Update - March 2010

As 2009 drew to a close, most trust and estate practitioners believed that Congress would freeze the estate tax threshold at the 2009 exemption and rate structure. This "fix" never happened! As a consequence, for individuals that pass away in 2010 there is no estate tax and new rules for income tax "basis" have become effective. Additional questions are now being raised about the propriety of the Carlton decision cited above and the ability of Congress to enact an estate tax retroactivity. However, for individuals that have already passed away, a legal battle is sure to come should Congress choose to embark on retroactive application of the Federal estate tax. In the meantime, at this point it is unclear whether Congress will enact an estate tax retroactive to January 1, 2010, whether an estate tax "fix" will be made during the year or whether we will revert to the 2001 law which would freeze the exemption at $1,000,000 per person with a maximum 55% bracket. We will have to wait and see. In the meantime, what should clients do? Clients may choose to revisit their estate plan to consider how assets are titled, to consider how assets will pass upon their demise and to consider their fiduciary choices. Sophisticated formulas including "marital deduction trusts" or "generation skipping trusts" could be modified by the "repeal" of the estate tax. Notwithstanding the confusion concerning the lapse of the estate tax, we believe that the vast majority of our clients will not need immediate corrections to their estate planning documents.

Economic Growth and Tax Relief Reconciliation Act -2001 (EGTRRA)

As many are well aware, the 2001 tax law change resulted in a “repeal” of the federal estate tax structure, at least a planned repeal anyway.  In a nutshell, the EGTRRA-2001 (the “2001 Tax Act”) calls for an increase in the “applicable exemption amount” over this decade of 2000 to 2009 culminating in complete repeal for individuals who pass away in 2010.  Effective January 1, 2011, the EGTRRA 2001 estate tax provisions expire and we revert to the law as it existed before passage of the 2001 Tax Act.  Because of the 1997 tax law changes, the applicable exemption amount from estate tax had been scheduled to rise from the $675,000 exemption amount which existed in 2001 to $1,000,000 by the year 2006.  Thus, the 2011 expiration of the EGTRRA 2001 tax provisions results in a return, not to the $675,000 exemption which had been in place in 2001, but to the $1,000,000 exemption amount which was already scheduled to occur. 

Under the 2001 Tax Act, the exemption amount for individuals that pass away in 2006, 2007 and 2008 was fixed at $2,000,000 per individual.  Effective January 1, 2009, the exemption rose to $3,500,000 per individual.  With proper planning, a husband and wife can utilize the exemption of each spouse thereby sheltering a total sum of $7,000,000 (twice the $3,500,000 exemption) from estate tax.

EGTTRA – 2001 Phase Out

A second and related element to the EGTRRA provisions is the reduction in tax rate.  Prior to the 2001 Tax Act, the maximum marginal bracket from federal estate tax was 55%.  Moreover, estates with a value amount between $10,000,000 and $20,000,000, the law provided for phase out of the exemption amount, thereby causing a 60% marginal bracket.  Nevertheless, as a result of the 2001 Tax Act, the maximum rate has been reduced to 45%.  Moreover, by virtue of the increase in exemption sheltering the progressivity in the rates, the law now provides for a flat fixed rate on any excess over $3,500,000 at a 45% fixed bracket. 

Notwithstanding the increase in the federal estate tax exemption, the gift tax exemption (for lifetime transfers) remains limited at $1,000,000 cumulative over the lifetime of a donor before the imposition of a gift tax. 

Another provision of the 2001 Tax Act, which has received much less attention, is the repeal of “step up” in income tax basis.  Recall that the rules enacted in 2001 allowing for the repeal of the federal estate also result in a repeal of the “step up” (or adjustment) in income tax basis to the fair market value as of the date of the decedent’s death.  See I.R.C. § 1014.  The Treasury Department has refrained from writing regulations to clarify the many questions which remain concerning the mechanism for this planned provision.  In the event that the law is not amended during 2009, we may see a world in 2010 where the estate tax is repealed and carry over income tax basis returns.   Thus, heirs will be obligated to pay income tax on liquidation of assets based upon the income tax basis in the hands of the original decedent/donor.  The law allows for a $1,300,000 basis “step up” provision to be allocated by the executor and a $3,000,000 spousal basis “step up” provision.  However, details on this provision are sparse.  See I.R.C. §1022 as effective January 1, 2010. 

