WHAT'S NEW

Federal and Illinois Estate Taxes Repealed as of January 1, 2010.

Since 2001, estate planners and their clients have been in a state of uncertainty with respect to federal estate taxes. These arose from passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). It was the expectation of most in the tax community that this uncertainty would be resolved by Congress before the end of 2009. The House of Representatives did pass a bill in early December of 2009 to permanently extend the 2009 estate tax rules and to repeal the carryover basis rules of EGTRRA (HR 4154), but the Senate failed to act before adjournment for the holidays and we accordingly now presently have no federal estate tax as of January 1, 2010, and a variety of other related new tax provisions, all effective for a period of one year. If Congress fails to take action in 2010, the estate tax laws will then automatically revert to the pre 2001 rules pursuant to the sunset provisions in EGTRRA. These sunset provisions were included as part of EGTRRA due to lack of the necessary votes in 2001 to override budgetary constraints.

Senate Finance Committee Chairman Max Baucus (D-MT) has pledged that efforts will be made to restore the estate tax in 2010 retroactive to January 1, 2010, thereby eliminating the "no estate tax" gap in 2010. Speculation is now focused on whether the Senate will be able to do so in 2010 and whether any changes would be retroactive. Timing of efforts in the Senate could be impacted by 2010 being an election year. This may delay such controversial legislation until as late as December of 2010. The length of any delay in addressing the issue also potentially impacts the constitutionality of any retroactive changes. Retroactive tax legislation is generally permissible if it is enacted to correct an error or mistake in the tax code, if there is a reasonably short time period involved, and there is notice or reasonable expectation on the part of taxpayers that a change could be made. In such cases, the United States Supreme Court has held that retroactive tax legislation can be "rationally related to a legitimate legislative interest."

The repeal of the federal estate tax as of January 1, 2010, was also accompanied by an expiration of the Illinois estate tax as of the same date due to the language of the Illinois statute. So, as of January 1, 2010, we no longer have either a federal estate tax or an Illinois estate tax.

Changes by either action or inaction on the part of Congress and the Illinois General Assembly, however, will be coming and we will update our website with developments as they occur. In the meantime and over the course of the next several weeks, we will present a history of where we have been, and a more detailed explanation of where we are currently...at least for this year.....

Where We Were Before EGTRRA of 2001?

As discussed above, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) is the legislation which resulted in the current state of affairs regarding federal estate taxes.  It also contains "sunset provisions" which will cause the estate tax laws to effectively revert to pre-EGTRRA law on January 1, 2011.  In order to fully understand what may occur next year, it accordingly is beneficial to understand this "old" 2001 law since it may, in fact, be the estate tax laws in effect after 2010.

Prior to the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the federal estate and gift tax system operated on unified basis with "applicable exclusion amounts" and a "unified credit." The "unified credit" was the amount of estate or gift tax computed on the "applicable exclusion amount." Many commonly referred to this as the "exemption," or the amount that could be passed by lifetime gifts and death transfers without the imposition of estate or gift taxes. The applicable exclusion amounts were being gradually increased on the following schedule:

                                                  2001                      $675,000

                                                  2002, 2003            $700,000

                                                  2004                      $850,000

                                                  2005                      $950,000

                                                  2006 and later     $1,000,000

As an example of the unified approach to the transfer taxes, consider a taxpayer who made a taxable gift of $100,000 in 2001. No gift taxes would be currently payable, but $100,000 of the exemption would be used. Thus, the remaining balance available to cover subsequent taxable gifts, transfers at death, or a combination of the two, would be only $575,000 in 2001, $600,000 in 2002 or 2003, $750,000 in 2004, and so on.

Estate and gift tax rates were graduated and began at 37 percent for amounts over $675,000 with maximum rate of 55 percent for amounts over $3,000,000.

