Effective January 1, 2010, the federal estate tax and generation-skipping transfer tax have been repealed, and basis adjustments applicable to a decedent’s assets have been sharply curtailed. The federal gift tax, however, remains in effect, albeit at a lower rate (35% vs. 45%), and with the existing lifetime exemption ($1,000,000).
The foregoing changes are effective only for 2010, and the federal estate tax and generation-skipping transfer tax are scheduled to be reinstated on January 1, 2011, with higher maximum rates (55% vs. 45%) and lower exemptions ($1,000,000 vs. $3,500,000) compared to 2009, and basis adjustments will revert to 2009 rules.
Barring the prospect of retroactive enactment of legislation reinstating the federal estate tax and generation-skipping transfer tax to January 1, 2010, uncertainty is the governing principle applicable to federal transfer taxes and prudent estate planning.
This Special Client Alert is intended to assist you in dealing with the current unsettled state of the law. It summarizes the radical changes that have occurred and are scheduled to occur, addresses some basic steps you can take to ensure your estate planning takes account of these changes, and discusses what the federal gift, estate, and generation-skipping transfer tax system may look like in the future.
A word of caution is in order. Although we believe that Congress will enact and the President will sign legislation retroactively reinstating the transfer tax law somewhat along the lines in effect in 2009, predictions of that kind have been proven to be hazardous. Neither we nor other knowledgeable experts predicted that Congress would fail to enact legislation to clarify the federal transfer tax system prior to January 1, 2010. Also, the constitutionality of retroactive enactment of “new” taxes - that is, creating new taxes that apply retroactively - is unclear, and will undoubtedly be tested in court if Congress enacts such a retroactive law.
II. Executive Summary
The much-heralded “death” of the estate tax has been exaggerated. We believe that Congress and the Obama administration will act to restore the estate tax in a retroactive manner, so that the estate tax will apply from January 1, 2010, onwards (as if it had never been repealed). Nevertheless, the federal transfer tax system will continue to be the subject of intense partisan politics, and no one can predict what the future holds. We urge you to check for updates in our future client alerts, and we will strive to keep you fully informed.
III. Summmary of Changes in the Law
To understand the current uncertainty in the law, a quick background review is necessary.
A. The Transfer Tax System.
A federal estate tax has been part of U.S. law since 1916. The estate tax is part of the “transfer tax” system, which consists of related taxes that impose a tax when assets are transferred (just as the income tax system charges a tax when income is earned).
There are three separate, but related, transfer taxes. First, the “estate tax” taxes transfers of assets upon death (from the decedent to his beneficiaries). Second, the “gift tax” taxes certain transfers made by a living person. Finally, the generation-skipping transfer (“GST”) tax taxes certain transfers made from a grandparent to a grandchild (and other similar multi-generational transfers).
B. The 2001 Tax Act – Estate Tax.
In 2001, Congress passed significant changes to the transfer tax system. The most important changes were (1) a gradual increase in the exemption that shelters an estate’s assets from the estate tax, and (2) in 2010, a one-year complete repeal of the estate tax. The schedule of exemptions and rates under the 2001 tax act was as follows.
C. The 2001 Tax Act - Gift Tax.
The 2001 tax act also provided that each individual, in addition to the annual gift tax exclusion (which is currently equal to $13,000) and non-taxable payments of tuition and medical expenses, could make lifetime gifts of up to $1,000,000 without incurring a gift tax. The 2001 tax act reduced the maximum rate on such gifts over $1,000,000 from 45% (for 2009 gifts) to 35% for gifts made on or after January 1, 2010.
Even though the estate tax was repealed as of January 1, 2010, the gift tax remains in full effect, although the rate is at a historic low. One reason for retaining the gift tax (even though its sister tax, the estate tax, was repealed) was to deter high net worth individuals (who are subject to high income tax rates) from transferring assets to less wealthy individuals who are subject to lower income tax rates. Congress determined that a gift tax was necessary to prevent attempts to avoid income taxes, which could lead to a serious loss of tax revenue.
In 2011, the gift tax returns to its historic 55% maximum rate, with a $1,000,000 lifetime exemption. The annual exclusion will be equal to $13,000, possibly adjusted for inflation.
D. The 2001 Tax Act – GST Tax.
Similar to the 2001 tax act’s treatment of the estate tax, the 2001 tax act repealed the GST tax, effective on January 1, 2010. Any transfer made during 2010 is not subject to the GST tax, regardless of the number of generations between the transferor and the transferee. However, on January 1, 2011, the GST tax returns with an exemption equal to $1,000,000, subject to an inflation adjustment from the $1,000,000 exemption applicable in 2001 and a top rate of 55%.
