PLANNING WITH DISAPPEARING ESTATE TAX by alicejenny

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									               PLANNING WITH A DISAPPEARING ESTATE TAX
               & OTHER SELECTED OHIO ESTATE TAX ISSUES
                            By Bill McGraw
                             October 4, 2003

I.    INTRODUCTION

      A.   With the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001
           (EGTRRA), planning uncertainty has become the rule of the day in the Federal Estate
           Tax arena.

      B.   Planning uncertainty also permeates the Ohio Estate Tax area. This is particularly
           true in the application of the Ohio Additional Estate Tax and the interplay of the
           Ohio Estate Tax with marital deduction formula clauses.

      C.   The purpose of this presentation is to discuss the Additional Ohio Estate Tax,
           selected issues regarding the marital deduction formula clause as applies to Ohio
           Estate Tax, selected issues regarding the marital deduction formula clause as it
           applies to Ohio estate tax, and discuss planning challenges in trying to serve the vast
           majority of our clients with estates between $1 million and $5 million.

II.   THE OHIO ADDITIONAL ESTATE TAX

      A.   Explanation of the Tax.

           The Ohio Additional Estate Tax was enacted in its present form in 1983 and has not
           been amended since. The applicable code section is ORC § 5731.18(A), which reads
           as follows:

           (A) In addition to the tax levied by §5731.02 of the Revised Code, a
           tax is hereby levied upon the transfer of the estate of every person
           dying on or after July 1, 1968, who, at the time of his death was a
           resident of this state, in an amount equal to the maximum credit
           allowable by Subtitle B, Chapter 11 of the Internal Revenue Code of
           1954, 26 U.S.C. 2001, as amended, for any taxes paid to any state.
           (emphasis added).

      B.   Phase Out of State Death Tax Credit Resulting from EGTRRA

           IRC § 2011 reduces the top rate for the State Death Tax Credit as follows:

                  2001                    16%
                  2002                    12%
                  2003                     8%
                  2004                     4%
                  2005                    State Death Tax Credit eliminated
                  2011                    State Death Tax Credit returns with top rate of 16%
C.   Impact on States.

     One area that received little discussion in the debate leading up to the passage of
     EGTRRA, was effect that the repeal of the state tax death tax credit would have on
     the revenues of the individual states. Nearly every state imposes a death tax equal to
     the state death tax credit. The ACTEC website contains a running score card on
     which states have passed “decoupling” legislation, thereby re-establishing
     independent stand alone state death taxes to replace the revenue lost from the
     elimination of the pickup tax. One commentator has estimated that repeal the state
     death tax credit will cost the states $100 billion in the next ten years. Therefore,
     understandably, many states have reenacted their stand alone estate taxes, known as
     “decoupling.”

D.   Will there be no Ohio Additional Tax in 2005?

     Because the Federal state death tax credit is repealed, effective January 1, 2005,
     shouldn’t it logically flow that the Ohio additional tax will also disappear? After all,
     ORC § 5731.18(A) states that taxes are imposed for an amount equal to the
     “maximum credit allowable by Subtitle B, Chapter 11 of the Internal Revenue Code
     of 1954, 26 U.S.C. 2011, as amended . . . .” Therefore, if § 2011 is amended to
     eliminate the state death tax credit, the maximum credit allowable will be zero, hence
     the Ohio Additional Estate Tax will be zero.

E.   Ohio Department of Taxation Position – “Heads I win, tails you lose!”.

     In an article entitled EGTRRA and the Ohio Additional Estate Tax in the
     January/February 2003 issue of the Probate Law Journal of Ohio, Marc Friedman,
     Esq., legal counsel for the Estate Tax Division of the Ohio Department of Taxation,
     takes the position that the Ohio Additional Tax survives in a Phoenix-like ascension
     with the following logic.

