TAX NEWS - JUNE 2010

U.S. Tax: In 2010, heirs inherit estate tax uncertainty

If you're rich, old and sick, your best financial move in 2010 seemed easy: Die now.

This simple sounding, albeit inconvenient, strategy turns on the fact that tax on very large estates fell to 0 percent this year, and this year only. But thanks to the lingering effects of the Bush tax cuts and Congress' procrastination, there's nothing simple about the estate tax this year.

In fact, confusion abounds for estate planners, tax lawyers, trustees, heirs and any elderly affluent individuals who woke up not feeling all that well this morning.

Tax experts and estate planners point out that while one part of the Bush cuts nixed the estate tax for 2010, another provision hits heirs with much of the tax that estates skip. And even if your rich uncle can time his shuffle off this mortal coil for this year, Congress may hit his estate with a retroactive tax.

"Nobody ever thought it would come to this," said Kay Bell, editor of the blog Don't Mess With Taxes. "We really thought that Congress could be grown-ups and do their jobs. And we were wrong."

How wrong? Take the case of Texas gas pipeline tycoon Dan Duncan, the 74th richest person in the world. Until March.

That's when Duncan died, generating what looked like a huge windfall for his heirs.

If the billionaire had died three months earlier, his $9 billion estate could have generated a tax bill of up to $4 billion. And, under the law as it stands today, if he died 10 months later, it could be up to almost $5 billion.

So you'd think that old Dan's timing was extremely fortuitous to his heirs. But they still could face sizable IRS bills even if the 0 percent estate tax sticks for this year, said Henry Lee, chairman of estate planning for the law firm of Howard & Howard in Royal Oak.

When the estate tax phased out, Lee said, so did rules allowing heirs to get a "step-up" in the basis of the assets they inherited. That meant heirs paid nothing on the past gains on their inheritances once the property had been subjected to estate taxes. But in most cases this year, any inherited assets that appreciated during the estate owner's lifetime by more than $1.3 million (or $3 million for a spouse) are taxable to heirs when they cash out.

"The people who have a lot of pre-death appreciation are going to be in for a real kicker," Lee said.


'Death tax' not quite dead

The estate tax never generated any big money for the U.S. Treasury, but was a social tool, aimed at preventing wealth from accumulating among a few family dynasties. Established in 1916, it became a target of anti-government neoconservatives who sent the hated "death tax" to its demise as part of the 2001 Bush tax cuts.

But only sort of. To pass the Senate with less than 60 votes, the cuts couldn't last more than 10 years. So the dreaded tax phased out, dropping from 50 percent on estates of more than $1 million (with a 5 percent surcharge on anything over $10 million) down to 0 percent for 2010. But the cuts expire next year, and the estate tax bounces right back to 2001 levels.

As 2010 neared and a heavily indebted government was under the control of a Democratic Congress and White House, tax lawyers felt sure the phase-out would be eliminated.

"Nobody in the world thought that 2010 would come out the way it did," Lee said.

But Congress dithered and, for once, it looked like Ben Franklin would be wrong: 2010 would be the one year when, if you couldn't avoid death, you would at least avoid taxes.


Waiting for Congress to act

While the death tax looks temporarily dead, estates and heirs are living in limbo.

Congress can't make new taxes retroactive, but it can make changes to existing taxes retroactive and is considering doing just that with the estate tax. The proposals include moving the rates back to 2009 levels or allowing estates and heirs to choose either the 2009 or 2010 rules.

For some heirs, it might be cheaper to have the estate pay taxes at the 2009 rate, Lee said.

That leaves estate experts planning for all possible scenarios, or figuring out new ones. Estate planners also are urging clients to make sure technical aspects of existing plans made under the old rules won't accidentally increase their tax bill, said Michael Collins, tax partner with BDO Seidman in Detroit.

"They all need to be reviewed because the formulas and values don't work right now," Collins said. "It creates a lot of problems."

The confusion has given rise to estate strategies that may work only for the next six months, said Michael Umphrey, partner in the Kemp Klein Law Firm of Troy.

"There's an awful lot of very complicated plans that are going to be expensive and unnecessary once Congress does something," Umphrey said. "There are some simple fixes, but they're all temporary. The truth is that nobody knows what to do."

That includes heirs who need to deal with their inheritances, and trustees who have to manage those assets through the ups and downs of a volatile stock market and economic recovery.

"We have a client worth about $17 million who died in mid-January," Umphrey said. "His beneficiaries are sorry to see the old boy go, but very happy to get the money. But now we need to sit on about 50 percent of it and wait to see what Congress does."

If, that is, Congress acts at all. With midterm elections and pressing issues, the estate tax is moving beyond the back burner.

In 43 years of estate planning, Umphrey said, he's never seen so much expensive uncertainty.

"We've got wealthy clients, and we don't know whether to tell them to live or die," he said. "But I have very few volunteers."