Estate Tax Update: It is 2010: NOW WHAT??

Estate Tax Update: It is 2010: NOW WHAT??

I. BRIEF HISTORICAL REVIEW OF HOW WE GOT INTO THIS MESS

The 2001 Economic Growth and Taxpayer Relief Reconciliation Act(EGTRRA), was adopted as a ten-year tax relief bill. The duration of the effectiveness of the bill was limited because proponents of the changes did not have enough Congressional votes to make those changes as permanent additions to the tax code. Instead of reducing the scope of those changes to try to get more Congressional votes for a permanent amendment to the law, proponents of the changes chose to make the more sweeping changes they preferred but only for a limited time.

As EGTRRA applied to estate taxes, the estate tax exemption amount increased dramatically over those years from $1,000,000 in 2002 up to $3,500,000 in 2009 (or a combined $7,000,000 amount for a married couple), and the estate tax rate was conversely reduced over that same time period. Then, in 2010, the estate tax was “repealed” (or more accurately, according to the statute, it “does not apply” to decedents dying after December 31, 2009).

We practitioners thought it was unimaginable that Congress would not deal with the pending repeal in 2009. There were several attempts to do over the 10 year period. Most recently, in Fall of 2009, the House of Representatives passed a bill that would have continued the estate tax with a $3.5 million applicable exclusion amount. But the Senate, paralyzed by partisan bickering, could not act. The unpredictable environment and the uncertainty of whether Congress will enact new law, causes profound uncertainties for estate planning in 2010 and beyond; most existing estate plans should be reviewed because of this.

The ten year tax relief bill “sunsets” on December 31, 2010, which means it ends and that door is closed. Therefore, the “repeal”of the estate tax law is currently scheduled to last only one year. After just one year of “repeal” in 2010, unless the legislature acts, the estate tax law is scheduled to be restored on January 1, 2011, but, of course, not with the $3,500,000 exemption. Instead, the estate tax exemption amount would be reduced to $1,000,000 (as would have been the case without the intervening ten-year tax relief bill from the EGTRRA ). We are going backwards in time and progress!

Stop and think about it; This can produce ridiculous results. A person dying on December 31, 2009, could be subject to an estate tax that wouldn’t apply to a similarly situated individual whose death occurred just the next day on January 1, 2010. And the reverse would be true for an individual whose death occurred on January 1, 2011, after the restoration of the estate tax, compared to a death the day before on December 31 2010. It also raises that specter of facilitating death for tax purposes in situations where that is possible.

That one-year repeal has made estate planning more difficult. With the “does not apply” repeal in 2010, to be followed by reinstatement in 2011, it has been really very difficult to advise clients about estate tax projections without knowing what the law would be when they will die. For the majority of people, the likely date of death is a mystery and for those who are likely to die in 2010, there is also, as I mentioned, the concern of facilitating the death during this tax year to take advantage of the lack of estate tax, pulling the plug earlier perhaps.

Since 2001, there have been numerous legislative proposals concerning the estate tax, including freezing the estate tax law as of 2009 for subsequent years (and thus avoiding the repeal), or conversely making the repeal permanent after 2010, or reforming the estate tax by significantly increasing the exemption amount and significantly decreasing the tax rate, or avoiding repeal but increasing the tax rate on extremely large estates (i.e., a “billionaire’s surtax”). Nothing happened though. On January 1, 2010, the “unthinkable” happened. The estate tax now “does not apply” to decedents dying during 2010, there is a modified carry-over basis system instead of adjusted basis for inherited capital assets, and those laws are scheduled to last for only one year.

II. SO WHAT DO WE HAVE FOR 2010?

Let’s break this out into what we have in 2010 and look at the three main areas of concern for estate planning:

• Estate Tax

Whether repealed or just “does not apply,” the primary effect is the same for the estate of a decedent dying in 2010; there is no federal estate tax due, and no federal estate tax return need be filed. A big difference though is where the government is going to get its tax from you. It used to be through an estate tax. To offset that, they allowed a “step-up in basis” for assets held by a decedent now in the hands of an heir. That allowed for current fair market value as of the date of death to be used. Now, it is on what is called a “Modified Carry-over Basis” with which the assets have capital gains tax treatment when inherited appreciated assets are sold. The heir now takes the basis the asset had in the hands of the decedent, hence a ‘carry-over basis’ and there is no step up to fair market value. On the sale of the inherited asset, the government now essentially has the capital gains tax in place of the estate tax to recoup that money. In some circumstances, you might pay more in capital gains than you would have in estate tax!

