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Under current law, the Federal estate tax will be eliminated for 2010. The income tax "step-up" in basis rule for most property included in a decedent's estate also is eliminated for that year. Rather, the decedent's basis "carries over" to those who succeed to the property subject to special rules. Although many, if not most, estate planners thought the chance of zero estate tax with carryover basis for one year was extremely unlikely-perhaps, even less likely than permanent repeal and carryover basis-it may be that 2010 will be known as the one year without estate tax.

It seems appropriate to think about that possibility in planning now. Perhaps certain clients (such as those who own property with liabilities in excess of income tax basis or what is called "negative basis" property) should be warned about the prospects of carryover basis. It also seems sensible to consider the carryover basis issues for many of our married clients who just might die in that year with a surviving spouse. This article will focus on how certain estate planning documents (e.g., Wills and revocable trusts) might be structured in light of the possibility of a year without estate tax.

How Big Is the Formula Marital Deduction If There Is No Marital Deduction?

Usually, the estate plan for a married person who wants to maximize the use of his or her unified credit (or Federal estate tax exemption) provides for his or her estate to be divided into two broad shares: one equal to the amount of the Federal estate tax exemption and the balance in a form qualifying for the estate tax marital deduction. Generally, there are three broad ways to effect this division: (1) make the amount of the Federal exemption a fixed sum of money; (2) make the amount of the marital deduction a fixed sum of money; (3) make each a fractional share. But, in each case, a word formula will be used to define at least one of them. Sometimes, it will define the Federal exemption-and although there are several variants, all essentially say to determine the maximum taxable estate the married person could have at death without paying Federal estate tax on account of the unified credit (and, perhaps, other credits). Other times, it will define the marital deduction. Again, there are several ways to phrase it but essentially it says to determine the minimum amount necessary as the Federal estate tax marital deduction to reduce the Federal estate tax to zero. Experience teaches that defining either the Federal exemption or the marital deduction that way works "just fine."

But just what does either word formula produce if there is no Federal estate tax in effect when someone dies? If there is no Federal estate tax, what is the maximum taxable estate one can have without increasing his or her Federal estate tax? The concept makes no sense because there will no longer be a concept of taxable estate. Alternatively, what is the minimum marital deduction necessary to reduce the Federal estate tax to zero when there is no concept of the marital deduction or Federal estate tax? One can imagine, in a case where the spouse of a second marriage succeeds to the marital deduction amount and children from a prior marriage of the decedent succeed to the exemption amount, that the widow(er) and the children would take diametrically different positions as to what each receives.

Even if there is no dispute among the surviving family members (e.g. they all agree everything passes under the disposition of the exemption share), the IRS may not agree. And it will have an interest in the outcome in at least two ways. First, it is likely that the exemption share will pass into a trust and the income earned thereon will not necessarily be taxed to the surviving spouse or to other family members. If the property passes to the surviving spouse (or to a marital deduction trust), the income will be taxed to the surviving spouse (except trust income allocated to corpus and not distributed). Second, the IRS will have a keen interest in the surviving spouse receiving more because the survivor likely will die in a later year when there is an estate tax. Certainly, some practitioners will contend that whatever the result, it can be resolved post-death by a disclaimer. For example, they will contend that the whole estate can pass under the Federal exemption disposition by having the widow(er) disclaim any marital deduction disposition under Code Sec. 2518. But if the proper construction is that there is no such disposition, the disclaimer will not produce the desired result. In any case, experience indicates that many a surviving spouse is reluctant to disclaim.

Perhaps the judges who will decide this issue will be consistent. But most would agree that a better choice is to let the clients decide. There seem to be two broad choices. One choice is to provide that, in the event there is no Federal estate tax in effect when the first spouse dies, the entire estate passes pursuant to the marital deduction disposition and rely on the surviving spouse disclaiming that disposition if it "makes sense" to do so. But, as indicated above, and as Professor Jeff Pennell has observed "among the world's greatest lies are: (1) 'The check is in the mail'; (2) 'I'm from the government and I want to help you'; and (3) 'Of course I'll disclaim if it will save taxes'." Tax Mgt Portfolio No. 843-2nd: Estate Tax Marital Deduction, at II.E.3, n. 55.

An alternative, and the one offered by Wealth Transfer Planning, is to direct that the entire estate passes pursuant to the disposition of the exemption amount. In such a case, it no doubt makes sense to insure that the surviving spouse is a beneficiary of that trust, either entitled to income or eligible to receive income and corpus. As offered by WTP, the widow(er) can be given the right to demand property from that trust for his or her health, education, maintenance and support and the right to direct where the trust is to pass upon his or her death. In addition, the trustee can be authorized to consider the needs of the surviving spouse as more important than those of other beneficiaries including remainder beneficiaries.

One more complication: the decedent's estate may still be subject to state estate tax even if there is no Federal tax. Hence, the practitioner must decide if the "traditional" division between an exemption share and a marital deduction share should be used to take advantage of the state exemption and to avoid state death tax (by also using the state estate tax marital deduction). Some practitioners likely will decide that it is preferable to pay a small state estate tax (by having the entire estate of the spouse dying in 2010 passing into an estate tax exemption or credit shelter trust) than potentially increasing the estate of the surviving spouse who is likely to die after the Federal estate tax has come back into effect. Wealth Transfer Planning offers all these options for drafters.

