Carryover Basis Rules  Before 2010, under the stepped-up basis rules, your beneficiary received an increase (or step up) in the basis of any assets she or he inherited. In other words, your beneficiary's tax basis for an inherited asset was equal to the value of the asset when it was inherited. In the event of a future sale, your beneficiary's taxable gain was therefore reduced by the amount of this increase in basis.

For 2010 only, in the absence of an estate tax, the stepped-up basis rules are replaced by carryover basis rules―plus a limited step-up allowance. The maximum step-up is $1.3 million in appreciation, with an additional $3 million in appreciation for assets passing to a spouse. For assets not stepped up, your beneficiary's basis in any inherited assets is the same as your basis in the assets. When your beneficiary sells an asset the taxable gain is based on the total appreciation from the time you acquired the asset―not simply the appreciation from the time your beneficiary acquired it from your estate.  

Potential Legislative Remedies
In early December of 2009, the House of Representatives passed legislation to extend the estate tax through 2010 using the 2009 rates and exemption amounts. Senate leaders allowed the tax to lapse, but have stated their intention to address resurrection of the estate tax in early 2010.

In general, the Congress has three options:

  Take no action to reinstate the taxes for 2010, and the current situation continues with reinstatement of the tax in 2011 at significantly higher rates.

  Reinstate the taxes for 2010 without making the change retroactive to January 1.

  Reinstate the taxes for 2010 and make the change retroactive to January 1. There are questions as to whether a retroactive reinstatement is constitutional, so this legislative approach could take years to reach an ultimate conclusion, likely in the U.S. Supreme Court.

Which action they'll actually take is yet to be determined. As decisions are made, I'll keep you informed in future issues of the newsletter.

What You Can Do Now
Given the current uncertainties, a wait-and-see approach may seem the only option. However there are things you can―and should―do now.

Begin by understanding the provisions of your current will and other estate planning documents.

  Do they contain formula clauses or other sophisticated tax provisions that may result in unanticipated consequences in the current volatile environment?

  Who are the beneficiaries you've designated for bank accounts, brokerage accounts, insurance policies, retirement plans and IRAs? These designations supersede the beneficiary designations in your will, so make sure they reflect your current wishes.

  How are your assets titled? The manner in which your assets are titled―for example, joint accounts―also supersedes any beneficiary designations in your will. If you're married or in a registered domestic partnership, appropriate planning can effectively double your tax exemption amount, but you must develop your plan accordingly and your assets must be titled appropriately to gain the benefit. 

Determine the approximate value of your estate. 

  If it's under $1 million, it isn't likely to be taxable for federal purposes regardless of any action Congress takes. In this case, the tax status is relatively certain, so it's easier to plan.

  If the value is greater than $3.5 million, it's likely to be taxed for federal purposes under any future scenario (except, possibly, during a portion of 2010). For these estates, uncertainties in the exemption amount and tax rate for 2011 complicate planning.

  If the value is greater than $1 million but less than $3.5 million, its tax status is more uncertain. If Congress extends the 2009 rates, it will likely not be taxable for federal purposes. But if they take no action, the estate is likely taxable beginning in 2011. There are also uncertainties in terms of the exemption amount and tax rate that further complicate planning.

  Finally, remember that Washington State's estate tax applies to taxable estates exceeding $2 million. Even if you don't have a taxable estate for federal purposes, you may need an updated estate plan to minimize state-levied estate taxes.

Gifting Strategies
The federal gift tax has not been repealed. However, you can make tax-free gifts of up to $13,000 per person for 2010, and an unlimited amount if the recipient is your spouse. If your gift to any one person exceeds the annual amount, it still passes tax-free as long as the total does not exceed your maximum lifetime gift tax exclusion amount of $1 million.

In the current low-asset-value/low-interest-rate environment, if you have a larger estate, you might consider gifting strategies to reduce the overall size of your estate. This strategy is particularly relevant for Washington State residents, as Washington has an estate tax but does not have a gift tax.