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Federal Estate Tax Repeal and Carryover Basis: Is It Time to Worry Yet?


The federal estate tax was repealed by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)1, effective January 1, 2010. However, to conceal the impact of the repeal on the federal budget Congress made the repeal effective for only one year. For decedents dying after December 31, 2010, the tax is reinstated with only a $1 million exclusion (after reaching a $3.5 million exclusion in 2009 in steps over the last few years).

Also moderating the fiscal impact of the repeal, Congress simultaneously enacted changes to the basis rules for calculation of capital gains tax. As explained in more detail below, the changed basis rules are intended to ensure that any appreciation in property value that occurred during the decedent’s lifetime will be taxed sooner or later. This amounted to a huge tax increase. Oddly, it seems not to have appeared on the public’s radar screen. Even more surprising, those rabidly opposed to tax increases of any kind under any circumstances have said barely a word.

Academics and other commentators have generally recognized the repeal of the estate tax and new basis rules for what they are: an attempt to score political points at the cost of imposing rules that are unfair, uncertain, and unworkable. As a result, just about every observer since enactment has predicted that Congress would clean up the mess before it goes into full effect on January 1, 2010. A fix seemed even more assured if we had a Democratic Congress, and an absolute lock if we had a Democratic President. So it certainly should have happened by now. There is only one problem: it hasn’t. As this is written, there are about two weeks until implementation of full estate tax repeal and new basis rules. As you read this, it will be days away or probably already history.

The purpose of this article is to remind us of the litany of woes that we may have learned about when the ink was still drying on EGTRRA -- but that we may have been led to disregard because of the chorus of optimistic statements and assurances that we would never have to deal with them.

Stepped-up basis

As many know, the biggest woe is the loss of an automatically adjusted basis at the death of the owner. Now, and since 1980, the basis of property “acquired from a decedent” equals its fair market value at the date of the decedent’s death.2 In most cases, this implies a stepped-up basis because of the inflation of value over time. A capital gains calculation that subtracts a new stepped-up tax basis from the eventual sales price will often produce little or no capital gain, and little or no capital gains tax. All the appreciation in the hands of the decedent simply escapes any tax.

EGTRRA blows all of this away. The revised rules eliminate the current step-up rules and replace them with a “carryover” basis system.3 This system provides that the recipient of property acquired from a decedent receives a carryover basis equal to the lesser of the decedent’s adjusted basis (or the fair market value of the property at the decedent’s date of death, just in case it went down in value after acquisition). The purpose is to guarantee that any appreciation in property value that occurred during the decedent’s lifetime will now be taxed sooner or later rather than disregarded.

The roving basis adjustment

Congress made modest concessions to complaints that it was reducing estate taxes for the few very wealthy while increasing capital gains taxes for everyone else. It provided a roving basis adjustment for property acquired from a decedent of up to $1.3 million in addition to the decedent’s existing basis, thereby sheltering that amount from eventual capital gains taxes.4 It also provided an additional $3 million in basis increase for property transferred to a surviving spouse.5 These rules were advertised as protecting the more modest estates and meant to silence the critics. However, the procedures Congress set up to implement the protections threaten to become a nightmare, and the substantive protections appear to be substantially narrower than those we are used to.

Burdensome procedures for implementation

Implementation of the carryover basis rules can be expected to be a major burden. Carryover basis has been tried before. It was enacted in 1976 and repealed in 1980 before it ever took effect because of a storm of criticism. Among other problems, it dawned on many observers that when a property owner died, he often took with him the best – and sometimes the only – source of information about its cost basis. Moreover, the necessary record-keeping required in the future and work to reconstruct records in the past looked uninviting, to say the least. According to the Congressional Research Service, the primary rationale for repeal was the unreasonable administrative burden on estates, heirs, and the Treasury Department.6

EGTRRA aggravates these inherent carryover basis problems with its rules for a roving “step-up.” For example, suppose a decedent dies with assets having $2 million in appreciation and five equal beneficiaries. The $2 million in appreciation exceeds the allowable $1.3 in available adjusted basis, leaving $700,000 with carryover basis. Which of the five heirs are going to get a stepped-up basis on the property received and which ones are going to be stuck with carryover basis? One possibility is that the owner can try minimizing taxes by guessing which recipients will sell assets and which will hold on to them, and then directing the executor to allocate the available step-up to the assets going to recipients who are likely to sell. In default of such complex arrangements, heirs and beneficiaries will be left to quarrel among themselves about how the basis step-up should be allocated. Even if the basis allocation goes peacefully, consider the “massive record-keeping burden over many decades . . . as heirs would have to track, asset by asset, how much of the valuable step-up each received.”7

Congress apparently thought it was resolving this issue by designating the “executor” as the person with the authority to allocate the allowable basis adjustment among the beneficiaries.8 But where is this “executor” supposed to come from? Where else but court appointment. Apparently it will soon be necessary to start a probate proceeding for every decedent who owned appreciated assets so that an executor can be appointed who is permitted to allocate the basis adjustment to particular assets.9 Congress was apparently unaware (or didn’t care) that most estates don’t have executors; that executors have to be appointed by a court; that probate proceedings are expensive, time consuming, and unwanted; and that avoiding such burdens is at the core of most estate planning. Worse, we now in California have substantially increased court fees in probate proceedings, making Congress’s invitation to seek appointment of an executor just for the purpose of allocating basis adjustments even more expensive and unwelcome.