Carryover Basis Matters

With respect to persons dying in 2010 (whether or not married), some consideration ought to be given to the carryover basis rules. Those rules are found in Code Sec. 1022, which will become effective if the currently enacted estate tax repeal rule is not changed before 2010.

Under Code Sec. 1022, the basis of assets included in the decedent's gross estate will not equal their estate tax values for any year that there is no Federal estate tax in effect. During that time, the decedent's basis will "carryover" to those who succeed to the property upon the decedent's death (although in no event can the basis exceed its fair market value at death).

There are exceptions and special rules. Under one of these, the executor/personal representative may allocate up to $1.3 million to increase the basis of assets up to their fair market value. (Actually, the $1.3 million amount is increased by certain pre-death losses of the decedent. Different thresholds apply for a non-citizen non-domiciliary of the United States.) For example, assume a decedent owns a piece of real estate worth $5 million on her death with respect to which her basis is $800,000. Under Code Sec. 1022, the decedent's $800,000 basis would remain the basis in the real estate when she dies. The executor/personal representative may increase the basis of the land to $2.2 million by allocating the entire $1.3 million basis increase to that asset.

Authorize Executor/PR to Allocate to Non-Probate Assets. Because the executor is a fiduciary under the decedent's Will and has no direct authority or responsibility with respect to non-probate assets, it may be that a beneficiary under the Will would contend that the executor must allocate, to the extent possible, the $1.3 million basis increase to probate assets. In that event, the beneficiary would also undoubtedly contend that an executor who allocates basis to property outside the probate estate, without specific authorization, would be subject to removal, surcharge or loss of commissions. Hence, it may be best to provide expressly in the client's Will that the executor/personal representative may allocate part or all of the $1.3 million basis increase allowed under Code Sec. 1022 to any asset or assets in the decedent's gross estate including those passing outside of the Will. Of course, this provision must be contained in the Will as it is the executor who makes the allocation (and not, for example, the trustee of any revocable trust created by the property owner, even if such as trust is the principal estate planning document used to transmit wealth when the property owner dies). Wealth Transfer Planning now allows drafters expressly to authorize the executor/personal representative to make allocation of basis increase (including the $3 million spousal basis increase discussed below) to non-probate property.

Authorize Executor/PR to Allocate to Own Assets. Whether or not the executor/personal representative is authorized to allocate the $1.3 million basis increase allowed under Code Sec. 1022 to any asset or assets in the decedent's gross estate, the question arises as to whether the executor/personal representative may allocate basis to property the fiduciary is "inheriting" individually or as a trustee, as opposed to being required to allocate all or a pro rata portion of the basis step up to property others receive. Hence, it may be appropriate for the property owner's Will to provide expressly that the executor/personal representative may or may not allocate that basis increase to assets that the executor/personal representative is receiving. Wealth Transfer Planning now allows drafters expressly to authorize the executor/personal representative to allocate basis increase to assets he or her is inheriting. An ancillary issue is that if, under the Will or governing law, the executor has the discretion to allocate basis increase to assets he or she is receiving, the fiduciary who does not do so might be treated as making a taxable gift, bestowing tax benefit away from himself or herself to another. See, generally, J. Blattmachr, M. Gans & S. Heilborn, "Gifts By Fiduciaries By Tax Options and Elections", Probate & Property, November/December 2004, Vol. 18 No. 6; republished in Digest of Tax Articles (March 2005). Wealth Transfer Planning now allows a drafter automatically to insert a provision into Wills and trusts to attempt to prevent a fiduciary from making such a gift. It seems appropriate to include that provision if the executor/personal representative will be authorized to allocate basis increase to assets he or she will be inheriting.

Make Bequest to Use Spousal Basis Increase. In addition to the $1.3 million basis increase the executor/personal representative may allocate to assets, that fiduciary is authorized to allocate up to $3 million to increase the basis of assets that are received by the property owner's surviving spouse or a QTIP (qualified terminable interest property) trust. For example, assume that the decedent bequeaths a piece of real estate worth $5 million to her husband. Also assume that her basis in the property was $800,000. Under Code Sec. 1022, the decedent's $800,000 basis would remain the basis in the real estate when she dies and is inherited by her husband. However, the executor/personal representative may increase the basis of the land to $3.8 million, by allocating the entire $3 million special spousal basis increase to that asset.

