Estate Tax Uncertainties Pose Challenges for Heirs

While the system is in flux, estate administration has become much more complicated.


Marianne Barcellona

In the final weeks of last year, as the repeal of the estate tax on Jan. 1 approached, some people speculated that heirs would reap a windfall if wealthy relatives died in 2010 and Congress took no action to restore the tax.

Not so fast. While the system is in flux, estate administration – the process of wrapping up financial affairs after someone has died – has become much more complicated. Best practices for those who lose a loved one in this environment vary significantly from what was customary in the past.

These are strategies to consider:

Reserve funds for tax. If Congress restores the estate tax retroactively, as it is likely to do, it could apply to the estates of people who died this year. So heirs of estates that would be subject to the tax need to set aside money for it. The amount that is tax-exempt will probably be at least $3.5 million (the 2009 level), and a spouse who is a United States citizen may inherit any amount tax-free.

Delay selling appreciated assets. Heirs now must use the original price paid for an asset when computing the income taxes they will owe if they sell it. Previously, they could use the value upon the owner’s death. Each estate is permitted to exempt $1.3 million of gains from this carry-over basis rule. An additional $3 million exemption applies to assets inherited from a spouse.

In the past, the standard thinking has been that an executor, the person who administers an estate, should sell investments as soon as possible (or at least diversify out of concentrated positions) and hold the proceeds in cash or an equivalent form. Because executors are legally obligated to preserve money going to inheritors or to pay estate tax, the theory was that they should not take market risk.

Now an executor, who can be a family member, friend or professional adviser, must consider the income tax effect of selling property that has increased in value. While the $1.3 million exemption can be applied to assets given to anyone, the $3 million one is limited to assets given exclusively to a spouse, either outright or in certain kinds of trusts.

So far, though, there is no way of reporting the basis and how the two exemptions will be allocated to various assets. The Internal Revenue Service has not yet created a form for the purpose, and there’s no rush: The form won’t be due until April 15 of next year, which is also the deadline to file the final income tax return for people who died in 2010.

To add one more layer of complexity, it is possible (though not entirely clear) that carry-over basis applies only to assets sold in 2010. This argument stems from a sunset provision in the current law, the Economic Growth and Tax Relief Reconciliation Act of 2001. It provides that in 2011, when the old estate tax is restored, the current law will be treated as if it “had never been enacted.”

Relying on this language, inheritors may be able to escape the carry-over basis rules by holding assets at least until next year. At that point, if an investment is sold, the capital gains tax would apply only to any increase in value after the date of death.

Locate investment records. Until now, the main challenge heirs faced was finding tax returns and brokerage statements that would lead them to what someone owned on the date of death. With carry-over basis rules, heirs must also determine the cost of those assets.

The best place to start is with the current brokerage house. But if the assets have been moved between financial institutions, the original cost might not be on file there.

Next, sort through papers that may predate computerized records. Income tax returns, which show dividend payments, might provide another clue about when an investment was purchased.

If heirs can’t prove what things cost, the IRS assumes the cost is zero, and could try to saddle them with capital gains tax on all the sales proceeds. In other contexts when the initial cost was unclear, advisers have had clients estimate when something was bought. Then it’s possible to get price information directly from public companies or by checking newspaper archives. The IRS is not likely to challenge this approach.

Stay tuned. If Congress extends the estate tax retroactive to Jan. 1, it may also create a choice between the carry-over basis system and an estate tax system, limited to deaths in 2010. For grieving heirs, that would add one more issue to the mix.

Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide (DJWorking Unlimited, 2009).