Estate Tax or Carryover Basis?

For decedents dying in 2010, Congress provided two systems of taxing estates and determining basis of their assets. Executors of those estates must determine the better course. To do so, especially for valuations of gross estates above the new $5 million exclusion, they must take many factors and considerations into account. Should they use the exclusion or elect out of the estate tax and instead allow assets to pass tax-free to heirs, in the prior-law system of modified carryover basis? The latter comes with its own basis exclusions but without the step-up to fair market value on the date of death.

Because Congress presented estates with this dilemma in mid-December 2010, it allowed estates until mid-September 2011 to file estate tax returns for 2010 decedents and extended the time for making the election indefinitely (as of this writing) past April 18, 2011. This article outlines some of the implications and explores how they might apply in several common scenarios.

A DECADE OF COMPLICATIONS

To say the least, estate planning for the last 10 years has been complicated. These complications are due in large part to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which made major revisions to the gift, estate and generation-skipping transfer (GST) tax regimes. Although EGTRRA made estate planning cumbersome, it was very taxpayer-favorable because it reduced tax rates, increased exemption amounts and eventually repealed the estate and GST taxes. The most complicating EGTRRA provision was the one that called for it to expire on Dec. 31, 2010, and the Internal Revenue Code in 2011 was to read as if EGTRRA had never been enacted.

Taxpayers, with the assistance of their estate planners, were required to factor the changes in EGTRRA into their estate plans as well as its sunset. One of the more difficult tasks was planning for the repeal of the estate and GST taxes in 2010—an event most estate planners believed would never occur, as many assumed Congress would act before 2010 to prevent it. When Congress did not prevent it, estate planners were swept into a whirlwind trying to adjust estate plans for the one-year repeal of the estate and GST taxes. And just when they thought they could breathe a sigh of relief that they had so properly planned, Congress threw them a curveball at the end of the year.

On Dec. 17, 2010, the president signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act. Among other provisions, the Tax Relief Act modified and extended the gift, estate and GST tax provisions—but only through Dec. 31, 2012. The act contains a couple of potential traps for 2010 for taxpayers and their tax advisers, the result of the retroactive reinstatement of the estate and GST taxes in 2010. This article focuses on the reinstatement of the estate tax.

LAW PRIOR TO THE TAX RELIEF ACT

Under EGTRRA, the federal estate tax was repealed for 2010. In its place, a new set of income tax rules applied to determine the basis of property received by heirs from a decedent’s estate. These new income tax rules have been commonly referred to as the “modified carryover basis” rules.

Section 1022 is applicable to property acquired from a decedent who died after Dec. 31, 2009. The basis of the property is the lesser of the decedent’s basis in the property or its fair market value at the date of the decedent’s death. In general, a decedent’s basis is the amount he or she paid for the property.

Before (and after) 2010, a person who acquired property from a decedent received a step-up in basis to the fair market value of property at the date of the decedent’s death under section 1014 if the property had appreciated since the decedent acquired it. This was an income tax trade-off to minimize the double-tax effect if both estate and income taxes applied to such property. For 2010, this section was repealed.

Under the modified carryover basis rules, the estate representative can increase the basis of items of property selected by the estate representative by a total of $1.3 million. The basis of any particular item may not be increased above its fair market value on the date of the decedent’s death. The $1.3 million limit is increased by the amount of the decedent’s unused capital loss carryovers and net operating loss carryovers.

Property subject to adjustment includes property in the decedent’s probate estate and property in a revocable trust. Basis allocation is not available for any property that would have been subject to the decedent’s general power of appointment; any property that would have been includible under section 2044 as qualified terminable interest property (QTIP); and property in a grantor retained annuity trust or a qualified personal residence trust that would have been includible in the decedent’s gross estate under the estate tax law if the decedent died during the term.

If the decedent was married at the time of his or her death and some of the decedent’s property passes to the surviving spouse, an additional $3 million basis increase may be used with respect to that property. To be eligible for the spousal basis increase, property must pass to the surviving spouse outright or as qualifying terminable interest property as defined in section 1022(c)(5) (similar to the definition of such property in repealed section 2056(b)(7)).

LAW AFTER THE TAX RELIEF ACT

The Tax Relief Act repealed the EGTRRA provisions that had repealed the estate tax in 2010. It set the top estate tax rate at 35% and provided for an exemption amount of $5 million. The effect of these provisions is to retroactively reinstate the estate tax to apply to decedents dying in 2010.