Re-Balancing of Assets

There is a dramatic increase in the exemption threshold from $2,000,000 to $3,500,000 effective January 1, 2009.  Families with asset base in excess of $4,000,000 should review their planning to determine whether assets are adequately balanced between spouses to accommodate the use of the available exemption in the event of the death of either spouse. 

Recall that it still may be appropriate for retirement funds to be payable to a surviving spouse in order to allow for a deferral of income tax.  Moreover, remember that joint assets will immediately vest in a surviving joint tenant and assets will pass by contract beneficiary designation before being disposed of pursuant to the terms of the Will.  Thus, even with properly structured wills and trusts, it is important to consider how assets are titled between spouses.  Once again, the dramatic increase in the exemption occurring December 31, 2008, will not only remove a large portion of taxpayers from the ranks of the federal estate tax but will also require a readjustment and re-balancing of assets between spouses in order to receive the maximum tax benefit.

The Annual Exclusion

In addition to lifetime “taxable” gifts which are permitted, each individual is permitted to make gifts to their heirs (or to anyone) of a relatively small amount known as the “annual exclusion amount”.  This sum had previously been fixed at $10,000 per donee per year.  As a result of the 1997 tax law revisions, the $10,000 exemption I.R.C. §2503 has been indexed for inflation resulting in a $13,000 per year gifting threshold for 2009. 

Where Do We Go From Here?

During the 2008 presidential campaign, details on estate tax proposals were not extensive.  The sum and substance of the campaign proposals was that Barrack Obama’s (Democratic) proposal was to freeze the exemption and rate permanently at the 2009 level.  Thus, the proposal would involve a $3,500,000 per person exemption with a singular rate of 45%.  By contrast, Senator McCain, the Republican nominee, proposed the possibility of a $5,000,000 exemption with a rate of 15% (e.g. a rate tied to the maximum capital gains rate).  Earlier in the year, there had been discussions about indexing the exemption amount for inflation.  However, one of the most telling votes of the summer was the Senate vote 99 to 1 to adopt an identical proposal (as proposed by Senator Obama) with a $3,500,000 per person exemption and a 45% fixed flat rate. 

One constitutional question which remains clear, however, is that should Congress choose to modify the estate tax during 2009, any such changes could be retroactive to January 1, 2009.  A United States Supreme Court case has held that the retroactive enactment of estate tax legislation passes constitutional muster.  See United States v. Carlton, 512 U.S. 26 (1994). 

The Obama Budget

On February 26, 2009, the Obama Administration released its budget which contained hints about the plan for the fate of the federal estate tax.  As was intimated on the campaign trail, the Obama budget continues to support the freeze to the federal estate tax exemption at the 2009 levels.  As indicated, the Obama proposal, if enacted, would result in a $3,500,000 per person exemption with a fixed 45% marginal bracket.  Further, according to the Treasury Department’s “Green Book” (General Explanations of the Administration’s fiscal 2010 Revenue Proposals) released in May, 2009, “The Administration’s baseline projection of current policy continues all of these expiring provisions except for repeal of estate and generation-skipping transfer taxes.  Estate and gift taxes are assumed to be extended at parameters in effect for calendar year 2009 (a top rate of 45 percent and an exemption amount of $3.5 million)”.  Thus, it seems likely that the administration will favor a 2009 rate and exemption freeze. 