     1.     Ohio Department of Taxation will accept all other Federal changes under
            EGTRRA.

     2.     ODT acceptance of EGTRRA includes the increase in the applicable
            exclusion amount to $1 million so as there is no pickup tax on estates under
            that amount. ODT’s position is that § 5731.17 adopts federal law by
            incorporating it by reference.

     3.     Mr. Friedman relies on In re Estate of C. Robert Hughes, deceased, Case No.
            881,475, 8th Dist. Ct. App., Cuyahoga (1980), which interpreted similar
            language contained in ORC § 5731.09, referring to the “as amended”
            language. In that case the Court ruled that only the federal law in effect at
            the time a statute was enacted could be incorporated into the Ohio statute and
            that the attempt to incorporate future amendments of Federal tax law was an
            unconstitutional delegation of legislative authority by the Ohio legislature.
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           a.     Note, however, that the Hughes Court’s treatment of Dery v.
                  Lindley, 57 Ohio St. 2d 5, 385 N.E.2d 291(1979), supports the
                  taxpayer’s position.

     4.    Additionally, ODT is relying upon State v. Gill, 63 Ohio St. 3d 53, 584
           N.E.2d 1200 (1992). That Court held, similarly, that a reference in an Ohio
           statute to a federal statute using “as amended” language means the federal
           statute as it existed on the date of enactment.

           a.     Note, however, that the Gill Court was interpreting a criminal fraud
                  statute (food stamps).

     5.    In an article entitled The Case against the Ohio Additional Estate Tax after
           EGTRRA, Probate Law Journal of Ohio, May/June 2003 by William J.
           Culbertson, the case is compellingly made that ODT cannot willy nilly pick
           and choose which elements of EGTRRA it chooses to incorporate into Ohio
           law “as amended” and which provisions of EGTRRA it chooses to reject.
           Mr. Culbertson correctly points out other elements of Federal tax law that
           ODT chooses to incorporate by reference “as amended” into Ohio’s tax laws:

           a.     Ohio Income Tax “adjusted gross income.”

           b.     “Taxable income” for estates and trusts in the fiduciary tax area.

           c.     When the General Assembly has determined not to accept a federal
                  change it has legislated against it (certain additional federal
                  depreciation under § ORC 5747.01)(A)(20).

     6.    As Mr. Friedman states in his article, “because the Additional Estate Tax will
           continue to be computed as it existed pre-EGTRRA, the applicable federal
           exclusion amounts are also frozen as they existed prior to EGTRRA in order
           to make the additional tax computation. For calendar years 2002 and 2003,
           the pre-EGTRRA threshold was $700,000, rising in increments to $1,000,000
           in 2006.” Query: Isn’t ODT adopting post-1983 changes in Federal estate tax
           law?

F.   Networking and Communication.

     1.    The Ohio Estate Tax Committee of the OSBA Estate Planning Trust and
           Probate Law Section is maintaining a volunteer registry for attorneys to log in
           their pending appeals of the imposition of the Additional Estate Tax. The
           purpose of the registry is to encourage communication among attorneys who
           are pursuing appeals of the imposition of the Additional Estate Tax. Specific
           information about your case will not be released without your specific
           consent. An attorney may “register” his or her case(s) with Bob Brucken
           (RBrucken@bakerlaw.com), or may communicate with Bob by mail at
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           Robert N. Brucken, Baker & Hostetler LLP, 3200 National City Center, 1900
           E. Ninth Street, Cleveland, OH 44114, telephone number 216-861-7552, fax
           number 216-696-0740.

     2.    Additional Articles. More articles are being planned for the Ohio Probate
           Law Journal. An upcoming article by Geoffrey P. Scott entitled Title 57 of
           the Ohio Revised Code has not been “Decoupled” from the Internal Revenue
           Code, will appear in the November/December 2003 Ohio Probate Law
           Journal. An additional article by your author will give the general
           practitioner a procedural roadmap for prosecuting an appeal of the imposition
           of the Ohio Additional Estate Tax.