The act, however, gives the estate of a person dying in 2010 an election to apply the law as if the act had not repealed the EGTRRA provisions. The representatives of such estates may elect to have no estate tax imposed, but they are required to use the modified carryover basis rules. The secretary of the Treasury is delegated the authority to determine the time and manner in which the election is to be made. This may be where the trip-up occurs. Originally, no estate would be subject to estate tax in 2010. That option is still available, but it is not the default option. The executor must make an affirmative election to opt out of the estate tax and apply the modified carryover basis rules. A tax adviser certainly does not want to make this incorrect assumption—especially for the estate of a super-wealthy client.

Because of its late passage, the Tax Relief Act provided additional time for the estates of decedents who died between Jan. 1, 2010, and the date of its enactment, Dec. 17, 2010, to file an estate tax return, pay estate tax or make a qualified disclaimer. The additional time is at least nine months from the date of enactment, Dec. 17, 2010—in other words, Sept. 17, 2011, or, rather, because that date falls on a weekend, Sept. 19, 2011 (although the IRS may set a later date). As of mid-May, the IRS had extended the due date for an election to opt out of the estate tax past April 18 but had not yet set a new due date.

TO ELECT OR NOT ELECT

If an estate planner were to take a simplistic view in determining whether an estate should make an election to use the modified carryover basis rules, he or she would assume that estates valued at or under $5 million would not make the election, and estates valued over $5 million would make the election. In most cases, the estate planner would be right; however, considerations that can rebut this simplistic view should be taken into account.

Estates less than $5 million. In general, if a person died in 2010 with a gross estate (before taking into consideration deductions and credits) of less than $5 million, the estate will not owe tax and its heirs will receive a step-up (or step-down) in basis of the assets in the estate equal to their fair market values on the date of the decedent’s death. The decedent’s estate will not have to file a federal estate tax return, nor will it be required to make any filings under the modified carryover basis rules. Essentially, the estate does nothing for federal tax purposes. Someone with a gross estate exceeding $5 million but with a taxable estate (after taking into consideration deductions and credits) of less than $5 million is required to file a federal estate tax return but owes no tax. The key here is to make sure the estate representative has accurate information about the fair market value of the estate’s assets. Assets without a readily ascertainable value (for example, real estate or nonpublicly traded stock) should be appraised by a qualified, independent appraiser.

Estates exceeding $5 million. In general, if a person died in 2010 with a taxable estate exceeding $5 million, the estate will want to elect to apply the law in effect before the Tax Relief Act’s enactment. Thus, the estate will not pay estate tax and will apply the modified carryover basis rules set forth in EGTRRA. However, depending on the size of the estate, several factors complicate this decision: (1) the basis of property (high or low); (2) when property may be sold (in the near future, later or never); (3) the type of property (for example, depreciable, nondepreciable or income in respect of a decedent (IRD)); (4) the estate tax marital deduction; (5) the estate tax charitable deduction; and (6) state death taxes. All of these factors will require the estate representative to “run the numbers” to determine whether the election to use modified carryover basis will minimize the overall tax effect of the decedent’s death.

For example, the estate tax for an unmarried decedent with a taxable estate of $7 million would be $700,000 [($7 million – $5 million) x 35%]. If the assets in the estate have a zero basis, are capital assets, and will all be sold in 2011 or 2012 for their date-of-death values, there would be no income tax due because the basis in the assets is stepped up to the date-of-death values. If, however, the estate elects out of the estate tax, the basis in the assets will be $1.3 million. The income tax on the gain on the sale of the assets ($5.7 million) will be $855,000, based on a 15% capital gain rate. In this situation, it would be tax-efficient to pay the estate tax rather than the income tax. This would also be the case for larger taxable estates if the assets will be sold after 2012 and the capital gains rate increases in 2013.

On the other hand, if the assets were split so that half are capital assets with a zero basis and half are the decedent’s interests in individual retirement accounts (IRAs), the $1.3 million basis increase will apply only to the capital assets. If the estate tax is paid, the total taxes would be $1,925,000 (estate tax of $700,000 and income tax of $1,225,000 (35% ordinary income rate on the $3.5 million IRA, not considering the IRD recipient’s income tax deduction for estate taxes paid on IRD)). If the estate elects out of the estate tax, the total income tax would be $1,555,000 ($330,000 on the sale of the capital assets at the 15% tax rate and $1,225,000 on the IRA). In this situation, it would be tax-efficient to elect out of the estate tax (see Exhibit 1).

