Removal of Step-Up Basis: Smaller Estates Pay More Taxes in 2010

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) that gradually raised the federal estate tax exemption from $675,000 in 2001 to $3.5 million in 2009 to no federal estate tax in 2010. The tax rate also dropped from 55% in 2001 to 40% in 2009 to no rate in 2010. Late in 2009, most estate planning professionals believed that Congress would not let the federal estate tax disappear in 2010. Well, it is May 2010 and nothing has yet been passed. However, what is not widely known is that taxes on estate assets are being assessed, only in a slightly different way. This modified tax also reaches into smaller valued estates than the federal estate tax reached in 2009.

It all starts with the belief that Congress makes some attempt at balancing their budget…I know I laughed when I wrote that, too. However, most discretionary pieces of federal legislation have been passed under the “premise” of PAYGO. PAYGO compels any new spending or any reduction in taxes collected to be offset by cuts in spending or tax increases assessed somewhere else in the federal budget. For EGTRRA to pass back in 2001, under PAYGO standards, the loss of revenue generated by the federal estate tax’s disappearance in 2010 needed to be generated from somewhere else.

In this case, Congress removed the carryover basis provisions on transfers of assets from the deceased to a beneficiary. In other words, the basis in an asset would not step-up. Under the Internal Revenue Code, the general “stepped-up” rule applied to property a beneficiary received from a decedent such that the beneficiary's basis equals the fair market value of the property at the time the decedent dies. For example, if Decedent owns a home she originally purchased for $100,000. Her basis in the home is equal to its cost, $100,000, assuming no adjustments. On the day Decedent dies, the fair market value of the home is $500,000. If Decedent bequeaths the home to Beneficiary, Beneficiary’s basis in the home will be the fair market value, $500,000. If the Beneficiary decided to sell the home the next day for its fair market value, the Beneficiary would owe no capital gains on that sale. In contrast, if Decedent sold the home immediately prior to dying, the Decedent, as a single filer taxpayer, would owe capital gains tax on $150,000. The fair market value of the house ($500,000) minus the original basis ($100,000) minus the $250,000 exemption for the sale of a personal residence, if all qualifications are satisfied.

The “stepped-up” basis exemption not only applied to bequeathed homes that have grown in value, but also family businesses that have expanded, or stocks that have risen in price; the old “step-up” rule wiped the slate clean. A beneficiary owed no capital-gains taxes for the appreciation that took place during the decedent’s lifetime and before decedent’s death and would only pay capital gains taxes for the appreciation after the transfer when a beneficiary sold the assets. With the “stepped-up” exemption eliminated, a beneficiary is not afforded the same protection.

However, it is not a completely unforgiving system. To provide a little balance to the system, Congress provided several exemptions. An executor can now assign a $1.3 million “step-up” exemption to the assets in the estate, and an additional $3 million exemption for assets left to a surviving spouse. Consider a non-spouse that inherits a home that was originally bought for $100,000 and is now valued at $3.0 million dollars. Assuming that was the only asset in the estate, last year there would be no tax due on that transfer, this year a tax would be assessed on $1.6 million over the $1.3 million exemption. That would mean a tax bill of $240,000 at the current 15% federal rate.

It gets even more complex when the executor has not been instructed by the decedent how to divide up the $1.3 million exemption among the various assets of the estate. The prevailing view by estate attorneys is that executors should divide the exemption out in some relationship to the assets bequeathed. But, there is no guarantee or law that states the executor has to do it that way. It can be a free-for-all. What’s to stop an executor from applying the exemption solely to property the executor inherits? It gets even more complicated if different types of asset classes are being bequeathed to beneficiaries with various levels of basis in those assets.

This unevenness of the exemption can become a nightmare for executors whose every decision on the exemption could give rise to litigation from disgruntled beneficiaries that feel they are being overburdened with their tax liability. Another issue that executors will face is simple record keeping of the basis for an asset. While the initial basis at purchase will be relatively easy to find, it does not account for the basis adjustments that occur because of capital improvements parents have made to a home or determining all the stock splits that occurred in a stock over 50 years.

How will the exemption reach deeper into smaller estates? In 2009, any testator that died with an estate valued below $3.5 million owed no federal estate tax on the estate. In 2010, capital gains tax will be assessed on any assets that appreciated in value more than the $1.3 million for any non-spouse exemption. For example, if a widowed mother had an estate of $2.4 million dollars with an original basis of $400,000 in those assets, the beneficiaries would owe capital gains tax on the $700,000. This would mean a tax bill of $105,000 at the current federal rate of 15% when only a year prior that estate owed no taxes. While, I will not begrudge a beneficiary inheriting a nice inheritance it still gives rise to an unexpected tax bill from Uncle Sam.

