Federal Estate Taxes

First of all, the Federal Estate Tax HAS NOT been permanently repealed, although a lot of folks seem to think it has been.  Yes, the applicability of the current law is suspended for the year 2010.  However, the tax is re-instituted at the old exemption equivalent level ($1,000,000) in 2011 if Congress does not act.  So, under current law, you'd better plan on dying in 2010!  That's only a joke, and a bad one at that, because during this year, the step-up in basis rules are not be applicable. That means that the settlement of everyone's estate will be subject to wealth transfer taxes in the form of income taxes for the year 2010.

Let me explain the tax impact of the loss of a step-up in basis by using a hypothetical situation. Under current law, if I established a $50,000 investment in a mutual fund, and when the account went to my son at my death it was worth $150,000, my son's basis (or tax cost) in the account is that $150,000 value on the date of my death. So, he can take the account, liquidate it for $150,000, and not owe any income taxes because there's no taxable gain on the transaction. However, if this scenario unfolds in 2010, my son would not receive a step-up in basis, therefore his tax cost in the inherited account would be my tax cost -- $50,000.  When he liquidated the account for $150,000, he would have a gain of $100,000, on which he would owe income taxes, regardless of the overall size of my estate. If that sounds like a worse result to you than what was experienced under the Federal Estate Tax, I think you're right.

The future of wealth transfer taxation has been a hot topic throughout several presidential administrations, but little has changed since the passage of the law recited above that also increased the exemption equivalent to the 2009 level of $3,500,000.  Many forces have sought the complete repeal of this tax, but many other forces think that the reach of wealth transfer taxes ought to be expanded.  During most of President George W. Bush's term of office, the Republicans controlled both legislative branches of the Congress and the White House, yet wealth transfer taxes were not permanently abolished.  Now that the Democrats have control of the House, Senate and the White House, there is a movement to expand the reach of these taxes. 

However, regardless of what happens in Washington, one of the big concerns in this wealth transfer tax discussion of which I find people are completely unaware, is the re-emergence of the states. Most states used to be happy to receive the 5% "sponge tax" the federal government would return to a state which did not have its own estate tax when one of its residents died owing Federal Estate Taxes. However, as the exemption equivalent reached $3,500,000, fewer estates were subject to this tax. So of course, there was less to send out to the states. What did the states do? Many imposed THEIR OWN wealth transfer taxes! At last count, there are 21 states, plus the District of Columbia, that impose some sort of wealth transfer tax, either in the form of an estate tax, or in the form of an inheritance tax. Taxpayers must be particularly aware that, although they might primarily “reside” in a state that does not impose wealth transfer taxes (such as Florida); another state could be the taxpayer’s state of “domicile.” At the time of the taxpayer’s death, the domiciliary state is going to be the state that primarily determines whether your estate will have to address wealth transfer taxes. For purposes of wealth transfer taxes, one can easily have a tax domicile in a state and be unaware of it.

I conduct a workshop that touches on this topic entitled, "Deadly Estate Planning Errors . . . and How to Avoid Them." One of the mistakes I talk about is thinking that these sorts of taxes have been repealed, or are going to be repealed, and failing to plan because of it. That is, in my opinion, a HUGE mistake. Like it or not, these sort of levies have a very long tradition in the United States.  In fact, one of the very first non-excise taxes imposed by the United States Congress was an estate tax . . . in 1798! That's 118 years BEFORE the imposition of the modern income tax. So, my view is that wealth transfer taxes, in some form or another, assessed at either the federal and/or state level, are here to stay. People ought to understand that and plan for it.