Ever since the estate tax lapsed on Jan. 1, there's been a lot of talk about the windfall it's creating for families of wealthy people, including billionaires, who have died in 2010. But behind the scenes, lawyers and accountants are wrestling with a far more practical problem that affects all inheritors this year: the tangled new income tax rules that apply to assets inherited in 2010.
Unless Congress restores the estate tax retroactively this year, vast sums will pass free of both estate tax and the generation-skipping transfer tax (on assets given to grandchildren). Under a 2001 law, these taxes are scheduled to return Jan. 1 at unfavorable rates that applied 10 years earlier. At that point, the amount that is exempt from each of these taxes will be $1 million, and the tax on the rest will be 55% (60% in a certain phase-out range). In contrast, the tax-free amount last year was $3.5 million, and there was tax of 45% on anything else not going to a citizen spouse or to charity. (For advice on how to deal with the return of the estate tax, click here.)
During the one-year "gap" as lawyers call it--and presumably only for inheritances received this year-- there are income tax issues to contend with. What's new: Heirs now must use the original price paid for an asset when computing the income taxes they will owe if they sell inherited assets. Previously, they could use the market value at the time of the owner's death. Each estate is permitted to exempt $1.3 million of gains from this carry-over basis rule. An additional $3 million exemption applies to assets inherited from a spouse.
This "carry-over basis" rule is new to both advisers and clients, so implementing it takes us into uncharted territory. And if a recent discussion on LinkedIn, the professional-networking website, is any indication, confusion is widespread. Even during the mid-August doldrums, there were more than a dozen exchanges about the subject among members of one professional group within the site. Some revealed basic misunderstandings. Others pointed to questions that are still unanswered by the Internal Revenue Service.
To further complicate matters, there's a possibility--though as the year wears on it seems increasingly remote--that Congress will restore the tax retroactively with the same $3.5 million exemption and 45% top rate that existed in 2009. Past court cases suggest that is perfectly legal. But some people with a lot at stake have argued that a retroactive tax is unconstitutional and threatened lawsuits. With the prospect of litigation looming, any legislation that takes effect in 2010 would almost certainly need to offer a choice for heirs of people who die this year: Pay estate tax, or use the modified carryover basis system that's in effect while there is no estate tax.
Whether heirs are stuck with carryover basis, or wind up with a choice for 2010 and elect to use the carryover basis/no estate tax option, inheritors and their advisers need to take the following steps.
1. Have assets appraised.
As in past years, unless the date of death value of a costly asset is obvious (as it is, for example, for marketable securities), you will need to get an appraisal.
If estate tax is an issue, you use this information to figure the total value of the estate, and then apply exemptions and deductions. For instance, you subtract charitable bequests from the total. There is also an unlimited marital deduction for assets passing to a citizen spouse, either outright or through certain kinds of trusts.
Under a modified carryover basis system, you use date of death values for a different purpose. Subject to certain limitations, if an asset is worth more when someone dies than she paid for it, her estate can apply the $1.3 million basis allowance to the difference. Once this allowance is used up, there might be income tax, but it's not triggered--meaning it doesn't have to be paid--until the asset is sold (a common misconception). At that point the total amount subject to tax would consist of the difference between the date of death value and the basis allowance, plus any appreciation after the date of death.
For example, let's say you inherit publicly traded stock from your mother. If she bought the stock for $500,000 and it's worth $2 million when she dies, there's $1.5 million of appreciation, or what tax geeks call "built in" or "unrealized" gain. Without a basis adjustment, if you immediately sold the stock, carryover basis rules would require you to pay tax on all that gain. But instead the law allows you to bump the basis up by $1.3 million, so it's as if the stock cost $1.8 million ($1.3 million plus $500,000) instead. When you sell it, assuming the value hasn't changed since Mom died, you would pay capital gains tax on $200,000 ($2 million minus $1.8 million).
2. Locate purchase records.
Your quest for the other vital data you need to cope with carryover basis--the original cost of the assets--could be far more complicated. If you can't prove what things cost, the IRS assumes the cost is zero and could try to saddle you with capital gains tax on the total sales amount.
With investments like Mom's stock, tax returns and brokerage statements can lead you to what someone owned on the date of death. Going back through the years, they also show dividend payments, which may provide another clue about when an investment was purchased.
But if the assets have been moved between financial institutions, the original cost might not be on file with the current broker. You may even have to sort through papers that predate computerized records.
In other tax situations, when the initial cost was unclear, accountants have had clients estimate when something was bought, then obtain price information directly from public companies or by checking newspaper archives. The consensus is that approach will work in this context, too.
Real estate can pose a much bigger problem, says Carol A. Harrington, a lawyer with McDermott, Will & Emery in Chicago. Consider a home that has been in the family for many years. Basis consists not only of the purchase price, but factors in capital improvements that add value to the home. To recreate those records, you might need to scour grandma's attic for canceled checks showing what she spent to renovate the kitchen or add dormers to the country house, for example.
The plot thickens with property inherited from real estate developers, says Dennis I. Belcher, a lawyer with McGuireWoods in Richmond, Va. Because many have both depreciated the property and borrowed heavily against it, they may have debt that exceeds the basis, he says. "If the fair market value has dropped, it's conceivable that their families won't have enough money to pay the capital gains tax."
3. Delay selling appreciated assets.
In the past, the standard thinking has been that an executor (the person who administers an estate), should sell investments as soon as possible (or at least diversify out of concentrated positions) and hold the proceeds in cash or an equivalent form. Because executors are legally obligated to preserve money going to inheritors or needed to pay estate tax, the theory was that they should not take market risk of continuing to hold the investments.