G.   Appeal.

     1.    Certificate of Determination of Appeal. Under ORC § 5731.27, the tax
           commissioner, if he or she determines a deficiency exists, issues a Certificate
           of Determination stating the adjusted amount of the tax due and the amount
           of any deficiency. This certificate is issued in triplicate, one copy of which is
           sent by certified mail to the person filing the return, one copy to the county
           auditor where the original return was filed and one copy is sent to the probate
           court in which the return was filed. The person required to file the return or
           “any interested party” shall have 60 days from the date of receipt of such
           certificate to file exceptions to the determination.

           The county auditor, if no exceptions have been filed, makes a charge based
           upon such Certificate of Determination and certifies a duplicate to the county
           treasurer who shall collect the deficiency charged.

     2.    Appeal. Under ORC § 5731.30, the commissioner, the person filing the
           return or any interested party may file exceptions, in writing, to the tax
           commissioner’s final determination of taxes with the probate court of the
           county, which must be filed within 60 days from the receipt of this Certificate
           of Determination. The filing shall state the grounds upon which such
           exceptions are taken.

           The probate court fixes a time, not later than ten days thereafter for the
           hearing of such exceptions and shall give notice of that hearing as it considers
           necessary. Upon the hearing, the court may make “a just and proper order.”

           Upon redetermination of the taxes pursuant to the probate court order, if no
           appeal is taken, the tax commissioner “shall issue his Certificate of
           Determination of taxes reflecting the corrected determination.”

           Appeal may be taken by any party from the final order of the probate court in
           the manner provided by law for appeals from orders of the probate court in
           other cases.
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H.   Possible Solutions.

     1.     At a presentation made at the 2001 Plisken Advanced Probate Seminar, your
            author advocated a legislative solution in order to clarify the differences
            between the Ohio Estate Tax and the disappearing Federal Death Tax Credit.

     2.     Reliance on a 1980 probate court case (notice the date of enactment of the
            current Ohio Additional Estate Tax statute as 1983) and a later criminal law
            statutory interpretation is a poor way to run a railroad. Indeed, refer to the
            newly published Ohio Resident Additional Tax Return, which contains the
            following language citing the Hughes and Gill cases:

            The additional tax statute, ORC Section 5731.18, does
            not give the taxpayer the option to forego paying the
            additional tax due to the State of Ohio. Under the
            Economic Growth and Tax Relief Reconciliation Act
            of 2001 (EGTRRA), the federal credit for state death
            taxes is reduced incrementally beginning in 2002 and
            is fully repealed in 2005. However, previously
            established case law (see In the Matter of the Estate of
            C. Robert Hughes, deceased, No. 881,475, 8th Dist.
            Ct. App. (1980) and State v. Gill, 63 Ohio St. 3d 53,
            584 N.E. 2d 1200 (1992) in the context of the
            EGTRRA legislation does not allow for this credit
            reduction in Ohio. Consequently, whenever the
            maximum allowable federal credit, prior to any
            reduction, exceeds the basic Ohio estate tax assessed,
            the difference is required to be paid to the State of
            Ohio.

I.   It’s the Revenue Stupid!.

     Due to the fact that the legislative fix would unarguably reduce revenue for the State
     of Ohio at a time when the State is attempting to increase revenues, a direct court
     challenge might be the only effective way to clarify the issue. Indeed, if a bill were
     introduced, the Legislature, in the interest of revenue, would be tempted to adopt the
     Ohio Department of Taxation position and make it a part of the statute. It is the
     understanding of the author that there are court cases proceeding to deal with the
     issue. It is urged that Ohio ACTEC and/or the Board of Governors of the OSBA
     Estate Planning, Trust and Probate section could support the efforts of the appellants
     with amicus briefs.




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III.   OHIO ESTATE TAX ISSUES IN A PLANNING CONTEXT

        Presuming you have an Ohio resident governed by the Ohio Estate Tax, there may be varying
results depending upon what type of estate plan is in effect for the decedent.

