When Congress repealed the “death tax”, no one expected that it would actually come to pass even though it was touted as a sure way to save America’s small businesses and to greatly simplify the lives of those who owned them. Now that the tax is repealed (albeit for only one year) one must still wonder if the lives of small business owners (and others) have been simplified . An often overlooked provision of the 2001 Law that repealed the Estate Tax is the creation of the modified “carry-over basis” rules. The concept is simple! Provide the heirs tax relief for up to $1.3 million of inherited property by allowing a “step-up” in basis for those assets to their fair market value at the death of the decedent. Any other property would retain a “carry-over” basis, generally valued at its original cost. This way, the Federal Government could tax the amount of gain on the sale of any inherited property in excess of the $1.3 million threshold.
To place the modified “carry-over basis” rules in perspective, one must review the rules for valuing inherited property as they existed prior to 2010 (the good old days?). When a person died prior to 2010, all of the assets in his or her taxable estate were “stepped-up” to their value on the date of the decedent’s death. This netted two favorable outcomes: first, the heirs did not have to search the decedent’s records for the original purchase price of the inherited property; and, second, the amount of gain on the inherited property was measured from its date of death value, which in many cases was higher than the original purchase price. This “step-up” in basis came at a price of inclusion of the inherited asset in the decedent’s taxable estate. But, since the vast majority of decedents were not subject to the Federal Estate Tax, there was in effect no penalty!
Under the rules in effect for 2010 (and only that year) the decedent’s estate is allowed a basis increase of $1.3 million on inherited property. Thus, for estates of less than $1.3 million, all the inherited property is allowed a “step-up” in basis. The Executor of larger estates would have to pick and choose which property would receive the “step-up” and which property would be inherited with a “carry-over basis”, generally an amount equal to its original cost basis. Further relief is allowed a surviving spouse. Qualified spousal property receives an additional $3.0 million basis increase. Qualified spousal property includes outright transfers to the surviving spouse as well as property passing to a so-called Q-TIP Trust for the spouse’s benefit.
Setting aside the uncertainty of whether the modified “carry-over basis” rules will survive past 2010, one must wonder how the lives of taxpayers were made simpler by the application of these rules. Won’t the testator have to place instructions in his or her Will on which assets the “step-up” would apply? The application of the modified “carry-over basis” rules makes the selection of an Executor all the more important because the allocation of basis to property will benefit one heir and disadvantage another. In the absences of such direction in the Will, the Executor is left to his/her own judgment on basis allocation. Again, an allocation of basis has the potential to benefit one group of heirs and disadvantage another. What is the Executor’s liability in such circumstances? What happens if the law is not changed and taxpayers must revert to the rules as they existed prior to 2010? Will the property inherited by a decedent in 2010 adjust to the date of death valuation in 2011, or will the modified “carry-over basis” rules still apply?
If uncertainty were not enough, Congress enacted reporting requirement with the modified “carry-over basis” rules which may prove burdensome on the Executor. While no Estate Tax Return is required for decedents dying in 2010, an Information Return for Estates in excess of $1.3 million is required in 2010. This Information Return must include the adjusted basis of the property in the hands of the decedent at the date of death and the date of death fair market value of that same property. Thus, the Executor must engage in a “treasure hunt” to ferret-out when the decedent purchased property and what the decedent paid for that property. To show that the IRS is serious about the whole affair, there is a $10,000 penalty imposed upon the Executor who is required to file an Information Return who fails to do so. If the failure to file the Information Return is due to an intentional disregard of the filing requirements, there is an additional penalty measured at 5% of the fair market value of the property in the decedent’s estate.
The general consensus is that the Congress will visit the Estate Tax mess in 2010; and, hopefully it repeal the mistake called modified “carry-over basis” rules. I continue to monitor the situation and will keep you updated in the future.