By Mark J. Bradley
December 29, 2009
In 2001, Congress made changes to the federal estate, gift, and generation-skipping transfer tax laws. To satisfy a procedural requirement in the Senate, the 2001 law contained a “sunset” provision, meaning that it would expire at the end of ten years, at which time the provisions of the law in effect in 2001 would be reinstated. The assumption was that during the ten-year period, Congress would be able to work out a permanent fix to the transfer tax laws.
The ten-year period expires at the end of this month and what almost everyone thought would never happen, is about to happen. In an editorial earlier this week, the New York Times referred to the current situation as an estate tax mess.
Here are some questions our clients have been asking in light of these developments.
Question #1: What happens to the estate tax and generation-skipping transfer (GST) tax as of January 1, 2010?
Answer: It’s important to look at what happens in both 2010 and 2011. Currently, everyone who dies in the United States can transfer up to $3.5 million of assets free of estate tax ($7 million for couples that plan properly). The rate of tax on each dollar above $3.5 million is a flat 45%. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Tax Act”), the estate and GST tax- – but NOT the gift tax- – are set to be repealed for one year beginning January 1, 2010.
In 2011, the estate and GST tax will be reinstated. The estate tax exemption will be reduced to $1 million, where it was in 2001, with a top rate of 55%. The GST exemption will be reduced to $1 million but indexed for inflation since 2001. The gift tax will return to the pre-2001 system with a $1 million exemption and a 55% top rate. The carryover basis provisions described above would no longer apply after the estate tax returns in 2011.
Question #2: Are there other provisions of the 2001 Tax Act that affect an inheritance?
Answer: There is a very important aspect of the 2001 Tax Act that has been underreported in the media. Under current law, most appreciated assets obtain a new cost basis, or starting point for measuring gain on a later sale, equal to the date of death value. Thus, if heirs sell the inherited property for the date of death value, there is no gain on the sale, meaning that there is no capital gains tax on the increase in value that occurred during the lifetime of the original owner. But when the estate tax is repealed in 2010, the decedent’s basis in an appreciated asset will “carryover” to the heirs. Hence, you will be hearing a lot about “carryover basis.” The capital gains tax will kick in once the gains in an estate exceed $1.3 million. There’s an extra $3 million exemption for assets left to a spouse.
Because of the $3.5 million exemption ($7 million for a couple), very few families are affected by the estate tax when a loved one dies. However, many families will be affected by these carryover basis provisions. House officials estimated that an extension of the estate tax (with a $3.5 million exemption) would have affected about 6,000 estates in 2010, but the new carryover basis provisions will affect more than 70,000.
Question #3: Will the estate and GST taxes be reenacted next year?
Answer: Keep in mind that we get our laws through a political process. Key lawmakers expect the fight over the estate tax to intensify in 2010 when the tax is gone, particularly in an election year. Furthermore, the carryover basis system will be extremely complex to administer and will be unpopular as well.
At this point, there is “massive, massive confusion” in the words of Senate Finance Committee Chairman, Max Baucus. It has been reported that some Republicans and conservative Democrats view the one-year repeal as creating leverage to insist on larger exemptions and lower rates (such as the $5 million exemption, 35% rate proposal). If the estate and GST taxes are repealed for a full year, their view is that returning to a $1 million exemption, 55% rate system would be viewed as a massive increase of the unpopular estate tax that would be politically unfathomable for all. However, it has also been reported that Democrats view the situation as giving them leverage since 60 votes in the Senate will be required to avoid returning to a $1 million exemption, 55% rate system.
Question #4: If the estate and GST taxes are re-instituted next year, will they be retroactive to January 1, 2010?
Answer: Representative Pomeroy [D-ND] reportedly has stated that the tax would not be applied retroactively to January 1. However, Senate Finance Committee Chairman Max Baucus has said “the correct public policy is to achieve continuity with respect to the estate tax” and that Congress will “clearly work to do this retroactively.” Obviously, that could be viewed as very unfair to people who have died in the interim and could be politically difficult to get through Congress in an election year.
Some legal scholars have expressed their opinion that re-instituting the estate and GST taxes retroactive to January 1, 2010 would be unconstitutional. While there have been a handful of cases (including U.S. Supreme Court cases) that have upheld the constitutionality of retroactive changes to the transfer tax system, those cases have generally involved retroactive tax rate increases. It may be more difficult to uphold the constitutionality of instituting an estate tax and GST tax system retroactively when no system exists, as opposed to just increasing rates retroactively.