Now an executor, who can be a family member, friend or professional adviser, must consider the income tax effect of selling property that has increased in value, whether a security, art or real estate. That's not a concern when the proceeds are going to charity, but it is when people are the beneficiaries, Harrington says.
To add one more layer of complexity, there is a slim chance that carry-over basis applies only to assets both inherited and sold in 2010. This interpretation stems from the sunset provision of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001--the law that provides for the one-year lapse in the estate tax. Section 901(b) of the law says that in 2011 old laws will apply as if EGTRRA "had never been enacted."
If that is true, inheritors may be able to escape the carryover rules by holding assets at least until next year. At that point, if an investment is sold, the capital gains tax would apply only to any increase in value after the date of death.
So what should executors do this year? As a practical matter it's still easiest to liquidate the assets, and that's what they should do unless, from an investment perspective, they have good reasons to hold them, says Harrington. On the other hand, Belcher is telling clients "don't sell assets unless there's an investment reason to do so." Some estates holding large positions are using derivatives to protect against investment losses, he says.
4. Postpone distributions.
If Congress restores the estate tax retroactively, it could apply to the estates of people who died this year. So heirs of estates that would be subject to the tax need to set aside money for it. Likewise, if there's modified carryover basis, they will need cash to pay the capital gains tax. Therefore a prerequisite to making distributions is to determine whether there is enough money to make the payouts under the worst of the two scenarios.
5.Extend paperwork deadlines.
The deadline for reporting carryover basis is April 15 of the year following a person's death--the same day on which his or her final income tax return must be filed. (This due date is different from the one that applies for the estate tax return, which is due nine months after the date of death.) As with an income tax return, it will be possible to extend the deadline by six months, to Oct. 15.
So far the IRS has not yet created the form that will be used for this purpose or the accompanying instructions. It might be a separate carryover basis return, using the Social Security number of the person who has died. Or, there might be a form or schedule for reporting carryover basis that gets attached to the final income tax return.
Either way, the form is likely to ask executors to list each asset, along with its basis and date of death value. They will also need to indicate which assets the free basis (that is, the limited $1.3 million/$3 million step-up in basis) will be applied to, and in each case how much the basis will get bumped up. There's no need to sell the asset before filing this form; what you're allocating is built-in gain between the original cost of the asset and the date of death value.
Certain limitations apply. For example, there is no basis adjustment on what is called income in respect of a decedent or IRD, says Keith Schiller, a lawyer in Orinda, Calif., and author of Art of the Estate Tax Return (Innovation Estate Planning Productions 2010). This is income that wasn't taxed before a person's death and would have been taxed if the individual had lived long enough to receive it. Schiller notes that examples include: distributions from traditional pre-tax individual retirement accounts; qualified retirement plans including traditional pre-tax 401(k)s; a company bonus; income from an S corporation; and money owed on a promissory note under an installment sale.
Also keep in mind that while the $1.3 million exemption can be applied to assets given to anyone, the $3 million one is limited to assets given exclusively to a spouse, either outright or in certain kinds of trusts, Harrington says. So you may not use this exemption for assets going into a trust that will benefit people in addition to the spouse.
Other issues remain unclear, including how an executor allocates basis to assets that have been put into a family limited partnership--a popular estate-planning tool that can serve a variety of functions. Schiller recommends taking an extension to file the return, both in the hope that the IRS will provide some guidance in the meantime, and to see what approaches the IRS accepts to balance various unknowns (like valuing assets when purchase records aren't available).
6. Apply the basis allowance fairly.
If some assets may be kept in the family, it's most efficient to allocate the basis to those that are likely to be sold first, Belcher says. But this strategy could cause some inheritors to benefit from the free basis more than others. And that "creates all sorts of conflicts," when an executor is also a beneficiary and allocating the basis a certain way would benefit herself.
This problem is analogous to one that has come up previously, when all assets were valued as of the date of death, Harrington says. Often several years pass before beneficiaries receive those assets. And meantime, values can fluctuate. When making in-kind distributions to beneficiaries (as opposed to handing out the proceeds of assets that have been liquidated), executors have always tried to give out assets that are not only roughly equal in value, but also have a roughly similar basis. The principles are the same in this setting, she says.
7. Guard against an executor's added risks.
Legally, an executor is a fiduciary, who is expected to act prudently and be impartial. Under the best of circumstances, it can be a difficult job, with a risk of liability for missteps. Still, the complicated landscape this year, especially as it involves carryover basis, seems to leave an executor extra vulnerable. As Belcher notes: "It's complicated, there's no guidance, there are no forms. And it may be around for only one year."
He suggests executors advise families of the uncertain state of the law, alert them to the investment risks of waiting to sell assets, give reasons for any strategies they recommend and ask beneficiaries what they want to do. Along the way, it's wise to document conversations with follow-up correspondence and notes to the file.
If you're an executor and family members disagree with your recommendations, do what they ask, Belcher advises. But in that case you might want to get them to sign a document releasing you from liability and indemnifying you for losses. Such precautions are unusual--executors are expected (and often paid) to navigate difficult situations. But in the current environment, you might just want this document in your back pocket.
Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide (DJWorking Unlimited, 2009). To keep readers current between editions, she writes for Forbes.com, issues updates that can be downloaded from the book's website, and tweets at http://twitter.com/djworking.