As you might have heard, there is currently quite a bit of confusion surrounding the federal estate, gift and generation-skipping transfer (“GST”) tax laws. As of January 1, 2010, new rules became effective for those taxing regimes. However, the impact of these new rules remains uncertain because there is a possibility that Congress will re-convene and pass legislation modifying the existing rules or even passing legislation that would apply retroactively to January 1, 2010. While we do not know what the future holds, this article: (1) provides background as to how we arrived at the present tax situation; (2) offers a brief summary of the current federal estate, gift and GST tax laws; (3) discusses what may be forthcoming from Congress; and (4) explains how the changes to these laws may impact your estate planning.
How We Arrived at the Present Situation. In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (the “EGTRRA”). In general, this law was enacted to help stimulate the economy and restore confidence following the September 11th terrorist attacks. One of the provisions of EGTRRA involved the eventual repeal of the estate and GST taxes. EGTRRA did not repeal these taxes immediately. Instead, such taxes were to be eliminated by gradually increasing the amount that can pass federal estate or GST tax-free and by gradually reducing the maximum tax rates. Pursuant to EGTRRA, the exemption equivalent grew from $675,000 in 2000 to $3,500,000 in 2009, and the maximum tax rates decreased from 55% in 2000 to 45% in 2009. EGTRRA provides that federal estate and GST taxes do not apply in 2010. All of the EGTRRA provisions expire after December 31, 2010.
Most experts did not expect us to reach 2010 without further direction from Congress. Over the past year, there seemed to be bipartisan support for freezing the equivalent exemption amount somewhere between $3,500,000 and $5,000,000 and for providing a maximum tax rate of 45%. In fact, on December 2, 2009, the House of Representatives passed a bill making the $3,500,000 federal estate and GST tax exemptions and the 45% tax rates permanent. However, the Senate was unable to reach agreement on this issue prior to the completion of the 2009 legislative session. The Senate is scheduled to discuss the House bill upon its return for the new session. Since this will not occur until the 19th or 20th of January, we will know nothing further before the session convenes.
Summary of Current Law. The federal estate and GST taxes are repealed for any individual whose death occurs during 2010 and the federal GST tax is repealed for gifts and other transfers occurring in 2010. For any deaths occurring in 2011 and later years, the estate and GST taxes will be reinstated similar to what was in place prior to 2010, but at tax levels not seen in some time. The amount exempt from federal estate tax will drop from $3.5 million in 2009 down to $1 million in 2011. The amount exempt from federal generation-skipping transfer tax will drop to $1 million in 2011, as adjusted for inflation. In 2011, both the maximum federal estate and generation-skipping transfer tax rates will increase to 55%.
There is one other major change that applies to property passing from taxpayers whose death occurs in 2010. Prior to January 1, 2010, the income tax basis of property acquired from a decedent was “stepped-up” or “stepped-down” to the fair market value of the property on the date of death. In general, for deaths occurring in 2010, the income tax basis of inherited property will be the lesser of the decedent’s basis in the property or the fair market value of the property on the decedent’s date of death. This means that inherited property can only be “stepped-down” and not “stepped-up.” Because of these new rules, capital gains tax is more likely to be payable by an estate beneficiary upon the sale of an inherited asset. However, Congress did provide some relief in the basis adjustment rules. First, the personal representative can allocate up to $1.3 million of value to readjust the basis of any property up to the fair market value. Second, the personal representative can allocate an additional $3 million of value to increase the basis of property passing to a surviving spouse. There do not appear to be any current guidelines or regulations regarding the determination of which specific assets are to receive a basis increase.
The federal gift tax structure remains unchanged throughout 2010, except that the maximum gift tax rate is reduced to 35%. In 2011, the maximum federal gift tax rate increases to 55%. As noted above, any gifts made in 2010 would not be subject to GST tax, even if the transfers were made to a grandchild, great-grandchild, or the like. In 2011, the GST tax will be reinstated at the increased 55% rate and would apply to all generation-skipping transfers in excess of the exclusion amount.
What May Be Forthcoming? We are unable to predict how Congress will address these issues. Based on the tone of prior negotiations, it appears that a majority of Congress supports maintaining the federal estate and GST taxes, but in a manner similar to that effective in 2009. However, it is unclear when any legislation will be passed and when it will become effective. There is a chance that any legislation will apply retroactively to January 1, 2010, even if the legislation is not passed until a later date. While there have been predictions of a Constitutional challenge to any retroactive application of these laws, we may not know for some time whether such challenges would be successful.
There is certainly a chance that Congress will be unable to reach an agreement on these issues. If this occurs, the present laws will prevail. While the current laws provide for estate and GST tax repeal in 2010, much more onerous tax provisions will be in force in 2011 and beyond. These laws would mean that any estate with assets in excess of $1,000,000 would need to file an estate tax return and would be potentially subject to the federal estate tax.
Impact on Estate Planning. The repeal of the federal estate and GST taxes may cause unintentional estate planning results because formulas often included in estate plans to determine the funding of different trusts and bequests may be based on the federal estate and generation-skipping exemption amounts available to an estate.
As an example, a husband is survived by his wife, and his estate plan includes a formula to direct his assets to be divided between a Residuary Trust and a Marital Trust. The Residuary Trust is designed to receive the husband’s remaining equivalent exemption (which previously would not exceed $3.5 million) with the remaining assets funding the Marital Trust. In 2010, without a federal estate tax and consequentially no equivalent exemption, this formula directs all of the husband’s assets to the Residuary Trust and no assets to the Marital Trust. From a tax standpoint, this may be ideal because the assets in the Residuary Trust will be free of federal estate tax in both the estate of the husband and in the estate of his wife. However, if the Residuary Trust does not provide sufficiently for the wife’s benefit during her remaining lifetime, then the wife may be unintentionally disinherited. As a second example, a grandfather crafts an estate plan that includes a formula to direct his remaining generation-skipping exemption amount (which previously would not exceed $3.5 million) into a Generation-Skipping Trust for his grandchildren’s benefit with the remaining assets passing outright to his children. In 2010, this formula may direct all of the grandfather’s assets to the Generation-Skipping Trust with no assets passing to the children.
The repeal of the federal GST tax and the lower gift tax rate applicable in 2010 may seem to create opportunities for tax-efficient gifting. However, the tax benefit only exists if the gifts are made during a period in which the 2010 laws are effective. Since there is a possibly that these taxes may be altered by legislation that is retroactive to January 1, 2010, all gifting decisions must be carefully considered.
What Should You Do? Until Congress acts further, those most likely to be affected by these recent changes include: (1) married individuals with an estate plan that divides assets between a Marital and a Residuary Trust Share, especially where the Residuary Trust Share is not held for the benefit of the surviving spouse; (2) individuals with an estate plan that maximizes the use of the generation-skipping transfer tax exemption; and (3) individuals with an estate plan that includes bequests tied to the amount of the now-repealed exemption. We would suggest that you review your estate planning documents and, if it seems that the change in federal transfer tax laws may have an impact on your plan, please contact your estate planning attorney for further consultation.