A popular axiom – referred to as Occam’s razor - holds that we should tend towards simpler approaches until we must trade simplicity for increased explanatory power. For estate trustees and beneficiaries considering tax strategies in the disposition of 2010 estate assets, this principle is a sound guideline.

Changes in the tax code put into effect last December that reinstated the 35% estate tax appear to offer estate executors a simple decision rule. Under scrutiny, however, one finds complexities that need to be examined in order to make the right choice.

Case in point: in an effort to avoid a constitutional challenge to the new estate tax provisions being applied retroactively to people who died in 2010, Congress gave estate executors the option to be subject to the 35% estate tax (with a $5MM exemption) or to affirmatively elect to apply the 2010 rules as if the law had not changed, which were zero estate tax and a modified carryover basis for capital gains taxes on inherited assets. 

On the surface, the choice does seem simple: why would anyone elect to pay an estate tax?

The choice becomes tricky when you take into consideration the fact that the 2010 “zero-tax” option offers no step-up in basis for calculating taxable capital gains. For example, if the estate has a $5 million asset that was purchased for a dollar, the beneficiaries will have a cost basis of a dollar when they sell the $5 million asset, and they have to pay capital gains on the entire amount. (This example is extreme, and doesn’t account for the ability of the executor to assign $1.3 million in basis increase to specific assets and up to an additional $3 million to certain property going to a surviving spouse, but it illustrates the point.) Electing to be subject to the estate tax, entitles the inherited assets to a step up in basis to the fair market value at date of death so the capital gains liability is significantly reduced.

One might argue that the trade-off can be resolved with a quick accounting exercise, which would determine whether the beneficiaries would be better off paying the estate tax and getting the step up in basis or avoiding the estate tax and accepting the carryover basis. In truth, it is not a black and white decision, due a number of important factors, of which the following are merely illustrations:

  • First, the 35% estate tax is a known quantity and you know when it is due. From a tax planning perspective that is a big plus. Going the capital gains route adds considerable uncertainty. Do you know when you are going to sell the asset or how it will be valued? Even if you do, you will have to project forward and make assumptions about what the tax rate will be at the time the asset is sold. Given today’s political and economic climate, predicting where capital gains rates will be in the next five to ten years could be a risky proposition.
  • Second, there are interfamily dynamics, which can get really interesting if you are the executor or personal representative with fiduciary responsibility. Today, it is common to have blended families with “yours, mine and ours” children, or second and even third families. In these cases, there may be a group who are not residual beneficiaries but who are recipients of assets that have substantially appreciated in value. They would prefer the payment of estate tax and the resulting step-up in basis. The problem is that estate taxes are generally paid from the residual estate, and those residual beneficiaries may not want to elect the estate tax option. This can put the executor into a bind – obliged to choose one of the two tax schemes with two groups of beneficiaries that have diametrically opposed positions on the strategy. In the end, one side is going to lose out, so the personal representative is left with making a “lesser of two evils” decision.

Other considerations would include:

  • Application of state statutes to interpret formula provisions and terminology used in Wills
  • Whether electing into the no estate tax regime affords an opportunity to reduce or avoid estate tax at the death of the surviving spouse, by avoiding the need to make a QTIP election for a marital trust
  • The size of the separate estate of the surviving spouse
  • Whether the estate assets are subject to depreciation recapture, so that potential tax arising from a lower basis is not just a function of capital gains rates but also ordinary income tax rates

Given the potential for huge shifts in economic value based on the decision created by the Carryover Basis Election, a fiduciary may want to obtain beneficiary consents to any basis allocations if possible. A fully supported petition for approval to the court with appropriate jurisdiction can also protect the fiduciary from potential claims of breach of the duty of impartiality to beneficiaries. In any event, given these complex factors, the fiduciary should use financial and legal advisors to evaluate options and arrive at an informed decision with an appropriate course of action. Otherwise, be prepared to suffer the results of this double bind dilemma.
Michael Roberts is an executive vice president at Reliance Trust Company