When Congress passed the 2001 Tax Act, few expected the provisions repealing the Federal estate tax and generation-skipping transfer (GST) tax in 2010 to take effect. Yet it has happened. With Congress unable to reach a consensus for even a one year continuation of existing law, the provisions of the 2001 Economic Growth and Tax Relief Reconciliation Act (the 2001 Tax Act) have suspended the application of the Federal estate and GST taxes for the year 2010.1 Without legislation, in 2011, the Federal estate, gift and GST taxes revert to 2001 law, with substantially higher rates and lower exemptions. The uncertain state of the transfer tax laws creates some tax planning opportunities, but many more pitfalls and uncertainties. Retroactive reinstatement is a possibility, although likely to engender Constitutional challenges that will take years to resolve.
All clients should conduct an estate planning review now to avoid unintended consequences for their intended beneficiaries.
Estate and GST Tax Considerations
Use of Tax Formulas
Many estate plans seek to take maximum advantage of the available tax exemptions, such as the estate tax exclusion and the GST exemption (each of which were $3.5 million in 2009), by using formula language in estate planning documents tied to technical tax terminology. The use of formula language has the benefit of allowing the estate plan of married clients automatically to adjust the share of the estate able to pass to family members other than the spouse without incurring estate tax. It accomplishes this by expressing the amount in terms of “the maximum amount that can pass without estate tax” or “the amount equal to the estate tax exemption in effect at my death.”
These formulas, however, have uncertain consequences when the tax or exemption referred to in the document is not in effect. What is the maximum amount that can pass without incurring tax? Perhaps it is the entire estate. On the other hand, the maximum amount sheltered by the exemption might be zero when the exemption is no longer in effect. Depending on the formula used and its possible construction, estate plans intended to have the same disposition could have diametrically opposite dispositive results when construed under current law. In the first case, the entire estate would pass to the exemption trust, which might be for the surviving spouse and descendants or exclusively for descendants. In the second case, the entire estate may pass to a marital trust exclusively for the surviving spouse.
Documents prepared after 2001 may have taken the possibility of repeal into account. In that case, the disposition under the document may be clear. Nevertheless, it seems unlikely that existing documents adequately take into account not only the possibility of repeal, but also the possibility of retroactive reinstatement. It may be that to avoid drafting complete alternative plans to address what was considered a remote possibility of estate tax repeal, existing documents include a disposition that would require a spousal disclaimer to accomplish the optimal tax planning in the event no estate or GST tax is applicable at death. Verifying whether or not that is the case, and whether the couple is still comfortable relying on disclaimer planning will be important. It also will be important to assure that a potential retroactive reinstatement of the estate and GST taxes is adequately taken into account. It is not clear, absent express language, that a retroactive reinstatement of the estate or GST tax would cause estate planning instruments to self-adjust. Moreover, a marital disposition that takes effect only in the event the estate tax is in effect at death may be inadequate to obtain a marital deduction upon a retroactive reinstatement of the estate tax because in general in order for a bequest to qualify for a marital deduction the spousal interest must be established at death and in all events.
Effect on State Death Taxes in States With An Independent Estate Tax
Formula provisions may also be used to minimize the application of state estate taxes. Many states have an independent estate or inheritance2 tax that includes an independent estate tax exemption, usually in an amount less that the Federal exemption. The state exemption permits a certain portion of the estate to pass without the imposition of state estate tax. The independent state estate tax may still be in effect in 2010 even though the Federal estate tax is not. Clients domiciled in states with an independent estate or inheritance tax3 (and clients who own real estate or tangible personal property in one of those states but are not domiciled there) should consult with their estate planning counsel to address the potential consequences of their estate plans under state law. It is possible, for example, that a plan that takes advantage of the repeal of the Federal estate tax would dispose of the estate in a manner that would subject the entire estate to state estate tax.
