Taxes are a contentious political issue. Elections for positions from county supervisor to the United States president have been won or lost on promises about and voting records on taxes. Now, with the passage of the Tax Relief, Unemployment and Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Act), lawmakers have decided to share the joy with executors of estates, putting them in a position in which they must decide which of two tax schemes will apply to estates of decedents dying in 2010. Whatever decision they make, it's sure to draw ire from the beneficiaries of some estates.

The Choice

The 2010 Tax Act reinstated retroactively the estate tax for estates of decedents dying after Dec. 31, 2009.1 For decedents dying in 2010 with taxable estates of more than $5 million, the tax rate is 35 percent. In addition, the 2010 Tax Act repealed the modified carryover basis rules. Those rules say that the income tax basis for determining gain or loss upon a taxable sale or exchange of inherited property is the lesser of its fair market value (FMV) at the decedent's death or the decedent's income tax basis in the property (that is, what the decedent paid for the property, as adjusted for the value of certain improvements, depreciation or a host of other items specified in the Internal Revenue Code). Instead, the 2010 Tax Act reinstated the “date-of-death” basis of property, which means that for income tax purposes, beneficiaries inherit the property at its FMV as of the date of the decedent's death, regardless of what the decedent paid for the property.

Congress, in its infinite 2010 wisdom, anticipated that some executors might prefer modified carryover basis to paying an estate tax, so Congress gave executors of decedents dying in 2010 a choice: Either pay the retroactive 2010 estate tax (35 percent with a $5 million exemption) and get a date-of-death basis, or elect out of that estate tax, but be subject to the modified carryover basis rules. It's likely that Congress gave executors the right to elect out of the estate tax to avoid constitutional challenges to retroactivity. The Internal Revenue Service has yet to provide critical guidance about how to make the election out of the estate tax system, as well as how to apply the modified carryover basis rules.

Congress had no similar concerns about retroactively applying the generation-skipping transfer (GST) tax without a right to opt out. The tax rate for 2010 taxable transfers is zero with a $5 million exemption that can be allocated to 2010 transfers to protect those transfers from future GST tax on taxable distributions or taxable terminations. All estates of 2010 decedents are subject to the GST tax rules, as amended.

Modified Carryover Basis

If an executor elects to apply modified carryover basis, here's how those rules work. Generally, the basis of property acquired from a decedent dying in 2010 is the decedent's cost basis. But if the FMV is lower, then FMV becomes the cost basis. That means basis can be stepped down, but not up. Contrast this to the rule if the estate tax is in force: Basis is set at date-of-death FMV, whether up or down from the decedent's cost basis.

The modified carryover basis rules provide a limited amount of step-up that may be allocated to built-in gain property that the decedent owned at death. Property owned at death differs from some kinds of property that must be included in the decedent's taxable estate. An example is a decedent who was the surviving spouse and was the life beneficiary of a qualified terminable interest property (QTIP) trust.2 Although such trusts are includible in the estate of the surviving spouse, the property held in such a trust isn't owned by the surviving spouse and so can't qualify for a basis step-up allocation when the surviving spouse dies.

A $1.3 million allowance for step-up is available for property passing to anyone ($60,000 for a non-U.S. resident decedent who's also not a U.S. citizen).3 That amount can be increased by the decedent's unused capital loss and net operating loss carryovers that expired upon death, along with losses that would have been allowable under IRC Section 165 if the property acquired from the decedent had been sold at FMV immediately before the decedent's death.

Another $3 million is available for property passing to the decedent's surviving spouse.4 Property passing to a surviving spouse includes property passing outright to the spouse as well as property passing in trust, provided that the spouse has the right to all income for life, similar to QTIP trusts. Property passing to a surviving spouse also includes the surviving spouse's share of certain property held in joint tenancy as well as the surviving spouse's share of community property.

Property left in a qualifying trust won't be included in the taxable estate of the surviving spouse. That's because for a QTIP to be included in the surviving spouse's estate, there must be a valid QTIP election on the predeceased spouse's estate tax return. But there won't be any such election in 2010 if the executor has elected out of the estate tax system. As a result, potential estate taxes on trust assets will be avoided when the surviving spouse dies. On the other hand, there will be no income tax basis adjustment at the surviving spouse's death.

Consequences and Conflicts

The 2010 Tax Act election potentially affects more than checks made payable to the U.S. Treasury during estate administrations. The election also may have unintended effects on beneficiaries.

Beneficiaries could be adversely affected in two ways if the executor decides to elect out of the estate tax. First, the beneficiary will be stuck with the decedent's income tax basis for inherited property. When the beneficiary sells the inherited asset, capital gains taxes will come due. Distribution to various beneficiaries of estate properties having dissimilar proportions of built-in gains won't be well received.

