Maryland Bar Bulletin
Publications : Bar Bulletin : October 2010

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 BAR BULLETIN FOCUS: ESTATE & TRUST LAW

Although the repeal of the federal estate tax during 2010 will result in huge tax savings for some estates, other estates actually will face a huge tax increase, due to the elimination of the automatic step up in basis.

The income tax basis of an asset is used to calculate gain or loss upon a sale of the asset. Commonly, the income tax basis is the original cost of the asset. The gain or loss is the difference between the sale price and the basis. In 2009 and prior years, the income tax basis of an asset in a decedent’s estate was adjusted to the fair market value on the date of death. This basis adjustment at death is commonly known as a “step up” in basis, because historically asset values have increased between the date of purchase and the date of death.

Nevertheless, it also is possible to have a “step down” in basis, if an asset decreased in value between the date of purchase and the date of death. The notion of a step down in basis at death was particularly relevant for people who died during the recession of 2008 and 2009.

Under the Economic Growth and Tax Relief Reconciliation Act of 2001, one of the trade-offs for the repeal of the federal estate tax during 2010 is the elimination of the automatic step up in basis during 2010. Instead, for decedents dying during 2010, the general rule is that the basis of an asset in the estate will be the decedent’s basis. This is known as “carryover” basis. If the fair market value of the asset on the date of death is lower than the decedent’s basis, then the estate’s basis would be the fair market value. Thus, although there is no automatic step up in basis for decedents dying in 2010, there still can be a step down in basis. If Congress does not act, then on January 1, 2011, the 2001 tax act will expire, and the automatic basis adjustment will return.

Fortunately, Congress has provided some relief from the harshness of the carryover basis rule. An estate is allowed to allocate $1.3 million in order to step up the basis of estate assets, but no asset’s basis can be increased above its date of death value. Furthermore, an estate may allocate an additional $3 million to assets passing to a surviving spouse or to a qualified terminable interest property (QTIP) trust. Note that it is not necessary for the estate to make a QTIP election, as long as the trust qualifies for QTIP treatment. As additional relief, the $250,000 capital gains tax exclusion upon the sale of a personal residence is extended to the decedent’s estate and the estate’s beneficiaries.

Certain items are not eligible for allocation of the step up in basis, including income in respect of a decedent (IRD) items and assets included in the gross estate due to a power of appointment. Assets in a revocable trust are not eligible, unless an election is made under Internal Revenue Code section 645 to treat the trust as part of the estate for federal income tax purposes.

No step up in basis is available for an asset received by the decedent as a gift within three years prior to death, unless the gift was received from the decedent’s spouse, and a gift from the decedent’s spouse is not eligible for a step up in basis to the extent that the donor spouse received the asset as a gift or inheritance.

In order to allocate the step up in basis, the personal representative of the estate will have to file an information return under Internal Revenue Code section 6018(c).  The return must show the property, the recipient, the decedent’s basis, the basis increase, the decedent’s holding period, and whether the gain would be treated as ordinary income. The return must be filed by the due date of the decedent’s final federal income tax return (including extensions). The personal representative must provide a copy of the information return to the estate beneficiaries, and there is a $10,000 penalty if the personal representative does not file the return.

A smaller estate which owns low basis assets may be much worse off due to the repeal of the estate tax. For example, a $3 million estate of a single individual would have paid no federal estate tax in 2009. If the decedent dies in 2010, only the $1.3 million basis adjustment is available. If the estate’s assets have a very low basis, then the estate (or the beneficiaries) could face a huge capital gains tax upon the sale of the assets. Many more estates will be adversely affected by the carryover basis rules than would have been affected by the federal estate tax. The Internal Revenue Service has estimated that 5,000 to 6,000 estates would have paid federal estate tax in 2010 if there were a $3.5 million exemption. In contrast, the IRS estimates that 60,000 to 70,000 estates will be adversely affected by the elimination of the automatic basis adjustment.

Some have speculated that for decedents dying in 2010, Congress might enact legislation allowing estates to choose whether to be subject to the estate tax and the step up in basis, or no estate tax and carryover basis. Others have opined that you can get the best of both worlds even if Congress does not give you a choice. The theory is that because the carryover basis rules expire in 2011, estates of decedents dying in 2010 may get a step up in basis anyway, as long as the assets are not sold during 2010. Other commentators, including Ron Aucutt of McGuire Woods, disagree with this theory.

In light of the possibility that we may be stuck with carryover basis for 2010, here are some possible planning opportunities: (1) Transfer assets to a dying spouse in order to achieve no federal tax and the additional $3 million step up in basis. (2) Create a testamentary QTIP for the surviving spouse (either automatically or by way of a disclaimer). If there is no tax in 2010, then do not make the federal QTIP election. The assets remaining in the trust at the surviving spouse’s death will be excluded from the surviving spouse’s gross estate for federal estate tax purposes (because no federal QTIP election was made), but the trust assets still qualify for the additional $3 million step up in basis. (3) Consider a formula bequest to allow a surviving spouse to take advantage of the additional $3 million step up amount. (4) Authorize the personal representative to allocate basis to non-probate assets and to assets the personal representative receives as a beneficiary (perhaps use an independent personal representative for latter, to avoid a potential conflict of interest or gift).

Edwin G. Fee, Jr., is a partner with Whiteford, Taylor & Preston L.L.P., and he is a past Chair of the MSBA Estate & Trust Law Section.

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Publications : Bar Bulletin: October 2010

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