Much has been said and written about the estate tax. What I’m going to point out to you today is that most people are missing the boat when following what’s going to happen to the estate tax now that the Bush tax cuts are set to expire. There is another aspect of the law that is likely to affect far more people than the estate tax itself ever will.

 In order to understand what I’m talking about, you need to know the context of our current estate tax law. As many of you know, the Bush tax cuts originally enacted in 2001 are set to expire at the end of next year – 2010. 

 The current estate tax exemption is $3.5 million per person, meaning that with proper planning and the right types of assets, a married couple can shield from the federal estate tax up to $7 million of assets. Without further legislation, 2010 sees the repeal of the estate tax (you can die with an unlimited amount of assets and your estate would not be subject to the tax) and in 2011 the estate tax exemption falls all the way to $1 million per person.

 Professionals who follow the estate tax suggest that Congress will make the 2009 law effective through 2010 before a more substantial federal estate and gift tax overhaul can be passed. In other words, don’t expect a full repeal of the tax next year. Expect 2010 laws to look like 2009 before Congress can further address the tax issues.

 What I’m here to tell you is that the estate tax is not going to be as relevant as it once was. I expect Congress to pass a law that makes the $3.5 million exemption effective for some time, and may even index that amount to inflation. One should still incorporate estate tax planning into one’s plan in order to maximize the federal estate tax exemption, but if my prognostications are on the mark, most of us won’t have to worry a great deal about the federal estate tax.

 Flying under the radar, however, is a very relevant discussion about repealing the step up in tax cost basis. Congress is seriously considering taking away the step up in tax cost basis.

 If you don’t know what that means, please stay with me here. Uncle Sam made a deal with us when he enacted the estate tax. He said that he’s going to tax the value of what we gift or otherwise leave to our loved ones at our death. The value of our assets above a given amount ($3.5 million currently) will be taxed. In exchange, Uncle Sam gives us a “step up” in the tax cost basis of those same assets that we leave our heirs. This step up in tax cost basis minimizes the potential for capital gains taxes.

 Suppose I own a beach front residence on Sanibel. I bought it for $500,000 in 1980. Today it is worth $2 million.  If I died today and left it to my three daughters, they inherit it at a step up in tax cost basis of $2 million. So if they turn around and sell it at $2 million, they incur no capital gain and do not pay capital gains taxes.

 This step up in tax cost basis occurs whether or not my estate is subject to federal estate tax. My stocks and other appreciating assets can benefit from the step up in tax cost basis, with the exception of stocks and other assets inside of IRAs or similar qualified retirement accounts.

 So as you can see, almost all estates benefit in some way from the step up in tax cost basis benefit the tax code bestows.  You should know that the Congress is talking about taking away this benefit.

 If Congress were to take away the step up in tax cost basis, all estates that have appreciated assets or property would likely be affected, not just the larger estates.

 Further, record keeping requirements would be necessary between different generations of family. The beneficiaries of the estate would have to know the decedent’s basis in the assets and property in order to properly report capital gain when anything was sold. If the beneficiaries can’t substantiate the decedent’s basis then it is likely that the IRS would treat the basis as zero. This means that all of the proceeds from the sale would be subject to capital gains tax.

 So if I inherited $100,000 of IBM stock from my father and couldn’t substantiate his tax cost basis, and then sold the IBM stock I would have to report $100,000 of capital gain.

 If my father’s estate is above the $3.5 million exemption amount, then it is possible that we would have both an estate tax and capital gains taxes under this scenario.

 Taking away the step up in tax cost basis could result in one of the largest tax increases in estate tax law history, and would likely affect a majority of all estates, no matter their size.

 Taking away the step up in tax cost basis is what you should watch for when you read stories about what Congress is going to do with the federal estate tax laws. I would urge you to write your representatives in Congress so that they will know that you are watching and how you feel about the issue.

 ©2009 Craig R. Hersch