To make matters worse for tax year 2011, this tax assessment system disappears and the federal estate tax reverts back to the year 2002 exemption level of $1 million with a 2001 top rate of 55%. As I said, the conventional wisdom was that some type of fix was going to pass in 2009 that would have spared the taxpayer from an inefficient system. Unfortunately, no action was taken and the court system will bear the brunt of beneficiaries litigating their way to lower taxes.

Basics of Estate Planning: To Trust or not to Trust...that is the Question? - Part II

Last month, I described several reasons why a person might move their assets into a revocable living trust. The reasons include the health and age of a person planning their estate and the desire for privacy. There are several additional factors that play into whenever transferring assets into revocable living trust makes sense for a client.

Another reason to establish a living trust is a person’s family situation. As I noted in the past, the more complex the family relationship, the more it makes sense to establish a living trust. With a large number of Americans getting divorced and then remarrying, merged families inherently create tension. Most of the strife arises between children of the settlor and a second spouse but could also surface between half-siblings and full siblings. Most often, children fear the second spouse could take the inheritance and “blow it” leaving nothing to the children. As I detailed in a past “Estate of the Month,” family discord might not even appear until after the death of one of the parents and inheritance issues arise. Another scenario occurs when a local child bears the burden of taking care of their elderly parent while other siblings reside across the country. The local child often feels that he or she “earned” more inheritance by taking on added responsibility.

Court decisions have generally found trusts harder to challenge by an aggrieved party than a will in litigation though not automatic protection. Establishing a living trust demonstrates that the settlor wanted assets to be transferred in a certain way to a certain person or entity. Since trusts are not published, it also creates a veil against perceived unequal inheritance arguments that might arise. If a settlor feels one of the beneficiaries, or non-beneficiaries, is going to challenge the will or their share in the will then a living trust would be good step in mitigating that challenger’s success.

Another good reason to create a living trust is if a settlor believes their spouse needs to be protected because the settlor believes their beneficiaries are incapable of making good decisions – be it financial or otherwise. A testator/settlor can appoint a trustee that will act with a fiduciary responsibility to the trust. While a settlor can define those responsibilities, generally a trustee must act with the best interest of the trust and duty to administer the trust in the best interest of the beneficiaries. A settlor does not even have to pick a relative to be trustee. A number of financial institutions have trust departments that will act as a trustee for a fee. Most of the time, a corporate trustee is appointed because one spouse has taken care of all the personal finances of the couple and wants to “protect” the surviving spouse from being scammed by con artist or making bad financial decisions that could leave the surviving spouse destitute.

The size of your estate and your current estate status also can indicate if some type of trust is necessary. Currently in 2010, there is no federal estate tax but it returns in 2011. A plain living trust will not insulate an estate from estate taxes though more complex trusts can provide asset protection. In 2011, any estate over $1 million will be taxed at 55% rate. There are number of bills floating around Congress attempting to reform estate taxes for 2011 so I won’t hazard guess at what the future rates could be. Further, a number of states have state estate taxes of their own with varying levels of exemptions and rates. As a note for the local metro area, DC has an exemption of $1 million, Maryland has a $1 million exemption but also has an inheritance tax, and Virginia has no estate tax. Thus, if someone gets close to certain threshold levels in their estate creating a living trust makes sense and something more complex is probably desirable.

The last reason supporting transferring assets into a living trust is based on whether a settlor owns real property outside of the state from their domicile. Based on a number of legal and constitutional reasons, states courts, including probate courts, only have jurisdiction over real property located inside their territory. Without jurisdiction, a court does not have the power to distribute or transfer the real property to a beneficiary. If a testator owns property in several states, like a home at the beach or in the mountains, an ancillary probate administration will have to be opened in each state where the real property is owned.

The issues with ancillary probate are two-fold. Ancillary probate adds to the cost of administration. More than one probate administration will generate duplicative fees, including multiple court fees, accounting fees, and attorneys’ fees. It could also mean paying state estate taxes on that real property if the ancillary probate state has an estate tax. A second issue is if a person dies intestate. Each state has different rules on intestate succession, and it is possible that the heirs of an intestate estate could be different in the state of the primary probate proceeding versus the state of the ancillary probate proceeding. That could mean potential litigation as the two beneficiaries fight over the property.

Next month, I close out this topic by discussing some of the factors where it might make sense to not transfer your assets into a living trust.

