As 2010 rapidly approaches, the future of the Federal estate and gift tax continues to be uncertain. The estate tax exemption is $3,500,000 for individuals who die in 2009. Under current law, in 2010, there will be no estate tax imposed, and the familiar step-up in basis rule will be replaced with a somewhat complex carry-over basis regime. In 2011, the pre-2001 estate and gift tax law returns, which includes, among other changes, an estate tax exemption amount of only $1,000,000.
Both President Obama and the U.S. Congress have expressed interest in modifying the estate and gift tax laws to avoid the uncertainty and inconsistency of the present law. On January 9, 2009, Representative Earl Pomeroy (D-N.D.) introduced H.R. 436, the “Certain Estate Tax Relief Act of 2009” (“H.R. 436”). On January 14, 2009, Representative Harry Mitchell (D-AZ) introduced H.R. 498, the “Capital Gains and Estate Tax Relief Act of 2009” (“H.R. 498”). An overview of the key features of both pieces of legislation follows.
H.R. 436: Certain Estate Tax Relief Act of 2009
The relatively straightforward H.R. 436 includes the following features: an exemption amount of $3,500,000 per individual, a maximum estate tax rate of 45% for estates up to $10,000,000, permanent incorporation of most of the 2001 estate and gift tax law changes and new limitations on valuation discounts.
Imposition of the Estate and Gift Tax
H.R. 436 makes permanent most of the Federal estate tax, gift tax, generation-skipping transfer tax and the step-up (or step-down) in basis rules applicable in 2009. The estate tax would continue to be imposed on estates valued at $3,500,000 or above. The maximum rate of estate tax for estates valued up to $10,000,000 will continue to be 45%. However, estates valued in excess of $10,000,000 will be subject to an additional 5% tax, not to exceed $3,619,200. Furthermore, gifts to individuals, other than a spouse, up to an aggregate lifetime amount of $1,000,000, will be exempt from the Federal gift tax. All other changes introduced in the 2001 tax legislation (and any modifications to those provisions made during the interim period) are made permanent. These provisions would be effective for decedents dying and gifts made after December 31, 2009.
Changes to Valuation Rules
A significant feature of H.R. 436 is its proposed modification to the rules applicable to valuing the donor’s interest in a family limited partnership or limited liability company (“FLP”) that holds investment assets.
First, the legislation disallows any discount for minority interests in an FLP that is controlled by the donor’s “family members”. For purposes of the rule, “family members” include the donor’s spouse, parents, grandparents, children, grandchildren, more remote descendants and the spouses of the donor’s children, grandchildren and more remote descendants. Second, “nonbusiness assets” held in the FLP will be valued as if the assets had been transferred directly by the donor to the donee. Nonbusiness assets are any assets not used in an active trade or business. There is an exception for real estate that is used to conduct a trade or business (such as development) in which the transferor materially participates.
To illustrate this proposed rule, assume that an FLP owns $2,000,000 worth of stocks and bonds. Absent the legislation, if the donor transferred a non-managing 10% interest in the FLP to his daughter, depending upon the terms in the FLP Agreement, the value of the interest might be discounted by about 35% for lack of marketability, minority interest and lack of control. Thus, for gift tax purposes, the value of the 10% interest would be $130,000, rather than $200,000. However, under the proposed legislation, the donor will instead be treated as having transferred 10% of the stocks and bonds to his daughter, which would be valued at $200,000, as no discounts would be available.
The effective date for the new valuation provisions is the date of the legislation’s enactment.
H.R. 498: Capital Gains and Estate Tax Relief Act of 2009
The notable features of H.R. 498 include: a permanent reduced capital gains tax rate; the phasing in of a $5,000,000 estate tax exemption; the elimination of the Federal estate tax deduction for state estate taxes; the unification of the estate and gift tax; and “portability” of the estate tax exemption for spouses. H.R. 498 also allows several of the 2001 estate and gift tax laws to sunset as of December 31, 2010. The current step-up (or step-down) in basis rule, however, is made permanent.
Capital Gains Tax
H.R. 498 makes permanent the reduced capital gains tax rates enacted in 2003. Generally, this rate is 15%. However, the legislation eliminates the taxation of dividends at capital gains tax rates.
Imposition of the Estate Tax
Under H.R. 498, the estate tax exemption would increase in increments to $5,000,000 by 2015. After 2015, the $5,000,000 exemption would be adjusted for inflation in $50,000 increments. The rate of the estate and gift tax would be tied to the capital gains tax rate. Estates valued up to $25,000,000 would be subject to a tax at the 15% capital gains rate. Estates that exceed $25,000,000 would be subject to a tax at two times the capital gains rate, or 30%. The $25,000,000 value used for determining the rate of tax would be adjusted for inflation as of 2015 in $50,000 increments.
H.R. 498 repeals two notable deductions. First, it takes away the Federal estate tax deduction for state estate taxes paid. Second, it repeals the deduction for family owned business interests currently available under the tax law.
H.R. 498 introduces the concept of “portability” to the estate tax system. This means that when a spouse dies, the estate tax exemption of the surviving spouse is increased by the deceased spouse’s unused exemption. For example, assume that Hank and Whitney are married and do not make any taxable gifts during their lifetimes. Hank dies in 2015 (when the exemption is $5,000,000) with a taxable estate of $3,000,000. Whitney dies in 2017 (when the exemption is $5,000,000) with a taxable estate of $10,000,000. Whitney will be able to pass $7,000,000 worth of assets from her estate free of Federal estate taxes. This $7,000,000 amount includes Whitney's exemption of $5,000,000 plus the $2,000,000 of exemption that Hank did not utilize upon his death.
Both H.R. 436 and H.R. 498 have been referred to the House of Representatives Committee on Ways and Means. As of the date of this article, the Committee has not scheduled a markup, hearing or other action relevant to either bill. H.R. 436 has no co-sponsors. H.R. 498 is co-sponsored by Mark Kirk (R-IL) and Glenn Nye (D-VA).