No doubt you have heard that the federal estate and generation-skipping taxes have been repealed for 2010, and while the federal gift tax remains, its rate drops from 45% to 35%. We believe this is a temporary reprieve, and Congress will act this year to restore these taxes. In fact, there is a very good chance there will be no reprieve at all because when Congress does act to restore the taxes, it will do so retroactively to January 1 of this year, meaning anyone who dies or makes a gift in 2010 will receive no benefit of the tax repeal or gift tax reduction. When Congress will act is hard to predict. We know that if nothing is done by year-end, the estate and generation skipping taxes will be automatically reinstated January 1, 2011.

Does this mean clients should generally ignore the current state of affairs and wait until these taxes are restored, most likely at the 2009 rates and exemptions? Yes, if we could be certain the taxes will be restored retroactively to the beginning of this year. However, since we can’t be sure about retroactive effect, failure to take some corrective measures now may leave you with a less than optimum estate plan, but only if:

  1. Congress fails to restore the tax retroactively to January 1 of this year,
  2. You are married, and
  3. You or your spouse dies this year before the effective date of the restoration of these taxes. If all of these were to occur, the provisions contained in your current will or revocable trust may, given the repeal of the estate tax, have two unintended effects.

First, the amount set aside in a “marital trust” for your surviving spouse may be smaller than you intended. In many cases, this is not an issue because the amount by which the marital trust is reduced is merely reallocated to a “family trust” for the benefit of your surviving spouse and children anyway, so there is no material disadvantage to the surviving spouse.

Second, the capital gain tax that your family might ultimately pay on the sale of any of your assets could be greater than you anticipated because the repeal of the estate tax precludes a “basis step-up” at death. As much as $4.3 million dollars of gain may be exempt if your will or revocable trust contains appropriate language to that effect.

So, if you are married and have reason to believe you or your spouse may die before Congress acts to restore the federal estate tax, we recommend that your current documents be reviewed to determine whether a corrective amendment is necessary to cover any gap between January 1, 2010 and the effective date of the restored tax law.

Also, regardless of whether you are married and whether you or your spouse may die this year, two additional items are worth noting:

  1. We recommend that grandparents postpone making annual exclusion gifts to any existing trust for a grandchild. Such gifts should be made only after certain technical issues are clarified which we expect will occur later this year. You may, however, continue to make annual exclusion gifts directly to adult grandchildren or to a custodian account under a Uniform Gifts (or Transfers) to Minors Act.
  2. If you are willing to bet that the restoration of the generation-skipping tax (i.e., the special tax applicable to gifts made to grandchildren) or the 45% gift tax rate will not be retroactive to January 1 of this year, there are some strategies that may be implemented before Congressional action to restore those taxes. We’d be happy to discuss them with you.

Finally, if you have not decided to leave your existing IRA to charity, we’d like to remind you about the opportunity to roll-over all or a portion of your IRA to a Roth IRA this year. The benefit of a Roth roll-over is that all future income and gain earned on the rollover amount is free of federal income tax, as are all future withdrawals.

In the past, a roll-over was only available for taxpayers with adjusted gross income of $100,000 or less, but beginning in 2010, the $100,000 limit disappears. Because the amount rolled over becomes currently taxable as ordinary income, the strategy generally makes sense only if you (i) have excess ordinary losses available in 2010, or charitable deductions (including any pledges you may choose to accelerate) or (ii) believe future ordinary income tax rates and investment performance will be high enough to justify the current tax expense of the roll-over.