CHAPTER 22

The IRS Is Back! And This Time, It’s for Real! OR “SORRY ABOUT YOUR PARENTS’ DEATHS.THAT WILL BE $200,000, PLEASE.”

I am sure that you’re thrilled at the prospect of reading another chapter about the estate tax. If you cannot tell, that is a mildly sarcastic statement. In truth, I’ll bet you approached reading this chapter with as much dread as I had when I approached writing it.

Writing about the estate tax in a way that keeps you interested is such a daunting and difficult task that I delayed the writing of this chapter until the very end. In fact, even when the bell tolled to signify that the time to write this chapter had arrived, I literally ran from my desk, plopped on my couch, and watched four movies in a row on HBO, Starz, Showtime, and The Movie Channel. I had not engaged in such mind-numbing procrastination tactics since I agonized over the writing of that paper for Professor Maniquis’ Romantic poetry class at UCLA in which I made a futile attempt to prove that the protagonist in Cervantes’ Don Quixote de la Mancha coupled with himself. I say “futile” because it earned a mere C minus, and I was lucky to get that.

As your Living Trust advisor, I need your energy level up to the point where can read this chapter about the estate tax without becoming drowsy. In my mind, there is no better way to get your adrenaline flowing than by making this statement: It’s serious time! If you are rich enough, the IRS will get a portion of your assets when you and your spouse are both gone. But, if you are aware of the estate tax process—and understand it—you will save your family some serious dough!

Now you are sufficiently energized to slog through some semiboring estate tax stuff that happens when both you and your spouse are dead. Let’s begin.

The Federal Estate Tax Return—Your “Death Inventory”

As I previously told you in Chapter 13, the estate tax is a tax on the transfer of assets after the death of the owner of those assets. Because this tax takes place after death, some folks call it the “death tax.” That is a completely misleading label, as it gives the impression that there is a tax on the act of death.

Let me be clear so you will never make this mistake again . . . or the first time. There is no tax because of death; there is only a tax on the transfer of wealth after death. So, the next time your Republican congressional representatives attempt to goad you into voting Republican because of their promise to abolish the “death tax,” you can now interpret what they really mean.

In Chapter 13, I discussed the estate tax in the context of the death of the first spouse to die, whom I call the deceased spouse. As a general proposition, there is no estate tax after the deceased spouse’s death, because there is no tax on the transfer of assets from the deceased spouse to the surviving spouse. This is called the marital deduction, which is a dollar-for-dollar deduction for every dollar that goes to the surviving spouse, or to a trust for the benefit of the surviving spouse. There is also no estate tax on the transfer of assets that pass to the exemption trust, which is a concept I also discuss in detail in Chapter 13.

Although there is usually no estate tax due after the deceased spouse’s death, the surviving spouse may still have to file the deceased spouse’s estate tax return. The estate tax return (known in the vernacular as Form 706) is like an inventory of assets that the deceased spouse owned at the time of death. In this return, the surviving spouse describes the nature and value of all assets in which the deceased spouse had an interest. But again, the fact that an estate tax return may be due after the deceased spouse’s death does not mean that an estate tax is due.

When the surviving spouse dies (that is, when both you and your spouse are dead), another estate tax return may be required. And this time, it’s for real. If you are rich enough, the IRS will ask for a portion of your assets in the form of an estate tax. Who qualifies as “rich enough”? To the IRS, you are rich enough to pay estate tax if the net value of your estate exceeds your exemption amount (more on this later in this chapter).

The responsibility for preparing and filing the estate tax return belongs to the after-death agent you named in your Living Trust. After the last spouse dies, your after-death agent must gather information about all the assets that have the surviving spouse’s name on them.

What kind of assets? All of them. Real estate. Stocks. Bonds. Treasury bills. Savings bonds. Brokerage accounts. Mutual funds. Checking accounts. Savings accounts. Certificates of deposit. Cash. Insurance. Promissory notes. Pedigreed dogs and cats. Jewelry. Antiques. Collections. Furniture. Automobiles. Oil and gas leases. Businesses. Limited partnership shares. Limited liability company membership interests. Mining rights. Time shares. If an asset does not fit into a category, it gets listed in the return as “Miscellaneous.”

The IRS does not care how the surviving spouse owned the assets. In the Living Trust. Out of the Living Trust. In joint names with any other person. In a survivor’s trust. In an exemption trust. In a marital trust. In an account with someone named as a beneficiary. In an IRA account. In a pension plan. In a 401(k). In a partnership. It just does not matter. If the surviving spouse’s name is anywhere on that asset, your after-death agent must list it in the estate tax return.

