In 2010 a whole new set of tax rules could apply to gifts and assets passing from estates.

The U.S. federal transfer tax system just found itself unceremoniously dumped on the side of the road by a Congress that sped off to attend to health care and other matters before the New Year. What just happened and what does this all mean to you?

Answer: (1) if no retroactive changes are made, in 2010 a whole new set of tax rules will apply to gifts and assets passing from estates; (2) Congress could change these rules in 2010 and may or may not make the new rules retroactive to January 1, 2010; and (3) if Congress does nothing to these rules in 2010, starting on January 1, 2011, yet another set of rules—those in place prior to 2002—will be reinstated.

Starting in 2010 (subject possibly to a retroactive change):

  • Estate tax – it’s repealed.
  • Generation-skipping tax – it’s repealed.
  • Gift tax – still applies, but the tax rate drops from the 2009 rate of 45% to 35%. The lifetime gift tax exclusion remains at $1 million. The annual exclusion remains unchanged at $13,000 per donee.
  • Carryover basis – beneficiaries take the decedent’s income tax basis in estate assets so that an appreciated asset, while not subject to estate tax, will be subject to income tax when the recipient sells it. To partially offset this result, however, each estate will be allowed up to $1.3 million of additional basis, plus an extra $3 million of basis for qualifying bequests to a spouse.

Starting in 2011 (assuming Congress takes no action to change this):

  • Estate tax – it’s reinstated with a maximum rate of 55% (compare 2009’s maximum rate of 45%). The exemption at death is reduced to $1 million (compare the 2009 exemption of $3.5 million).
  • Generation-skipping tax – it’s reinstated at a flat rate of 55%. The GST exemption returns as an inflation-adjusted $1 million—approximately $1.3 million (compare the 2009 exemption of $3.5 million).
  • Gift tax – the maximum tax rate increases from 35% to 55%.
  • Basis – the longstanding rule of adjusting the income tax basis of a decedent’s assets to the value of the asset at death is reinstated.

What’s next?

We do not know. Members of Congress have promised to act early in January 2010 to pass retroactive legislation to eliminate any gap in the transfer tax system. Whether that will come to pass, and if so whether that action will survive a constitutional challenge, we also don’t know. We do know this: if Congress takes no action, the more onerous pre-2002 transfer tax regime will be reinstated in 2011.

What do the law changes mean to you?

There are two main questions for you. One is how does your existing estate plan operate if you die in 2010 assuming no further changes in the law? Second, are there opportunities for wealth transfer in 2010 that some may want to take advantage of prior to a change in the law?

Many estate plans may need to be amended

Many existing estate plans are built around formulas that refer to the pre-2010 estate and generation-skipping tax regimes. These formulas may not operate as intended if death occurs when the estate and generation-skipping taxes are not in effect. Depending on the formula, the result could be that more property is allocated to the children and less to the spouse, or vice versa.

It is possible also that the current formulas will not readily accommodate the full additional basis that will be available under the new carryover basis rules ($1.3 million general addition and $3 million for qualifying transfers to a spouse).

For these reasons, you may want your plan reviewed starting in early 2010. While your plan may contain directions as to how your formulas should operate if there is no estate tax at your death, you may want to review the result to see if it is appropriate at this time. You may wish to make a change that would only apply if death occurs when the scheduled 2010 regime is in place. That way, if the estate and GST taxes are reinstated, or if the pre-2002 regime returns as presently scheduled in 2011, the provisions will adjust or deactivate as appropriate so that the existing formulas in the estate plan documents will cover all of the likely possible tax regimes.

We do not know if or when Congress will act to resolve the uncertainty that it has created. If Congress acts early in 2010, the time and expense incurred in reviewing or revising estate plans during any gap period may prove to have been unnecessary. Because of this possibility, many individuals, particularly those who are in good health, may decide simply to take no action and thus incur no fees until the transfer tax landscape becomes more certain.

Possible wealth transfer planning opportunities

The reduction in the gift tax and the elimination of the generation-skipping tax may be only temporary if not retroactively reinstated, and if so, a window for planning opportunities may exist in 2010. For instance, individuals who have been considering a taxable gift may be able to reduce their gift tax bill by making a taxable gift at the new 35% rate rather than the 55% rate scheduled for 2011. Transfers to grandchildren may only be subject to gift tax and not the additional 55% generation-skipping tax that can apply under 2011 law. It might be possible to create trusts for the ultimate benefit of multiple generations that will not be subject to a reinstated generation-skipping tax. Any such planning will be complicated and risky because of the real possibility of retroactive transfer tax legislation in 2010.