During 2010 only, the basis of the decedent’s property after death will be the lesser of the decedent’s basis and the fair market value of the property. There is some minor relief to the carry over basis: The new law for 2010 provides that a limited amount of additional basis can be added to a decedent’s capital gains assets which kind of makes up for the loss of the estate tax exemption. Up to $3 million of additional basis can be added to assets passing to a surviving spouse or in trust for a surviving spouse (if certain technical requirements are satisfied) and another $1.3 million of additional basis can be added to other assets regardless of to whom the property passes.

1. Gift Tax

The gift tax is not “repealed” nor suspended, even in 2010. The gift tax law continues ineffect during 2010 with the same $1,000,000 cumulative applicable exclusion amount. There is also a bit more liberal finding of “a completed gift”.

1. Generation-skipping Transfer Tax

The generation-skipping transfer (“GST”) tax is suspended in 2010 but not fully “repealed.” Like the estate tax, the GST tax simply “shall not apply” in certain circumstances. The purpose of this tax seems clear. What was happening was grandparents were giving to grandchildren, skipping over the parent generation. This meant that the opportunity to potentially tax the transfer at the parent level was lost so instead of getting to potentially tax a transfer twice [once at each level], the government was only able to tax once. Hence, the establishment of the very, very complicated generation-skipping tax laws.

“Generation-skipping transfer” is a technical term defined in Internal Revenue Code section 2611(a) and means one of three types of transfers (either a “direct skip,” a “taxable distribution” or a “taxable termination”) to a generation-skipping beneficiary (a “skip person,” whether an individual or a trust that qualifies as a “skip person”). The GST tax law “shall not apply” in 2010 to any such transfer to a “skip person.” Therefore, no completed transfer in 2010 will generate any generation-skipping transfer tax liability this year. This allows for excellent planning for 2010!

It is going to get very confusing later on what was free from GST and what will still be into the future. For example, consider a fully funded trust so a completed transfer, to a trust that includes both “skip” people and “non-skip” people. By the time the assets belong to the “skip” people, the GST will likely be back into play, or rather still remain in play. There may be exemptions that apply. Or not!. This issue certainly needs further clarification from the IRS or by judicial interpretation.

III. THE LAW SCHEDULED FOR 2011

As I wrote earlier, the ten-year tax relief bill (EGTRRA) is schedule to sunset on December 31, 2010. If there has not been any legislative action before then, this is someof what will happen:

1. The estate tax law will again apply to decedents dying after December 31, 2010.
2. The restored estate tax will have a $1,000,000 applicable exclusion amount, the maximum estate tax rate will be increased back up to 55%, and the 5% surtax on taxable estate value between $10,000,000 and $17,184,000 will be restored.
3. The state death tax credit will come back, and so also will the requirement to file California state estate tax returns and pay that “pick-up” tax.
4. The Qualified Family Owned Business Interest [QFOBI] deduction will be back (valued at the $300,000 maximum)
5. The gift tax will continue with the $1,000,000 gift exemption amount reunified with the estate tax applicable exclusion amount.
6. The GST tax will apply to generation-skipping transfers occurring after December 31, 2010. The GST exemption amount will be $1,340,000 (the amount that would have been indexed for inflation in 2010).
7. Some useful GST tax provisions will go away, since they were part of the EGTRRA ten-year tax relief provisions.
8. The familiar adjusted basis rules of IRC section 1014 will return.

The way that the EGTRRA sunset provision was drafted presents its own problems: it tells us the Internal Revenue Code will apply again after December 31, 2010, “as if the provisions and amendments [of EGTRRA] had never been enacted.” OK, this is stupid wording. What happens to proper lawful transactions that were put in place during the EGTRRA time. If it is ‘as if it had never been enacted’, then the propriety or legality of the transaction comes into question, doesn’t it. This too will require legislative input or judicial interpretation.

IV. TOTAL GUESSES AS TO POTENTIAL LEGISLATIVE ACTION

• Retroactive reinstatement of the estate tax in 2010? This is a talked about a lot. Might not the Congress say here is how we are treating 2010 and may make those laws retroactive. This, of course, raises a lot of constitutional and other issues so, were this to happen, wisdom seems to suggest they will also offer the option to opt in/opt out for 2010?
• “Patches” for the gap year have been provided by the legislature in many states but just not California! These provide guidance for wills and trusts interpretation.
• Estate tax reform for 2011? Maybe they will come up with a whole new plan and get us back on track to the 2009 rates. Each time we have been close though, lately, some disaster has distracted them. There was health care reform in 2009 and prior to that, Hurricane Katrina. Wouldn’t it be nice if they just dealt with it!