As you probably have heard, the Federal transfer tax (estate, gift and generation-skipping transfer tax) system is currently in a state of great uncertainty.
- Current State of Affairs
As things now stand, unless Congress takes action to change this:
Estate Tax: There will be no Federal estate tax for persons dying in 2010. On January 1, 2011, the estate tax returns, with a maximum applicable exclusion (sum of taxable gifts made during life and assets passing estate-tax-free at death) of $1 million (down from $3.5 million in 2009) and with a top tax rate of 55% (up from 45% in 2009), and a 5% surcharge for certain large estates.
Income Tax: There will be no “step up” in basis for the assets of a person who dies in 2010. Income tax basis is the value from which gain or loss on assets sold is measured. In general, prior to 2010, the income tax basis of an asset was reset at the death of the owner to the date of death value. In 2010, there will be no automatic resetting of basis. Instead, the decedent’s income tax basis in assets will “carry over” to the persons who inherit the assets. Fortunately, there are some statutory adjustments that can be made to this carry over basis – a $1.3 million adjustment for assets passing to anyone and an additional $3 million adjustment for certain assets passing to or for the decedent’s spouse. On January 1, 2011, the basis “step up” rules will apply again.
Generation-Skipping Transfer Tax (“GST”): The tax code provisions regarding the GST (the tax on assets passing to persons more than one generation younger) will not apply during 2010, but will apply again starting in 2011. This gap in a donor’s ability to apply GST exemption during 2010 may affect, in ways we cannot now fully predict, persons who make gifts in 2010 to trusts (such as to irrevocable life insurance trusts) that may ultimately pass to their grandchildren (or others treated for GST purposes like grandchildren). In 2011, the exemption from the GST will be reduced from $3.5 million in 2009 to $1,060,000, increased by an inflation factor.
Gift Tax: The gift tax continues in effect, with a rate of 35% (down 10% from the 45% rate in 2009), and an applicable exclusion of $1 million (total amount of taxable gifts that may be made without paying gift tax). Starting in 2011, the maximum tax rate will be 55%, with a 5% surcharge for certain large gifts.
- When Will Congress Take Action and What Will It Do?
The answer to this question is a resounding: “No one knows.” Ultimately, members of Congress must craft a tax law that a majority of both Houses can support. That may happen in 2010, but many knowledgeable observers now believe it will not happen in 2010, and may not happen until well thereafter. In the interim, Congress may temporarily reinstate the law in effect in 2009. Whether Congress crafts new tax law or temporarily reinstates the law in effect in 2009, it may attempt to do so retroactively (such as to January 1, 2010). Either way, there will likely be court cases challenging the constitutionality of any retroactive change. An alternative scenario for the interim period is that Congress will do nothing until it has enough votes for a permanent change to the tax law.
- What Should Individuals Do in This Period of Uncertainty?
It is important for you to consider contacting us, to have us review your estate planning documents, and then meet or talk with you to discuss how this uncertainty may affect the estate plan you currently have in place and what changes you might want to consider making during this period while Federal transfer tax matters are uncertain. Some examples (not an exhaustive list) of ways in which the current state of the law could adversely affect your estate plan include the following:
- Disposition Depends on Transfer Tax Concepts: Your estate planning documents may refer to transfer tax concepts in determining who gets what and how much at your death.
Plans Using Marital Deduction: The Trust Agreements (or Wills) of married couples often divide the estate of the first spouse to die into two portions. One portion is equal to the deceased spouse’s unused estate tax applicable exclusion. The remaining assets comprise the other portion and are protected from estate tax by the marital deduction on the first spouse’s death. Under this type of plan, estate tax can be avoided entirely on the first death, and the estate tax applicable exclusion portion also escapes estate tax at the death of the surviving spouse. In some estate plans, the entire applicable exclusion portion passes to persons other than the surviving spouse (for example, to the children). If the Trust or Will formula for dividing the estate would allocate all of such a decedent’s assets to the applicable exclusion portion when no estate tax is in effect, the surviving spouse could inadvertently be “disinherited.”
Plans Using Charitable Deduction: Some individuals structure their Trusts or Wills to provide that at their deaths (or the death of a surviving spouse), individuals (children or others) will receive the applicable exclusion amount and charities will receive the remainder because there is an estate tax deduction for assets that pass to qualified charities. If the formula for dividing the estate would allocate all of such a decedent’s assets to the applicable exclusion portion when no estate tax is in effect, then the charities would be “disinherited,” or, if the formula works in reverse, the individuals would be “disinherited.”
Plans Using GST Exemption: Some Trusts or Wills provide that the amount that can be protected from the GST by the decedent’s GST exemption will pass to certain trusts or individuals, and assets in excess of that exemption will pass differently. If the provision regarding the GST exemption has no effect when a person dies, the ultimate disposition may not be what the decedent desired.
- Income Tax Planning: If a portion of a married person’s Trust benefits the surviving spouse and children or does not require all of the income to be distributed to the spouse, that Trust will not qualify for the $3 million additional basis adjustment for spouses. For clients with significant, low basis assets, it may make sense to amend the Trust to benefit only, and to require income distributions to, the spouse during this interim period.
- Gift Planning: Some individuals may wish to consider making large gifts during a period in which the gift tax rate is at 35% and there is no GST. Prior to doing so, one should take into account the possibility that the gift tax rate could be increased and the GST reinstated retroactively, and analyze techniques that could mitigate risk should that happen.
- GST Planning: Many people have irrevocable Trusts to which they make annual contributions, such as irrevocable life insurance Trusts. These individuals should consider whether to suspend gifts for 2010 or loan, rather than gift, funds to the Trust during this period when no GST exemption may be allocated to Trusts.