Married couples with larger estates. One obstacle in making an informed decision for estates of married individuals in the range of $5 million to $10 million is the uncertainty about the future of the estate tax. The only thing certain is that the portability of the estate tax exemption, in which any unused exemption of the decedent may be used by the surviving spouse (but only in 2011 and 2012—see “Seven Good Reasons Credit Shelter Trusts Remain Relevant,” JofA, June 2011, page 44), is not available to the surviving spouses of decedents who died in 2010. For a married individual who died in 2010, the decision whether to file an estate tax return and make a QTIP election to obtain a marital deduction may depend on the anticipated amount of the estate tax exemption at the date of the surviving spouse’s death. If the estate planner anticipates that the estate tax exemption will remain $5 million, it may be better for the current estate to file the estate tax return, claim the marital deduction, and get the step-up in basis for the assets. But if the estate tax exemption is expected to return to $1 million before the surviving spouse dies, the current estate probably would want to opt out of the estate tax, so that property in the trust that would have been subject to the QTIP election will not be subject to estate tax upon the death of the surviving spouse.

For example, suppose a husband died in 2010 with an estate of $8 million consisting of stock in the family business in which he has a zero basis, and his wife has an estate of $2 million. The husband’s will calls for his property to be divided, with $5 million passing to a trust for the benefit of their children and $3 million passing to a trust for the benefit of his wife, for which the QTIP election would be made if the estate tax option is selected. Assume the assets in the children’s trust are sold at a time when there has been no appreciation since the date of the husband’s death.

If the estate selects the estate tax option, no estate tax would be due, because the marital deduction would reduce the taxable estate to $5 million, and the estate tax exemption will cover that amount. All the property in the estate would receive a basis equal to its fair market value at the date of the decedent’s death. No income tax is due when the assets in the children’s trust are sold.

When the wife dies, her gross estate will include her own assets and the assets in the QTIP trust—a total of $5 million (assuming, for simplicity, no appreciation in the value of the property). If the estate tax exemption is $5 million, no estate tax will be due at her death. The assets in her estate, including the assets in the QTIP trust, will receive a basis equal to their value at the date of her death (helpful if there has been appreciation in the value of the property between the two deaths). If, however, the estate tax exemption in the meantime had reverted to $1 million with a maximum estate tax rate of 55%, the estate tax due at her death would be $2,045,000.

If, instead, the husband’s estate had elected out of the estate tax, the basis of the assets would generally have been the decedent’s basis with modifications. The property passing to the trust for his wife would have qualified for the $3 million basis increase (receiving a full fair market value basis). The $1.3 million basis increase would have been allocated to the assets passing to the children’s trust. When the assets in the children’s trust are sold, income tax in the amount of $555,000 ($3.7 million x 15% capital gain rate) would be due. Upon the wife’s death, none of the property in the trust for her benefit would be included in her gross estate. Even if the estate tax exemption reverts to $1 million, the estate tax on her $2 million estate would be only $435,000. Guessing wrong about the amount of the estate tax exemption in the future could cost the family more than $1,055,000 in unnecessary federal tax (see Exhibit 2).

For the super-wealthy such as George Steinbrenner (owner of the New York Yankees), Mary Cargill (Cargill Inc.), Dan Duncan (oil and gas) and Walter Shorenstein (real estate), who all died in 2010—each with a net worth over $1 billion—the decision to elect to use modified carryover basis would probably be a no-brainer, given the values of their estates. Undoubtedly, one would wonder why these decedents would incur such a large upfront tax just to get a step-up in the basis of their assets. This decision is made even easier by the fact that most of the estates of the super-wealthy may not be liquid or the payment of estate tax would cause them to liquidate high-performing investments. Indeed, those decedents’ estates whose assets exceed $25 million will probably elect the modified carryover basis rules.

CONCLUSION

Estate planners who have clients who died in 2010 will have to work with the deceased client’s estate representative to determine whether to make the election provided under the Tax Relief Act. If the client’s estate is worth less than $5 million, the estate representative generally will not make the election; the assets of the estate will receive a step-up in basis; and the estate representative will not have to deal with the obscure modified carryover basis rules. If the client’s estate is worth more than $5 million, the client’s estate representative has an additional decision to make—one that could be very difficult depending on the relative size of the estate.

Estate Tax or Modified Basis Rules for Estates of Decedents Dying in 2010: A Spreadsheet Tool for Analysis

A Microsoft Excel spreadsheet accompanying this text is intended assist estate executors/executrixes in evaluating the options of estate tax or modified carryover basis for estates of decedents dying in 2010. Sample numbers are shown, but the user can customize inputs and analyze the results. (Click here to download.)

