In 2010, when the estate tax is scheduled to “go away” at least for one year, it is replaced with an insidious carry-over basis system. Tracking tax-basis information for clients will require careful record keeping and revisions in estate-planning documents. Despite the overall negative impact of the changes, clients can still benefit with proper record keeping.
If a client dies before 2010, the basis of his assets for income tax purposes is stepped up to their value for federal estate tax purposes. These values are usually determined as of the date of your customer's death, but with an option to value assets six months after death. (The six-month option can be used only if it reduces both the gross estate value and estate taxes.)
So if your customer has an account with an aggregate, adjusted cost basis of $100,000, but a federal estate tax value of $1 million, the basis of the assets for heirs becomes $1 million. Heirs like this because their capital gains tax is lessened when they sell the property, and the person from whom they received the property never paid the capital gains tax ahead of death. (But dying is quite a price to pay to avoid capital gains taxes!)
All this changes in 2010. Heirs lose the advantageous step up in cost basis. In the above example, the heirs' cost basis will also be $100,000 — a horrific result.
We had this same system in 1976, and it was repealed in 1978 because it was too complex and unworkable. People died without basis information.
Those negatives aside, here's one benefit to the changes. For certain estates that qualify, the basis of assets passed to a nonspouse can be increased by the executor of an estate by up to $1.3 million (and that number is adjusted for inflation).
Applying this principle to our example would mean the executor could potentially adjust the basis by $1.3 million, so the heir's cost basis of $100,000 can be stepped up to $1 million. You cannot adjust cost basis higher than the value of the assets on the date of death, so there will be circumstances in which the $1.3 million cannot be fully utilized. Conversely, there will be cases in which the $1.3 million will not be enough to avoid the negative impact of the tax law because the value of the assets on the date of death is much higher than $1.3 million.
There is another wrinkle to this. Property left to a surviving spouse in a manner that qualifies (and there are very strict rules) gets a basis adjustment of up to $3 million (separate from the $1.3 million). This means the total adjustments can be $4.3 million. Under the right circumstances, the spouse could be allocated the entire $4.3 million basis adjustment, drastically reducing capital gains taxes.
However, qualifying for this significant basis adjustment could be negated because of current language contained in many estate plans. This can happen especially when gifts are made in trust for spouses, as opposed to outright gifts. In order to secure these increases to cost basis, estate-planning documents must be updated. This is something you can encourage clients to do now with the help of their estate-planning experts. Meanwhile, secure accurate cost-basis information on all your clients' assets. They may need it come 2010.
Roy M. Adams is worldwide head of the Trusts and Estates Practice Group at the law firm of Kirkland & Ellis in New York. In addition to his law practice, he lectures extensively on estate planning and has authored several professional texts including “Contemporary Estate Planning: A Definitive Guide to Planning and Practice.”