Stuart A. Rader, Esq. February 2010
This article is not intended or written to be used as legal advice, and cannot be used, for the purpose of avoiding tax-related penalties.
The year 2010 presents challenges to estate planners and individuals reviewing their estate plans. The federal estate tax rules changed radically in 2010 and could change dramatically again in 2011 unless Congress passes new legislation. This newsletter is intended to advise you of what has happened and to encourage you to review your estate plan as soon as possible. As discussed below, the 2001 legislation mandated the changes in law in 2010, but hardly anyone thought that Congress would allow it to happen. In short, estate planning professionals were planning on action in Congress in late 2009 to change the law. This was attempted to some extent in the House of Representatives but the Senate took no action.
2001 Tax Act. In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) which provided for significant phased-in increases in the federal estate, gift and generation skipping tax (GST) exemptions and lower tax rates. EGTRRA provisions included:
· In 2009, the estate and GST exemptions increased to $3.5 million per decedent, with a flat 45% estate and GST tax rate on any excess. The gift tax exemption was $1 million, with tax rates from 41% to 45%.
· In 2010, the federal estate and GST taxes are repealed or inapplicable for one year. The $1 million gift tax exemption remains. There is a reduced gift tax of 35% as compared to the 2009 45% rate for gifts above the $1 million exemption that are not covered by the $13,000 annual exclusion. Thus, to take advantage of the 2010 provisions, one would have to: (a) die in 2010; or (b) make a taxable gift in 2010 and pay the gift tax. Further, the step up in basis rules (which gave a date of death fair market basis for most assets of a decedent) were replaced for 2010 deaths with an adjusted carryover basis. These new basis rules permit a step up in basis of up to $1.3 million, plus an additional $3 million for certain spousal transfers at death.
· On January 1, 2011, EGTRRA will be automatically repealed, resulting in the return of 2001 estate tax rules. This includes a return to the $1 million estate and GST exemption and a maximum 55% tax rate plus the possibility of an additional 5% surtax. This change is in significant contrast to the manner of taxation in the two prior years. In 2009, there was a $3.5 million estate and GST exemption and flat 45% tax rate, and in 2010, there is no estate and GST tax.
What Happened in 2009? Estate planning practitioners universally expected Congress to vote to extend the 2009 estate tax rules through 2010. However, unexpectedly in December the House failed to act on a one year extension and instead sent the Senate a bill to make the 2009 rules permanent. Because the Senate was focused on health care and there was broad disagreement in the Senate on what to do with estate taxes, Congress enacted no changes to the EGTRRA’s 2010 rules. Thus, effective as of January 1, 2010, there is no federal estate or GST tax until January 1, 2011.
Planning in Chaos. Congress’s failure to adopt estate tax legislation in 2009 and the possibility that changes will not be adopted during 2010, radically change the estate planning considerations of many clients. For example, Congress has indicated that in 2010 about 6,000 decedents will benefit from the elimination of estate taxes, but over 70,000 heirs will pay higher income taxes because of the change in the income tax basis rules for assets received from decedents.
2010 Changes. The U.S. has an unpredictable planning environment in which any number of radically different changes may occur in 2010:
· Congress may do nothing in 2010, in which case there is an adjusted carryover basis, and no federal estate or generation skipping tax for people who die in 2010. While statistically, most will people will not die in 2010, you still need to consider planning for that possibility, because not planning for these changes, if death occurs, can be disastrous. For example:
- Formula clauses (e.g. terms that allocated your estate exemption to a “by-pass trust” or “credit shelter trust”) in your planning documents could inadvertently disinherit some heirs and/or your surviving spouse and/or create conflicts among family members on how your documents should be properly interpreted;
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Conflicts could arise among your heirs and fiduciaries on asset basis issues;
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Inadvertent generation skipping taxes could be incurred after 2010; and
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Passing assets directly to your surviving spouse may result in higher estate taxes after 2010.
· Congress may adopt legislation to apply the 2009 rules in 2010, retroactive to January 1, 2010. There is broad disagreement on whether a retroactive tax bill is constitutional. If a retroactive law is adopted, it will be challenged as unconstitutional and it could take years for the appellate and possibly, the U.S. Supreme Court to rule on the issue. Until there is judicial authority, uncertainty will prevail. In any event, your estate plan should contemplate dying both before or after a potential retroactive enactment, which may or may not be constitutional.
· If Congress acts in 2010 to address the estate tax issues, it could:
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Adopt permanent estate tax exemption, beginning in 2010 or 2011 (If so, most commentators anticipate estate tax exemptions to fall between $2-5 million and tax rates 35% to 45%);
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Adopt a temporary higher estate exemption;
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Adopt rules to limit or eliminate valuation discounts on closely held entities; and
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Adopt rules to make Grantor Retained Annuity Trusts (“GRATs”) for a minimum duration and a minimum amount of a present interest gift to the remaindermen (next generation heirs) and making unavailable the zeroed out GRAT (the present value of the gift to remaindermen is close to or is zero).
2011 Changes. Unless Congress enacts new legislation in 2010, then on January 1, 2011, a number of automatic changes occur to the federal tax code, including:
· The estate tax exemption returns to $1 million per decedent (the 2001 amount);
· The GST exemption returns to $1 million per person, with an adjustment for inflation;
· The estate tax rate increases (e.g., 55% above $3 million and 60% above $10 million);
· States which remain “coupled” to the federal estate tax will have their state death taxes restored (Thus, if you own property in one of these coupled states, you could have new exposure to a state estate tax);
· The fair market value step up in basis returns for assets passing from a decedent; and
· The top income tax rates go up by at least 4.6%, capital gain tax rates go up by up to 5% and dividend tax rates increase by up to 24.6%.
Higher Taxes. No matter what happens to the estate tax, substantial tax increases are looming. A $12 trillion deficit is projected for the next decade. The Congressional Budget Office indicates that the Social Security Trust Fund will pay out more then it receives starting in 2011 or 2012. Given slow economic recovery and the fact that we are in a mid-term election year, the federal government will probably not increase taxes until sometime in 2011. While substantial tax increases are likely, we just don’t know any details.
ROTH IRAs. In 2010, taxpayers can convert traditional IRAs to ROTH IRAs and can pay the income taxes due on such conversion in 2010 or equally in 2011 and 2012. There are significant benefits and traps for the unwary in making these decisions. Each person contemplating a transfer from a traditional IRA to a ROTH IRA should seek competent tax advice to analyze all the relevant factors.
No one knows what the future will be regarding estate and GST taxes. Uncertainty makes it difficult to plan. There are options available that provide flexibility in your documents during this uncertain time.
Due to all the factors discussed, now is a perfect time to review your current estate plan and determine what changes need to be made to your current plan to minimize taxes and to reduce the possibility of future family conflicts by reason of the quirks and inconsistencies in the law.