Estate Tax Roulette

By William F. Devine

April 2011

After striking more poses than a Brazilian supermodel in a Monte Carlo casino, Congress passed new estate tax laws for this year. How do the new laws affect you? That depends on how your life evolves, and on whether Congress installs an amendment to the new laws over brunch today.

What you choose.

If you serve as executor or trustee for someone who died in 2010, the new laws in essence require you to choose between paying estate tax and paying capital gains tax. Isn’t choice good? Not necessarily.

The estate tax, at death, taxes estate assets above $5 million at 35 percent. If you choose to pay the estate tax, then—let’s oversimplify, so this doesn’t turn as dry as a march across the Sahara with just one camel—the assets remaining after paying that tax are assigned a basis (i.e., cost) that is increased, so that when you sell those remaining assets, the estate pays little or no capital gains tax on them. So, Option 1—you pay estate tax, but no capital gains tax.

Mustard, serendipity, envoy, crux, improvise, behoove, double-team, triple, ski, jest—English abounds with nouns and verbs that help life sparkle, but writing about tax laws requires using 98 percent prepositions. This aggravates Estate King no end, and an inquiry will be held. Heads may roll. Let’s continue.

The capital gains tax, at sale, taxes the amount by which an asset’s sale price exceeds its basis. If you choose not to pay the estate tax, then—once again, we oversimplify—if you sell the assets for more than their basis, that gain is subject to the capital gains tax, currently 15 percent and set to go to 20 percent in 2013. So, Option 2—you pay capital gains tax, but no estate tax.

Which Option is better? Well, if the estate does not exceed $5 million in value, choose estate tax (which will be zero), take the basis increase (which means capital gains tax will be little/zero), and tip the croupier as you leave the table. No estate tax plus no capital gains tax means you played your cards perfectly.

If the estate value exceeds $5 million, making the right choice involves more work and more risk. First, the work. Calculate the estate tax under Option 1, then build a spreadsheet for Option 2. Make sure that, for each asset, the spreadsheet incorporates the decedent’s basis and projections for market performance, sale price, sale date, and capital gains tax rate. Make sure the spreadsheet compares the capital gains tax it calculates with the estate tax you calculate under Option 1.

Now the risk. Remind yourself that the number your spreadsheet calculates for Option 2 depends on multiple projections. Acknowledge that the reliability of a projection declines as the date for selling an asset moves further into the future. Note that, in the neighborhood where you grew up, “multiple projections of declining reliability” was a 75-cent way of saying “guess,” ergo, the Option 2 number is a guess. Admit that, ever since all your guessing on that Mrs. Allen seventh grade Algebra test earned you a C-minus, you have resented any person, board game or law that forces you to guess with math.

Now pick your tax. Just one last thing—remember that, if you choose the Option that does not maximize the estate’s value, beneficiaries could complain about you, perhaps bitterly and perhaps in probate court. Bonne chance, mesdames et messieurs.

When You Go. 

If you die in 2011 or 2012, you can leave up to $5 million free of estate tax to people not your spouse. The IRS takes 35 percent of any amount over $5 million.

Lawmakers consider the long-term impact of incentives in the latest draft of proposed legislation.

If you die in 2013 or thereafter, by contrast, you can only leave $1 million free of estate tax to people not your spouse. The IRS takes 55 percent of any amount over $1 million.

So the new laws offer you a $2.2 million incentive—55 percent of $4 million—not to live beyond New Year’s Eve 2012.

Estate King understands incentive as well as the next monarch, but this is an incentive not to live. Were the legislators paying attention when these new laws were made, or were they downstairs in the old Senate baths playing roulette?

When You Give and Go. 

If you give money away in 2011 and 2012, you can give away up to $5 million free of tax to any person(s).

Once you arrive in 2013, however, you can only give away up to $1 million free of tax to any person(s), with any additional gifts taxed at 55 percent.

What if you give away $5 million in 2011, but don’t die until 2013 or beyond? Under the new laws, your estate may incur a 55 percent tax on that extra $4 million you gave away in 2011, even if market reversals leave your estate with no funds with which to pay that tax.

How will your executor cover the tax in that case? He could have his lawyers try to retrieve some of the gift money from the beneficiaries, but bonne chance with that—it’s about as easy as quelling an 18th century peasant revolt.

His lawyers will surely be told, “Let him eat cake.”

Where Congress Veers.

No matter where your estate planning energy level lies on the scale between listless and explosive, Estate King recommends that you learn to love the unknown. Congress strikes the tax. They revive the tax. They all but strike the tax. They revive the tax. Depending on when you checked over the past 1000 days, the cost of trying to leave $5 million appeared to be, depending on date of death, $1.3 million, $700,000, nothing, $2.2 million, nothing, and $2.2 million. The rules of the game fluctuate more widely and more often than ever before, so your planning should incorporate the likelihood of more wild change.

What will that change look like? If Estate King owned that crystal ball, Estate King would be Sports Book King.

For now, understand that in yanking the estate tax laws around so hard, Congress has quite possibly turned your estate planning documents against you. Many trusts operate on formulas based on the largest amount one can leave without paying estate tax. With that amount now boosted to $5 million, your trust may now leave too much money to the wrong person.

So should you revise your estate plan based on the new laws, even though they will soon be replaced with fresh legislation du jour? Should you line up a string of tax-free gifts to take advantage of today’s $5 million untaxed max, even though those gifts might be hit with tomorrow’s retroactive tax? With policy so incoherent and unstable, seeing all consequences of any estate planning step will take more thought than usual.

Instead of impulse-buying one of the schemes being sold to thousands of people, understand that your circumstances, regardless of what anyone may tell you, are really really unique. Maneuvers abound, but do any fit you? Study what your documents say, then think long and longer about how to assume a stance that protects the people you hold most dear.