An important aspect of the the tax legislation that overwhelming passed both House of Representatives (277-148) and the Senate (81-19) and will soon become law, i.e. this afternoon, is the retroactive reinstatement of the estate tax for the estates of decedents dying in 2010.
Under HR 4853, the estate tax will automatically apply to the estates of decedents dying in 2010 with a $5 million exemption and 35% rate. However, HR 4853 also provides that estate tax will not apply to a decedent's estate if an estate's executor elects out of the estate tax.
The relevant provision of HR 4853 is as follows:
(c) Special Election With Respect to Estates of Decedents Dying in 2010.--Notwithstanding subsection (a), in the case of an estate of a decedent dying after December 31, 2009, and before January 1, 2011, the executor (within the meaning of section 2203 of the Internal Revenue Code of 1986) may elect to apply such Code as though the amendments made by subsection (a) do not apply with respect to chapter 11 of such Code and with respect to property acquired or passing from such decedent (within the meaning of section 1014(b) of such Code). Such election shall be made at such time and in such manner as the Secretary of the Treasury or the Secretary's delegate shall provide. Such an election once made shall be revocable only with the consent of the Secretary of the Treasury or the Secretary's delegate. For purposes of section 2652(a)(1) of such Code, the determination of whether any property is subject to the tax imposed by such chapter 11 shall be made without regard to any election made under this subsection.
Stepped-Up vs. Carry-Over Basis
Why wouldn't the executor of an estate of a decedent dying in 2010 elect out of the estate tax?
Previously, when a decedent died, his/her beneficiaries would receive the decedent's assets with a "stepped-up basis", i.e. their bases would equal the fair market value of the estate's assets on the day of the decedent's death. However, the repeal of the estate tax for 2010 required that beneficiaries would have the same bases as the decedent, i.e. "carry-over basis".
Basis is important because it is the value upon which the taxable gain is calculated upon an asset's sale. For example, a decedent purchased an asset for $100,000 but the asset is worth $500,000 on the day of the decedent's death. The asset is thereafter sold for $500,000. If a beneficiary received the asset with a stepped-up basis, the beneficiary would have no taxable gain. However, if the beneficiary received a carry-over basis in the asset ($100,000), the beneficiary would have a taxable gain of $400,000.
What Does This Mean?
Unless an estate exceeds the new $5 million exemption, an executor will probably not want to opt out of the estate tax and thereby allow the estate's beneficiaries to receive assets with stepped-up bases. For these beneficiaries, the retroactive reinstatement of the estate tax may allow for higher bases in assets and possibly relieve substantial headaches associated with carry-over basis.
For example, a decedent's estate was worth $4.5 million. The decedent had a total basis of $1 million in the estate's assets. If the executor doesn't elect out of the estate tax, the decedent's beneficiaries will receive the estate's assets with a basis of $4.5 million and will not be subject to estate tax. However, if the executor does elect out of the estate tax, the beneficiaries will receive the assets with a basis of $2.3 million ($1 million carry-over basis + 1.3 million aggregate basis increase provided under current law).
This brief overview of some important considerations associated with The Middle Class Tax Relief Act of 2010 is by no means comprehensive. Always seek the advice of a competent professional when making important legal and financial decisions.
