Wednesday, February 17, 2010

Important Tax Changes for 2010 -- Part Two.....written by Greg Gann

A) Federal Estate Taxes:

The big news is that for the 2010 tax year, there are no estate taxes; well that is unless the law is repealed and made retroactive. This is a repeal with a one year term limit. Estate taxes are only applicable for “wealthy” estates. Certain members of Congress have politicized the tax by branding it as a “death” tax, and encouraging a large percentage of the population for whom estate taxes have no relevance to fight the battle for permanent repeal. In reality, by and large, only one to two percent of the entire American population is subject to these taxes, yet clever marketers have incited people of average means to join the tea party. The amount of an estate that can be left to beneficiaries exempt from federal estate taxes has been increasing since the enactment of the 2001Tax Act. In fact, the exemption has escalated from $ 1 million in 2001 to $ 3.5 million in 2009. The Byrd Rule is legislation which limits the duration of laws with a negative fiscal impact to ten years. It was anticipated back in 2001 that Congress would re-enact the terms of the estate tax law prior to 2009 and disqualify the one year suspension of any federal estate tax. However, that never happened. Therefore, under present law, there is no tax in 2010; however, due to the Byrd Rule, the tax reappears in 2011 back to the 2001 level of $ 1 million.

At first blush, as a beneficiary, it would appear that 2010 might be a really good year for your loved one to pass away, speaking only fiscally of course. However, there were other parts of the 2001 Tax Act that have not been sufficiently publicized or politicized, and these provisions will in reality negatively impact far more estates than the estate tax would have.

The provision in the law about which I refer relates to what is commonly known as a “step-up” in cost basis. The step-up allows beneficiaries to value the assets that they inherit based on the market value at the date of the donor’s death. Here’s the kicker. Although the estate tax has been eliminated for 2010, the step-up in cost basis has been significantly altered to the detriment of taxpayers. Under present law, the estate of a decedent who dies in 2010 can allocate a maximum of $1.3 million as an aggregate step-up. Beyond that, the beneficiary will step into the “shoes” of the decedent and receive his/her cost basis in the assets. Therefore, when the beneficiary in turn sells those inherited assets, he/she will pay tax on the gains over and above what the donor paid originally for the asset, over the $ 1.3 exemption. If the asset happens to be property that the donor owned for a great number of years, the gains could very well be very substantial. Assets left outright to a spouse receive an additional $3 million “spousal property basis increase”.

Unless the law is modified, 2010 may very well turn out to be a windfall year for a super-wealthy person to die, from solely a tax perspective. However, it may be a disaster for a middle class estate. The following example will elucidate the dilemma. Let’s say two widows at the date of death each owned the same numbers of shares of stock purchased on the same day. And, let’s say the cost basis of that stock was $10,000, and that the market value at the date of death was $100,000. Let’s also assume that the wealthy widow’s estate was valued at $20 million and that the middle class widow ‘s estate was valued at $1 million. In this example, the wealthy widow gets a big advantage in 2010 because she will incur no federal estate tax, which in 2009 and other prior years would have resulted in roughly $50,000 in estate tax. Her beneficiary will have to pay capital gains tax on the $90,000 gain resulting from the sale of the stock. With the capital gains tax rate of 15% through 2010, the beneficiary will incur a capital gains tax of approximately $13,500, approximately $36,500 better than had the estate been subject to federal estate taxes. In contrast, the middle class widow in 2009 would still have fallen within the federal estate tax exemption, and hence had a zero estate tax. In 2009 and prior years, her beneficiaries would have received the step-up in cost basis for the stock and therefore, they would have incurred zero capital gains taxes. In reality, in 2010, the beneficiaries of the wealthy and the middle class widows incur identical capital gains taxes on the gains from the stock sale. Consequently, the middle class heirs owe the $13,500 in capital gains taxes, thereby reducing their net inheritance by this amount. The bottom line is that the super-wealthy may turn out to be the big winners in 2010, and the middle class may be incurring even greater proportions of the tax burden in the U.S.

B) Other Significant Tax Changes:

1) The maximum amount of equipment placed in service that a business can expense as a deduction is cut by nearly 50% from $250,000 to $135,000.

2) Taxpayers age 70.5 and older can no longer make a charitable contribution directly from their IRA’s, and thereby avoid income taxation on the amount donated. This could have a huge negative impact on a non-profit’s budget.

3) 2010 represents the last year during which capital gains will be taxed at the rate of 15% and 0% for taxpayers in the 10% and 15% tax brackets. Next year, the rate goes to 20% for most taxpayers and 10% for taxpayers in the lower brackets. However, gains on assets held for five years or longer, beginning in 2011 will be taxed at 18% and 8% respectively.

4) For taxpayers in tax brackets of 15% or higher, 2010 represents the last year in which dividends will be taxed like capital gains at a significantly reduced rate of 15%. After 2010, dividends will be taxed at the highest earned income rate. Ouch.

C) Important Take-Aways:

1) It is important to appreciate that there is no federal estate tax in 2010; however, significant gift taxes which affect the majority of taxpayers remain, making it equally as expensive to gift in 2010 as it was in 2009. A donor can gift up to $1 million as a lifetime exemption as well as $13,000 per year as an annual gift exclusion amount, but gifts in excess of these exemptions remain taxable transactions.

2) The estate tax in Maryland remains unaffected by changes to the federal system. As such, estates whose values exceed $1 million are still subject to Maryland estate taxes.

3) Because the federal estate tax exemptions have been changing regularly over the last several years, it is common language in wills and trusts to leave assets to non-spouse beneficiaries up to the federal exemption amount with the residual to go to the spouse. As an unintended consequence of your estate planning documents, your estate plan may leave everything to children or other relatives, unintentionally disinheriting your spouse.

Clearly 2010 is a year of significant tax and estate planning review. Feel free to contact me regarding any specific situation where you have concern or just seek clarity. We are also well suited to recommend accountants and estate planning attorneys who specialize in these areas. In law school, I remember references in several business and tax classes to a famous United States judge and judicial philosopher by the name of Learned Hand. Judge Hand professed, “Anyone may arrange his affairs so that his taxes shall be as low as possible. And, there is not even a patriot duty to increase one’s taxes. Nobody owes any public duty to pay more than the law demands”. In a year where we will all be affected by rising tax rates, it is important to heed the advice of Judge Hand and plan accordingly.


Greg Gann

Please talk to your financial advisor and tax advisor for advice on your specific situation prior to executing any strategy as individual situations may vary.