Current federal estate tax law may significantly affect your existing estate plan. Under current law, the one-year repeal of the federal estate tax in 2010, scheduled to be followed in 2011 by a reinstatement of the federal estate tax at 2001 levels, has created considerable uncertainty and may result in your estate planning documents distributing your assets in a manner inconsistent with your wishes. It is important for you to review your estate plan and contact your estate planning attorney to ensure that your existing documents continue to reflect your estate planning wishes, in light of current law.
Federal estate tax under EGTRRA – Repeal in 2010, Reinstatement in 2011
January 2010 brought with it a new year – and an uncertain estate tax landscape. Despite numerous legislative proposals to reform or extend the federal estate tax laws enacted under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), December 2009 ended without the passage of permanent or even temporary transfer tax reform.
Since its passage, EGTRRA has been scheduled to temporarily repeal the federal estate tax for a one-year period beginning January 1, 2010. EGTTRA will then “sunset” in 2011, resulting in the reinstatement of the federal estate tax as if EGTRRA had never been enacted – including an exemption amount of just $1 million and a top marginal estate tax rate of 55 percent. Congress in 2009 considered several proposals that would further modify the estate and gift tax, including proposals that would potentially extend the 2009 $3.5 million exemption amount permanently (thus cancelling the one-year estate tax “repeal” in 2010). Although the majority of commentators believed Congress would act to prevent such a repeal, no legislation was passed, and, under the terms of EGTRRA, the federal estate tax has now been repealed for 2010.
It’s 2010 and EGTTRA is still in effect – what does this mean for your estate plan?
Under current law, 2010 brings significant changes in the taxes that may be due at or following death. Federal estate, generation skipping transfer and gift taxes are affected as follows:
- No federal estate tax in 2010
- No generation skipping transfer tax in 2010
- Gift tax remains in place at a top marginal rate of 35% (decreased from 45% in 2009)
Significantly, although the federal estate and generation skipping transfer taxes have been repealed for 2010, death may cause a new form of taxation: in lieu of an estate tax, the increase in value of assets held by the decedent will, under 2010 law, be captured upon sale of the assets in the form of capital gains tax. This new basis rule is referred to as “modified carryover basis.” Under prior law, heirs received a “step-up” in basis that assigned to inherited assets a basis equal to the value of the asset at the decedent’s death (or in some cases, the value at an “alternate valuation date” six months following the death). Under current law, during 2010 the basis rules change dramatically: instead of receiving a “step-up” in basis, assets will retain the same basis they had in the hands of the decedent (“carryover basis”), which in the majority of cases will be substantially lower than the value at the decedent’s death, resulting in significant capital gains tax exposure upon sale of the assets. The new basis rules do allow for a $1.3 million “step-up” in basis for assets passing to non-spousal beneficiaries; assets passing to a surviving spouse (or a trust for a surviving spouse) may be allocated $3 million in “stepped up” basis.
The new basis rules may present significant challenges. Capital gains will be recognized upon the sale of estate assets, including sale of assets necessary to generate cash for expenses of administration such as payment of debts and tax liabilities. In addition, without proper recordkeeping by the decedent, it may be difficult to determine what the decedent’s basis in the asset was, and in the absence of proper documentation, such basis may be deemed to be zero – resulting in even greater capital gains tax exposure. Even the ability to allocate among estate assets a $1.3 million basis “step up” (or $3 million in the case of assets passing to a surviving spouse) presents uncertainty and risk: the personal representative or trustee may face disagreement from heirs or beneficiaries as to the proper allocation of the available step-up amount, and the resulting anger of heirs unhappy with the personal representative’s decisions regarding allocation. The IRS has issued no regulations addressing the new basis rules.
What is the Impact of 2010 Law on your Estate Plan?
Many estate planning documents prepared before 2010 utilize a formula to allocate assets to a “credit shelter” or “family” trust at death. Often, this formula directs an amount equal to the federal exemption amount (or similarly, “the largest amount not subject to federal estate tax”) to a credit shelter trust, with the remainder of estate assets passing to a surviving spouse and/or children. If your estate plan was created using formula funding to take advantage of then-current law, EGTTRA’s continued effectiveness in 2010 may mean that your plan no longer allocates assets in a manner consistent with your wishes.
For example, if your estate planning documents were created in 2001 – and utilized a formula to fund a credit shelter trust with an amount equal to the federal exemption amount – the credit shelter trust would have been funded with $675,000 in 2001. Now, under current law, if the decedent died in 2010 no federal estate tax would exist, substantially changing allocation of the estate’s assets. In a $3.5 million estate:
- In 2001, $675,000 would pass to the credit shelter trust, leaving $2.825 million to pass outside the credit shelter trust to a surviving spouse or children;
- Under current law, the entire estate would be allocated to the credit shelter trust, leaving no assets remaining to pass outside the credit shelter trust.
