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TAX UPDATES > E-Alert: Estate Tax and Generation Skipping Tax Repeal
It appears that we have reached the point of no return. Effective Jan. 1, 2010, we will have a repeal of the estate tax and the generation skipping tax. Although the gift tax has not been repealed, there will be a reduced tax bracket from 45 percent to 35 percent. This has been a complete surprise to many planners who have assumed that Congress would pass legislation that would, at a minimum carry forward the 2009 rates and exemptions into 2010. This has certainly muddied the waters and has made it difficult to plan for our clients. So what does the future hold and more importantly, how should we discuss this with our clients?
What are the repercussions of an estate tax repeal?
Elimination of the step up in basis rule. For decedents dying after Dec. 31, 2009, the basis of property acquired from a decedent would be the lesser of the decedent's adjusted basis or the fair market value of the property on the decedent's death. This results in assets potentially being "stepped down" should FMV be lower than the asset"s basis at date of death. This of course, means that more modest estates will be subject to additional tax (in the form of a capital gains tax) that would not otherwise be impacted because of the estate tax repeal.
Furthermore, calculating the date of death basis may be a daunting task – particular for assets acquired over time several decades ago!
There are two exceptions from the carryover basis provisions:
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The executor can allocate up to $1.3M (increased by unused losses and loss carryovers) to increase the basis of assets; and
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The executor can also allocate up to $3M to increase the basis of assets passing to a surviving spouse either outright or in a QTIP trust. This is an increased basis of $1.3M and $3M, not assets having a value of $1.3M or $3M, so the allocation process may get complicated.
To properly account for these "step up" exceptions, many taxpayers would need to file estate tax returns that otherwise would not have due to the smaller size of the estate (under $3.5M). House officials have estimated that an extension of the 2009 estate tax into 2010 impacts only 6,000 estates, while this new carryover basis provisions will impact over more than 70,000 estates.
Estate tax recapture provisions would continue to stay in force. Persons who are subject to various "recapture" provisions are not off the hook in 2010. For example, the QDOT tax (with respect to a qualified domestic trust created to obtain a marital deduction for amounts passing to a noncitizen spouse) continues on trust distributions for 10 years after the estate tax is repealed. However, this QDOT tax that is otherwise applied at the surviving spouse's subsequent death would not apply if the surviving spouse dies after 2009.
The recapture provisions for special use valuation, QFOBI deductions, §6166 installments, and qualified conservation easements also continue to apply in 2010.Therefore, post mortem requirements related to these elections would need to be continued.
Will the repeal actually happen?
There will likely be an estate and GST tax established sometime during 2010. The issue is whether there will be a "repeal window" available for donor and decedents who make gifts or bequests during the "repeal window." There has been a rumor that Senator Baucus, Chairman of the Senate Finance Committee, and Representative Rangel, Chairman of the House Ways and Means Committee, would sign a "letter of intent" to give notice to taxpayers not to rely on the repeal and to anticipate an estate tax that would be retroactively applied back to Jan. 1, 2010. Since there are a great deal of similarities between Pomeroy"s bill (HR 4154) and Baucus's bill (SB 722), the assumption is an estate tax "band aid" whereby the 2009 estate tax laws would be carried forward temporarily into 2010 until it can be better addressed in the future. The ability to retroactively apply their tax back to 2010 has some precedence in the form of two Supreme Court cases, U.S. v. Hemme, S. Ct. 2071 (1985) upheld the retroactive application of what is now §2010(b). In addition, U.S. v. Carlton, 512 U.S. 26 (1994) upheld the validity of retroactive legislation regarding an estate tax deduction that was allowed at one time under one of the various provisions of §2057 for the sale of stock to an ESOP.
Some experts believe that it will be much more difficult to uphold the constitutionality of instituting an estate tax and GST tax system retroactively when no system exists, as opposed to just increasing rates retroactively. By analogy, the Supreme Court refused to uphold the retroactive effect of the gift tax, when it was instituted in 1924 (Untermyer v. Anderson, 276 U.S. 440 (1928)). Because of the potentially high estate tax liabilities of decedents who die during this "repeal window", it is clear that the retroactive application of an estate tax will be challenged on a constitutional basis.