Estate of the Month - Even Lawyers Get it Wrong: John O'Quinn

On October 29, 2009, attorney John O’Quinn died in a single vehicle accident when the SUV he was driving skidded across the median of a rain-slicked parkway just outside downtown Houston went airborne and slammed into a tree. O’Quinn was a Texas plaintiffs’ attorney that had won billions of dollars in verdicts against makers of breast implants, pharmaceuticals and tobacco products and earned millions of dollars in fees. However, what I find interesting is the lingering estate issues he failed to correct, even though he was a lawyer and should have known better. He left behind a multi-million dollar estate and was not survived by any family members. He executed a valid will in 2008 that stated he was single and left his entire estate to his charitable foundation.

This would normally be the end of the story but O’Quinn was survived by a long-term partner, Darla Lexington. She lived with O’Quinn for more than 10 years in his home in Houston. However, the partnership was never solemnized with a ceremony or any official marriage license. In many states, that would be the end of the discussion, but Texas is one of 13 states along with the District of Columbia that recognizes the formation of common law marriages if a certain criteria are met. To further complicate the matter, Texas is a community property state; all the property acquired during the marriage is considered community property and subject to a 50% division of the property. If a common law marriage is found, Lexington would be entitled to half of O’Quinn’s estate. It wouldn’t even matter if O’Quinn had a will stating Lexington should not inherit anything from his estate because most states have laws that prevent one spouse from disinheriting the other spouse. There is a strong legal argument that Lexington could reach into O’Quinn’s estate.

The first issue is to determine whether Lexington and O’Quinn had a valid common law marriage. In Texas, the requirements for the finding of a common law marriage are:
• You must have “agreed to be married.”
• You must have “held yourselves out” as husband and wife. You must have represented to others that you were married to each other. As an example of this, you may have introduced you partner socially as “my wife,” or you may have filed a joint income tax return.
• You must have lived together in this state as husband and wife.

Lexington’s claim of a valid common law marriage will rest almost purely on the facts and that will almost assuredly mean some type of litigation. The third criteria is easily satisfied as Lexington and O’Quinn lived in the same home in Houston when O’Quinn died. Lexington recently moved out of O’Quinn’s home for it to be sold.

The first and second criteria are intertwined and will rely mostly on evidence and witnesses from both parties demonstrating whether there was or was not a common law marriage. In support of Lexington’s claim are several facts supporting requirement one and two. There was apparently a press event in 2001 announcing O’Quinn and Lexington’s engagement which would support the intent to be married. As for holding themselves out as husband and wife, Lexington’s lawyer has asserted that O’Quinn referred to Lexington as “his wife” a number of times though there is no record of any joint tax returns at this point. What is likely to happen is that Lexington’s attorney will introduce witnesses saying O’Quinn held Lexington out as his wife while O’Quinn’s estate will present evidence to the contrary. Also, Lexington’s daughter spoke at O’Quinn’s funeral demonstrating a close relationship bordering on father-daughter level and also implying a husband and wife relationship.

The one big fact that no common law marriage was formed is the 2008 will that O’Quinn executed leaving his estate to his charitable foundation. It is likely the estate will assert that O’Quinn would have left some part of his estate to Lexington, if he viewed her as his wife. In normal circumstances, most spouses drafting an estate plan will make some type of bequests demonstrating support to their surviving spouse. There is no evidence at this point, but if O’Quinn had executed a will prior to 2008 that left part of the estate to Lexington and then cut her out in the 2008 will that would support an argument that Lexington was not considered his wife. However, this evidence might never surface as most good estate planning attorneys have their clients destroy any previous wills before executing a new one.

O’Quinn could have taken steps to mitigate, not only the likely probate litigation, but also Lexington’s ability to reach into his estate. First, O’Quinn, if it was not his intent, should not have been as free with the inferences to be married to Lexington or call her his “wife.” This would negate any potential common law marriage claims. As a high level attorney, he should know that language and word usage has consequences and here that means the claim of a common law marriage. Second, O’Quinn could have taken several steps to remove some of his property outside of his estate. Ignoring potential tax issues, he could easily have afforded to create a number of irrevocable trusts that would have sheltered his estate from creditor attack and still eventually be used to fund his charitable foundation. O’Quinn could also have set up a living trust solely for himself that would have demonstrated his intent never to be married. Again, he might face some tax issues but I’ll save that for another day.

My initial read of the situation, but is purely a guess, is that a common law marriage is going to be found and Lexington could be awarded 50% of the estate. The real issue is that enormous assets from O’Quinn’s estate could be exhausted by the legal fees accrued in the litigation, if Lexington opts to battle it out. Both parties might come to some type of agreement. Though, as a practical matter, settlements usually occur later in the proceedings after most of the legal fees have accrued. Despite the outcome, some of O’Quinn’s estate will not be fulfilling his intent, as it either goes to Lexington or is used in legal fees, because he committed the same mistakes many non-lawyers: not looking at the big picture.