With the repeal of the federal estate tax set for 2010 and its reinstatement scheduled just one year later, estate tax planning has become more complicated than ever. Wealthy clients need to incorporate flexibility into their current plans while taking advantage of favorable planning opportunities.
The current estate tax outlook substantially changes estate taxation every year for the next three years. As included in the Economic Growth and Tax Relief Reconciliation Act of 2001, the maximum federal estate, gift and generation-skipping transfer tax rate in 2009 is 45 percent, the estate and GST tax exemptions are $3.5 million, and the gift tax exemption is $1 million.
In 2010, EGTRRA repeals both the federal estate and GST tax and the rules that provide inherited assets with a step-up in basis to fair market value. Inherited assets will have a carry-over basis. Estates will receive a $1.3 million credit to increase the basis of assets generally and an additional $3 million to increase the basis of assets received by a surviving spouse as “qualified spousal property.”
The gift tax remains in effect, with a $1 million exemption and a maximum tax rate of 35 percent. The federal estate, gift and GST taxes are all reinstated in 2011 to pre-EGTRRA levels, including a maximum estate and gift tax rate of 55 percent (with a 5 percent surcharge on estates over $10 million), a unified gift and estate tax credit of $1 million, a flat GST tax rate of 55 percent and a GST tax exemption of $1,120,000 (indexed for inflation).
Potential for Reform
Apart from the uncertainty of three different tax regimes in three years, if EGTRRA remains in effect, the resulting carry-over basis system will cause significant difficulties for clients and their advisors. Estates of individuals who die in 2010 likely will have trouble ascertaining the basis of a decedent’s assets acquired years before death.
Accountants, other advisors and the IRS also will struggle to adapt to a completely new tax system, requiring new forms, accounting and audit procedures, software, etc. Implementing the carry-over basis system would incur substantial administrative costs that would be money wasted if the estate tax returns in 2011.
Accordingly, Congress has been working on estate tax reform legislation this year. Senate Finance Committee Chairman Max Baucus, D-Mont., unveiled a proposal last month to make permanent key features of the 2009 estate tax rules. President Obama also has voiced support for freezing 2009 rates and exemptions.
[Editor’s Note: The Senate version of the budget plan passed by Congress last Thursday included a bipartisan amendment that raises the estate tax exemption by $1.5 million to $5 million for individuals and $10 million for couples, and cuts the maximum rate from 45 to 35 percent. However, the House version, which was also approved Thursday, maintains the estate tax at 2009 levels. Under the House version, which preserves Obama’s proposal, individual heirs would be able to exempt $3.5 million from taxes, while couples could exempt $7 million. Amounts above the exemption cutoff would be taxed at 45 percent. A conference committee will resolve the differences between the House and Senate versions after Congress returns from recess later this month.]
Other proposed changes that may accompany a “freeze” of the 2009 laws include:
· Allowing “portability” of the estate tax exemption between spouses (meaning a deceased spouse’s unused exemption can pass to the surviving spouse);
· Re-integrating the estate and gift tax exemptions to the same amount, in order to minimize planning complexity;
· Allowing minority and other valuation discounts only for active business entities. This limitation would generally prevent clients from using family entities to transfer passive investments to their beneficiaries at discounted values for estate and gift tax purposes;
· Limiting the use of beneficiary “crummey” or withdrawal powers in order to qualify gifts in trusts for the annual exclusion from gift tax’
· Limiting the duration of the GST tax exemption to one additional generation, essentially eliminating the perpetual deferral of estate or GST taxes for GST-exempt amounts; and,
· Eliminating certain favorable planning techniques, such as qualified personal residence trusts, which allow clients to transfer to their beneficiaries a portion of the appreciation in their principal residence, estate and gift-tax free.
Alternatively, in order to buy additional time and avoid full repeal, Congress could pass a one-year “patch” that keeps 2009 rates and exemptions in place for 2010.
Dealing with Uncertainty
The current situation causes significant uncertainty for both clients and advisors. Accordingly, clients now more than ever need to review, update and implement their estate planning. To deal with the current uncertainty and take advantage of available planning opportunities, clients should consider the following options:
Use Exclusions. Make transfers now that take advantage of current exclusion amounts in order to ensure tax-free benefits.
Prepare for Carryover Basis. Revise estate-planning documents to include provisions that become effective only if the estate tax is repealed. For example, the documents could provide that the entire estate passes to a trust that prevents inclusion of the assets in the surviving spouse's estate (in case the estate tax returns) but also qualifies for the $3 million basis increase for qualified spousal property.
Lock-in Low Rates. Implement estate-planning techniques that provide an arbitrage between actual investment returns and federally set interest rates, with any excess growth passing estate and gift tax-free to the client’s designated beneficiaries. Historically low interest rates and depressed asset values make this an opportune time for such planning.
Make Grandfathered Transfers. Make transfers eligible for valuation discounts now (such as gifts or sale of interests in family entities) before the law changes and removes the discounting opportunities.
Provide for Liquidity. Ensure availability of liquid funds (such as through life insurance) to cover higher estate tax costs, should pre-EGTRRA rates return.
Plan for Valuation Adjustments. Incorporate provisions in planning documents that can adjust to a higher gift tax valuation and limit gift tax exposure if discounts are later challenged or eliminated.
Ultimately, clients who implement planning now can insulate themselves from the future actions of Congress, whatever they may be, and obtain some much needed peace-of-mind in this uncertain environment.
Jonathan M. Forster is a shareholder and national chair of wealth management and co-chair of life insurance groups with the law firm Greenberg Traurig, LLP. Jennifer M. Smith is an associate with Greenberg Traurig.