How does your after-death agent go about getting this information?

For real estate, the after-death agent has to hire a real estate appraiser. I say “hire” because appraisers do not prepare those reports for free. Your after-death agent must pay a fee from your Living Trust assets in order to report the value of your real estate to the IRS so the IRS can impose an estate tax on that value. It’s a nasty little circle.

For all your other assets, your after-death agent must obtain all the statements and documents that represent those assets. This means your after-death agent will root through your main financial workspace to look for bank statements, brokerage statements, income tax returns, and all other documents that will provide a clue as to the nature and extent of your non-real estate assets. If the surviving spouse has an asset that is not evidenced by a statement, such as a receivable not reduced to writing, your after-death agent may never know about it and will not list it in the estate tax return. Since the IRS imposes an estate tax on only the assets listed in the return, the omission of undiscovered assets may be just fine with you; but unknown assets also do not get transferred to your children or other heirs.

In addition, as incongruous as this may sound, the estate tax return must also list any transfer or gift made by the surviving spouse that exceed the annual gift exclusion. What is the annual gift exclusion? It is the amount the IRS says you can give away each year to any person with no gift tax to you and no income tax to your recipient. Right now, the amount of the exclusion is $12,000.

So, if you give your son $50,000 right now for a down payment on a house, your after-death agent is required to list that gift in the estate tax return as the value of that gift over the $12,000 exclusion (or $38,000). Put another way, the value of that gift over and above your $12,000 exclusion ($50,000) is added back into the inventory and is counted for estate tax purposes as an asset that you owned at your death.

Again, I know it may be difficult to wrap your head around this concept. How can a gift before your death be considered an asset that you owned at your death? Here’s how. The IRS does not want you to think you can avoid an estate tax by giving away what you own before your death. If you could do that, so would millions of others, and the IRS would never collect any estate tax dollars. So, the IRS says that any gift you make above a certain amount (the annual gift exclusion) is, from an estate tax reporting standpoint, put back into your estate.

At some point, your after-death agent will conclude the search for the assets that are owned by the surviving spouse at death. He or she will have the real estate appraiser reports, the bank and brokerage statements, the canceled checks from the insurance policy payouts, and all other relevant documents to show ownership and value, and will also have the information about all the gifts and transfers over the annual gift exclusion made by the surviving spouse to any other person. Your after-death agent will then feed that information to the Living Trust attorney, who will, in turn, input it into special software that adds it all up and calculates the estate tax.

After completing that task, the attorney will call your after-death agent to give the big news on the amount of estate tax to be paid. As you will see, the amount of the estate tax to be paid is absolutely dependent on the year of the surviving spouse’s death.

The Not-So-Good News

If the surviving spouse dies in 2008, there will be no estate tax if the total value is less than $2 million. This figure of $2 million is the surviving spouse’s exemption amount in 2008. In English, this is the amount the IRS says that the surviving spouse can transfer after death to anyone and in any manner without the imposition of any estate tax. If you are the surviving spouse and your total net worth (including the gifts added back into your asset inventory) is less than $2 million, your after-death agent will not have to raid any of your assets to pay an estate tax. Lovely.

However, if the total net worth of the surviving spouse is more than $2 million, there will be an estate tax on every dollar above that amount. The rate of tax starts at about 33 cents on the dollar, with the top tax rate at 45 cents on the dollar.

Let’s move on. If the surviving spouse dies in 2009, there will be no estate tax if the total value is less than $3.5 million. The exemption amount jumps significantly from $2 million in 2008 to $3.5 million in 2009. If you are the surviving spouse and your net total worth (including the gifts added back into your asset inventory) is less than $3.5 million, no estate tax will be paid. Again, however, if the net total exceeds the exemption amount in 2009, the IRS imposes a tax on that overage.

Here is where it starts to get juicy. Under current law, there is no estate tax at all in 2010. If you are the surviving spouse and die in 2010, it does not matter what your net total inventory is. The entire amount will pass to your children or other heirs with not one penny of estate tax. This is amazing. For one year only, the estate tax is repealed, which is the first time since 1931 that no estate tax exists in the United States.

