Under current law, the amount that an individual can pass to his or her heirs free of Federal estate tax (the “applicable exclusion amount”) is $2,000,000, and the highest Federal estate and gift tax rate in 2008 is 45%. Unless Congress acts to provide permanent estate tax relief, the estate tax applicable exclusion amount will increase to $3,500,000 in 2009 and the estate tax will be repealed for one year only in 2010. After that, the estate tax applicable exclusion amount will decrease to $1,000,000 (adjusted for inflation), and the highest Federal estate and gift tax rate will increase to 55%.
Unlike the changes to the estate tax applicable exclusion amount, the lifetime exclusion from gift tax remains constant at $1,000,000. That is, every individual may make gifts (in excess of the annual gift tax exclusion amounts and payments of education and medical expenses directly to the providers) of up to $1,000,000 in the aggregate during his or her lifetime, before having to pay any gift tax. This $1,000,000 threshold does not apply to gifts between spouses, which are not subject to gift tax. As a result, there is no limit on the amount of gifts spouses may make to one another so long as the receiving spouse is a U.S. citizen or resident.
The current Federal estate tax laws have led to uncertainty and made it difficult for people to predict how their estates will be impacted by the tax. There have been several proposals in recent years to revise the Federal estate tax laws, ranging from complete elimination of the Federal estate tax to increases in current exemption amounts coupled with reductions in the tax rate.
In order to avoid a one-year repeal of the Federal estate tax in 2010 followed by the reinstatement of pre-2001 law in 2011, Congress must act in 2009. Last Spring, the Senate Finance Committee held hearings on possible reforms to the Federal transfer tax system. Those hearings provide clues as to the type of action Congress may take. A few of the more likely scenarios follow.
Continuance of the Estate Tax. The tax plans of both Senators McCain and Obama call for a continuation of the Federal estate tax regime in 2010 and beyond. Senator Obama’s plan (set forth at his website) would make the 2009 exclusion amount and rate permanent. In other words, we would have a $3,500,000 estate tax exclusion per person ($7,000,000 per married couple), and a maximum estate tax rate of 45%. Senator McCain has not endorsed any particular proposal, but has indicated support for a plan that would increase the estate tax applicable exclusion amount from $3,500,000 to $5,000,000 per person (up to $10,000,000 million per married couple) and would lower the estate tax rate to match the capital gains rate (currently, 15%).
Portability of the Estate Tax Exclusion and the GST Tax Exemption. A “portable” estate tax exclusion means that any unused portion of a deceased person’s applicable exclusion amount would be made available to his or her surviving spouse. If the applicable exclusion amount is portable, then couples who either are unable or fail to sever jointly owned assets or transfer assets from the wealthier spouse to the less wealthy spouse before the death of the first spouse may take advantage of each spouse’s applicable exclusion amount. In other words, the estate tax applicable exclusion would no longer be a “use it or lose it” provision. (Such portability would be applicable only once, thus eliminating the multiple successive marriage ploy.)
For example, if a married couple has assets of $4,000,000 held in a joint brokerage account, the standard estate planning recommendation for 2008 under present law would be to create a $2,000,000 account in husband’s name, and a $2,000,000 account in wife’s name. Upon the death of the first spouse, the $2,000,000 in his or her sole name would be held in a Family or Credit Shelter Trust for the benefit of the surviving spouse and the couple’s children for the life of the surviving spouse. On the death of the surviving spouse, all of the assets (including any growth) remaining in the Family or Credit Shelter Trust, together with the $2,000,000 (assuming neither growth nor discrimination) in the surviving spouse’s sole name will pass, free of any estate tax, to the couple’s children.
Without such planning, on the first spouse’s death, the jointly held assets pass to the surviving spouse. As a result, the first spouse’s $2,000,000 exemption is not used. Instead, the surviving spouse has $4,000,000 in his or her estate, only $2,000,000 of which is exempt from estate tax on the surviving spouse’s death. If a portability provision were in place, then the surviving spouse’s estate would be entitled not only to the surviving spouse’s $2,000,000 exemption, but also to the deceased spouse’s $2,000,000 exemption.
Note: It is important to remember that, even with a portability provision, having assets set aside in the Family or Credit Shelter Trust on the death of the first spouse is beneficial. If a Family or Credit Shelter Trust is created, the appreciation of trust assets will escape estate tax at the death of the surviving spouse. Thus, if the $2,000,000 of assets in the trust grow from $2,000,000 to $5,000,000 by the time of the surviving spouse's death, the entire $5,000,000 is exempt from estate tax. Had the $2,000,000 passed directly to the surviving spouse, the $3,000,000 of appreciation would be subject to estate tax at the surviving spouse's death.
Reunification of Estate and Gift Tax Exemptions. Since 2001, the Federal estate tax exclusion and the generation skipping transfer (GST) tax exemption amounts gradually have increased from $1,000,000 to $3,500,000, while the lifetime exemption from gift tax has remained constant at $1,000,000. The discrepancy between the gift and estate tax exclusions creates a disincentive to engage in business succession planning during life, as business interests passed to the next generation by gift could trigger a gift tax liability, while those same interests potentially could pass free of estate tax if held until the grantor’s death. Reunification of the estate and gift tax exclusions would promote simplicity and would not hinder the lifetime transfer of family businesses.
Elimination of Minority Interest Discounts. The Democrat-controlled Congress is concerned with ensuring that any decrease in revenue collection is offset by a comparable revenue-raising measure. Portability of the estate tax exclusion amount, higher exclusion amounts and reduced tax rates all will reduce the revenue of the Federal government. To help “offset” these revenue reductions, one oftenmentioned proposal is to eliminate or curtail the use of valuation discounts when transferring minority interests in entities that are not “active” trades or businesses to family members.
For example, if Client owns 80% of the interests in a limited liability company (“LLC”) holding passive investments, and the LLC’s value is $100,000, Client’s 80% interest has a value of $80,000. Under current rules, if Client gives a 20% interest to each of her two children, those interests should be valued at a discount to take into account the inherent lack of control and lack of marketability associated with a minority interest in the LLC. Under the Senate Finance Committee proposal, the value of each 20% interest for transfer tax purposes would be one-quarter (20/80) of the value of Client’s 80-percent interest, or $20,000. This value is a pro-rata share of the value of Client’s controlling interest and does not reflect any minority or lack of marketability discount.
If you have been planning a transfer of a family business entity to the next generation and would like to utilize valuation discounts, you should consider completing the transfer in the 2008 tax year. Any legislation enacted in 2009 could be effective retroactive to the first of the year.