Friday, October 23, 2009


I just finished reading a a Wall Street Journal article by Laura Saunders on the issue of what will happen to the Estate Tax next year the and consequences thereof. The current Federal Estate Tax exemption ($3.5 million) is set to "disappear" next year. (The current law is expiring). Most people would say "Great! So it doesn't matter how much I own, if I die next year there will be no estate tax due for my kids." Unfortunately, there may be much bigger problems to consider.

The current estate tax law was enacted by Congress back in 2000. It increaed every year and it is currently at $3.5 million per person ($7 million per couple). In otherwords, if you and your spouse own $7 million in assets and died in 2009, you can pass all the assets to your heirs and they wont owe any estate tax - which is at 45%.

Under the current law, the will be no federal estate tax at all for 2010 and in 2011 it will follow the current lifetime gift tax exemption of $1 million per individual ($2 million for a couple). In the above situation, if the above couple died in 2011 with an estate of $7 million, $5 million would be taxed - if the rates stays at 45% - then the heirs would owe $2.25 million on their inheritance.

It is believed among most in the industry that Congress will step in very soon and extend the current exemption because of the collateral tax damage this "lapse" can cause. It is really an issue of what is called a "step-up in cost basis". This means that when someone inherits an asset, the value of that asset is "stepped up" to the current value at the time of inheritance (date of death). Without a "step-up", the asset would retain the original value from when the original owner acquired it. If the estate tax goes away, so will this "step-up in cost basis".

Here's an example:

Let's say your mother leaves your son a stock that she bought in 1970. She paid $5 for the stock but tody it is valued at $75. Under the current tax law, if mom died today, when your son inherits the stock, the value is $75. So if next year your son sells the stock and it sells for $80, he will only have to pay capital gains tax on the $5 profit. Without the "step up", the original cost of $5 for the stock would transfer to your son (called a "carry-over basis"), so when he sold the stock at $80, he would now have to pay capital gains tax on $75 profit. Now if you apply that same principal to something larger, like a home purchased for $50k in 1970 and is valued at $750k today, it is clear how much of a tax burden this will place on your son. This is also why gifting an asset versus allowing it to pass through inheritance is not always the best option.

There are many possible solutions being proposed in congress right now. Something may be passed by the end of the year, something may happen later and be applied retroactively, it is definately an area to be aware of and if you haven't developed your estate plan, yet, it is definately a time to get things done and protect your estate not only from probate, but also to attempt to minimize the tax burdens on your heirs while we still have the ability to do so.

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