Why this anomaly in estate tax law where the repeal lasts only one year? Because when the Republicans came into power in 2000, they could not muster the two-thirds vote required to carry out their oft-promised permanent “death tax” abolishment. The one-year repeal was a compromise that the Republicans could live with in order to show the voters that they had made good on their campaign promise.

But here is something you probably don’t know about the increased exemption amount in 2009 and the one-year-only repeal in 2010. In order to make up the amount of tax revenue lost as a result of those changes, starting in 2010 Congress has canceled a much-loved and often-used tax break called “stepped-up income tax basis.”

Specifically, your basis in an asset is what you paid for that asset. If you paid $10,000 for a residential property in Santa Monica in 1931, and you sell it for $1 million in 2008, the difference between the two numbers ($1 million minus $10,000 equals $990,000) is your profit. And you know what the IRS loves to do with profit? Tax it!

But, if you still own that property when you die, your basis in that property steps up to the fair market value of the property as of your death. This is just fine with the beneficiaries who inherit that property from you. If your $10,000 basis steps up to $1 million at your death (because that is what an appraiser says it’s worth on your death) and the inheritors of that property sell it for $1 million, there is no taxable profit. The difference between the sale price ($1 million) and the stepped-up basis ($1 million) is zero. No profit, no tax!

Lovely!

Not so lovely, however, is the congressional trade-off that begins in 2010 when stepped-up basis is canceled (but for a few exceptions). This means that your $10,000 basis in your Santa Monica house stays as $10,000 on your death. If the inheritors of that property sell it for $1 million, the profit is $990,000, which will be subject to a capital gains tax of at least 20 percent.

Congress thought it was doing taxpayers a favor with the increased exemption amount and one-year-only repeal. Hardly. Whereas the estate tax affects only the richest 2 percent of the American population, the elimination of stepped-up basis will touch about 12 percent of taxpayers. As a result, the government may end up with more of our dollars in income taxes that it would with estate taxes.

The cancellation of stepped-up basis was always part of the proposed legislation to repeal the estate tax, but was rarely, if ever, mentioned in the national media. That’s not a surprise. Why would any news source want to report complicated and boring implications of proposed major tax revisions when the big ratings (and big advertising dollars) are in such human-interest stories as waterskiing squirrels and setting a world record for the most tuba players ever gathered in one spot?

Enough ranting about this tangent concerning the cancellation of stepped-up basis and the dumbing-down of national and local news. The question you want answered is: What happens with the estate tax on January 1, 2011, when the one-year-only repeal is over?

Under current law, the estate tax kicks back in with a relatively low exemption amount of $1 million. If you are the surviving spouse and you die in 2011, and the net value of your estate (including the gifts added back into your asset inventory) is more than $1 million, your after-death agent will have to raid your assets to pay an estate tax.

Going from a completely non-estate tax year of 2010 to a taxable estate year of 2011 is bad enough. But going from a $3.5 million exemption amount in 2009 to a $1 million amount in 2011 is, in my opinion, an even more insufferable comparison. Of course, if you are the surviving spouse and die in 2011 with less than $1 million, your beneficiaries have nothing to worry about. However, with your real estate, cash and brokerage assets, IRAs, pension plans, annuities, insurance, and other commonly owned assets, it is somewhat foreseeable that your estate can easily hover around, and perhaps exceed, the taxable estate territory of $1 million or more.

In any event, that is the estate tax picture under current law. With that in mind, you can now understand my previous statement that the amount of the estate tax depends on the year of the surviving spouse’s death. As a Living Trust lawyer, there are many methods and plans that I can design to reduce or eliminate the estate tax when you and your spouse are both dead. But, the tool that you really wish I had is a crystal ball that could foretell the year of your death.

Indeed, if I could predict that you will die in 2009 and 2010, then you could determine that estate tax prevention plans, and the costs and fees associated with those efforts, would be unnecessary. Obviously, no such tool exists. So, just to protect my backside, I must assume that (1) you will not die until after 2010 when the applicable exclusion amount is a mere $1 million, and (2) your total net worth will exceed that $1 million mark. And that assumption will require you to throw money in my general direction to come up with expensive and high-maintenance tax-prevention techniques.

With the estate tax the political football it has become, I believe that changes in our executive and legislative branches could bring changes to the estate tax law. When 2010 rolls around, newspapers and Internet news sites will attempt to galvanize the reading public with the fact that 2011 will bring with it the return of the estate tax and lowering of the exemption amount to $1 million. If the public is paying attention, perhaps they will bring enough pressure on their elected representatives to revert to the old estate tax system where only the richest 2 percent of Americans are subject to the tax. I believe, as do many of my colleagues, that if this reversion is enacted, it could manifest as a permanent exemption amount from $3 million to $5 million.

