By Deborah L. Jacobs
Ever since the estate tax lapsed on Jan. 1, there's been a lot of talk about the windfall it's creating for families of wealthy people, including billionaires, who have died in 2010. But behind the scenes, lawyers and accountants are wrestling with a far more practical problem that affects all inheritors this year: the tangled new income tax rules that apply to assets inherited in 2010.
Unless Congress restores the estate tax retroactively this year, vast sums will pass free of both estate tax and the generation-skipping transfer tax (on assets given to grandchildren). Under a 2001 law, these taxes are scheduled to return Jan. 1 at unfavorable rates that applied 10 years earlier. At that point, the amount that is exempt from each of these taxes will be $1 million, and the tax on the rest will be 55% (60% in a certain phase-out range). In contrast, the tax-free amount last year was $3.5 million, and there was tax of 45% on anything else not going to a citizen spouse or to charity. (For advice on how to deal with the return of the estate tax, click here.)
During the one-year "gap" as lawyers call it--and presumably only for inheritances received this year-- there are income tax issues to contend with. What's new: Heirs now must use the original price paid for an asset when computing the income taxes they will owe if they sell inherited assets. Previously, they could use the market value at the time of the owner's death. Each estate is permitted to exempt $1.3 million of gains from this carry-over basis rule. An additional $3 million exemption applies to assets inherited from a spouse.
This "carry-over basis" rule is new to both advisers and clients, so implementing it takes us into uncharted territory. And if a recent discussion on LinkedIn, the professional-networking website, is any indication, confusion is widespread. Even during the mid-August doldrums, there were more than a dozen exchanges about the subject among members of one professional group within the site. Some revealed basic misunderstandings. Others pointed to questions that are still unanswered by the Internal Revenue Service.
To further complicate matters, there's a possibility--though as the year wears on it seems increasingly remote--that Congress will restore the tax retroactively with the same $3.5 million exemption and 45% top rate that existed in 2009. Past court cases suggest that is perfectly legal. But some people with a lot at stake have argued that a retroactive tax is unconstitutional and threatened lawsuits. With the prospect of litigation looming, any legislation that takes effect in 2010 would almost certainly need to offer a choice for heirs of people who die this year: Pay estate tax, or use the modified carryover basis system that's in effect while there is no estate tax.
Whether heirs are stuck with carryover basis, or wind up with a choice for 2010 and elect to use the carryover basis/no estate tax option, inheritors and their advisers need to take the following steps.
Originally published on Forbes.com Personal Finance channel, http://www.forbes.com/finance/. Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide (DJWorking Unlimited, 2009). To keep readers current between editions, she issues updates that can be downloaded from the book's Web site www.estateplanningsmarts.com, and tweets at http://twitter.com/djworking.