allowed to the extent of $1.3 million per estate, and in addition up to $3 million for qualifying transfers to the surviving spouse. It’s possible you’ll need to file something with the IRS after a death in order to use this step-up.
• Now that you’ve figured out the deal for 2010, we’ll tell you that Congress might reinstate the estate tax and the 45% gift tax rate retroactively for the full year 2010, with the same $3.5 million per-estate exemption as last year (and the accompanying full step-up in income tax basis). Congress might also change the law for 2011, or it might just let us drift into the law already prescribed for next year (again, with an exemption of only $1 million per estate).

So what to do?

Make Tax-Saving Gifts. 2010 is a good year for tax-saving gifts. The short explanation is that estate and gift taxes are more likely to increase than decrease. For instance, there is talk of Congress’s curtailing certain valuation discounts available under current law. Gifts to grandchildren are especially favored (in the right situation), with the generation-skipping tax being apparently suspended right now. There are ways to try to get the benefit of the suspension in the law, without much downside risk in the event of retroactive change.

Review Your Wills. If your Will (or Living Trust) has a tax-driven formula prescribing the nature of trusts to be established for your surviving spouse, it should be reviewed. We would want to confirm that (a) the formula doesn’t create tax on the death of the first spouse to die, due to the recent divergence of Federal and State tax laws; (b) the trusts make full use of the step-up in income tax basis; and (c) you don’t inadvertently disinherit a group of heirs, say if you were giving the tax-free amount to your children and the rest to your spouse or a charity.

Even if you don’t have a formula clause in your Will, you might want to add a tax-sensitive trust to your Will in case the exemption does go down to $1 million.