“Portability”

One issue which has been considered favorably in legislative circles is the concept of “portability of available estate tax exemptions”.  While we are all familiar with the concept of establishing a trust for the benefit of the surviving spouse as a means of protecting the estate tax exemption of the predeceasing spouse, there has been some discussion about whether this procedure could be simplified.  It has been suggested that an estate tax exemption could be “portable” between spouses.  This means that when one spouse passes, the surviving spouse would automatically receive the estate tax exemption of that predeceasing spouse.  Thus, the exemption would be “portable” from one predeceasing spouse to a surviving spouse. 

For example, suppose husband and wife have an estate of $7,000,000.  If the estate was left directly to the surviving spouse, the survivor could pass away with a total $7,000,000 exemption because, not only would property pass from the predeceasing spouse to the survivor, but also the exemption would pass as well.  The concept of “portability” has several tax benefits including the potential that the “step up” in income tax basis could carry from the predeceasing spouse.  The gain would be eliminated at the first death as well as at the death of the survivor. 

While the concept of “portability” has initial appeal, there are a variety of technical issues associated with this technique which remain open and problematic.  First, suppose the surviving spouse remarries.  How would the exemption rules apply?  Second, would the predeceasing spouse be required to file an estate tax return in order to show the transfer of the exemption?  If the predeceasing spouse left $3,500,000 directly to the heirs, would the surviving spouse also receive the exemption and if not, how would that be tracked for estate and gift tax purposes?  The need to file a return mitigates against the ease associated with this proposed system.  Third, suppose the predeceasing spouse does not bequeath property to a survivor because the assets are in the name of the survivor.  Would the exemption still carry over?  If not, how would the transfer of exemption be tracked?

In addition to technical issues associated with the benefits of “portability”, there are also non-tax and other benefits derived from the use of a trust which would be lost.  First, with the increasing occurrence of blended families, leaving assets directly to a surviving spouse precludes control over the funds at the “second” death.  Assets left outright to a surviving spouse will be subject to complete control and disposition by the survivor.  Second, it is likely that spouses may continue to use trusts for state tax purposes.  Specifically, in New Jersey, we would need a trust to capture the $675,000 exemption amount of the predeceasing spouse.  It appears at this writing that states would not mirror the federal rules. 

The portability concept was incorporated into a bill introduced by powerful Democratic Senator Max Baucus (D-Mt.) which allows portability only where the estate of a predeceasing spouse makes an election on a timely file estate tax return (Form 706).  Further, the exemption is limited to the lesser of a “basic” (e.g. one) exemption or the unused exemption of the first to die.  This would limit exclusions for multiple marriages. 

Discounts

One recent development concerning the federal estate tax that has received considerable attention is H.R.436.  This Bill was introduced on January 9, 2009 by Representative Earl Pomeroy (D) of North Dakota.  Representative Pomeroy is not considered to be a traditional source for estate tax legislation; however, this Bill has received attention because it reflects a theme from Treasury echoed during the Clinton era.

The Pomeroy Bill H.R.436 both freezes an exemption threshold at $3,500,000 per individual and it fixes the estate bracket at the current 45% amount.  These changes are not unusual.  Where H.R.436 deviates from conventional thinking is that it adds a provision to eliminate “discounts” used in estate planning.

Under Section 4 of H.R.436, the law would be modified to differentiate between discounts for marketability and discounts for control.  First, as to discounts for marketability, there would be denial for an entity holding interests in “passive” assets.  The new law defines “passive” assets to include non-business assets with an exception for certain working capital.  The Bill also cross references to the, “passive asset” definition in I.R.C. §469, the provision which limits deductibility of losses associated with passive investments (most typically involved in real estate investment).  A second portion to the Bill would limit discounts for lack of control where transfers are made to members of the family (cross referencing to the farm use valuation provisions of I.R.C. §2032A).

One interesting sidelight to this proposed bill is that the provisions are estate tax rules only.  It appears, at first blush, that this Bill, if enacted, would permit lifetime transfers subject to the traditional marketability and minority interest discounts.  However, the estate tax planning landscape would be changed dramatically and obviously, the legislative process often has a means of correcting perceived deficiencies with any potential proposed statute. 