The top section of the spreadsheet, headed “Estate Assets (FMV and Adjusted Basis) and Related Bequests,” allows the user to input various estate assets, including the fair market value of each asset, the decedent’s adjusted (carryover) basis and the percentage of that asset left to as many as five beneficiaries. Line 23 of this first section allows the user to input the estimated year in which each beneficiary will most likely sell the inherited assets. The final line in the first section allows the executor to allocate the exceptions (step-ups in basis) among the beneficiaries that are allowed under the carryover basis rules. This includes up to $3 million for a surviving spouse and up to $1.3 million for other beneficiaries. 

The second part of the spreadsheet (“Other Estate Tax Inputs”) provides for inputs necessary to compute the current estate tax due in 2010, if the executor so elects, as well as other information related to the carryover basis rules computations. There are inputs for prior transfers, lifetime gifts, liabilities of the estate, etc. There are also inputs for projected capital gains rates in the future, in case the executor wants to make various assumptions as to how capital gains rates might change in the future and affect capital gains taxes when beneficiaries sell. These are assumed to be 15%, 20%, and 25% in the example. The rates also could be changed to match the character of various estate assets and/or marginal tax bracket of the beneficiary and corresponding capital gains rates. Finally, there is an input line for the “present value factor” which can be used to discount the capital gains taxes paid by the beneficiaries on sales (based on the assumed sales dates) back to the present, to compare with the estate taxes due if the estate tax is paid.

The third part of the spreadsheet, headed “Estate Tax Computation,” computes the net estate tax based on all the inputs above.

The fourth part of the spreadsheet (“Present Value of Capital Gains Taxes Paid” computes the total gain or loss on the sale of each estate asset (comparing the fair market value of the asset with its adjusted basis from inputs above), and allocates that gain to each beneficiary based on the percentage of the estate asset inherited. In the example shown, there is a $118,000 gain on the sale of Securities #1, and this gain was split 50/50 between beneficiaries B and C, since each inherited 50% of that asset. The gain is only for the difference between FMV of the asset at decedent’s death and the adjusted basis, since any other gain due to appreciation after inheritance would be taxed the same under either option).

The gains recognized by each beneficiary are then totaled, and any carryover basis exception allocations (described above) are subtracted from the gains. Then, the net taxable gain is taxed according to the appropriate capital gains rate for that year (input above), and the net tax due is discounted back to the present. In the example, Beneficiary B’s total gains are $824,250, the tax rate for the year of sale (2012) is 15%, and the $123,638 gain is discounted two years at a 5% discount rate to determine the present value of that tax paid.

Finally, all of the net present values of taxes are added together, yielding total additional capital gains taxes paid by beneficiaries in the example of $825,947.

The final section of the spreadsheet (“Summary”) compares the present value of paying the estate tax ($982,575) with the present value of paying additional capital gains taxes by all beneficiaries ($825,947). Thus, it appears that electing carryover basis in this situation is the optimal decision for the executor. 

By John O. Everett, CPA, Ph.D., professor of accounting, Virginia Commonwealth University; William A. Duncan, CPA, Ph.D., associate professor of accounting, Arizona State University; William N. Kulsrud, associate professor of accounting, Indiana University—Indianapolis; and Ira Abdullah, Ph.D. candidate, Virginia Commonwealth University.

EXECUTIVE SUMMARY

  With enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Congress reinstituted the estate tax, but with a $5 million exclusion.

  Because it did so late in 2010, Congress gave executors of estates of 2010 decedents a choice: Either they could apply the new provisions or the prior-law regime of no estate tax but with a modified carryover basis of assets. Congress also extended the due date for such estate tax returns to Sept. 19, 2011.

  The previous 10 years of estate and gift tax returns have been complicated, but the Tax Relief Act’s extension of the estate tax only through the end of 2012 leaves the future estate tax rate and exclusion amount uncertain. With future capital gains tax rate increases also possible, a prime factor in either option is anticipated future tax rates and the estate exclusion amount.

  Other factors, especially for estates exceeding $5 million in value, include whether the basis of property is high or low, anticipated future sales of the property, its type, the estate tax marital and charitable deductions, and state death taxes.

Justin P. Ransome (justin.ransome@us.gt.com) is a partner and Frances Schafer (fran.schafer@us.gt.com) is an executive director, both in Private Wealth Services at Grant Thornton LLP in Washington.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

AICPA RESOURCES

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