One can have suspicions that Congress might have intended these procedures to be so cumbersome and burdensome that many taxpayers would simply throw up their hands and give up on seeking a basis adjustment. Intended or not, it seems fairly clear that it is the relatively wealthy who will have the knowledge and resources to pursue their rights, and the less wealthy and less informed who are more likely to default into carryover basis and then get hit with higher capital gains taxes.

Substantive protections

Even assuming that the identity of the assets subject to adjustment is clear and that there is a handy executor willing to make the allocation, the chance of receiving an adjusted basis is still pretty dicey. This is because EGTRRA’s revised basis rules also constrict the assets that are eligible for an adjustment. Under the new rules the assets will need to pass two tests: they will have to have been “acquired from a decedent” 10 and they must have been “owned by the decedent” at the time of his death.11 It turns out that a lot of typical asset arrangements planners now use will apparently fail to meet these two tests.

Most prominently, it seems doubtful that the retention of a life estate interest or a right of occupancy will meet these tests. In the past this has not been a problem. According to a catch-all provision in the existing tax rules, any property required to be included in the “gross estate” subject to the estate tax has been deemed to have been acquired from a decedent and therefore eligible for a stepped-up basis.12 Life estate interests were among those assets fully subject to the estate tax (including both the life and remainder interest), and that’s why they have clearly been entitled to a stepped-up basis on the whole value of the property.13 However, with the repeal of the estate tax, there can hardly be “gross estate” subject to the estate tax any more. So this whole line of argument for an adjusted basis will become obsolete. Like the present law, the new law does not specifically address life estates. However, without the “gross estate” argument it seems extremely doubtful that a life estate will be deemed either “acquired from a decedent” or “owned by a decedent” for purposes of obtaining a stepped-up basis. It seems likely that either only the life interest will be entitled to an allocation of basis adjustment14 or that none of it will be eligible15; the statute is not clear.16

EGTRRA is more explicit about powers of appointment. It says that the decedent will not be considered the owner of any property by reason of holding either a general or special power of appointment.17 So it appears that a trust that grants the decedent a power of appointment will no longer be a means of achieving a step-up in tax basis. Further, property will not be considered to have been “owned” by the decedent if he or she acquired it by inter vivos transfer within three years before the decedent’s death (with exceptions for transfers by spouses).18

The only reassuring news is that property will be considered both acquired from a decedent and owned by the decedent (and therefore eligible for an allocation of basis) if it is a transfer in trust that is revocable.19 Oddly, property will be deemed acquired from a decedent, but not necessarily as owned by the decedent if the decedent transferred the property to a trust and retained only the right to “alter any beneficial interest by the ability to alter, amend, or terminate the trust.”20 It is not clear if this difference is intended to make any difference. More confusion.

There are many additional complex EGTRRA carryover basis rules, e.g., on eligibility for spouses21, ownership requirements22, cost-of-living adjustments23, and treatment of liabilities24. They will not be addressed here since this article is intended only as a “heads-up” about the new rules, not a guide to their use.

Plans for the future

The President and Congressional leaders announced in early 2009 that they intended to act quickly to prevent repeal of the estate tax.25 Indeed, the Obama Administration announced in its proposed 2010 budget that it was in favor of making the 2009 rules permanent.26 Then as summer turned to fall, the conventional wisdom seemed to be that, even if there were not enough time this year for a thoughtful overhaul of the estate tax and carryover basis rules, there was still enough time for Congress to simply extend the 2009 rules into 2010 as a temporary stopgap. However, wars and health care issues have apparently distracted Congress from focusing on such less visible tax matters. By September, leaders in Congress had reportedly given up on any fix before the end of the year.27

Then there was a surprise in early December as this article was being written. On December 3, on a 225 to 200 largely party-line vote, the House passed the “Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009,” HR 4154.28 Essentially it makes permanent the estate tax and stepped-up basis rules in effect this year (2009). The House sent the bill on to the Senate where approval of its provisions before the end of the year seemed fairly unlikely. Among other problems, not only Republicans, but some powerful Senate Democrats are holding out for more generous provisions29 for the remaining 5,500 estates (.23 percent to all estates) that might still be subject to the estate tax.30

