New Estate Tax Law: New Choices

Written By: Gerald E. Kubasiak

Kubasiak, Fylstra, Thorpe & Rotunno, P.C.

Chicago, IL

After going through a year of no estate tax and much uncertainty, the estate tax is now back. The new law re-creating the estate tax (the "New Law") adds yet another layer of complexity to the estate of an individual dying in 2010, rather than simplifying the issues. Under the New Law, the executor of such an estate may elect to apply the law as it existed in 2010 (the "2010 Law"),or may apply the New Law imposing an estate tax. On its face it might appear that there is no issue: elect the 2010 Law because there will be no estate tax. However, under the New Law there is an exemption (i.e., no estate tax) for the first $5 million in assets. In addition, the New Law brings back the "step-up" in the basis of the assets included in the decedent's estate. Under the 2010 Law, there was no tax but the basis adjustment was limited to a general "step-up" of $1.3 million and a $3 million "step-up" on assets passing to the surviving spouse.

As a comparative example of the different results, consider the following facts. Assume that the decedent died in 2010 and left a will drafted in 2000 which did not contemplate the "no estate tax" of 2010. The will provided for a Marital and a Family (or credit) Trust with the funding of each determined upon the amount of tax to be paid. (The will provides that the Marital Trust will be funded on the basis of the "least amount of estate tax.") The decedent has a taxable estate of $5 million, including a one-third interest (with two other shareholders) in a family business which is taxed as an "S" corporation. Currently, there is a pending sale of the operating assets of the family business for $12 million. There are $600,000 of liabilities to be paid, which would leave a net sale distribution of $11.4 million, evenly in three parts, or $3.8 million to each shareholder. The adjusted basis of the decedent's stock as of December 31, 2009, was $244,981, without any step-up adjustment (aside from any additional earnings or distributions during the year) that would be used to measure any gain or loss on liquidation. The plan is to liquidate the business after the sale.

If you apply the New Law, there is an unlimited step-up in the adjusted basis of the assets included in the decedent's taxable estate. However, if the will provides under the "formula" that the first $5 million of value goes into the Family Trust (to absorb the $5 million exemption), those assets would not be subject to step-up. Under the 2010 Law, you would be able to apply at least a $1.3 million step-up. Getting the additional $3 million step-up would depend on whether the stock of the family business went into the Marital Trust. Because the language in the will refers to funding the Marital Trust with an amount dependent upon an estate tax, you might argue an ambiguity in the language because there is no estate tax and ask for a court determination that the assets go into the Marital Trust rather than the Family Trust.

The election of what law to apply and how to fund the Marital and Family Trusts impacts two things. First, the adjustment to basis will affect the taxable gain or loss on the liquidation of the family business. Second, it will affect the potential size of the surviving spouse's taxable estate at her death. To the extent the family business stock or the proceeds from a sale, go into the Family Trust, it would not be included in the surviving spouse's taxable estate (as the New Law is written). If the stock of the family business (or sale proceeds) goes into the Marital Trust, it will be included in the taxable estate of the surviving spouse.

In analyzing the basis issue, there are three initial questions: (1) how much is the gain (and what is the character of the gain) resulting from the sale; (2) in what year will the gain be recognized; and (3) what is the adjusted basis in the stock? As a starter, the adjusted basis will be $244,981. This may be adjusted depending on the law that is elected. In addition, because the corporation is taxed as an "S" corporation, the gain on the sale of the assets will be passed through to the shareholders and will increase the basis. The basis in the stock will then be used to measure the gain or loss to the shareholder on liquidation.

Using our example, if the assets in the business were sold for $12 million and the business had a basis in those assets of $6 million and $600,000 of expenses, the company would have a taxable gain of $5.4 million. The character of the gain would depend on the nature of the assets. It is likely that most of the gain would be a capital gain. As a result, each one-third owner would have income of $1.8 million. In addition, the basis in the stock of the decedent (regardless of any other "step-up") would increase by the $1.8 million gain and would increase from $244,981 to $2,044,981. The gain or loss resulting from the liquidating distribution of the remaining cash (assuming that the $12 million sale proceeds were reduced by $600,000 in liability) in the amount of $11,400,000, or $3.8 million to each shareholder, can result in several results. These are dependent on the possible adjustments to the basis of the stock. Is there no step-up at death? A step-up of $1.3 million or is there a step-up to the full fair market value of the stock of $3.8 million?

In the following examples assume in (1) that the executor elects to apply the New Law with the Family Trust being funded with the first $5 million including the stock in the family business and as a result, no step-up in basis; (2) elect the 2010 law with the assets going into the Family Trust; and (3) elect the 2010 Law and obtain a court determination allowing the assets to go into the Marital Trust. You have the following results:

	Example #1	Example #2	Example #3
Gain in Sale of Assets	1,800,000	1,800,000	1,800,000
Date of Death Basis Step Up in Basis Allocation of Profit to Basis	244,981 0 1,800,000	244,981 0 1,800,000	244,981 0 1,800,000
Base on Liquidation Liquidating Distribution	2,044,981 3,800,000	2,044,981 3,800,000	2,044,981 3,800,000
Gain (Loss)	1,755,019	455,019	(1,800,000)

In either case, there is no estate tax. The major factor affecting any adjustment to the basis of the stock is whether the stock passes into the Marital Trust or the Family Trust. If the executor elects the New Law and the assets pass into the Family Trust there will be no basis adjustment. If you elect the 2010 Law, you can get the benefit of a $1.3 million step-up. However, if you elect the 2010 Law you need to look to the language of the document which provides for the method of funding the trusts. The only way you can get a larger step-up than $1.3 million is if the funds go into the Marital Trust (or outright to the surviving spouse). Again, you might accomplish this by arguing that the funding language is ambiguous. However, as noted above, such a result could result in a substantial difference in the amount of income taxes that may be payable. As you can see from this discussion, this New Law legislation does not come under the description of "simplification."

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