Investing with William Creekbaum: Estate taxes are in flux

Under current law, Jan. 1, 2010, marked a one-year repeal of the U.S. federal estate and generation-skipping transfer taxes. It is not clear what will happen next. In the middle of the current uncertainty, a focus on estate planning basics and a close evaluation of whether certain strategies are appropriate may be essential to successfully navigating the changes to come.

The legislative outlook for federal estate and generation-skipping transfer taxes is cloudy at best. Under current law, both the federal estate and generation skipping transfer taxes will return on Jan. 1, 2011. As of that date, absent an act of Congress, the exclusion for each tax will be what it would have been had the current law not been passed (i.e., $1 million for the federal estate tax and $1 million, indexed for inflation, for generation-skipping transfer taxes). The highest marginal estate-tax rate will be 55 percent for taxable estates greater than $3 million.

It is possible, however, that prior to Jan. 1, 2011, Congress will reinstate the transfer-tax system that applied in 2009: a top marginal 45 percent tax rate for estate, gift and generation-skipping taxes, a $3.5 million exemption for estate tax and generation-skipping transfer tax and a $1 million exemption for gift tax. If Congress does reinstate the transfer-tax system in this (or some other) fashion, it may decide either to make the law retroactive to Jan. 1, 2010, or allow for some gap. If Congress acts to make the law retroactive, lawsuits will inevitably be filed testing the constitutionality of retroactive enactment. These lawsuits would probably not be resolved for years. It is impossible to predict when, how or if Congress will act - or what the result of any legal challenges may be.

If the legal and legislative possibilities are not confusing enough, the waters are further muddied by the fact that 2010 is a Congressional election year. In the 2010 midterm elections, 36 of 100 U.S. Senate seats are being contested and all 435 voting members of the House of Representatives are up for reelection. Therefore, it is possible that any law passed in 2010 might be further amended in 2011.

Additional factors that complicate planning and could undermine the benefits of the elimination of the estate tax include:

Gift Tax - Under current law, only the estate and generation-skipping transfer taxes have been repealed in 2010. There is still a federal tax that applies to taxable gifts in excess of $1 million (in the aggregate, during life). In 2010, the highest marginal federal gift-tax rate has been reduced from 45 percent to 35 percent.

State Estate Tax - Although federal estate and generation-skipping transfer taxes have been temporarily repealed, state estate taxes still exist. More than half of the states have enacted laws that impose a state estate tax upon the estate of a decedent. Therefore, it is important to make sure that estate planning takes state transfer-tax laws into account. This can be especially complex when real estate is owned in more than one state or time is divided between or among more than one state.

Carry-Over Basis - Prior to Jan. 1, 2010, when a beneficiary inherited an asset from a decedent, the asset was usually received with a "stepped-up" cost basis, equal to the value of the asset on the date of death (or an alternate valuation date six months after death). If the asset were later sold for that stepped-up value, there would be no capital gains tax due on the sale because there would be no gain on the asset sold. Under current law, in 2010, beneficiaries will take as their inherited cost basis the lesser of the decedent's ("carry over") cost basis or fair market value.

TAXPAYER RESPONSES

People have reacted to uncertainty about the future of the federal estate tax in several ways. Some are renewing their focus on estate-planning basics by better aligning their estate plans with larger family goals, organizing documents and contacts (even more important as carryover basis rules will put the burden on heirs to determine the cost basis of inherited assets) and confirming that beneficiary designations are accurate.

Many are restructuring their estate planning documents - taking into account the possibility that they may die when there is no estate tax - and often are making alternative plans under their wills or revocable living trusts, to be enacted depending on whether any estate tax will be applied to their estate.

Others are aggressively taking advantage of the reduction in the gift-tax rate and the one-year absence of the generation skipping transfer tax. This may be accomplished by making large lifetime transfers at lower gift-tax rates and free from any generation-skipping transfer tax. However, if Congress were to pass a new law deemed retroactive to Jan. 1, 2010, these transfers might be subject to transfer tax at a higher rate (in the case of federal gift tax) and may become taxable (in the case of generation-skipping transfer tax).

With so many moving parts, changes in estate-tax laws will remain in the news throughout 2010. Thus, each new development will require careful analysis and a focus on finding strategies that conform to the new rules and meet individual needs.

• William Creekbaum, MBA, CFP, a senior investment management consultant of Morgan Stanley Smith Barney LLC, can be reached at William.a.creekbaum@mssb.com or 689-8704.