       A.     Analysis of the Impact on Existing Documents - Common Formula Clauses.

              1.      Minimum Total Tax. Many estate plans have language that provide for the
                      funding of the marital deduction to the extent required to produce the
                      maximum reduction in all (federal and state) estate taxes. Typical language
                      provides the marital gift be funded with “the smallest amount [fractional
                      share] [if any be required] that will produce the largest possible reduction in
                      the federal and state estate taxes that otherwise would be payable as a result
                      of decedent’s death.”

                      In Ohio this clause limits the Credit Shelter Trust to the lesser of the federal
                      applicable exclusion amount (presently $1 million) or the current Ohio
                      exemption amount of $338,333, thereby under funding the Credit Shelter
                      Trust.

              2.      Minimum Federal Tax, Taking Estate Death Tax Credit into Account, Only
                      to the Extent it Does Not Increase State Death Taxes.

                      a.      Under this method, the B Trust would be funded to the current federal
                              applicable exclusion amount, presently $1 million. Typical language
                              provides that the marital gift be funded with the “smallest amount
                              [fractional share] [if any be required] that will produce the largest
                              possible reduction of the Federal Estate Tax that otherwise would be
                              payable as a result of the decedent’s death after taking into account all
                              credits allowable against said tax; provided, however, that the state
                              death tax credit shall be taken into consideration only to the extent
                              that additional state death taxes are not caused thereby.”

                      b.      In the Ohio Estate Tax calculation, if the B Trust were funded to the
                              maximum federal applicable exclusion amount of $1 million, there is
                              a potential $44,700 tax imposed on the excess over the Ohio
                              exclusion amount of $338,333.

                      c.      If you have a B Trust that qualifies for the marital deduction, you
                              may use the approach suggested by James Leonard in the July/August
                              2001 issue of the Probate Law Journal of Ohio (expanded and
                              clarified in the September/October 2003 issue), which he calls the
                              “leveraged exclusion amount.” Because the Ohio Estate Tax law
                              allows an old-fashioned marital deduction for a life income interest, if
                              you have a QTIP-eligible credit shelter B Trust, using a separate
                              deduction for the life estate marital deduction and a separate QTIP
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                   deduction, and temporarily dividing the trust, you may be able to
                   reduce or eliminate the Ohio Estate Tax. This is an excellent
                   technique which should be employed whenever possible. This is also
                   a powerful argument for examining all existing B trusts and if you do
                   not have a QTIP eligible B Trust plan in place, you should
                   communicate with clients to review their trust plans.

     3.     Minimum Federal Tax Taking into Account the State Death Tax Credit.
            While the State Death Tax Credit remains in effect, this technique has the
            effect of expanding the credit shelter trust amount because of the State Death
            Tax Credit. Once the State Death Credit is fully phased out, this type of
            clause will have the same affect as the other minimum federal tax option
            described above.

B.   Solutions.

     1.     A Single QTIP Trust. This technique leaves the decedent’s entire estate to a
            trust that qualifies for QTIP treatment. The executor then elects QTIP
            treatment for a portion of the trust. In Ohio, the executor will not have to
            decide between electing QTIP treatment for more than the amount required to
            eliminate the Federal Estate Tax in order to save Ohio Estate Taxes because
            of the availability of both the Ohio QTIP election and the old-fashioned life
            estate marital deduction.

            a.     Clayton Planning. Under Clayton v. Commissioner of Internal
                   Revenue, 976 F2d 1486 (5th Circuit 1992) approved by Treasury Reg.
                   § 20.2056(b)-7(d)(3), the marital deduction will be allowed for a
                   QTIP trust which is funded only to the extent that the executor elects
                   the QTIP treatment. This is a very flexible way in which an executor
                   can take into account the combined estate tax impact over the deaths
                   of both spouses.