If the estate and GST taxes are reenacted retroactively to January 1, no doubt there will be numerous lawsuits over the constitutionality of the provision, which probably will ultimately be resolved by the U.S. Supreme Court after years of litigation in the lower courts.
Another possibility is that the estate and GST tax system will not be reenacted retroactively, but carryover basis would be eliminated retroactively.
Question #5: What planning steps should clients consider in early 2010, when there is the possibility of having no estate or GST tax system in place?
Answer: First, people with large estates might consider transfers to long-term trusts for descendants that might be free of GST tax constraints. The trusts would be created at a time when there is no GST tax, and if the GST tax is re-instituted, existing trusts that are created during a time that no GST tax existed may be grandfathered from the new tax.
Second, consider gifts to grandchildren or more remote descendants that would otherwise be subject to the GST tax as direct skips. Of course, gifts in excess of the donor’s $1 million exemption and $13,000 annual exclusions will be subject to gift tax, but clients who plan to make large gifts anyway should consider doing it early in 2010 when there is a chance that they may pay just a 35% gift tax rather than the 45% top rate that applies this year and the top 55% rate that will apply beginning in 2011.
Third, consider making discounted gifts, outright or in trust, of fractional interests in real estate or of minority interests in closely held corporations, family limited partnerships, or limited liability companies. The tax-writing committees of Congress are considering dramatic changes in the rules regarding valuation discounts. If there is an estate and gift tax reform package adopted next year, it could include those provisions.
Even if there is no legislation, there are indications that the IRS will issue regulations that would place significant restrictions on valuation discounts on entities that are valued on the basis of their liquidation value, such as family limited partnerships holding marketable securities or other assets other than operating businesses. Therefore, to have a chance to take advantage of the lower 35% rates in 2010 and to avoid the coming restrictions on valuation discounts, clients should consider making desired gifts and sales as early in the year as possible.
Question #6: If the estate and GST taxes are repealed, how will that impact clients’ estate plans, and must clients then have their estate planning documents reviewed?
Answer: A typical estate plan for married individuals is to leave as much as possible to trusts or individuals other than the surviving spouse without generating any federal estate tax (in order to avoid having those assets be subjected to estate tax at the surviving spouse’s subsequent death). Those types of plans may be impacted dramatically by this law change.
For example, if a client’s plan is to leave as much as possible to a credit shelter trust for the decedent’s spouse and children without generating federal estate taxes at the first spouse’s death, with the balance of the estate passing to the surviving spouse, that plan may be construed to leave the entire estate to the trust if there is no federal estate tax system in place, depending on the specific wording of the decedent s will or trust document. That may not at all be what the client intended.
In those situations, there may be expensive court fights over the construction of the document in light of the client’s intent, but the laws of most states are that the client’s intent is irrelevant if the document is not ambiguous. Particularly for married individuals with these kinds of formula driven clauses, it will be important for clients to have their estate plans reviewed.
In addition, if we are going to have a carryover basis system, many clients wills and trusts will have to be modified to include provisions to take advantage of the $1.3 million (for any recipients) and $3.0 million (for surviving spouses) basis increase allocations by personal representatives or trustees.
Drafting to account for these provisions can be complex. One challenge will be to leave enough assets to spouses to be able to take full advantage of the $3.0 million of basis increase. Another will be to give the personal representative the discretion to make the allocations, including allocations to property that passes by beneficiary designation outside the will or trust.
Any change in a client’s estate plan should, of course, take account of the very strong possibility that the estate tax will be reenacted and that the carryover basis provisions will be repealed, so that the plan would not have to be redrafted yet again if and when that happens.
We would be happy to discuss any additional questions you might have about how these changes in the law will affect your estate plan. Feel free to contact Mark Bradley, the author of this article, or any of the attorneys in the Trusts & Estates Practice Group of Ruder Ware.
This document provides information of a general nature regarding legislative or other legal developments, and is based on the state of the law at the time of the original publication of this article. None of the information contained herein is intended as legal advice or opinion relative to specific matters, facts, situations, or issues, and additional facts and information or future developments may affect the subjects addressed. You should not act upon the information in this document without discussing your specific situation with legal counsel.
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