Fallout from the Estate Tax Repeal of 2010

By William Finnecy, CPA, CVA and Albert Isacks, CPA

President Obama quickly has begun to address the economy, the budget deficit, healthcare, taxes, and many other challenging issues, among them the uncertainty in the federal estate tax law.

As of today (Feb. 4, 2010), there is no estate or generation-skipping transfer (GST) tax for 2010, and the lifetime gift tax exemption amount is $1 million with a 35 percent tax rate. Many in Congress and elsewhere believe the estate and GST tax can be reinstated retroactively to Jan. 1, 2010. Tax gaps may exist depending on congressional action or inaction, both presenting planning opportunities and pitfalls. This letter attempts to address this dilemma.

For 2009, the estate tax exclusion amount was at a historic high of $3.5 million, up from $2 million in 2008, with a flat tax of 45 percent on the excess. As part of the tax reductions passed in 2001, the estate tax for 2010 has been repealed for a single year. Further, the 2001 law is scheduled to expire in 2011 and return the estate tax to a top marginal rate of 55 percent and an applicable exclusion amount of only $1 million. Most practitioners consider the existing 2010 full year repeal to be unlikely and that Congress will retroactively reinstate the 2009 law, but no change in the 2001 law (affecting 2010 estate and GST tax) has been made at this time.

On April 29, 2009, Congress agreed to a budget resolution “extending the law as in effect for 2009 for the Estate and Gift Tax” through 2019. The resolution does not specify the exact revisions to be made to the tax code, but at least it indicates the general direction the law will follow. More detailed guidance from Washington can be expected before long. This was also included in the budget resolution that the president submitted in January to Congress.

If this resolution is enacted into law, it will give much needed certainty to the estate planning process. It is now a good time to review estate plans in light of these facts. Other factors, such as historically low interest rates and reduced asset values, may also suggest changes to consider.

Review of Existing Wills

The increase of the federal estate exclusion to $3.5 million in 2009 ($7 million for a couple) and unlimited in 2010, with appropriate planning together with reduced asset values, may allow some clients to simplify their planning. However, many states have not raised their exclusion amounts to match the federal level. These lower and differing exclusions can also have significant consequences.

Credit Shelter Trusts. Many wills provide for “credit shelter trusts,” typically to maximize the amount of assets passing free of estate tax on the surviving spouse’s death by taking advantage of the maximum federal exclusion. The increased federal exclusion amount may result in a will creating a trust of up to $3.5 million in 2009 and unlimited amount in 2010 upon the death of the first spouse to die. Although a trust of this size is advantageous for federal tax purposes and will not trigger a federal estate tax, it may trigger significant state estate taxes and may provide a surviving spouse with insufficient personal funds due to the lack of a marital deduction. For many clients, this result will be an unwelcome departure from a plan originally designed to defer all estate taxes until the second spouse’s death. Additionally, clients with such wills may find that the size of the credit shelter trust substantially exceeds the amount originally anticipated, which could affect the surviving spouse’s access to resources.

Under these circumstances, formulae for smaller credit shelter trusts, designed to create trusts which will pass free of both federal and state estate taxes, may be worthy of consideration.

Specific and “Cash” Bequests. The proportion of an estate represented by bequests made to family members, other persons or charitable organizations, if in the form of stated dollar amounts or of specific property, may have been altered by declining asset values. Whether such bequests continue to meet a client’s original objectives relative to the overall value of his or her estate should be re-considered.

Estate Planning Techniques

With an economic climate of declining asset valuations, reduced retirement savings, financial institutions facing difficulties and recession (or worse) dominating the news, lifetime transfers of assets to younger generations may seem to have a low priority. However, lower asset values combined with historically low interest rates present particularly attractive opportunities for transferring wealth.