The federal estate tax also provided for a state death tax credit which was available to offset or reduce the amount of tax actually payable to the federal government. Being a credit, it was a dollar for dollar reduction of the federal estate taxes. As will be discussed in later postings to this web site, the amount of this state death tax credit was adopted by Illinois as the amount of Illinois estate taxes owed, or what was commonly referred to as a "pick-up tax."

The generation skipping tax rate was at the highest marginal estate tax rate which was 55 percent as noted above. The GST tax was designed to prevent transfers beyond one generational level (e.g., to grandchildren or great grandchildren) without the imposition of any transfer tax (i.e., any estate or gift tax). An exemption existed for such transfers, however, up to the applicable exclusion amount.

With respect to the income tax basis in transferred assets, two general rules existed depending upon whether the transfer was a lifetime gift or a transfer at death. In the case of lifetime gifts, the income tax basis to the donee was the lesser of (i) the donor’s adjusted basis in the asset, or (ii) the fair market value of the asset at the time of the gift (a carryover basis). In the case of transfers at death, the income tax basis to the beneficiary of inherited property was generally (i) the fair market value on the date of death, or (ii) the fair market value on the alternate valuation date (i.e., six months after the date of death), if alternative valuation was elected (a stepped-up basis).

Where We Are Now With EGTRRA of 2001....2010

The changes made by the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) in 2001 were extensive and pervasive. And in the case of estate and gift taxes, the date of January 1, 2010, marked the final major overhaul. It was a date that most in the tax community never envisioned would come without prior action by Congress to address a more permanent solution. Succinctly stated, the reason is that all of the provisions of EGTRRA were scheduled to expire December 31, 2010, unless Congress took steps in the interim to make the changes permanent. This is commonly referred to as a "sunset provision." Many of the other tax law changes enacted under EGTRRA were in fact separately addressed over the previous eight years, but resolution of the estate and gift tax provisions has yet to be accomplished. Whether retroactive changes will in fact be enacted in 2010 is an open question, and a discussion of the "current law" which became effective January 1, 2010, is therefore in order. At the same time, remember that the following provisions effective on January 1, 2010, are effective for only one year and will expire on December 31, 2010, absent further Congressional action to modify them or make them permanent.

Estate Tax Repeal. New Code Section 2210 enacted by EGTRRA provides simply that "this chapter [Chapter 11 - Estate Tax] shall not apply to the estates of decedents dying after December 31, 2009." Thus, the entire chapter in the Internal Revenue Code governing federal estate taxes was repealed on January 1, 2010. However, remember the sunset language above which governs EGTRRA. New Code Section 2210 which repealed the estate taxes is also inapplicable after December 31, 2010, as are all of the other changes made by EGTRRA, including the increased applicable exclusion amounts we previously enjoyed through 2009. This is legislatively what causes reversion to the pre EGTRRA laws of 2001.

GST Tax Repeal. New Code Section 2664 enacted by EGTRRA provides simply that "this chapter [Chapter 13 - Tax on Certain Generation-Skipping Transfers] shall not apply to generation-skipping transfers after December 31, 2009." Thus, the entire chapter in the Internal Revenue Code governing generation skipping transfers was repealed on January 1, 2010. However, again remember the sunset language above which governs EGTRRA. New Code Section 2664 which repealed the generation-skipping tax is also inapplicable after December 31, 2010.

Gift Tax. The federal gift tax was not repealed by EGTRRA. At the time, there was concern on the part of Congress that the absence of a gift tax might result in taxpayers shifting low basis assets to donees in a more favorable tax position with the expectation that the donees would subsequently return the net sales proceeds to their donors. The gift tax applicable exclusion amount, or exemption, continues to remain at $1,000,000 for 2010. The gift tax rate on taxable gifts aggregating in excess of $1,000,000 is a flat 35 percent for 2010. Again, however, remember that this change was made by EGTRRA and thus lasts only through December 31, 2010, under the sunset provisions.

