“It was the best of times, it was the worst of times; it was the age of wisdom, it was the age of foolishness; it was the epoch of belief, it was the epoch of incredulity; it was the season of Light, it was the season of Darkness; it was the spring of hope, it was the winter of despair; we had everything before us, we had nothing before us; we were all going directly to Heaven, we were all going the other way.”

So began A Tale of Two Cities by Charles Dickens, an epoch novel set in London and Paris during the French Revolution.

While A Tale of Two Cities was written in 1859, Dickens could just as well have been writing about the transfer tax regime of the United States in 2010. The one year repeal of the estate tax that the vast majority of trust and estate practitioners thought would never come to fruition is almost over. This year has been the best of times because it has offered many potentially unique opportunities for planning particularly with regard to the generation skipping transfer tax. But it has also been the worst of times with the specter of retroactive legislation hanging over us, formula clauses imbedded in most sophisticated testamentary instruments which could potentially result in dire unintended consequences absent remedial legislation enacted by the states, uncertainties about compliance with a one year experiment in carryover basis, and an unresolved estate tax structure for 2011 and the years to follow.

Opportunities and Uncertainties

Grantor Retained Annuity Trusts (GRATs)

It is difficult to imagine a better environment for GRATs. To the extent that the total return on a GRAT exceeds the “hurdle rate” set monthly by the Internal Revenue Service (IRS), the excess return can pass transfer tax free to the next generation. At present, the hurdle rate is less than 2.0 percent. At the same time, stocks are recovering from one of the most severe downturns in history and the S&P 500 is up nearly 7.5 percent year to date.

It should be noted, however, that Congress has entertained legislation this year that would require a minimum term of 10 years for GRATs and has also considered prohibiting the establishment of so-called “zeroed out GRATs” which are calculated to yield no taxable gift on formation. While this legislation was not enacted, it may be revisited in the foreseeable future as part of a compromise package. These potential restrictions on GRATs also make 2010 an ideal time to take advantage of this popular estate planning vehicle.

Lifetime Gifts

Generally speaking, donors are hesitant to make gifts which exceed their annual gift tax exemption of $13,000 per donee and their lifetime exemption of $1 million. However, there are two often overlooked benefits to making taxable gifts. First, the donor does not pay tax on the gift tax paid in order to make lifetime transfers. Second, any appreciation in the value of gifted assets in the hands of the donee avoids the imposition of transfer tax. These two factors combined with a federal gift tax rate of 35 percent in 2010 make this an extraordinary time for making lifetime gifts. The gift tax rate is scheduled to increase to 55 percent in 2011.

Generation Skipping Transfers

The one year repeal of the generation skipping transfer (GST) tax, coupled with low gift tax rates, has made 2010 an ideal time for making outright gifts to grandchildren. Grandparents’ concerns about placing substantial assets in the hands of young or financially immature grandchildren may be addressed in part through the use of structures such as FLPs and LLCs.

In addition, the absence of the GST tax has provided a brief window in which certain trusts not exempt from this tax might be terminated. Thus, all non-exempt GST trusts should be reviewed to determine whether such an early termination is both possible under the terms of the governing instrument and advisable given the objectives of the particular trust and the family dynamics.

Administration of Estates of 2010 Decedents

While many extremely wealthy citizens died during 2010 and their estates stand to benefit substantially from the one year repeal of the estate tax, it is rarely reported that their executors have been put in the untenable position of complying with tax reporting requirements for carry over basis on forms which have yet to be released by the IRS. In many estates with low basis assets, particularly those where there are surviving spouses, the capital gains taxes imposed in 2010 exceed those that would have been paid had the estate tax been retained.

The Outlook for 2011

Dickens’ setting of the French Revolution is also apropos to what’s going on in Washington, D.C. today given that the debate over the fate of the estate tax has been rife with the rhetoric of class warfare. The well entrenched gridlock on the subject of the estate tax stems from the diametrically opposed views of Democrats and Republicans.

  • The Democrats’ view is that in difficult economic times those who have thrived and become wealthy should be willing to pay more taxes and thereby provide benefits for the less fortunate.
  • The Republicans’ view is that the federal government is profligate in its spending and that it is disruptive to family-owned enterprises to impose a “death tax” of approximately 50 percent when such businesses are transitioning to the next generation.

Truth be told, there is some merit to both positions.

If no action is taken by Congress with regard to the estate tax prior to January 1, 2011, the exemption will plummet to $1 million and the maximum rates will rise to 55 percent. While such a drastic change from the estate tax regime of 2009 would make the estate tax a reality for many middle class American families, legislators have been preoccupied with the possible extension of the Bush-era income tax reductions.

Nonetheless, as we go to press, President Obama and Republican leaders in Congress have reached a tentative agreement on estate taxes which calls for a $5 million exemption and a top rate of 35% for the next two years. This agreement represents a substantial increase in the 2009 exemption of $3.5 million and a substantial reduction in the 2009 rate of 45%. Republicans are referring to the agreement as a compromise, but many Democrats have disdainfully referred to it as a capitulation and have vowed to oppose this aspect of the agreement. If the agreement reached on estate taxes is enacted into law, it will provide some certainty for the next 24 months. However, the President has already signaled his plans to make the need for increased revenue to address the growing budget deficit a major priority in his campaign for re-election, and thus the debate is expected to continue.

Dickens brings A Tale of Two Cities to a close with a fitting quote for those thinking of revisiting their estate plans in this time of change. “It is a far, far better thing that I do, than I have ever done; it is a far, far better rest that I go to than I have ever known.”

A modest investment of time and money devoted to updating your estate plan now can be expected to yield substantial tax savings for your family, will provide you with peace of mind for years to come and will be seen as one of your most considerate and caring acts.