There is tremendous uncertainty in the estate tax law that may directly impact your estate planning documents. The federal estate tax and the federal generation-skipping transfer ("GST") tax have been repealed as of January 1, 2010. However, both taxes are scheduled to be reinstated—not at the 2009 levels, but as they existed in 2001—on January 1, 2011. The 2001 tax act included significant changes that have been implemented over the past decade, but also included a "sunset" provision that causes the estate tax law to revert back to pre-2001 law at the end of 2010. If this sounds like it is confusing, it is. Despite knowing since 2001 that these provisions would create chaos and uncertainty, Congress failed to act to create any kind of permanent fix for the estate tax before the limited repeal took effect.
This client alert will highlight the most significant issues raised by the repeal and subsequent reinstatement of the estate tax. We urge you to contact the Reed Smith attorney with whom you regularly interact so that he or she may connect you with an attorney on our Wealth Planning Team. We can then review your estate planning documents in order to ensure that your intent is carried out despite the changes and uncertainty in the law. For many clients, these changes may have little or no impact. However, in some cases, the impact could be dramatic and could result in unintentionally disinheriting a beneficiary.
Through the end of 2009, the law provided for a $3.5 million exemption from both the federal estate tax and the GST tax, a $1 million exemption from federal gift tax, a top estate tax and gift tax rate of 45 percent, and a full step-up in basis of assets passing from a decedent. As of January 1, 2010, the federal estate and GST taxes have been repealed, the federal gift tax remains in effect although with a lower top tax rate of 35 percent, and the full basis step-up has been eliminated. Absent Congressional action, on January 1, 2011, the estate and GST taxes will be reinstated, but with only a $1 million exemption and a top tax rate of 55 percent for estate and gift taxes. That means many more estates will be subject to estate tax than under the law as it existed December 31, 2009. The level of flux in estate tax planning is unprecedented.
Speculation has been widespread that Congress may take action on the estate tax sometime in 2010. The Democrats have indicated their intention to seek to reinstate retroactively the now-repealed estate tax. Republicans have been clear in their opposition to reinstatement of the estate tax. What all of this means is unclear. Congress could sit in deadlock on this issue until January 1, 2011, when reinstatement occurs under the terms of the 2001 tax act. A compromise permanent "fix" of the estate tax could be passed with a retroactive effective date of January 1, 2010. Such a retroactive reinstatement would almost certainly trigger a court challenge to the constitutionality of the retroactivity, and could leave us with uncertainty far beyond 2010.
While there may be opportunities for some arising from this uncertainty, the potential pitfalls can be significant. The wills or revocable trusts of many married couples provide for certain formula bequests in order to maximize estate tax savings upon the death of the first spouse to die. With a formula bequest, the marital trust is often funded with the maximum amount necessary to avoid the imposition of estate tax, and with the balance going to the family trust. In 2010, with no estate tax, a formula funding like this could result in the family trust receiving the entire estate and the marital trust receiving nothing.
If the beneficiaries of the marital and family trusts are substantially the same, there may be no issue with your documents. However, if you have substantially different beneficiaries of the marital and family shares, such as with a blended family or when a spouse is the beneficiary of a marital share and charity receives the balance of your assets, it is important to determine whether your documents will continue to implement your intent.
In other situations, the concern results from the repeal of the generation-skipping tax rendering meaningless any references to the generation-skipping tax (or GST) exemption. It is particularly important that estate plans be reviewed where the governing document provides that the generation-skipping exempt amount is to benefit grandchildren directly with the balance designated to primarily benefit children.
State inheritance and estate taxes may also be directly impacted by the repeal. Many states have modified their estate or inheritance tax systems since the 2001 tax act. Many states have "de-coupled" their structure from the federal structure, and will apply estate or inheritances taxes despite the federal repeal. A review of your specific estate planning documents in light of residency and property ownership could help avoid unintended state estate and inheritance tax consequences.
Planning Opportunities May Exist
The repeal of the estate and GST taxes may also provide additional wealth transfer opportunities for some clients. In general, the use of grantor trusts, and in some very limited cases, gifts to skip-persons, may provide some opportunities for you depending upon your tolerance for risk —given that we do not know whether Congress will pass a retroactive reinstatement of these taxes.
The other significant change that took effect January 1, 2010 involves limits on the basis step-up on property passing from a decedent for income tax purposes. The estates of decedents dying in 2010 will not receive a full basis step-up. The beneficiaries of the estate will need to establish the basis of assets that the decedent acquired while living. Therefore, it is important to retain all documents that establish the historic purchase price (and the cost of any improvements) to assets such as real property. As a result of the limitations on basis step-up, many more taxpayers will be affected by a capital gains tax than were affected by the estate tax.