A final note about H.R.436 is the provision which adds a 5% surtax on estates over $10,000,000 dollars.  There are currently other provisions proposed in Congress which would take alternate steps; however, until enacted, estate tax planners must “stay tuned”. 

Another proposal for elimination of inter-family discounts was proposed in the Treasury Department’s “Green Book” or General Explanation of the Administration’s Fiscal 2010 Revenue Proposals.  In this proposal, the Treasury requested that the provisions of Section 2704 of the Internal Revenue Code be modified to ignore valuation restrictions when a family controlled entity is transferred among family members.  In effect, this provision would allow for the IRS to disregard any restrictions that might be contained in an agreement concerning the limits on the transferor’s ability to transfer an interest (marketability) or obtain distributions (minority).  The proposal made by Treasury provides that the Treasury Department would also be granted regulatory authority to create safe harbors in certain circumstances.  Most surprising in this request is that the effective date that has been requested by the Treasury is retroactive to the effective date of Section 2704-October 8, 1990!  Unlike the Pomeroy Bill discussed above, this provision seems to apply broadly across all types of family controlled entities whether the entity includes passive assets or active businesses. 

Scoring

In late April, the tax writing committees began “scoring” tax legislation including estate tax.  “Scoring” is the concept of figuring out how much any particular proposal will “cost” the federal government.  In other words, a tax reduction can be viewed like a “use” of government money or as an expense – even though it is actually a reduction in revenue.  When Congress considers “scoring”, the debate will become more interesting.  Under procedural rules known as “pay go” or “pay as you go”, the government is supposed to figure out how to pay for any tax change by either increasing other taxes or cutting spending.  The “cost” of merely “fixing” the law to create a permanent exclusion of $3,500,000 per person plus the 45% (the 2009 fix) rate is large – between $300 billion and $600 billion.[1]  Budgetary protocol requires that cost and revenue be estimated over a ten year time horizon.

Why is the freeze at the 2009 limit so expensive?  Remember that current law calls for a return to pre 2001 rates, effective January 1, 2011.  This is existing law.  Revenue estimates under current law produce the baseline for comparison.  Therefore, the projection assumes a return to a $1,000,000 person exemption limit coupled with pre 2002 rate brackets which range up to 55%.  Thus, because the government has “assumed” and projected the receipt under existing law, an increase of the exemption “costs” considerable funds.  Earlier (pre 2008), negotiation had suggested a “fix” only until 2012 or 2014 to limit these costs; however, there now seems to be some motivation to make the estate tax “fix” permanent (until changed by a later law). 

How does the “pay go” rule mesh with the budget process?  There has been some discussion that the government should suspend the “pay go” rule in order to make the estate tax change necessary.  This approach would allow it to correct these problems.  However, fiscally conservative democrats (called the “blue dog democrats”) may not agree to the suspension – particularly in light of the projected budget deficits now before Congress.

At a May 1, 2009 ABA Real Property Probate and Trust law section meeting, Catherine Hughes, attorney advisor in the Treasury “Tax Legislative Counsel”, hinted that perhaps the 2009 rate and exemption freeze could be enacted for 2010 only.  This would permit the issue to become a political issue during 2010 (an election year for Congress) with the possible pending reduction of the exemption from $3,500,000 to $1,000,000 looming at the year end. 

Would the one year freeze raise money in fiscal estimate?  Probably.  While there would be estate tax collected on many estates (e.g. people that die in 2010 with estates over $3,500,000 without sufficient use of charitable and marital deduction) there will also be a loss of some revenue to the IRS due to the loss of the pending return to modified carryover basis.[2]  As the debate is carried on, there may be posturing by various constituencies.  One example of posturing can be seen in a bill introduced by Congressman Jim McDermott H.R.2023.  In addition to the 2009 fix with the $3,500,000 exemption 45% bracket, there was also an increased rate on large estates (over $10 million).  Further, he requested that the legislation “costs” be “scored” with and without portability of exemptions (portability generally favors “smaller” estates - $3 - $7 million) and with and without allowing a deduction of State taxes.  One mechanism for increasing estate tax is to deny the deduction for State estate tax (like the New Jersey estate tax).[3]  More in tax dollars would be raised for the federal government but we would see an ever increasing number of New Jersey residents with large estates seeking to relocate to non (estate) tax jurisdictions (like Florida) where the savings can be substantial.  Because the top State estate tax bracket occurs at $10 million in value and is deductible, the effective tax rate is 53.8%.  If the State tax was not deductible the marginal rate of estate tax for New Jersey residents over $10,000,000 in value would be 71% (45% federal plus 16% New Jersey). 