            b.     Rev. Proc. 2001-38. Under Rev. Proc. 2001-38, if a QTIP election is
                   made that was not necessary to reduce the estate tax to zero (an “over-
                   election”), the Service will disregard the election and treat it as null
                   and void. For example, in Letter Ruling 2002-26020, the Service
                   disregarded a QTIP election that was made for a Credit Shelter Trust.
                    There is some question as to whether the application of Rev. Proc.
                   2001-38 is automatic, or whether it applies only if the surviving
                   spouse or the surviving spouse’s estate applies for relief thereunder.
                   If an application for relief is required in order to invoke Rev. Proc.
                   2001-38, it may be possible to leave the difference between the
                   Federal exempt amount and the State exempt amount in a separate
                   QTIP Trust and make a QTIP election for that trust. (See III B.2.c.


                                     -7-
                             above); see also Steiner, Coping with the Decoupling of Estate Taxes
                             after EGTRRA, Estate Planning Journal, April, 2003.

              2.     Disclaimer Plans. In this type of plan, which my clients seem to favor, the
                     trust provides that the entire trust goes to the surviving spouse outright. The
                     portion then disclaimed drops into a single QTIP Trust. Thus, federal taxes
                     can be minimized over both deaths and with the combined leveraged
                     exclusion amount method, using the interplay between the Ohio QTIP
                     election and the Ohio life estate marital deduction, Ohio estate taxes are
                     minimized on the first death. Although this may expose some part of the
                     QTIP B Trust to Ohio Estate Tax on the second death, most couples seem to
                     like the flexibility of this method. Of course, if this is a second marriage with
                     two sets of children, it may not be advisable to leave the entire estate outright
                     to the surviving spouse. In such case, you could use the single QTIP trust
                     approach described above.

IV.    PLANNING FOR A TYPICAL (NEWLY DESCRIBED AS A MODEST) ESTATE OF
       $1 MILLION TO $5 MILLION.

       With the eventual elimination the Federal Estate Tax in 2010, the rapidly escalating
applicable exclusion amount, and the decrease in stock values since 2001, many clients do not
believe they need estate tax planning.

       A.     Review of Existing Plans.

              Because many A-B trust plans were devised in a rising stock market when the federal
              exemption amount was $600,000.00, many clients with the formula marital deduction
              clause have plans that will over-allocate assets to the credit shelter trust. These
              clients need to be contacted with a letter that recommends that their plans be
              reviewed.

       B.     The Future of the Estate Tax.

              1.     What? Me worry? There are generally two prevailing attitudes concerning
                     the Federal Estate Tax. The Alfred E. Newman attitude is that the tax will
                     eventually be eliminated and, therefore, no sophisticated planning is
                     necessary.

              2.     The other prevailing attitude is that there will be some “permanent” (if that
                     term can ever be used in the estate tax context) relief establishing an
                     applicable exclusion amount of somewhere between $2 million and
                     $5 million. People in this camp believe that the current estate tax scheme
                     will never survive to 2010. Depending on the outcome of next year’s
                     Presidential and Congressional elections, our hope as planners is that
                     Congress and the President will enact some permanent estate tax bill that will
                     eliminate the planning uncertainties.
                                               -8-
           Truly wealthy clients will still need to plan for estate taxes. However, in our
           neck of the woods, as Bill Fields puts it, “we are ever on the elusive search
           for the federally taxable estate.”

           With the stock market downturn within the last three years, people who had
           taxable estates, suddenly have non-taxable estates, particularly when the
           applicable exclusion amount rises to $1.5 million in three months and
           $2 million in 2006.

C.   Examples.

     1.    Married Clients. Consider the client who is married, has two children in
           college and has an estate of approximately $1.2 million, consisting of a house
           worth $250,000, stock options that are presently in the money for $100,000, a
           vacation home worth $150,000 and other investment assets totaling
           $700,000. If at least one of the spouses lives until January 1, 2004, there will
           be no Federal estate tax. Therefore, no planning is needed and no harm, no
           foul.

