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Death and Taxes. Think Again.
By Dane Dickler, Senior Manager - Tax & Business Services

This year, Congress has done little in the way of gift and estate tax reform. As a result, 2010 is sizing up to be the year for affluent individuals to transfer wealth.

The biggest failure of Congress has been their inability to keep the estate tax from lapsing in 2010. This is good news for those who expect to receive an inheritance. Because there is no estate tax in 2010, all assets included in the estate of a 2010 decedent pass to the beneficiaries estate tax free.

But there is a catch. The beneficiaries inherit the carryover basis of the deceased. The basis in bequeathed property for 2010 is the lesser of the fair market value of the property at the time of death or the decedent’s basis.  For basis purposes, it’s as if the deceased gifted their property to their beneficiaries.

The holding period of the bequeathed property is determined based on the value of the property in the hands of the recipient.  If the recipient’s basis is the same (in whole or in part) as the decedent’s basis, then the holding period of the deceased is tacked (added) to the holding period of the recipient. On the other hand, if the decedent and the recipient do not have the same basis in the bequeathed property, the holding period of the deceased would not tack onto the holding period of the recipient.  For example, if the fair market value of the property on the date of death is less than the decedent’s adjusted basis in the property, the recipient would have a basis equal to the fair market value on the date of death and would not tack the holding period of the decedent.  Conversely, if the recipient received the decedent’s basis they would also receive the decedents holding period.

To make up for some of the loss in benefits that heirs would have been entitled to, the IRS allows the executor of the estate to allocate $1,300,000 in additional basis to the bequeathed assets.  In addition, a spouse is entitled to a $3,000,000 step-up in basis for assets passed to them. These basis adjustments have no impact on the holding period of the recipient.

In addition to the obvious benefit of the zero estate tax for 2010, the current interest rate environment makes split interest trusts increasingly more attractive. A split interest trust is established to hold property where the benefits are split into two components, a present interest and a future interest. The present interest is typically enjoyed by the grantor while the future interest is enjoyed by the ultimate beneficiaries.

One of the more popular split interest trusts is the Grantor Retained Annuity Trust (GRAT). Many wealthy individuals establish GRATs with short durations (typically 3 years or less) in the hope they can transfer assets to their beneficiaries without paying gift tax on the remainder interest in the trust. Given the low interest rate environment, investments held in a GRAT simply need to outperform the applicable federal rate (AFR) in order to realize a transfer tax benefit.

The applicable federal rate is the monthly interest rate published by the IRS under the Internal Revenue Code. Currently rates are low, allowing grantors to benefit when property transferred to a GRAT grows at a rate higher than the AFR.

GRATs have become so widely used that legislation in the House of Representatives to restrict the usefulness of GRATs has been proposed. The House bill proposes that the life of a GRAT be no shorter than 10 years. This would curtail the benefits of wealth transfer by increasing the likelihood that the grantor would not outlive the duration of the GRAT. In which case, the GRAT assets would generally be included in the gross estate of the grantor, negating the expected transfer tax benefits. A longer duration GRAT would also negate the benefit of putting assets in a GRAT that are expected to increase in value over a short period of time. The risk is that the GRAT assets could increase in value in the short term and then subsequently decline in value over the remainder of the GRAT term. This could result in over-valuation of the assets transferred.

Another area where leverage is available is the gifting of low value assets. The current values of real estate and closely held businesses are historically low. This creates an opportunity to transfer such assets at a reduced value. If the grantor believes that the assets will increase in value, and they plan on passing the assets to their heirs, now is a good time to transfer these assets out of their estate.

In addition to today’s depressed asset values, the gift tax rate is 35% for 2010. Individuals should strongly consider gifting assets during their life as opposed to passing their assets at death. The gift tax is calculated on a tax-exclusive basis while the estate tax is calculated on a tax-inclusive basis. In other words, the gift tax is paid by the donor from their gross estate during life, effectively reducing their taxable estate; whereas the estate tax is paid using gross estate assets and does not reduce the taxable value of the gross estate. However, the gross up rule equalizes the transfer tax on gifts made within three years of death.

If an individual decides to make an outright gift or to transfer assets into a trust they should be aware of the potential pitfalls of doing so too early in the year. If an individual gifts property and then dies in 2010 they would unnecessarily have paid transfer tax on gifted assets. In addition they would not be entitled to a step up in basis on the gifted assets as described earlier. The other major concern is that Congress could act before the end of 2010 to retroactively institutes the estate tax or propose other onerous transfer tax legislation. Any changes to the current transfer tax laws would change the estate tax planning opportunities.

Senate Finance Committee Chairman Baucus says it is increasingly unlikely that the estate tax will be reinstated retroactively. Lawmakers may permit heirs with modest inheritances to elect to benefit from stepped-up basis rules and other expired provisions. Baucus stated, “practically speaking, the later that we take up and pass the estate tax law or provision, the more difficult it is to make it retroactive. However, it's possible there could be an election for the executor which would, in effect, make that question moot,” he says.

If the legislation is passed, individuals would have the ability to choose to apply the expired transfer tax rules. This would benefit individuals with modest inheritances, primarily those with estates of $3.5 million or less where the assets are not left to a surviving spouse.

Individuals should be aware the estate tax will return in 2011 under the 2001 transfer tax rules, with the estate tax exemption reduced to $1.0 million and a transfer tax rate of 41-60%. A Senate bill has been introduced adopting a lifetime exclusion amount of $3.5 million and a progressive tax rate of 45% to 55%, depending on the size of the gross estate, with a 10% surcharge for estates in excess of $500 million.

Opportunities exist in 2010 for prudent planners to transfer assets to their beneficiaries while minimizing transfer tax liabilities. Due to uncertainty surrounding future transfer tax laws, the window for taking advantage of many of these opportunities is quickly closing. Individuals are encouraged to consult their dedicated Marcum tax professional to insure they take advantage of the opportunities still available.

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