Second, a decision to elect out can cause uncertainty about how formula bequests work, prompting fights among beneficiaries and executors. Many estate plans are predicated on the underlying assumption that the estate tax will exist and so must be minimized, or at least deferred, until a surviving spouse dies. Formula bequests predicated on this assumption are likely to fail. For example, say a bequest is made to a surviving spouse (or to a trust that benefits the surviving spouse for life) of the least amount needed to reduce the federal estate tax to zero. What becomes of that bequest if the estate tax doesn't apply because the executor has elected out of the estate tax and into carryover basis?

Even before executors had to make the 2010 Tax Act election, political fights in public elections paled in comparison to some family fights over estates and trusts. The probate litigation forecast is stormy with intensifying lightning strikes as surviving spouses seek to salvage lifetime financial security no longer assured by a marital bequest tailored to eliminate estate taxes. The decedent's children, on the other hand, will vigorously argue that they (or a trust for their benefit) are entitled to the entire estate, to the exclusion of the surviving spouse, since no marital deduction is needed to minimize estate taxes. Pity the poor surviving spouse acting as fiduciary.

Some states enacted legislation to interpret estate plans. For example, some states adopted the fiction that the decedent died in 2009, when the amount effectively exempt from estate taxes was $3.5 million. Others took more sophisticated approaches. But, most states remained on the sidelines.

Balancing Tax Consequences

This turmoil about interpreting tax-driven estate plans brings an important lesson into sharp focus for estate planners. Testator intent as it relates to family, as opposed to taxes, must be discussed, understood and ultimately articulated in estate plans as the guiding principle in those plans. Taxes are the caboose, not the engine.

Aside from interpreting estate plans, executors and trustees (in instances in which decedents left trusts) will be busy crunching numbers. But which taxes should be the decision-making standard: those currently payable or those foreseeably payable by the trust and its beneficiaries? Or should the exercise include taxes potentially payable? And what assumptions, if any, about the time value of money should be made in relation to future sales of built-in-gains property?

Tax estimates will turn on valuation. Within the range of reasonable values of hard-to-value assets, such as an equity interest in a family business, there has been a natural and understandable tendency to lean towards the low side of the valuation range to minimize estate taxes. But when estimating values for the 2010 Tax Act election decision, the full range of values must be considered. On the one hand is the familiar process of waiting for the estate tax audit and possibly litigating to achieve estate tax finality. If the executor decides to stay in the estate tax system based solely on the low end of the reasonable valuation range, but estate taxes finally turn out to be settled based on some higher value producing more taxes than would be paid on built-in gains, the executor's decision not to opt out of the estate tax could come into question. On the other hand, if the executor elects modified carryover basis and the capital gains taxes are paid soon after distribution, but turn out to be higher than expected because assets sold for more than the estimated values upon which the 2010 election decision was made, the individual who pays those capital gains taxes may be displeased.

Both executors and trustees must find a way to deal with the 2010 Tax Act election successfully, meaning without getting embroiled in beneficiary lawsuits. Say, for example, that an executor or trustee has concluded that it's best to elect out of the estate tax and into modified carryover basis rules. In developing a distribution plan, he wants each of the beneficiaries who are entitled to an “equal” share of the estate's property to receive property representing a reasonable representation of post-death appreciation or depreciation. At the same time, the beneficiaries are to be similarly situated as to the distribution of built-in gains. It might not be feasible to craft a distribution plan that satisfies both requirements, short of giving each beneficiary a fractional interest in each and every asset. That's because it's possible for some assets to have a basis equal to date-of-death value, while others have built-in gains to varying degrees.

With all the potential problems and conflicts, executors and trustees will want to seek finality by engaging in peace processes with their beneficiaries. Some executors and trustees may turn to the courts for direction, while others may invite beneficiaries into a resolution process. That may prompt the beneficiaries to “lawyer up,” but alternative dispute resolution methods might still be employed to identify and resolve conflicts.

Making the Election

The “executor” makes the election out of the estate tax and into modified carryover basis.5 Here, “executor” means “the executor or administrator of the decedent, or, if there is no executor or administrator appointed, qualified, and acting within the United States, then any person in actual or constructive possession of any property of the decedent.”6 This is the same person who's responsible for filing the decedent's estate tax return.

Once made, the executor can only revoke the election with the IRS' consent.