This surprising result – the allocation of all assets to a credit shelter trust – could present problems in a number of situations. The credit shelter trust distribution standards may be limited and restrict the amount or type of distributions that may be made to a surviving spouse, resulting in fewer assets being available to the surviving spouse than anticipated. Full allocation to a credit shelter trust may be especially problematic in typical second marriage situations, where a credit shelter trust may benefit the decedent’s children of a prior marriage, with the intention that assets in excess of the federal exemption amount would pass directly to the surviving spouse. In such a case, the surviving spouse may, contrary to the intent of the decedent, receive nothing – opening the door to potential litigation over the proper distribution of the estate.
The temporary repeal of the estate tax should be considered just that – temporary. Married couples in particular should be mindful of the fact that even if there exists no federal estate tax in the year of the first spouse’s death, the estate tax may be reinstated, possibly at a lower exemption level or higher tax rate, by the time of the second spouse’s death. Consideration of this possibility and careful estate planning may help reduce the estate taxes that may be owed at the second spouse’s death.
Minnesota Estate Tax Exposure
The repeal of the federal estate tax for 2010 may cause your estate to pay Minnesota estate tax. Minnesota’s estate tax exemption has remained fixed at $1 million since 2001, and has not increased on par with the federal exemption amount or current repeal. As a result, there now exists Minnesota estate tax exposure on the value of a decedent’s estate in excess of the $1 million Minnesota exemption amount. For example, in a $3.5 million estate, there may exist up to $2.5 million in Minnesota estate tax exposure, depending on how the estate is devised. Formula funding of a credit shelter trust to the maximum federal exemption amount – meaning to the full extent of your estate during the 2010 federal estate tax repeal – could generate a Minnesota estate tax liability of approximately $229,200. Of course, the larger the estate, the greater the potential Minnesota estate tax exposure.
If your estate plan includes a certain type of marital trust commonly called a “QTIP” trust, assets directed to such a trust that would under prior law have been exempt from federal and Minnesota estate tax at the death of the first spouse to die may, in 2010, be subject to Minnesota estate tax – creating the potential for a significant Minnesota estate tax liability at the death of the first spouse to die. A “QTIP” trust is intended to give a surviving spouse an income interest in trust assets, but not the power to independently reach trust principal. Prior to the 2010 repeal of the federal estate tax, the decedent’s executor could make a federal “QTIP election” that allowed assets passing to an appropriately structured QTIP trust to qualify for the “marital deduction” from estate tax (allowing such assets to pass to the QTIP trust free of federal or Minnesota estate tax at the death of the first spouse to die). Under current law, however, there exists no federal estate tax and, accordingly, no federal QTIP election. The Minnesota Department of Revenue has taken the position that because no federal QTIP election can be made under current law, assets passing to a QTIP trust will not be eligible for the marital deduction and will, therefore, be subject to Minnesota estate tax at the death of the first spouse to die. This surprising interpretation may result in many estate plans “losing” the marital deduction and becoming subject to unanticipated Minnesota estate tax at the death of the first spouse.
The federal estate tax repeal may affect your existing estate plan in a number of ways, including how your assets are allocated and whether Minnesota estate tax is payable upon your death. In Minnesota, plans incorporating QTIP trust are a particular concern for 2010. You should review your estate planning documents carefully to ensure they continue to reflect your wishes, taking into consideration current law.
What Happens Next?
It is uncertain to what extent, or when, Congress may act to modify federal transfer taxes. A number of scenarios are possible, including the following: (1) quick Congressional action to restore the federal estate and generation-skipping transfer taxes at 2009 levels, retroactive to January 1, 2010; (2) retroactive restoration of the estate and generation-skipping transfer tax at higher or lower exemption levels, and/or a higher or lower top marginal tax rate; (3) prospective restoration of the estate and generation-skipping transfer taxes, creating a period between January 1, 2010 and the date of effectiveness during which no such taxes were due; or (4) Congressional inaction, resulting in the continued 2010 repeal of the federal estate and generation-skipping transfer taxes and the 2011 “sunset” of EGTTRA. A number commentators have questioned the constitutionality of a retroactive estate tax, and it is widely anticipated that the retroactive application of the estate tax would be challenged in court.
