Overview of 2010 Estate Tax and Gift Tax Rules

Modified Carryover Basis vs. Estate Taxes

Man Signing Tax Form
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Thanks to the passage of the estate tax provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ("TRUIRJCA" or simply "TRA 2010" for short), the heirs of decedents who died during 2010 will have the choice between using the modified carryover basis rules or applying the retroactively reinstated estate tax. Here is a summary of the changes made to the federal estate and gift tax laws under the terms of TRA 2010:

Modified Carryover Basis Rules

Under the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (or "EGTRRA" for short), the federal estate tax exemption was gradually increased, and the estate tax rate was gradually decreased until 2010 when the federal estate tax was scheduled to completely disappear for that year only. In place of the federal estate tax, EGTRRA introduced the "modified carryover basis rules," which affect the income tax consequences of inheriting property. Under the modified carryover basis rules, the income tax basis of inherited property could be stepped up by $1.3 million, as opposed to an unlimited step-up in basis under prior estate tax laws.

In addition, if the property was inherited by a surviving spouse (either directly or through a qualified terminable interest property (or QTIP) trust), then the property could receive an additional $3 million step-up in basis.

Under the terms of TRA 2010, the estate tax is the default rule for 2010 decedents. So in order for the heirs of 2010 to opt into the modified carryover basis rules and out of the estate tax rules, the heirs will need to file a new IRS form called Form 8939, Allocation of Increase in Basis for Property Received from a Decedent. It is an information return only, as opposed to a tax return, and will be due on or before January 17, 2012. Extensions of time to file Form 8939 will not be granted, and amended forms may be filed only in limited circumstances.

Information on extensions and amendments can be found in the instructions and Notice 2011-66.

Which 2010 estates should choose to apply the modified carryover basis rules as opposed to the estate tax rules? In general, the heirs of a 2010 estate that exceeds $5,000,000 will need to run the numbers to determine if applying the modified carryover basis rules versus the estate tax rules makes sense since there will be a breaking point at which it will make more sense to apply one instead of the other.

2010 Estate Tax Rules

Under the provisions of TRA 2010, the federal estate tax, which, as mentioned above, was supposed to completely disappear for the 2010 tax year under the terms of EGTRRA, was miraculously resurrected and retroactively applied back to January 1, 2010, for all 2010 estates. The kicker to this new estate tax law is that it offers the largest estate tax exemption ever - $5,000,000 - and smallest estate tax rate ever - 35%. Aside from this, the heirs of 2010 decedents who opt to make use of the estate tax rules instead of the modified carryover basis rules will receive a full step-up in basis of their inherited property.

As mentioned above, the estate tax rules are the default rules for 2010 estates. It means that if the gross estate did not exceed $5,000,000, then the heirs did not have to do anything and received a full step up in basis in their inherited assets. But if the estate exceeded $5,000,000 in value, the death occurred between December 1 and December 17, 2010, and the heirs wanted to apply the estate tax rules instead of the modified carryover basis rules, then the heirs would have needed to file a federal estate tax return, IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, on or before September 19, 2011.

But the IRS created confusion by not releasing the final version of 2010 Form 706 until early September.

For the heirs of 2010 estates that exceeded $5,000,000 and their deceased benefactor died between December 18 and December 31, 2010, if they wanted to apply the estate tax instead of the modified carryover basis rules, then they would have needed to file IRS Form 706 on or before nine months after their deceased benefactor's date of death, except that, as mentioned above, the form was not released until early September.

For this reason the heirs of 2010 estates who need to file Form 706 but could not get it prepared and filed on time should have filed IRS Form 4768, Application for Extension of Time To File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes, in order to receive an automatic six-month extension of time to file Form 706 and pay any taxes that may be due.

2010 Gift Tax Rules

While TRA 2010 made significant changes to the rules governing federal estate taxes, it did not affect the lifetime gift tax exemption, which remained at $1,000,000. However, under the provisions of EGTRRA, the gift tax rate was supposed to be reduced from 45% in 2009 to 35% in 2010, and TRA 2010 did not affect this reduction in the gift tax rate.

For those who made taxable gifts in 2010, they will need to file IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, on or before April 16, 2012 (since April 15 falls on a Sunday).