Grantor Retained Annuity Trusts

Another adverse development to the estate tax law and the planning afforded is the suggested requirement that for any gift to a Grantor Retained Annuity Trust (GRAT) established pursuant to I.R.C. §2702, the law would limit the ability of the donor to “zeroed out” the gift.  Obviously, with the stock market and other values significantly depressed, now is an excellent time to be considering the transfer of assets in a Grantor Retained Annuity Trust.  With a GRAT, in the event that the value of the assets in the trust appreciates over the trust term at a rate greater than the currently depressed market rates (2% in February, 2.4% in March and May), the excess appreciation will pass gift and estate tax free to the remainder heirs.  A Grantor Retained Annuity Trust is statutorily permitted pursuant to the provisions of Chapter 14 (I.R.C. §2702).  Moreover, under current law, it is actuarially permissible to remove the growth without being obligated to utilize any gift tax exemption by virtue of the “zeroed out” GRAT, a technique which values the retained annuity interest at an amount exactly equal to the value of the stock transfer. 

Under another proposal that has been discussed, the amount of gift on any transfer to a GRAT would be required to be at least ten percent (10%) of the initial fair market value of the assets transferred.  This is comparable to the provisions required for Charitable Remainder Annuity Trusts contained in I.R.C. 664(1)(1)(D).  This proposal is merely rumored to be under consideration and is apparently being considered by Treasury. 

In the May, 2009 “Green Book”( General Explanation of the Administration’s Fiscal 2010 Revenue Proposals) produced by the Treasury Department, zeroed out GRATs would be permitted; however, the proposal suggests that the term be a minimum term of 10 years.  This would substantially increase the risk that a grantor would pass away during the GRAT term and there would be a much higher likelihood that the GRAT would lose the anticipated transfer tax benefit. 

Consistency Issues

One curious element to Treasury proposals released in May, 2009 is the recitation provided of existing law.  As many tax practitioners are aware, the “basis” of an asset is “stepped up” to the fair market value of the asset at the time of decedent’s passing.  This is required by I.R.C. §1014.  The Treasury Department’s “Green Book” (General Explanation of the Administration’s Fiscal 2010 Revenue Proposals) indicates that it is possible for a beneficiary to take a basis in an asset for purposes of determining gain or loss which is not consistent with the value utilized for estate tax purposes.  The proposal contained in the Treasury Department’s Green Book includes a new requirement mandating consistency between the basis for estate tax purposes and for income tax purposes.  Thus, in the future there would be a mandated rule which would require consistency.  It is not clear the extent to which this provision would make sense, particularly due to the fact that so few estates will be required to file estate tax returns with increased $3,500,000 per person exemption amount.  At present, a very small number of estates will be required to file federal estate tax returns.

[1]   The Tax Policy Center www.taxpolicycenter.org estimated the cost over the years 2009-2018 to be $284 billion whereas the Center, on Budget and Policy Priorities (report dated 1-29-09), www.cbpp.org estimated the cost over 2012-2021 to be $609 billion. 

[2]   Existing law provides that in 2010 a step up of income tax basis is permitted only for $1.3 million (plus $3,000,000 to a spouse) of unrealized gain. 

[3]   Beginning in 2005, the State taxes paid became deductible in calculating the federal tax.  Thus, lessening the burden on estates of residents (like New Jersey) in States that impose such tax.