Under current law, EGTTRA is scheduled to “sunset” and the federal gift, estate, and generation skipping transfer tax laws, as well as the “step up” tax basis rules, will be reinstated under the rules that were in effect in 2001 prior to EGTTRA’s enactment, resulting in 2011 in a federal estate tax exemption amount of $1,000,000, a generation-skipping transfer tax exemption amount of $1,340,000, and a gift tax exemption amount of $1,000,000 – along with a top marginal tax rate of 55 percent.
Significantly, the “sunset” of EGTTRA scheduled for 2011 could result not only in the reinstatement of the federal estate tax at a lower exemption rate and higher top marginal tax rate, but also in the reinstatement of state estate tax in a number of states that do not currently have a state estate tax (resulting from the “decoupling” of the federal and state estate taxes under EGTTRA). If you are a resident of a state other than Minnesota, you should contact your estate planning attorney to determine whether your estate plan will reflect your wishes if your state of residence reinstates or otherwise modifies its state estate tax.
2010 Roth IRA Conversion Opportunity
Another opportunity presents itself in 2010 for individuals of all income levels to convert traditional IRAs (and certain 401(k) and 403(b) plans) into Roth IRAs. In 2010, an individual may convert a qualified account to a Roth IRA and may defer income tax liability on such conversion until the filing of the individual’s 2011 income tax return – at which time the individual may elect to spread the income tax liability equally over the 2011 and 2012 tax returns. Importantly, the conversion may be “recharacterized” prior to the due date for filing the 1040 for the year of conversion, allowing the individual the opportunity to essentially “undo” the conversion if so desired – eliminating the income tax liability associated with the conversion.
This recharacterization opportunity may serve as a good chance to review the conversion with the benefit of some hindsight to determine whether the conversion and associated tax liability were appropriate for the individual’s circumstances.
Additional proposed changes to federal law
Grantor retained annuity trust (GRAT)
A GRAT allows an individual (the “grantor”) to transfer ownership of rapidly appreciating assets to an irrevocable trust and retain an annuity interest for a trust term of a specified number of years. GRATs often are funded with highly volatile assets that are expected to appreciate at a rate in excess of the theoretical interest rate set forth by the IRS. Often, successful GRATs have a short term of two to three years. At the end of this trust term, the remaining property passes to the remainder beneficiaries of the trust. If properly structured, a GRAT may incur no gift tax at funding, allowing the grantor to pass on substantial assets to the GRAT beneficiaries free of gift tax.
In order to realize the tax benefit of a GRAT, the grantor must survive the trust term. Currently, GRATs often are structured with a term of as little as two years; however, proposed legislation would require a minimum ten-year term. This term change would reduce the likelihood that GRAT assets would “outperform” the IRS theoretical interest rate over the duration of the trust period. Further, this increased minimum term may reduce the likelihood that the grantor will survive the trust term, therefore limiting the success of a GRAT as an estate planning tool.
Stock concentrations, certain real property holdings and other business interests may be ideal assets for funding a GRAT. Clients who may be interested in creating a GRAT under current law are encouraged to contact us to determine whether this estate planning technique is right for you.
Family Limited Partnerships (FLP)
An FLP is a sophisticated estate planning tool that may allow an individual to pass assets to family members at a substantial gift tax “discount.” In an FLP, the donor makes gifts of nonvoting or limited partnership interests to family members, while maintaining a voting or general partner (controlling) interest.
While there are many non-tax reasons for creating FLPs, part of their appeal lies in the fact that, for estate tax purposes, the value of a non-voting or limited partnership interest may be discounted by approximately 20-40 percent (or more) for lack of marketability, minority interest and lack of control. Proposed legislation, however, would place new limitations on valuation discounts in FLPs, significantly decreasing or, in some cases eliminating, valuation discounts and the accompanying transfer tax savings.
Individuals who may be interested in creating a Family Limited Partnership are encouraged to contact us to discuss the proposed legislation and whether creating a Family Limited Partnership under current law would be of benefit to you.
Estate planning opportunities in a down economy
The recent economic downturn has created several opportunities for estate planning. With asset values down, now may be a good time to consider transferring the assets, and future appreciation on the assets, from your estate.
Qualified personal residence trust (QPRT)
A personal residence trust may allow you to transfer substantial appreciation on your homestead or vacation residence, free of gift tax.
Historically low interest rates and depreciated asset values may present an excellent opportunity to transfer wealth with little or no gift tax consequences.
If you have an existing GRAT that was adversely affected by the economic downturn, now may be an ideal time to consider a “re-GRAT” by substituting less volatile assets for the assets in your current GRAT, then using the more volatile assets to fund a new GRAT.