Minimizing the Potential for Future Estate Tax
A year without estate tax is now a strong possibility. Property passing outright to any beneficiary, however, could be subject to future estate tax. Accordingly, the best estate plan for 2010 may be to require all bequests, especially those passing to a surviving spouse, to be held in trust. Valuable tangible personal property and residences frequently pass outright to a surviving spouse, but those devises may be subject to estate tax when the spouse later dies. On the other hand, property passing in trust when the estate tax is not in effect may avoid estate tax upon the deaths of both spouses, passing the entire estate to children estate tax free.
GST Tax Concerns
Although the GST tax is also repealed for generation-skipping transfers occurring in 2010, the consequences of any such transfers in subsequent years is far from clear. Transfers in trust are particularly uncertain because many of the rules mitigating the imposition of double GST tax also may have been suspended in 2010 under the 2001 Tax Act. The result could be that property transferred in trust for grandchildren without GST tax in 2010 becomes subject to GST tax in 2011 and thereafter.
The sunset provisions of the 2001 Tax Act state that the estate, gift and GST tax laws are to be applied after December 31, 2010 as if the 2001 Tax Act had never been enacted. The 2001 Tax Act included many provisions affording taxpayers relief in the GST area. Those provisions included an increase in the GST exemption above $1 million indexed for inflation under prior law, automatic allocations of GST exemption to certain types of trusts deemed highly likely to result in future GSTs, and the opportunity to apply to the IRS for relief from inadvertent failures to make appropriate GST elections and allocations. It is unclear whether the sunset provisions of the 2001 Tax Act would, in effect, eliminate those tax benefits retroactively. Therefore, extreme caution should be used when dealing with existing trusts that may be exempt from GST tax and in making GSTs, particularly GSTs in trust, in 2010. Even annual gifts to existing trusts for grandchildren may be ill advised in 2010.
Possible Retroactive Reinstatement of the Federal Transfer Taxes
If the prior inaction of Congress is any indication, it seems possible that the one year of estate and GST tax repeal and reduced gift tax rates may survive. If Congress does act, the resulting legislation may be prospective or retroactive, notwithstanding the potential for challenges on Constitutional grounds. It is worthwhile noting that the U.S. Supreme Court jurisprudence on retroactivity in the tax area is more favorable to the government than to taxpayers. One should be circumspect in planning under the assumption that if the law is made retroactive it would follow the law in place in 2009. While certain members of Congress have suggested that approach, nothing assures it. Therefore, planning that assumes, for example, that if retroactively reinstated, a taxpayer would have a $3.5 million estate tax exclusion and GST tax exemption seems unwise.
The Need for Advice
Addressing all the possibilities effectively probably requires more than the language contained in most estate planning instruments. Many estate planning documents rely heavily on tax concepts and provisions that may not be in effect in 2010. Even existing irrevocable trusts are likely to contain references to provisions of the Internal Revenue Code that were contemplated to be amended or superceded, but probably not repealed. Charitable bequests also could be at risk. A charitable bequest that requires the recipient charity to be qualified for an estate tax deduction, for example, may fail under the literal terms of the instrument if there is no charitable estate tax deduction in 2010. Accordingly, there is no substitute for conducting a comprehensive estate planning review.
Income Tax Consequences During Repeal
Modified Carryover Basis
Prior to repeal of the Federal estate tax, the income tax basis of assets included in a decedent’s gross estate would be “stepped up” (or “stepped down”) to their fair market value at the time of the decedent’s death. In conjunction with the one year repeal of the estate tax, a modified carryover basis regime was adopted. Thus, in 2010, the income tax basis of property acquired from a decedent is the lesser of the decedent’s basis for income tax purposes or the fair market value of the property at the date of death. Under the modified carryover basis system, each decedent has two available basis adjustments which may be allocated by the decedent’s executor to the decedent’s assets. The first is a $1.3 million adjustment which may be applied to any “property acquired from the decedent” (which is specifically defined and may not include all the property that would have been part of the decedent’s gross estate under prior law). A married decedent has an additional $3 million of available basis adjustment that may be applied only to “qualified spousal property.” Qualified spousal property includes property passing outright to a surviving spouse and property passing in trust for the spouse provided the spouse has an income interest for life and no person, including the spouse, may appoint the trust property to anyone other than the spouse during the spouse’s lifetime. Neither basis adjustment may be used to increase the basis of an asset above its fair market value at the decedent’s death. It should also be noted that both basis adjustments apply to increase the basis of an appreciated asset from the decedent’s basis to fair market value at the time of death. They do not operate so as to increase basis of an asset worth the adjustment amount.
