Gone Today, Back Tomorrow with a Vengeance: The Repeal and Reinstatement of the Federal Estate and Generation Skipping Transfer Taxes

April 21, 2010 | Matthew W. Thompson

In the federal estate tax world, there's good news and there's bad news. The good news is that the federal estate and generation-skipping transfer ("GST") taxes are repealed for 2010. The bad news is that the repeal is temporary, as both taxes are scheduled to be reinstated in 2011 at higher levels and rates that will impact many more taxpayers. This article addresses the events that brought about these unlikely circumstances, predicts the confusion and problems that will result, and introduces some unique planning opportunities available to those who act quickly.

How did we get here?

As an initial matter, the federal estate tax is the tax that the federal government imposes against the value of an individual's estate upon death. Fortunately for taxpayers, the tax is not imposed against assets passing to a surviving spouse or charity and generally exempts a certain portion of the value of the estate from the tax altogether – no matter who the ultimate recipient might be. However, the tax rate for the portion of the estate that is subject to the tax is in the 45% to 55% range.

The GST tax is an additional tax imposed on transfers of assets to members of future generations other than the next one, thus "skipping" one or more generations. The rate for this tax is just as substantial.

In 2001, Congress enacted a law that gradually increased the amount that could be transferred free of estate and GST tax, with a complete repeal of both taxes in 2010. That law, however, included a "sunset" provision which makes the repeal temporary unless Congress acts to make the repeal permanent (which is not likely to occur in the current political climate). As a result, the pre-2001 tax rules will be reinstated after 2010 unless Congress passes some other estate taxation scheme. For estates in excess of $1 million, both taxes will become a concern again.

Most observers predicted that Congress would take action to prevent the one-year repeal and subsequent return to the pre-2001 situation. In fact, the House of Representatives passed a bill in December 2009 that would have made the estate tax applicable only to that portion of an estate in excess of $3.5 million. This effectively would have exempted all but the very wealthiest Americans from the tax. Efforts to pass a similar bill in the Senate failed, however, and the issue was left to be decided at a later date. As a result, the following rules apply in 2010:

A decedent dying in 2010 can leave his or her entire estate tax-free regardless of who the beneficiaries may be;
Gifts made over the course of a lifetime in excess of $1 million will be taxed at a 35% rate; and,
Estate beneficiaries assume a "carry-over" tax basis for inherited assets. This means that a subsequent sale of an inherited asset by the beneficiary will result in capital gains tax calculated based on the appreciation (or depreciation) in the value of the asset since it was acquired originally by the decedent. (Under the previously applicable law, the beneficiary received a "step-up" in tax basis so that capital gains were calculated at the time of sale based only on appreciation occurring since the death of the decedent.) There is, however, some relief from the carry-over basis rules – the estate is allowed to increase the basis of inherited assets by up to $1.3 million, and increase the basis of assets inherited by a spouse by an additional $3 million.

However, upon expiration of the repeal on January 1, 2011, the following rules will apply:

The estate tax exemption amount for decedents dying in 2011 and thereafter will be $1 million. Estate assets in excess of that amount will be taxed at a rate as high as 55% if the beneficiaries are not surviving spouses or charities;
The GST tax will apply to transfers in excess of $1 million if the recipients of the transfer are more than one generation removed from the decedent;
Gifts made over the course of a person's lifetime in excess of $1 million will be taxed at a 45% rate; and,
Estate beneficiaries again will enjoy a "step-up" in tax basis in all inherited assets for capital gains purposes.

Oh, the trouble it will be!

This dramatic shift in the tax law from one year to the next likely will lead to confusion and problems.

First, the ability to leave a fortune untaxed will be entirely dependent on the timing of death. For example, if a wealthy individual dies on December 31, 2010, leaving a $10 million estate to the individual's grandchildren, there will be no tax. If the same individual, however, survives one more day and dies on January 1, 2011, then the total estate and GST tax bill will be more than $6.75 million!

Second, the wills and trusts of many individuals do not give instructions on how their estates should be distributed if there is no estate tax. Often these documents were prepared with complicated formula distributions designed to minimize taxes through available credits and deductions. With repeal of the estate and GST taxes for 2010, the tax concepts underlying those formulas are irrelevant and meaningless. Judicial interpretation may be necessary before an executor or trustee can move forward with distribution, which will add expense and delay to the estate administration process.

Third, the "carry-over" basis rules discussed above likely will prove impracticable. These rules make it necessary to:

Determine the original basis in property long held by decedents;
File a tax return to allocate the allowable increase in the basis of inherited assets; and,
Document all of this information for future purposes, resulting in an accounting nightmare and increasing the cost of administering every estate. In fact, similar rules enacted in the 1970s were quickly repealed as a result of the same issues.

Finally, because of the problems discussed above, Congress may pass new legislation this year that reinstates the estate and GST taxes retroactively to January 1, 2010. However, there are questions as to whether such legislation would be constitutional. Therefore, the estates of decedents dying this year could be frozen for years pending the resolution of that issue by the courts.

Is 2010 a window of opportunity?

Despite the confusion and problems that the anticipated changes in the federal estate and GST tax law might cause, the period of repeal offers significant planning opportunities for those who act quickly. Lower gift tax rates make certain traditional planning techniques even more advantageous and affordable, and the ability to make those transactions benefit multiple generations without the imposition of GST tax makes them even more compelling.

For example, consider a potential gift to a "dynasty" trust. If the dynasty trust is designed properly, the assets in it will not be taxed in the estates of any trust beneficiaries for several generations. To date, these trusts typically could be funded only to the extent of the donor's available GST exemption amount – thus limiting the usefulness of this planning technique. In 2010, however, there is no GST tax. Therefore, the only funding limitation will be the donor's ability and willingness to pay gift tax (assessed at a 35% rate) on transfers to the dynasty trust. Assuming the donor can afford it, making a substantial gift and paying the associated gift tax clearly is preferable to retaining the assets and having them taxed as a part of the donor's estate at a 55% rate upon death (assuming the donor dies after the repeal has expired). The benefit of the gift approach is enhanced further by the fact that the trust will avoid estate taxes for generations to come.

In addition, 2010 may be the best remaining opportunity to employ some traditional planning techniques that have come under scrutiny as being too taxpayer-friendly. For example, the Grantor Retained Annuity Trust ("GRAT") is a kind of trust that enables the tax-free transfer of trust appreciation to trust beneficiaries. Changes to the tax code, however, are being discussed that potentially would reduce the effectiveness of this kind of planning. Likewise, Congress may curb "discounted" transfers of family-owned businesses to the younger generation. Therefore, some savvy taxpayers are moving forward with these planning techniques before the available window is closed.

Conclusion

The repeal of the federal estate and GST taxes in 2010 and subsequent reinstatement of both taxes in 2011 will cause problems for many. Now is a good time to review estate planning documents and overall personal circumstances to ensure that these problems can be minimized. In addition, the period of repeal offers a small window to engage in significant estate planning for reduced or no tax cost that can benefit generations to come.

For further information regarding the issues described above, please contact Matthew W. Thompson.

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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.