           However, if the spouse owning the stock options lives, the stock market
           recovers and the value of the underlying options increases, indeed
           dramatically, we suddenly have a taxable estate.

           What do we advise this client? We can point out the risk of planning vs. no
           planning. We could take a wait and see approach by using the all-to-spouse,
           disclaimed amount to a QTIP eligible B Trust. However, this will necessarily
           involve more planning than a simple spouse-to-spouse Will.

           If there is a genuine question as to whether or not any estate tax planning is
           needed, the client must be informed about the uncertain nature of the law and
           the risks involved. Of course, these points should be clearly documented in a
           letter or memo to the client, or memo to the file, summarizing the discussion.
            Given drafting uncertainty and drafting flexibility, we are driven back to the
           flexible planning scenarios covered in the previous Ohio Estate Tax section.
           Disclaimer based plans and QTIP eligible B trusts seem to provide the
           maximum flexibility at this time.

     2.    Planning for Singles. Without the availability of a marital deduction,
           unmarried people should consider the use of short-term Walton-type GRATs
           and charitable planning techniques in order to minimize estate taxes.

     3.    Second Marriages. With the increasing prevalence of second marriages, the
           advisability of the QTIP trust looms large.



                                     -9-
                  a.      Many challenges exist in dividing the estate between children from a
                          prior marriage and children from the current marriage. You may have
                          three different sets of children to plan for.

                  b.      When assets are modest (less than $2 million), the couple may be in
                          the position of choosing between which set of children they wish to
                          favor. Again, the QTIP trust will provide maximum flexibility.

                  c.      A problem arises when people of more modest means wish to achieve
                          everything without the use of a trust. I find these situations most
                          challenging from a planner’s standpoint. Many people decide to trust
                          the surviving spouse to do the right thing. However, I will never
                          forget the post-death discussion of one particular estate where the first
                          thing the surviving spouse wanted to do was write a new Will,
                          leaving the children of the first spouse out of the plan.

      D.   Conclusion.

           Our challenge as estate planners will be to devise flexible plans compensating for
           uncertainty in both the Federal and Ohio Estate Tax areas. Our challenge is to
           provide tax sufficient plans with flexibility to meet all situations, known and
           unknown. Our clients want to hold us accountable for events that nobody could
           anticipate. Therefore, flexibility, communication, education and documentation will
           continue to minimize the risk for us as estate planners.

IV.   RAMIFICATIONS ARISING FROM PERMANENT ELIMINATION OF THE
      ESTATE TAX.

      A.   If the Estate Tax Repeal under EGTRRA is ever made permanent, there may be a lot
           of work for estate planners to do to pick up the pieces.

      B.   Impact on Testamentary CRT’s and Testamentary Transfers to CRT’s.

           EGTRRA seems to introduce a technical problem insofar as qualifying testamentary
           CRT’s (and possibly testamentary additions to inter vivos CRUT’s) under Section
           664. If the estate tax charitable deduction goes away, how do you reconcile having a
           qualified CRT when the IRS has a history of saying the transfer has to be deductible
           if the trust is to be qualified?

           1.     The problem is the IRS interpretation of regulations providing that a CRT is a
                  “trust with respect to which a deduction is allowable under Section 170,
                  2055, 2106 or 2522...” and meets all other characteristics of a CRAT or
                  CRUT. A testamentary transfer to a CRAT would not sustain a deduction
                  under any of these Code provisions if the estate tax were repealed. What if
                  the decedent died in the last year there was an estate tax, but the testamentary
                  CRT is funded in a year in which there is no estate tax. The regulations
                                            -10-
            provide that for purposes of the estate tax charitable deduction, the CRT is
            normally “deemed” to be created at death. For income tax purposes, the trust
            doesn’t come into existence until it is at least partially funded (and the
            grantor trust rules don’t apply).