Repeal of Stepped-Up Basis Rules. One of the most controversial changes in EGTRRA is the repeal of the "stepped-up in basis" rules which were generally applicable to inherited property prior to 2010. Under these rules, the income tax basis to the beneficiary of inherited property was (i) the fair market value of such property on the date of death, or (ii) the fair market value on the alternate valuation date (i.e., six months after the date of death), if alternative valuation was elected. (Exceptions existed for certain assets which constituted income in respect of a decedent. With respect to retirement plans, individual retirement accounts, annuities and other similar assets, no step-up in basis was permitted.) IRC Section 1014 which provided these tax basis rules was repealed by EGTRRA with respect to decedents dying after December 31, 2009. In its place was enacted new IRC Section 1022. Although the estate tax was the primary headline making its way into the news cycles, this new provision will have a much broader impact and will likely affect many more families than the estate tax. Effectively, this new Section 1022 replaces the estate tax with a capital gains tax. With certain exemptions, the new law requires inherited assets to retain a carryover basis from the decedent similar to the gift tax rules. As such, it will also require extensive record retention from the decedent's records (assuming such records can even be located). This will likely produce an accounting nightmare as was the case when a similar law was enacted in the late 1970's, but which was subsequently repealed retroactively.

For decedents dying after December 31, 2009, and before January 1, 2011, property acquired from a decedent will be treated as if transferred by gift. The basis of the beneficiary acquiring the property will be equal to the lesser of (i) the decedent's adjusted basis in the property, or (ii) the fair market value of the property at the date of the decedent's death. Three important exceptions to this rule, however, are also included, being:

     1.  Each estate will receive $1.3 million of basis to be added to the carryover basis of any one or more assets held at death. IRC Section 1022(b). This amount is subject to cost of living adjustments.

     2.  Each estate will be allowed an additional $3 million of basis which can be allocated among the assets passing to a surviving spouse. This amount is also subject to cost of living adjustments.

     3.  The estate will also generally receive additional basis equal to the sum of (i) the decedent's unused capital loss carryforwards, (ii) the decedent's unused net operating loss carryforwards, and (iii) the amount of losses that would have been allowable if the property acquired from the decedent had been sold at fair market value immediately before death.

In no event, however, can the basis of an asset be increased above the fair market value of the asset immediately before death. Basis may also not be added to (i) stock of certain foreign entities, (ii) property that is treated as income in respect of a decedent, or (iii) property acquired by the decedent by gift (other than from a spouse) during the three year period ending on the date of the decedent's death.

The personal representative will be responsible for selecting the assets that will receive the increase in basis.

This new law is also scheduled for repeal under the sunset provisions discussed above as of January 1, 2011.

New Information Return Requirements; Penalties. IRC Section 6018 was previously the Code section requiring the filing of federal estate tax returns. EGTRRA amended this section by effectively repealing the prior Section 6018 (titled Estate Tax Returns) and replacing it with new Section 6018 (titled Returns Relating to Large Transfers At Death). In general, the new provision requires a return to be filed when the value of all property (other than cash) acquired from a decedent exceeds the dollar amount applicable under IRC Section 1022(b)(2)(B), i.e. $1,300,000 for 2010. The information to be included in the informational return with respect any property acquired from the decedent is:

     1.  The name and tax identification number of the recipient of such property;

     2.  An accurate description of such property;

     3.  The adjusted basis of such property in the hands of the decedent and its fair market value at the time of death;

     4.  The decedent's holding period for such property;

     5.  Sufficient information to determine whether any gain on the sale of the property would be treated as ordinary income;

     6.  The amount of basis increase allocated to the property under IRC Section 1022 (discussed above); and

     7.  Such other information as the Secretary may by regulations prescribe.

The informational return is due and must be filed with the income tax return for the decedent's last taxable year or such later date specified in regulations prescribed by the Secretary.

