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Why 2010 Means Trouble for Many Living Trusts

You may have heard that 2010 is the year without an estate tax.  It’s caused some people to suggest that if you have to pick a year to die, pick 2010.

Not so fast.

In the absence of the death tax this year, there is a substitute tax system that is likely to collect more money from more people upon their deaths.  This one-year system will seriously impact the way they planned for their property to pass to their loved ones.  To make things even more complicated, most living trusts aren’t equipped to deal with the 2010 rules.

Anyone who didn’t plan with an attorney who prepared for this year’s issues should have their trust reviewed and quite possibly restated.

How Did We Get Here?

The 2010 rules were actually enacted in 2001.  That’s when President Bush signed a law that gradually reduced the maximum rate of the federal estate tax from 55% to 45%.  The law also gradually increased the amount of property that a person could pass free of federal estate tax from $675,000 per person in 2001 to $3.5 million per person in 2009.  This meant that, with planning, a married couple could pass up to $7 million free of federal estate tax if they both died in 2009.  This was a very good result.

But the fight against the death tax didn’t just decrease rates and increase the exemption over time.  It actually eliminated the tax entirely, but only for 2010.  To compensate for this one-year, death-tax vacation, Congress replaced the estate tax with a capital gains tax.

Here’s how it works.  When a person died before this year, all their assets would be valued at their fair market value as of the date of death.  This meant that when a surviving spouse or other heirs sold assets that had increased in value during the original owner’s life, they would not have to pay capital gains tax on any of that growth.  This tax-free revaluation on death is commonly referred to as a “step-up in basis.”  For many heirs this meant huge tax savings.

But in 2010 property that passes at death does not automatically receive this step-up in basis.  Instead, there are some credits that, if planned for correctly, will “step-up” some of the property.  Assets that do not take advantage of these credits will be subject to tax on the increase in value from the date the property was first acquired.  That could mean tens of thousands of dollars of tax liability!

How Does This Affect You Or Your Loved Ones?

You should know that the 2010 rules can affect you in two major ways.  First, if you are married, you must make sure that your property will be left according to your desires (i.e., not as dictated by Congress).  For more than 50 years it has been common to use a written mathematical formula to divide the assets of a married couple when the first spouse dies to maximize estate tax savings.  We call this “A-B” planning.  Formulas have also been used to provide funds for charitable causes and to benefit family and friends.  Almost all of these formulas depend on having an estate tax.  Now, in 2010 when there is no estate tax, the formulas will not work.  If your spouse is not your sole beneficiary (for example, if you have children from a prior marriage), the existing formula could cause your spouse to be disinherited (or at least receive less than you intended).  It’s that serious.

Second, as noted above, your trust must be designed correctly if it’s going to take advantage of certain tax credits availbable only in 2010.  In particular, the credits don’t apply for any children who inherit this year in so-called “lifetime trusts.”  The rules are also extremely tricky for any surviving spouse who wants to take full advantage of the credits.  If your trust doesn’t comply with the rules, Uncle Sam ends up the winner when your spouse or other heirs go to sell trust property (i.e., even decades later).

What Should You Do?

If you haven’t already done so, we encourage you to meet with us as soon as possible to review your estate plan and make any changes that are necessary for this law.  We need to ensure that your property is positioned to enjoy as much protection as possible.  It’s time to think differently to ensure that your wishes are fulfilled no matter what Congress throws at us this year.  Your plan should also be ready to deal with the return of the estate tax in 2011, which, for the time being, is scheduled at a 55% rate on every dollar over $1 million in your estate (including life insurance and retirement accounts).

For more information about 2010’s crazy rules, consider reading “Estate-Tax Repeal Means Some Spouses Are Left Out,” The Wall Street Journal (January 2, 2010) and “A Bizarre Year for the Estate Tax Will Require Extra Planning,” The New York Times (January 8, 2010).

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