As discussed in a previous article, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended through 2012 most of the so-called “Bush era tax cuts,” which were originally contained in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). For decedents dying in 2011 or 2012, the 2010 act increases the unified exemption for estate tax purposes to $5 million and reduces the top estate tax rate to 35 percent.
For decedents who died in 2010, the 2010 act provides executors of such estates with an interesting and potentially problematic choice of either becoming subject to the estate tax provisions of the 2010 act or electing out of the estate tax but remaining subject to the carry-over basis rules contained in EGTRRA. The “default” position under the 2010 act is for estates of decedents dying in 2010 to be subject to the estate tax provisions of the act.
Under EGTRRA, the estate tax was eliminated for decedents dying in 2010, but property passing from such a decedent’s estate would be subject to a modified carry-over basis regime so that such property would receive a basis equal to the lesser of the decedent’s adjusted basis or the fair market value of the property on the date of the decedent’s death. EGTRRA also contained several modifications to this carry-over basis approach. Under these rules, every estate was generally permitted to increase the basis of assets transferred to any beneficiary of the estate by up to $1.3 million, which could be further increased by the amount of a decedent’s unused capital losses, net operating losses and certain “built-in” losses. It is the obligation of the executor of the estate to allocate this basis adjustment among the assets in the decedent’s estate by filing an information statement with the IRS and each affected beneficiary. Moreover, the basis of property transferred to a surviving spouse could be further increased by an additional $3 million.
Prior to 2010, the recipient of property passing from a decedent received a “stepped-up” basis in the inherited property. The basis of property passing from a decedent’s estate would be stepped-up to the fair market value of the property as of the date of the decedent’s death (or, if an alternative valuation date was elected, the earlier of six months after the decedent’s death or the date that the property was sold or distributed by the estate).
For assets that appreciated while owned by the decedent, this step-up in basis eliminated the recognition of income upon the subsequent sale of the property with respect to any appreciation in the value of the property as of the date of the decedent’s death (or alternative valuation date). If the value of property on the date of the decedent’s death was less than its adjusted basis, the property would receive a step-down in basis when it passed from the decedent’s estate.
For decedents who died in 2010 owning assets with a net aggregate value under $5 million, the choice presented by the 2010 act is easy. For such estates, there would be no reason or rationale to elect out of the estate tax and become subject to the modified carry-over basis rules since such estates would owe no estate tax and could enjoy a full step-up in the basis of estate assets. Conversely, for estates significantly in excess of $5 million, electing out of the estate tax will generally make sense since the estate tax on assets in excess of $5 million is 35 percent while the capital gains rate currently is at 15 percent.
For example, an estate that has assets worth $20 million would owe approximately $5,250,000 in estate taxes if no election is made to opt out of the estate tax. Assuming that the decedent had a $1 million aggregate basis in these assets on the date of death, the election out of the estate tax and the application of the modified carry-over basis rules would result in no estate tax and a maximum capital gains tax of only $2,655,000 upon a subsequent sale of estate assets for $20 million. For estates with assets only modestly in excess of $5 million, the proper choice is less certain.
In general, every executor of an estate of a decedent who died in 2010 needs to calculate the overall estate and income tax consequences of an election out of the estate tax. In essence, executors of estates with appreciated assets must weigh the estate tax costs versus the future capital gains tax that would be imposed on a subsequent sale of estate assets if the modified carry-over basis rules are imposed as a result of an election out of the estate tax.
In a recent article, one noted commentator also noted that the election out of the estate tax for decedents dying in 2010 may be helpful where the decedent had a large amount of accrued passive losses that would otherwise be “lost” if the decedent’s assets were stepped-up to their fair market value. Code Section 469 limits the ability of a taxpayer to deduct for income tax purposes losses incurred in the conduct of a trade or business in which the taxpayer does not “materially participate.” Such non-deductible “passive” losses may be carried forward and applied against future passive gains. However, any unused passive losses can be deducted on a decedent’s final income tax return to the extent that the amount of the losses exceeds the basis of the property in the hands of the transferee.
Accordingly, electing out of the estate tax and becoming subject to the modified carry-over basis rules could result in an increase in the amount of passive losses that may be deducted on the decedent’s final income tax return. In certain situations, the income tax savings of electing out could be greater than the estate tax cost.
The choice faced by executors for decedents dying in 2010 can be further complicated where there are specific assets allocated to specific beneficiaries under the terms of the decedent’s will. Absent clear direction in the decedent’s will, the allocation of the $1.3 million basis adjustment available under the modified carry-over basis rules could be contentious. Similarly, there is an inherent conflict between the beneficiaries of specific assets or bequests and an estate’s residuary beneficiaries since the recipients of specific assets would bear the future capital gains cost if the election is made to opt out of the estate tax while the residuary beneficiaries would bear the estate tax burden if no such election is made.
To allow executors adequate time to make an appropriate election with respect to decedents who died in 2010, the 2010 act extends the filing deadline for certain transfer tax returns. In the case of a decedent dying after Dec. 31, 2009, and before Dec. 17, 2010, the due date for filing the estate tax return (Form 706) will not be earlier than Sept. 17, 2011 (nine months after the date of enactment). For decedents dying after Dec. 17, 2010, but prior to Jan. 1, 2011, the estate tax return is due nine months from the date of death.
For estates that elect out of the estate tax and into the carry-over basis regime, a carry-over basis return (Form 8939) must be filed on the due date for the filing of the decedent’s final income tax return, including extensions (i.e., April 18, 2011, plus extensions). To date, Form 8939 has only been issued in draft and it does not appear that the nine-month extension period granted for Form 706 applies to extend the filing due date of Form 8939 beyond April 18, 2011, (plus extensions).
The 2010 act imposes a special burden on executors of estates for decedents dying in 2010. Such executors must first decide whether to elect out of the imposition of the estate tax. This election can only be made after a thorough analysis of both the estate and income tax consequences of such an election. If the decision is made to elect-out of the estate tax, additional problematic decisions must be made with respect to the allocation of basis among estate assets. •
Mark L. Silow is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.