What will this new estate and gift tax look like?
The most likely scenario would be an "estate tax carryover." However, many Senate Republicans are using this delay to push for either favorable estate tax changes (e.g., an increase of the estate tax lifetime exclusion to $5M) or a permanent repeal of the estate tax altogether. Although they do not have the support necessary to carry out these changes, they do have enough presence to delay the passage of any estate tax law. That means this issue could continue well into 2010.
How should I plan?
Review of the client's current estate plan. Of particular concern are clients nearing death. Many estate plans have not taken into consideration this repeal. The tax formulas otherwise designed to minimize estate tax under the 2009 tax formulas may now distribute assets (either over-favoring the spouse or the descendents) in a way that no longer matches the client's testamentary intent. These clients should consider a contingent provision that distributes assets to the spouse and children in a specific matter (e.g., fractionally between the marital trust and the Bypass trust) in the event of an estate tax repeal. This will ensure that his or her true testamentary wishes are meant.
Inter-vivos planning - the conservative approach. This assumes that the proposed retroactive application of an estate and GST tax will pass constitutional muster. Under this approach planning will be driven by the assumption that the 2009 will carry over to 2010 and that there will be no "estate tax repeal window." It also assumes a "wait and see" approach to this issue. Therefore, planning that has been established with the client would continue, such as use of annual exclusion gifts, continued funding of the irrevocable insurance trust, etc. This should be the direction taken by virtually all of our clients.
A final important planning point to consider is the likelihood that a new estate tax law will bring forth the elimination of valuation discounts of nonbusiness assets transferred to related parties as well as place special restrictions on grantor retained annuity trusts (GRAT's); that is, increase the minimum required term of a GRAT to 10 years. Because of these potential changes, we continue to counsel our clients to strongly consider the use of valuation discounts and GRAT's as part of their gift plan to protect these tax benefits while they remain available to them.
Inter-vivos planning – the aggressive approach. This assumes the "estate tax repeal window" will be available. Although the appropriate path for most of our clients would be the conservative approach, the client's legal counsel may still suggest an aggressive planning approach – maybe due to the size of the client's estate. Among the planning opportunities that we may see in the event of repeal would include the following:
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Clients who plan to make large taxable gifts (above the $1M lifetime exclusion) should consider making them in early in 2010, when there is a chance that they may pay just a 35 percent gift tax rather than the current 45 percent top rate.
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Transfers to long-term trusts for descendants that might be free of GST tax constraints. The trusts would be created at a time when there is no GST tax, and if the GST tax is reinstituted, existing trusts that are created during a time that no GST tax existed may be grandfathered from the new tax.
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Gifts to grandchildren or more remote descendants that would otherwise be subject to the GST tax as direct skips. (Consideration would be given to using a trust formula based on the maximum amount that can be conveyed currently without the imposition of a GST tax or without changing the GST inclusion ratio of the trust. This would allow the GST trust to take into account any possible retroactive legislation related to the GST tax.)
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A GST repeal would permit a GST trust to make a distribution or terminate during this "repeal window," passing the assets to the younger beneficiaries. There may be no GST tax imposed if there is no GST tax system in place. However, remember that there is a significant risk that the GST tax will later be enacted retroactive to Jan. 1, and the GST tax would apply unless the courts hold that the retroactive application of the tax is unconstitutional.
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If a client is a beneficiary of a marital trust that will be taxed at his or her death (if the estate tax is reinstituted), another planning possibility is to have the trustee make a significant distribution to the client, and have the client make gifts to children or grandchildren, again planning to take advantage of the possibility of the lower 35 percent gift tax rate and the ability to make such gifts in long-term trusts that may escape GST tax.
Remember, the aggressive approach assumes a "repeal window." A full discussion with the client and the client's counsel is highly recommended to ensure that the repercussions of this planning are fully understood by the client prior to the implementation and execution of the plan.
For more information
If you have questions, please contact
AuldridgeGriffin to further discuss your estate planning needs.
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