In the meantime, with the current law in place, there are masses of Living Trust beneficiaries who would find it very convenient if you had the decency to die before 2011 when the $1 million exemption amount returns. I predict that in 2010, we will read or hear of accounts of terminally ill surviving spouses dying in droves before the clock turns to 12:01 A.M. on January 1, 2011. Some will be suspicious deaths that result in police investigations of persons who would benefit from the estate tax break given in that one year. Perhaps there will be arrests and convictions.

Obviously, this is not what Congress intended with the one-year-only repeal of the estate tax; but, according to the law of unintended consequences, this is what I believe we will get: deaths of terminally ill seniors hastened by their estate-tax-break-seeking beneficiaries. I hope I’m wrong, but I truly believe I will be proved right.

The Estate Tax Return Process

Still awake? Yes, you are. How can you nod off while reading about murder in the context of estate tax repeal? It cannot be done. But, let’s get back on track to the story of the surviving spouse’s estate tax return.

If the Living Trust lawyer ascertains that an estate tax is due, your after-death agent will have to write a check from your Living Trust assets to cover that tax. If there are insufficient liquid assets to pay the tax, your after-death agent will have to sell something to generate those funds, most likely your Living Trust real estate. Of course, the sale of real estate incurs a number of costs and fees over and above the estate tax, such as broker commissions, escrow fees, installation of low-flow toilets, water-heater bracing, documentary transfer taxes, recording fees, and many miscellaneous charges. It’s as if the estate tax is being paid at 105 percent of its value—that is, 100 percent for the tax and an additional 5 percent for costs needed to come up with the money to pay the tax.

After your after-death agent signs the estate tax return, the Living Trust lawyer sends the check and the return to the IRS. The return and check must be sent within nine months of the date of the surviving spouse’s death. An extension of six months can be obtained to file the return, but the extension request (Form 4768) must be accompanied by a check for the estimated estate tax.

If your after-death agent cannot obtain the funds to pay the estate tax within that nine-month period, the lawyer can request an extension of time to pay the estate tax for up to one year (also on Form 4768). However, after the nine-month date, the IRS’s interest clock ticks away on the unpaid estate tax. The interest rate is very high, typically from 9 percent to 12 percent.

The estate tax return and check are sent to the IRS estate tax return center in Cincinnati. Every single estate tax return is sent to this location regardless of the state of the surviving spouse’s residence, because this is the only location in the United States set up for anthrax screenings for estate tax returns.

Here is another indignity suffered by your Living Trust beneficiaries. Your after-death agent will not make any distribution of Living Trust assets to your beneficiaries until the entire estate tax process is completed. “Completed” means more than just the writing and sending of the check for the estate tax. The estate tax process is not completed until the IRS has examined and accepted the estate tax return.

If the IRS accepts the return as filed, it will issue a “closing letter” to your after-death agent. This is like getting a “pass” on a test. However, if the IRS wants more information, or wants to contest some aspect of the return, it will issue an “examination letter” in which the assigned IRS officer, who will be an attorney, will state the issues he or she desires to address.

Playing the Waiting Game After Your Estate Tax Return Is Filed

In my experience, the time it takes for the IRS to issue a closing letter ranges from one to two years from the date of filing. Remember, the estate tax return is filed up to 15 months after the death of the surviving spouse. Applying my incredible math skills, this means your Living Trust beneficiaries may wait a long time for your after-death agent to distribute their Living Trust shares. Out of all the phone calls I receive on a daily basis at work, I would estimate that 20 percent of them are from Living Trust beneficiaries asking, in essence, “Are we there yet?”

Why does the IRS take its sweet time to examine the estate tax return? Unlike an income tax return, which has a 1 percent chance of audit, every estate tax return the IRS receives is audited. It’s a 100 percent chance of audit. In addition, each person examining each estate tax return is an IRS attorney. As you may have experienced, it takes a long time for an attorney to do anything.

If the IRS contests a matter in the estate tax return, it will most likely concern the valuation of real property. In my experience, real estate valuation is the number-one issue raised by the IRS during estate tax return examinations.

The IRS is always wary that the return may include a property valuation that is too low. If the IRS does not agree with the value of the property as contained in the appraisal reports that have accompanied the return, the IRS will obtain its own appraiser, who invariably will value the real estate higher than the appraiser retained by your after-death agent.