Of course if the Senate does not act this year, any revisions it approves will be after full implementation of both repeal of the estate tax and carryover basis rules on January 1. Although analysts disagree, there is now talk that a retroactive application of revisions sometime in 2010 will not be unconstitutional.31

How should this all affect the planning we do for clients? Until recently it seemed that the EGTRRA rules would never, could never, go into effect. So most planners have continued believing that the old rules would somehow still apply in the future. Everything seemed to point in the direction of a fix by the end of the year, but it looks like it’s not going to happen. So if you believe that repeal of the estate tax and carryover basis rules will really apply during 2010, your planning can switch from estate tax planning to step-up planning – but only for those clients who you can reliably predict will die before the estate tax comes back in 2011 (good luck). You have also have to believe that Congress will not try to enact, or be able to enact, a retroactive extension of the estate tax into 2010. Or you can simply believe that none of this can possibly be true, and everything will stay the same -- never mind what the law says. With only a few days to go before the full repeal and carryover basis rules go into effect, maybe it’s time to start worrying.

Endnotes

1. Pub. L. 107-16, 115 Stat. 38, June 7, 2001
2. IRC §1014(a)
3. IRC §1022
4. IRC §1022(b)(2)(B)
5. IRC §1022(c)
6. As quoted in “The Estate Tax, ‘Double Taxation,’ and Carry-Over Basis,” by Iris J. Lay, Center of Budget and Policy Priorities, July 7, 2002: http://www.cbpp.org/cms/index.cfm?fa=view&id=2083
7. “Will the Estate Tax Disappear?,” Laura Sanders, The Wall Street Journal, October 23, 2009.
8. IRC §1022(d)(3)(A)
9. Id., Any basis adjustment is allocated by the executor on an asset-by-asset basis. The executor must elect which asset receives an increase in basis and the amount of the basis increase allocated to that asset. Some observers believe that a trustee or other representative can take the place of an “executor” (see CEB, California Estate Planning, §12.22. Of course there are no IRS proposed regulations on such points, let alone actual regulations, because these rules were never expected to be implemented.
10. IRC §1022(a)(1)
11. IRC §1022(d)(1)(A)
12. IRC §1014(b)(9) It has not been necessary that the property in the gross estate actually generate any actual estate tax, just that it be includible.
13. IRC §2036(a)
14. “Beware of the Tax Relief Act’s New Basis Rules,” Robert Anderson, The Elder Law Report, November 2002, Vol.14, No. 4, at page2
15. “Are You Ready for Carryover Basis Rules?”, Bradley J. Frigon, The Elder Law Report, September 2009, Vol. 21, No. 2, at page 4.
16. IRC §1022(d)(1)(a)
17. IRC §1022(d)(1)(B)(iii)
18. IRC §1022(d)(1)(C).
19. IRC §1022(e)(2) “acquired” and IRC §1022(d)(1)(B)(ii) “owned.”
20. IRC §1022(e)(2)(B) “acquired”
21. IRC §1022(c)
22. IRC §1022(d)(1)
23. IRC §1022(d)(4)
24. IRC §1022(g)
25. “Obama Plans to Keep Estate Tax,” Jonathan Weisman, The Wall Street Journal, January 12, 2009, http://online.wsj.com/article/SB123172020818472279.html
26. “Night of the Living Death Tax,” The Wall Street Journal, March 31, 2009: http://online.wsj.com/article/SB123846422014872229.html
27. “Debate Over Estate Tax Likely to Wait Till 2010,” by Walter Alarkon, The Hill, September 15, 2009: http://thehill.com/homenews/senate/58665-debate-over-estate-tax-likely-to-wait-until-2010
28. H.R. 4154, December 3, 2009, Thomas, Library of Congress, thomas.loc.gov/cgi-bin/bdquery/z?d111:HR4154
29. Senator Blanche Lincoln (D., Arkansas) and Senator John Kyl (R., Arizona) want a maximum 35% rate with at $5 million exemption, rather than the House’s 45% rate and $3.5 million exemption. “House Bill Extends Current Estate Tax,” Martin Vaughan and John D. McKinnon Washington, The Wall Street Journal, December 4, 2009, http://online.wsj.com/article/SB123986877297775207.html
30. 2009 figure, according to “Tax Topics; Estate and Gift Taxes,” Tax Policy Center, Urban Institute and Brookings Institution. http://www.taxpolicycenter.org/taxtopics/estatetax.cfm
31. “Will the Estate Tax Disappear?”, supra, at 7.

(Gregory Wilcox is an attorney in private practice in
Berkeley, California)