Absent some eleventh hour action in Washington, D.C., the federal estate and generation-skipping transfer (“GST”) taxes will be repealed in 2010. The repeal is temporary, however, as both taxes are scheduled to be reinstated in 2011 at 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. The good news is that 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. The bad news is that the tax rate for the portion of the estate subject to the tax is in the 45%-55% range.
The GST tax is an additional tax imposed on transfers of assets down more than one generational level. The tax rate for this tax is just as substantial.
In 2001, Congress enacted a law that gradually increased the amount that could be transferred estate- and GST-tax free, with a complete repeal of both taxes scheduled to take place in 2010. That law, however, has a “sunset” provision which makes the repeal temporary. As a result, the pre-2001 tax rules will be reinstated after 2010. For estates in excess of $1million, both taxes again will become a concern.
Most observers predicted that Congress would take action to prevent the one-year repeal and subsequent return to pre-2001 rules. In fact, the House of Representatives finally turned to the issue this month, passing a bill that would make 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 at compromise in the Senate, however, have failed. As of the publication of this article, it appeared that the Senate would not address the issue again in 2009. The current political and economic environments make extensions of the repeal very unlikely. As a result, the following rules will 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 will 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 in the value of the asset since it was originally acquired by the decedent. (Under the current law, the beneficiary receives a “step-up” in tax basis so that capital gains are calculated at the time of sale based only on appreciation occurring since the death of the decedent.) There will be, however, some relief from the carry-over basis rules – $1.3 million can be allocated by the estate to increase the basis in inherited assets and an additional $3 million can be allocated to increase the basis in assets inherited by a spouse.
Then, upon expiration of the repeal in 2011, the following rules will apply:
- The estate tax exemption amount for decedents dying in 2011 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 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 year to year likely will lead to confusion and problems.
First, the ability to leave a fortune will be entirely dependant on the timing of death. For example, if a wealthy individual dies in 2010, leaving a $10 million estate to the individual’s grandchildren, there will be no tax. If the same individual, however, survives 2010 and dies in 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 will become 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 will make it necessary to (i) determine basis in property long held by decedents, (ii) file a tax return to allocate affirmatively exemption to increase the basis in inherited assets, and (iii) document for future purposes all of this information, resulting in an accounting nightmare and increasing the cost of administering every estate. In fact, similar rules enacted in the 1970s were repealed quickly as a result of the same issues.
Finally, because of the problems discussed above, there have been indications that Congress might pass new legislation in the first part of 2010 that reinstates the estate and GST taxes retroactive to January 1, 2010. Such legislation, however, may not be constitutional. Therefore, the estates of decedents dying in the first part of 2010 could be frozen for years pending the resolution of that issue.
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 somewhat capping the utility of this planning technique. In 2010, however, there will be 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 tax clearly is preferable to retaining the assets and having them taxed in 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 only enhanced by the fact that the trust will avoid estate taxes for generations to come.
Conclusion
The repeal of the 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.