     2.     After the repeal of the estate tax, there are no string provisions to pull assets
            into the estate. The answer would appear to be that there is no way to
            construe a possible “transfer” to the CRT after the repeal of the estate tax,
            unless there is a transfer to a testamentary CRT or testamentary addition to an
            inter vivos CRUT. (A CRAT is not permitted to receive an additional
            contribution.) So the question of needing a deduction for each “transfer”
            seems not a problem for this very common scenario, the purely inter vivos
            CRT where the donor retains the income interest. But, note that a relatively
            small testamentary addition could lose the trust’s exempt status as it winds
            down and then distributes assets to a charity. For a more expansive
            discussion of this problem, see Pusey, What if the Estate Tax is Repealed -
            Parts 1 and 2, Plan Giving Design Center of TGDC/USA.

B.   Gift Tax.

     One of the major policy decisions of the 2001 Act was to “de-unify” the transfer tax
     system and discriminate against intro vivos non-charitable transfers in relation to
     testamentary transfers. The gift tax exemption is pegged at $1 million beginning in
     2003. Lifetime transfers do not enjoy the scheduled increases in the estate tax
     exemption. The gift tax rates are tied to the estate tax rates, except in 2010 when the
     gift tax rate is thirty-five percent (35%). For planning purposes, what do we advise
     clients regarding incurring a taxable gift when the gift tax exemption is frozen at
     $1 million and the estate tax exemption is increasing? Do we encourage them to
     make taxable gifts and pay the tax, or do we consider other planning techniques
     which would not involve the use of an intentionally taxable gift?

C.   Carry-over Basis.

     In order to avoid being accused of allowing significant amounts of capital gains to go
     untaxed, EGTRRA brings back a very bad nightmare known as “carry-over basis.”
     Under current law, when heirs sell inherited assets, they pay capital gains tax on only
     the appreciation of the assets from the stepped-up basis value at the time they
     inherited the assets. When the estate tax is repealed in 2010, however, a new (old)
     approach known as “carry-over basis” goes into effect. Under this approach, the
     original cost basis of assets that are inherited will be “carried over” to the heirs.
     Therefore, when the heirs sell the assets, they will be responsible for paying capital
     gains tax on all the gains that have accrued since the decedent originally acquired the
     assets.



                                      -11-
              Under the carry-over basis rules, the “basis” assigned to the assets in an estate could
              be increased by $1.3 million. For example, an estate that includes an asset valued at
              $10 million, but was initially purchased for $5 million, would be eligible for the $1.3
              million basis adjustment. As a result, an heir who inherits this asset and immediately
              sells it would have to pay capital gains tax on $3.7 million ($10 million sale value,
              minus the $6.3 million adjusted basis amount). For assets bequeathed to the
              decedent’s spouse, an additional $3 million adjustment would be allowed for a total
              basis adjustment of $4.3 million.

              The administrative nightmare in trying to apply the carry-over basis rules will be
              immense. As some of us may recall, a carry-over basis provision was enacted as part
              of the Tax Reform Act of 1976. Assets received a new stepped-up cost basis as of
              January 1, 1977 values. The record keeping requirements that the carry-over basis
              provision would entail would be formidable. Keep in mind that if an estate cannot
              definitively prove cost basis, the cost basis is deemed to be zero.

              Additionally, executors and trustees would face substantial complexity in figuring out
              how best to allocate the $1.3 million and $3 million in basis adjustments among the
              assets in an estate in order to minimize subsequent capital gains taxes.

              Executors, hence heirs, would have the burden of establishing separate “baskets” for
              the stepped-up cost basis assets and the carry-over basis assets. Obviously, over time
              and multiple generations, these records would become increasingly difficult to track.

         D.   What Will Happen?

              My best guess is that Congress will enact a higher “permanent” applicable exclusion
              amount somewhere between $3.5 million (the scheduled exemption increase in 2009)
              and $5 million. Stepped-up basis will be retained and the attorneys’ and tax
              accountants’ nightmare known as carry-over basis will go away, for now.



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