Clarification is still needed about two due dates: (1) when elective allocation of basis increases is due, and (2) when the election into modified carryover basis is due. The date for making elections to allocate basis increases could be set by the Treasury Secretary, but if the Treasury Secretary doesn't do so, the date is the date when the decedent's final income tax return is due. For 2010 decedents, that date is April 18, 2011.7 The time and manner for electing out of the estate tax and into carryover basis is to be established by the Treasury Secretary.8 The IRS needs to clarify and unify these two dates, as well as establish whether extensions of time are available. As a practical matter, it would make sense to set the time at the extended due date of the estate tax return. That would allow time for gathering the information needed to ascertain the amount of the estate tax before deciding on the 2010 election. For its part, the IRS hasn't yet finalized forms, so it appears that a due date in April isn't likely.

It remains to be seen whether the IRS will resist permitting protective elections. Protective elections are the result of court doctrines, not express tax statutes, so the IRS might not succeed in barring them in this context.

It should be possible to obtain an extension to make a late election, as permitted for other elections under IRS regulations.9 Executors can apply for an extension by private letter ruling whenever, as here, the due date isn't set by statute but by the Treasury Secretary.

Evaluating Alternatives

If the value of the decedent's assets and adjusted lifetime gifts added together is $5 million or less, no estate tax return is due. The default rule is application of the estate tax and FMV cost basis, using date-of-death values. So the executor won't need to make an election in this case. If the value of the taxable estate net of all deductions is $5 million or less, an estate tax return is due, but there's no tax. All assets will have a FMV cost basis. So here too, the executor won't need to make an election (but will be required to file an estate tax return).

If an estate tax would be due (that is, the taxable estate is over $5 million), the executor must evaluate the options. The starting point is to understand how each of the two sets of rules is likely to apply. The estate tax is something practitioners have experience with. Not so, the modified carryover basis regime. One indication of the extent of uncertainty is the nine-page comment letter on draft Form 8939 sent to IRS by the American Bar Association's Real Property Trust and Estate Law Section of Taxation.

To begin with, it will be necessary to establish the acquisition date for all assets, along with income tax cost basis before the decedent died and FMVs at date of death. The decedent's tax accountant will be a valuable source of information and insight.

A plan must be developed for use of the limited step-up allocations that may be made under IRC Section 1022(b) and (c). It might help to refer to Form 8939, in draft form as of this writing (proposed instructions not yet published). (See “Tax Law Update,” this issue, at p. 12.)

Future Capital Gains Taxes

Estimating capital gains taxes likely to be incurred in the near future requires identification of the appropriate tax rate. Although the rate is commonly cited as being 15 percent, there are higher rates that apply to certain types of assets, and some sales are subject to ordinary income recapture. And those rates will increase automatically after 2012 if Congress doesn't act.

It may be that the trustee will avoid paying the capital gains taxes and the beneficiaries will potentially have to pay instead. Future tax rates are difficult to predict in the current legislative environment. But it will be up to those beneficiaries to decide when, if ever, capital gains taxes will be paid. There are three obvious ways to avoid such taxes: hold the asset until death; engage in a like-kind exchange; or contribute the asset to a qualifying charity.

If assets will be held in a trust that's not includible in the estate of the surviving spouse, those assets won't get a fresh basis when the surviving spouse dies. Some have suggested that such trusts could be drafted to grant an independent trustee a special power to distribute assets to the surviving spouse whenever the trustee determines, in the trustee's absolute discretion, that to do so would be in the best interest of the surviving spouse.10 Such a power could be employed to place low-basis assets in the spouse's estate or for the surviving spouse to make lifetime gifts.

Stay Tuned

As the year progresses, so will the thinking and knowledge of practitioners. Experiences will emerge and new insights will, too. We all have a lot to offer each other in this critical task.

Endnotes

  1. Section 301 of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act Of 2010 (the 2010 Tax Act), H.R. 4853, P.L. 111-312 (Dec. 17, 2010).
  2. Internal Revenue Code Section 2056 (b) (7).
  3. IRC Section 1022(b).
  4. IRC Section 1022(c).
  5. The 2010 Tax Act, Section 301(c).
  6. Ibid, note 2 and IRC Section 2203.
  7. Internal Revenue Service Notice 2011-17, IRB 2011-10 (March 7, 2011).
  8. Ibid and note 2.
  9. Treasury Regulations Section 301.9100-1 and following.
  10. This idea was proffered during several sessions of this year's 45th Annual Heckerling Institute on Estate Planning, Jan. 10-14, 2011 in Orlando, Fla.

Michael J. Jones is a partner in Monterey, Calif.'s Thompson Jones LLP and chairs the Trusts & Estates Retirement Benefits Committee