The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the act more commonly called the “Bush tax cuts”, instituted gradual sweeping changes to the rules governing estate tax in the United States. From 2001 to 2009, the rate of estate tax decreased incrementally from 55% to 45%, and the unified credit exclusion—the amount of inheritance exempt from estate tax—rose from $675,000 to $3.5 million. After nine years of gradual adjustment, however, on January 1, 2010, a drastic change went into effect. Overnight the estate tax was repealed and inheritance was now to be taxed, when applicable, as capital gains.
Almost no one expected this provision of the EGTRRA to actually happen. Estate taxes, after all, constitute a substantial revenue stream for the government. We’re nine months into 2010 now, however, and Congress was unable to pass legislation preventing the repeal, and since January they have not been able to reinstate the estate tax. This has created a complex and confusing situation, untested waters in the sea of estate planning where even the IRS isn’t sure what to do.
On January 1, 2011, however, we’re in for another drastic change. The EGTRRA contained a “sunset” clause which provides that its provisions will extend until December 31, 2010, and then they will expire, reverting the US tax laws to their pre-EGTRRA state. While the confusion of 2010 can be daunting for estate planners and the executors of estates, and while the particular rules of 2010 present unique benefits and pitfalls to heirs, the shift at the beginning of 2011, the overnight expiration of the Bush tax cuts, will create new risks that, especially for the small business and small farm owner decedents, represent perhaps even greater danger.
In 2009 if someone died who owned a farm worth $3 million, the heirs or legatees would inherit the farm. The estate tax credit was $3.5 million, so the new owners would pay no estate tax. If the farm was instead worth $5 million, they would pay estate tax (at 45%) on $1.5 million. There would be no capital gains tax on the inherited property, regardless of its value.
If the same situation happened this year, there would be no estate tax, regardless of the value of the farm, but if and when the farm was sold it would be subject to capital gains tax. The situation is not that clear cut—and who would expect taxes to be any other way?—but that’s the basics. The current system has its advantages. Capital gains tax is much than estate tax. Furthermore, since no tax is incurred until the inheritance is sold, one could wait to sell until more favorable conditions arose—now, for example, is not an ideal time to be trying to sell a house. The present situation is most ideal for those individuals who have the resources to wait to sell. It is much harder on middle income individuals who, if they inherited a $3 million farm, could not afford to sit and wait for it to appreciate.
The return of the estate tax in 2011 will likely be even harder on middle income individuals. Unless new legislation is passed that says otherwise, the estate tax rate will be 55% (in the highest bracket) and the unified tax credit will be $1 million. Someone who inherited $3 million in 2011 will have to pay estate tax on $2 million. If, hypothetically, the inheritance were entirely in cash, this would not be a problem. The price tag would be high but the heir would still come out with a profit. A farm, a house or shares of stock, however, are obviously not cash and they cannot necessarily be easily or quickly translated into usable funds. If someone inherits a $3 million farm in 2011, she would also receive an estate tax liability. If she is wealthy enough to have those funds available, she can pay the IRS and move on with her life. But if she does not have that much in the bank, the situation for the majority of Americans, she faces a more difficult decision.
For more information and to figure out how estate tax rules affect you, contact Laura Paplauskas or Paul Horowitz at Horowitz and Weinstein.