IV. Current State of the Law
A. Tax Year 2010.
On January 1, 2010, assuming no retroactive legislation, the following tax law is in effect:
- There is no federal estate tax for persons dying in 2010, but only for 2010.
— The estate of a person who dies in 2010 would not be subject to estate tax. A $10,000,000 estate passing to children could have been subject to a federal estate tax of approximately $3,000,000 if the decedent had died in 2009, leaving a $7,000,000 inheritance for the beneficiaries. The same estate, assuming the decedent dies in 2010, would owe no federal estate tax, and the beneficiaries would inherit the entire $10,000,000, free of federal estate tax.
- There is no GST tax for transfers made in 2010.
— This is another dramatic change. A bequest of $1,000,000 to a decedent’s grandchild, if made under the estate plan of a decedent as a result of her death in 2009, could have been subject to an estate tax of $450,000 and a separate GST tax of approximately $175,000, leaving just $375,000 for the grandchild. The same bequest, made as a result of a decedent dying in 2010, would not be subject to any federal estate tax or GST tax.
- The maximum tax rate on gifts is 35% for gifts made in 2010, down from a maximum tax rate of 45% for gifts made in 2009.
— Unfortunately, the only way to take full advantage of the 2010 repeal of the estate tax is to die. The federal gift tax, which applies to lifetime gifts beyond a $13,000 per-donee annual exclusion, tuition and medical payments, and a per-donor $1,000,000 lifetime exemption, remains in effect during 2010 and beyond.
— The annual exclusion (presently $13,000 per-donee in 2010) will continue to be indexed for inflation, while the lifetime exemption is set to remain at $1,000,000 per donor indefinitely. The only scheduled change is to the maximum gift tax rate, which dropped to 35% for gifts made in 2010.
- With regard to decedents dying in 2010, the income tax bases of a decedent’s appreciated assets are no longer fully adjusted (“stepped up”) to their fair market value.
— Under prior law, the income tax basis of any asset owned by a taxpayer is adjusted ("stepped-up," in the case of an appreciated asset, but also “stepped-down,” in the case of a depreciated asset) at the taxpayer's death to equal the asset's fair market value at that time. This basis adjustment eliminated built-in capital gains, which typically resulted in income tax savings regardless of whether the taxpayer's estate was subject to estate tax.
— For taxpayers who die in 2010, the basis step-up at death is eliminated, subject only to exceptions applicable to the first $1,300,000 of gain in a taxpayer's estate and an additional $3,000,000 of gain on assets bequeathed to (or in a qualifying trust for) a surviving spouse. The decedent’s personal representative (executor or trustee) has discretion regarding the allocation of such increased basis among beneficiaries.
— On the other hand, the basis "step-down" at death for assets with built-in losses will remain in effect for 2010.
— For those with relatively modest estates, the potential tax costs of losing the basis step-up at death will exceed the savings afforded by estate tax repeal!
- The bottom line: No estate tax for now, but don’t uncork the champagne just yet.
B. Tax Year 2011.
The 2010 changes are short-lived. Under current law, if Congress again fails to act, the following changes will take effect on January 1, 2011:
- The estate tax returns, with a maximum rate of 55% and an exemption from the estate tax equal to $1,000,000.
- The maximum tax rate on gifts increases to 55%.
- The GST tax returns, with a maximum rate of 55% and an exemption from the GST tax equal to $1,000,000, subject to inflation occurring since 2001, so that a GST tax exemption of approximately $1,300,000 would apply.
- The income tax bases of assets acquired from a decedent are reset to fair market value.
V. Planning Ideas
In view of the on-again, off-again federal transfer tax system, sensible planning is extremely difficult. A strategy that may work today could lose its effectiveness in less than a year. However, there are some principles to bear in mind.
After the dust settles, your estate plan may not be materially affected by the changes. For instance, if you live until 2011, the current law’s restoration of the estate tax (but at a higher rate and a lower exemption amount) means that your estate plan is probably structured correctly. However, you should at least consider a review of your estate plan based on the following concerns raised by the repeal of the federal estate tax:
A. Immediate Concerns Regarding Gifts to Children and Spouses
- Estate Tax Repealed - All assets pass to descendants, nothing for spouse.