Further, the person making the return is required to furnish to each person named as a recipient a written statement showing (a) the name, address and phone number of the person required to make the return, and (b) the information set forth in the return with respect to the property passing from the decedent to the specific recipient. The written statement must be furnished not later than 30 days after the date that the informational return is filed with the Internal Revenue Service.

The executor of the estate is the party required to file the informational return with the Internal Revenue Service, and to send the informational statements to the recipient beneficiaries. If the executor is unable to make a complete return as to any property acquired from the decedent, then the executor is required to include in the return a description of such property and the name of every person holding a legal or beneficial interest in the property. Upon notice from the Internal Revenue Service, the named person or persons shall then be required in a like manner to make a return as to such property.

IRC Section 6019(b) was also added by EGTRRA to IRC Section 6019 (titled Gift Tax Returns) to now also require written statements to be furnished to recipients of gifts for which a gift tax return is otherwise required to be filed. This written statement must show (a) the name, address, and phone number of the person required to make the gift tax return, and (b) the information specified in the gift tax return with respect to the property received by the donee. The written statement must be furnished not later than 30 days after the date that the gift tax return is filed with the Internal Revenue Service.

New Code Section 6716 was also enacted by EGTRRA to impose penalties for failure to comply with the new return and written statement requirements under both IRC Section 6018 (Returns Relating to Large Transfers at Death) and 6019 (Gift Tax Returns). Specifically, any person required to file the informational return under Section 6018 (Large Transfers) with the Internal Revenue Service by the due date and who fails to do so shall be liable for a penalty of $10,000, unless it is shown that such failure was due to reasonable cause. If the failure was due to intentional disregard of the filing requirement, the penalty shall be five percent (5%) of the fair market value of the property with respect to which the information is required. With respect to the written informational statements due to the beneficiaries under both 6018 (Large Transfers) and 6019 (Gift Tax Returns), the penalty is $50 for each such failure, unless it is shown that such failure was due to reasonable cause. If the failure was due to intentional disregard of the requirements for furnishing the written beneficiary statements under both Sections 6018 and 6019, the penalty shall be five percent (5%) of the fair market value of the property with respect to which the information is required.

Again, however, remember that these changes were made by EGTRRA and thus last only through December 31, 2010.

Principal Residence Sales. IRC Section 121 provides for the exclusion of specified amounts of gain on the sale of a principal residence by a taxpayer if certain conditions are met, including ownership and use requirements. With the new carryover basis rules, Section 121 was amended by EGTRRA to provide for a "carryover" of the exclusion as well. IRC Section 121(d)(11). Specifically, the exclusion shall apply to property sold by (a) the estate of a decedent, (b) any individual who acquired the property from the decedent, and (c) a trust which immediately before death was a revocable trust established by the decedent.

Where We Will Be in 2011?

Expectations are high that Congress will take action to address the estate and gift tax issues during 2010.

As the law presently stands, however, the sunset provisions of EGTRRA provide that we will effectively revert to pre-EGTRRA law as of January 1, 2011. We will then be back to:

     1.  An applicable exclusion amount for estate and gift taxes of $1,000,000.

     2.  A top marginal rate of 55 percent for estate and gift taxes.

     3.  A stepped-up basis generally for inherited assets.

     4.  A generation skipping tax rate of 55 percent.

     5.  A GST exemption of $1,000,000, indexed for inflation from 1997.

Update!!!

An amendment to H.R. 5297 (the Small Business Lending Bill) was introduced on July 14, 2010, to modify the estate tax rules, and includes the following proposals:

     1.  The estate tax exemption would start at $3.5 million and gradually increase to $5 million by 2020.

     2.  The estate tax rate would start at 45% and would be reduced by 1% per year to 35% by 2020.

     3.  For those dying in 2010, there would be an option to use the 2009 exemption of $3.5 million and retain the benefits of stepped-up basis, or accept the 2010 rules with no estate tax and lose the benefits of the stepped-up basis rules.

We will update our web site with further developments.

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