One simple way to insure there is enough property to which the special $3 million spousal basis increase can be allocated is to bequeath all assets to the surviving spouse. However, as indicated above, a married property owner may not want to have his or her entire estate pass to the surviving spouse for several reasons. One reason is that if the estate tax is reenacted by the time the surviving spouse dies, assets the survivor has inherited outright presumably would be included in the survivor's gross estate for Federal estate tax purposes. Hence, the married property owner may want his or her entire estate to pass into a trust which will not be included in the gross estate but from which the surviving spouse may benefit. For several reasons (including creditor protection for the surviving spouse and to permit maximum income shifting among surviving family members), the married property owner may want the assets placed in a trust from which the trustee may distribute property to the surviving spouse or to the property owner's descendants. But such a trust is not the type to which any portion of the special spouse $3 million increase in basis may be allocated under the Code Sec. 1022 carryover basis rules may be allocated. Hence, either an outright bequest to the spouse or to a QTIP trust (from which all income must be paid to the spouse for life) must be created to be able to make that allocation.

An initial question is in making such a disposition to ensure use of the $3 million spousal basis increase, should the disposition pass outright to the surviving spouse or to a QTIP trust? It is at least arguable that a QTIP trust is preferable. One reason relates to estate tax inclusion when the surviving spouse dies. Certainly, anything he or she inherits will be in his or her estate when he or she later dies (and the estate tax likely back in effect). But the QTIP trust may not be so included. At least under current law, that QTIP trust created by a married person while no Federal estate tax is in effect would not be included in the estate of the surviving spouse. Although a QTIP trust is included under Code Sec. 2044 in the estate of the spouse for whom it was created, that section applies only if the spouse who created it got the benefit of an estate or gift tax marital deduction. Since there would have been no estate tax in effect when it was created, it should not be included in the estate of the surviving spouse. Thus, using a QTIP may be the better choice to take advantage of the $3 million spousal property increase in basis. In any event, WTP offers both.

The disposition to or for the spouse to which the executor/personal representative is to allocate the special $3 million increase in basis may be structured in several ways. It is important to realize that it is a $3 million increase in basis and not just an allocation to $3 million worth of assets to which the allocation applies. An example may help to illustrate this principle. Assume a married woman dies bequeathing her husband stock worth $3 million in which her basis was $1.4 million, a piece of land worth $2 million in which her basis was $100,000, and a painting worth $4 million of which her basis was $1 million. The inherent gain in the assets are (1) $1.6 million in the stock, (2) $1.9 million in the land, and (3) $3 million in the painting. Suppose the executor wants to increase the basis in the stock to its $3 million fair market value. The executor would not allocate the entire $3 million basis increase to the stock even though it is worth $3 million, but would allocate only $1.6 million. The carryover basis of $1.4 million plus the allocation of an additional $1.6 million of basis to the stock will increase its basis to $3 million, its fair market value when the property owner died. (Note again that the executor cannot allocate more to an asset than will increase its basis to its fair market value at the decedent's death). The executor will allocate the balance of the special spousal basis increase (such balance being $1.4 million) to the other assets. For example, the executor might allocate this balance to the painting, bringing its basis up from $1 million to $2.4 million. Alternatively, the executor might allocate the entire $3 million basis increase to the painting, bringing its basis up from $1 million to its full fair market value of $4 million.

There seem to be two principal ways to structure the bequest to the spouse or a QTIP trust. One is to minimize the amount that will be transferred to the spouse or the marital trust. The other is to maximize income tax savings. Here is an illustrative comparison. A married man dies with two assets. One is a $4 million parcel of land in which his basis is $1 million. The inherent profit in the land is long-term capital gain. The other asset is inventory he owns worth $10 million with a basis of $7 million. The inherent profit in the inventory is ordinary income. Both assets have inherent untaxed profit of $3 million. If he makes a bequest of the land to his wife, she will inherent directly only $4 million of value. Assuming the capital gains tax rate is 20%, allocating the $3 million of basis increase to the land saves 20% of $3 million or $600,000. If, instead, the wife receives the inventory and the $3 million increase in basis is allocated to it, the allocation will save $1.2 million if the ordinary income tax rate is 40%, but the wife then will receive $10 million from the husband, thereby increasing what she owns and what may be included in her gross estate.

Clients need decide whether their principal goal is to minimize what the surviving spouse receives (or will be paid to a QTIP trust for the survivor) while still being able to use the entire special spousal $3 million increase in basis, or to minimize potential income taxes even if it means the survivor (or the QTIP trust) will receive more. Wealth Transfer Planning now offers both these choices.

Summary

While most would probably place the odds at less than fifty percent that the year 2010 will bring a repeal of Federal estate tax and its companion carryover basis, it is far from impossible. It seems prudent to plan for repeal of Federal estate tax and carryover basis by having a decedent's estate planning documents structured to maximize flexibility and savings. Additionally, married clients need to decide how much should pass into a non-marital deduction trust and how much, if any, should pass to (or in a QTIP trust for) the surviving spouse. Although from an overall perspective it seems appropriate to minimize what the survivor inherits if there is no estate tax, the carryover basis provisions suggest that a sizable disposition to the spouse (or, perhaps, better yet, to a QTIP trust) to take advantage of the $3 million spousal increase in basis rule under Code Sec. 1022. Also, executors/personal representatives should be specifically authorized to make such allocations of basis increase as they think best. Wealth Transfer Planning now offers these options and it is suggested that practitioners consider incorporating them now in documents.

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