— If you are married and your plan provides that your assets that are free from estate tax will pass to your children or other descendants,1 with the balance to your spouse (in trust or outright), your estate plan arguably will disinherit your spouse. If you die when there is no estate tax, your entire estate will be exempt from federal estate tax and will pass to your descendants under the terms of your estate plan. Nothing will be left to the surviving spouse.
- Estate Tax Repealed - All assets pass to spouse, nothing for descendants.
— In contrast, if you are married and your plan provides for a gift of assets to your children or other descendants equal to the federal estate tax exemption, with the balance passing to your spouse (in trust or outright), your estate plan arguably will disinherit your children from receiving an immediate gift at your death. Because the entire estate passes free of federal estate taxes there is no such tax, and because there is no such federal estate tax exemption in 2010, all of your estate passes to your spouse, and there is no gift made to your children.
- This issue is likely to arise for couples who have children from prior relationships. This issue requires attention regardless of whether the estate tax remains repealed or is restored (with a $3,500,000 tax exemption likely). With a high exemption amount and potentially depressed asset prices due to the 2008-09 recession, we recommend a review of your estate plan if your estate plan makes gifts at your death to your children and your surviving spouse.
B. Income Tax Basis Step-Up.
- If the estate tax repeal remains permanent, you should consider amending your estate plan to include a direction to your personal representative regarding the $1,300,000 income tax basis step-up allocation.
- If you are married, you also may wish to revise the bequests to the surviving spouse to ensure full use of both the $1,300,000 exception and the $3,000,000 spousal exception.
- In any case, you should carefully review your financial records to ensure that you have accurate income tax basis information — a good idea even under current law, but essential in the event the step-up rule ceases to apply.
C. Lifetime Planning Opportunities.
- While interest rates are at an all-time low, many gifting strategies work very well to minimize transfer taxes. In addition, because asset values are currently depressed, making gifts to your descendants now can save significant estate taxes (those assets will likely appreciate and could be subject to significant estate taxes at your death). Finally, there is some danger that Congress will eliminate certain favorable gifting strategies (such as the use of short-term grantor retained annuity trusts and valuation discounts on certain gifts), so that you should start to consider lifetime gifting strategies.
- The 35% federal gift tax rate for gifts made in 2010 is historically low. If it becomes apparent that Congress will take action (or inaction) to allow the estate tax to return to a rate of 45% or even 55%, you may want to discuss lifetime gifts to your descendants. Even though the tax would be due now, a 35% tax rate may be cheaper to pay than a significantly higher 45-55% tax in the future. Further, assuming the estate tax is reinstated, the gift taxes paid will be excluded from your taxable estate, assuming you live more than three years after the date of the gift.
D. Generation-Skipping Transfer Tax Planning.
- We recommend a review of your plan if it presently provides for gifts to grandchildren at death, either by means of a direct gift to grandchildren (or more remote descendants) or trusts for your children that eventually pass to your grandchildren.
- If those gifts are based on the amount of your remaining GST tax exemption, those gifts may not be made if you die while the GST tax is not in effect.
- Although beyond the scope of this Special Client Alert, there may be sophisticated GST tax strategies involving the creation of a special type of irrevocable trust that would benefit your surviving spouse and then your grandchildren, if it becomes apparent that the GST tax exemption will decrease in the future.
E. Conclusions Regarding Planning.
- The confusion over the future of the estate tax should not be a reason to avoid dealing with your estate planning. In fact, due to the current economic conditions and the possibility that any future legislation may eliminate benefits available under certain gifting strategies, now is the time to actively consider your estate planning.
- There is a significant possibility that the estate tax will be reinstated and apply retroactively to January 1, 2010, and that the prior amount of exemption ($3,500,000) will apply. It is also possible that the exemptions from the estate tax will increase. Because the distribution of assets under your estate plan may be keyed to the amount of the estate tax exemption, now may be a good time to review your estate plan.
- Stay informed. The more time that passes without an estate tax or GST tax and with a gift tax at a lower rate, the more likely it is that certain tax strategies will become especially effective. As time progresses, we will alert you as to such special opportunities.
VI. Final Remarks
Congress’s failure to address the transfer tax system has left clients and estate planners in a state of uncertainty, which can only make estate tax planning more difficult. However, tried and true principles such as (a) careful consideration of your estate plan to ensure it meets your desires, (b) consideration of lifetime gifts to your children and other beneficiaries to reduce your taxable estate, and (c) periodic consultation with your advisers regarding your estate plan will continue to prove their worth.