Maximizing the Use of the $3 Million Marital Basis Adjustment
In order to take advantage of the $3 million spousal basis adjustment, property must pass to the spouse in qualified form. Therefore, documents that require property to pass to a non-marital trust if the Federal estate tax is not applicable, in an effort to maximize the wealth transfer in an environment of repeal, will forego the opportunity to use the spousal basis adjustment. Assuming that estate planning documents will distribute sufficient assets outright to the spouse or to a qualified marital trust, it may be appropriate to grant an executor broad discretionary authority to allocate assets among the various bequests under the estate plan to maximize the benefit of the basis adjustments. Property not intended to be sold for a significant period of time, for example, may not be a good candidate. In addition, it may be appropriate to review whether the named executor, who is also a beneficiary, would have a conflict of interest exercising such authority.
Maintaining Records in a Modified Carryover Basis Regime
If carryover basis survives for 2010, individuals will need to maintain accurate basis records. Investment assets present far less of a concern than assets that may have been in the family for many years, such as closely held business interests, family real estate or valuable artwork and antiques. Clients should begin assembling records now to reduce the administrative burden on their fiduciaries.
Avoid Requiring the Sale of Assets on Death
An estate plan may require the sale of assets upon the decedent’s death. Requiring the sale of an asset may take an administrative burden off the beneficiaries or may be needed to fund devises, raise cash for administrative expenses and taxes, or avoid family disputes. The decedent might also be a party to a buy/sell agreement or other contract permitting or requiring the sale of assets upon the decedent’s death. Under the law applicable until 2010, a provision requiring of the sale of an asset by the executor could permit the expenses of sale to become deductible for estate tax purposes, and generally did not have the potential to trigger substantial income tax because all assets included in a decedent’s gross estate acquired a new basis equal to fair market value at death. In 2010, a required sale of assets acquired from a decedent may trigger substantial income tax under the carryover basis regime. Accordingly, estate plans or contracts containing sale provisions or put and/or call rights should be reviewed to determine the potential income tax consequences under a carryover basis regime.
LIFETIME PLANNING OPPORTUNITIES
Congressional inertia may have created certain lifetime wealth transfer opportunities. The Federal gift tax rate in 2010 is reduced to 35%. The GST tax is repealed. To date, no legislation has been enacted changing the taxation of qualified personal residence trusts, grantor retained annuity trusts or family limited partnerships. Capturing the opportunities will require an approach that addresses the possibility of retroactive reinstatement of the Federal estate, gift and GST taxes at rates and with exemptions yet to be determined. It is also possible, through continued Congressional inaction, that the law will revert to its status in 2001 with a $1 million exemption (indexed for inflation in the case of the GST tax) and a top Federal rate that for estate tax purposes could reach 60% in some cases. Therefore, one should proceed with appropriate advice. Certain types of gift trusts and transfers that employ new tax formulas will likely be the best approach.
TIME FOR REVIEW
At a minimum, all clients should review their estate planning documents with their advisors in light of the uncertain state of the Federal and state transfer tax laws to determine whether or not:
- the client’s current testamentary estate planning documents would exclude intended beneficiaries or bequests through the use of tax driven word formulas;
- outright bequests should be converted to bequests in trust to address the possibility that repeal remains in effect only for 2010 but not thereafter;
- the executor of a married decedent has sufficient authority or direction to maximize the use of the $1.3 million general and $3 million spousal basis adjustments in the event of death in 2010;
- any of the client’s other estate planning documents contain language that becomes uncertain and therefore likely to result in family controversy when construed in an environment of repeal and possible retroactive reinstatement of the applicable transfer tax laws; and
- estate planning documents or contracts to which the client is a party contain provisions requiring the sale of assets at death.