Usually, these disputes settle at the median value between the high and low appraisals, but don’t count on that. While the majority of IRS attorneys I have encountered have been pleasant to deal with and will readily accommodate an expense-saving deal, I have also experienced the wrath of those few who refuse to bend at all. In such event, the appraisal battle goes to the next level of scrutiny with that attorney’s administrative superior. If a deal cannot be struck, the battle wages on to the Tax Court to let the judge decide.

However, rarely, if ever, will I let an appraisal battle or any other estate tax return issue go to the Tax Court level, as the legal costs can potentially eat up any estate tax savings that a favorable Tax Court ruling could offer. I would rather your after-death agent hold his nose, make the best deal possible, and walk away with hurt pride, but also with your Living Trust assets largely intact.

If the examination process results in the imposition of more estate tax, the IRS will charge interest on that extra amount. Certainly, that is to be expected. But what is truly unfair is that the interest will be deemed to retroactively begin from the nine-month date, not the date that the final ruling is made. This means that if the IRS has taken its sweet time examining the estate tax return and finalizing the case, interest is accruing during that entire time!

On one occasion, I dealt with an IRS attorney during an examination of an estate tax return where we engaged in an otherwise typical appraisal battle. About eight months into that examination, the IRS attorney quit and went into private practice. It took the IRS about 13 months to hire a new attorney and get him up to speed on a caseload that included my case.

When the examination was concluded, the new IRS attorney’s report stated that additional estate taxes were due. Fair enough; but I was shocked to read that interest was charged for the 13-month hire-and-catch-up period! Although I try to keep my clients from IRS levels beyond the examination level, I was so incensed by such gall that I offered to take this issue to Tax Court . . . for free! Ultimately, I raised such a stink that the IRS attorney backed off on those charges.

But whether or not heroics are involved, at some point the issues raised for examination will be resolved and a closing letter will be issued, leaving your after-death agent to finally distribute the Living Trust assets to the beneficiaries you’ve named in your Living Trust.

Seek Out Solutions to Reduce Your Estate Tax

There are dozens of plans and techniques of which you can avail yourself to reduce your estate tax. Innumerable books have been written on this subject. While most are reader-friendly, most bring back nightmares of the most insufferably boring textbook of your school days.

If this were a book with the estate tax as its main subject, I would describe the menu of plans that you could implement to reduce or eliminate the estate tax on the death of the surviving spouse. However, such a discussion would turn this book into something it is not intended to be. This is a book on how to live and die with a Living Trust, and the vast majority of estate tax reduction plans have absolutely zero relation to your Living Trust. For such a discussion, I will take the easy way out and refer you to the reader-friendly laundry list of options that appear in my first book, Beyond the Grave: The Right Way and the Wrong Way of Leaving Money to Your Children (and Others), in Chapter 37 entitled “How to Leave More to Your Children and Less to the IRS.”

When you read that chapter or other books on how to reduce or eliminate estate taxes, you will notice that all estate tax planning techniques have one central common trait, which is: They all involve some element of giving up control of your wealth now, while you are alive. Why? Because the less you own when you die, and the lower the value of the assets you own on your death, the less the estate tax will be. For my estate planning attorney brethren reading this paragraph, I must add this little private message: Yes, gentlemen. Of course I realize that is a broad and sweeping generalization for which there are a lot of exceptions. But I’m attempting to convey, in plain English, an overarching concept in order to assist my readers with comprehending what can be a very complex subject. Back off, please.

If you have little or no problem conveying assets during your life to your children, grandchildren, or charities of your choice (whether or not above the annual gift exclusion), you are already ahead of the game. But, if the mere thought of releasing your kung-fu grip on your assets makes you weak at the knees, then forget it. My philosophy is: Never part with wealth that you feel you will need or that you feel you will miss. To your beneficiaries who end up paying more estate tax because of your inability to part with your money now, I say, tough! It’s your money and property. You do or not do whatever estate tax planning you want. Your beneficiaries are fortunate to get what they get.

Having referred you elsewhere for your estate tax reduction training, I must add that there is one estate tax issue that is directly related to your Living Trust that is crucial in the context of payment of the estate tax following the death of the surviving spouse. But, I can almost guarantee that your Living Trust attorney has never discussed this issue with you. This issue concerns what your Living Trust says about who pays the estate tax, and it is covered in the next chapter.