Grantor Retained Annuity Trust (GRAT). This estate planning technique utilizes IRS-approved discount factors to make gifts of assets having the potential for appreciation with minimal or no gift tax consequences. In a GRAT, the client transfers property to an irrevocable trust, retaining the right to a fixed annuity for a term of years, and the value of the gift to the trust for gift tax purposes is reduced by the IRS-determined present value of the client’s retained interest. If the client survives the term of the trust, any property remaining in the trust, including any appreciation in the trust assets that exceeds the IRS-assumed rate of interest (which is 3.0 percent  for January, 2010, and is recalculated monthly), passes to the client’s beneficiaries free of any gift or estate tax.

Obviously while some GRATs may appreciate and succeed, others may fail. A GRAT may currently be structured so as to “zero out” the taxable gift with an annuity set at a level so that the present value of the client’s retained interest is equal to the value of the property transferred to the trust. This approach allows the use of any number of GRATs, some of which are likely to succeed.

There is some discussion that Congress may change the law to require that a gift to a GRAT have a value of greater than zero for gift tax purposes and also have a minimum term of 10 years, therefore requiring the use of a portion of the client’s lifetime exclusion for gifts (currently at $1 million, beyond which gift tax would be payable) and discouraging the use of an unlimited number of GRATs. However, low interest rates, currently low asset values and favorable law make a GRAT a particularly attractive estate planning tool at this time.

Qualified Personal Residence Trust (QPRT). A silver lining of the cooling real estate market is the opportunity to use a QPRT to transfer a “personal residence” (e.g. a primary residence or vacation home) to beneficiaries while values are low. In a QPRT, the client transfers a home to an irrevocable trust, retaining the right to reside in a home rent free for a fixed term of years. The amount of the taxable gift made upon the initial transfer of a home is the value of the residence, discounted by the IRS-determined present value of a client’s retained interest.

If the client survives the term of the trust, the value of the home, including all appreciation after the creation of the trust, will be removed from the client‘s taxable estate. After the trust term ends, a rental arrangement for the client’s continued use of the home can be structured, and rent payments from the client to the beneficiaries (which can be used to pay property taxes, insurance and other home expenses) can further reduce the client’s taxable estate. The trust can be extended and appropriate provisions included so that no income tax is payable by the beneficiaries on the rental income, thereby creating more tax savings.

GST Trust Planning in 2010. If you have used most of your lifetime GST exemption amount, little additional multi-generational gifting can be completed without incurring transfer taxes. Assuming a window of opportunity exists in 2010 because currently no estate tax or GST tax exists and Congress has not acted to reinstate the estate tax and GST tax, you may be able to make unlimited gifts to grandchildren and later generations or to multi-generational trusts without incurring the GST tax. If the estate and GST tax were reinstated, transfers to these multi-generational trusts could potentially be grandfathered and escape the tax altogether.

A strategy using a GST trusts to plan for the potential change in the GST tax law would follow the creation of a so called GST flexible trust. In a so called GST flexible trust, you would create and fund a trust for the benefit of your children, grandchildren and future generations with the children’s portion going to one sub-trust and grandchildren/future generations portion going to a separate sub-trust. The trust would also contain certain flexible language in it where the children’s and grandchildren/ future generation’s shares would be governed by a formula tied to the then-allowable GST exemption amount (grandfathered amount) transfer, thus preserving options to any final 2010 law changes.

If Congress were to retroactively reinstates the GST tax to the beginning of 2010 and the taxpayer had transferred more to the trust than the allowable GST exemption amount, only that portion of the transfer which equals the taxpayer’s then-allowable GST exemption amount would pass to the grandchildren and younger generation’s trust with the remaining portion passing to the children’s trust.

Low Interest Loans to Family Members. Low interest loans can transfer significant value to family member without constituting gifts for tax purposes. The IRS prescribes minimum interest rates that must be charged to avoid triggering a taxable gift, but those rates are currently very low. Younger family members may be able to invest the borrowed funds for substantially higher returns.

For example, in January, 2010, a client could lend a child (or other family member) an unlimited amount for a nearly nine-year term at the fixed rate of 2.45 percent. (If the loan term is nine years or longer, the minimum rate is currently 4.11%, and if the loan term is shorter than three years, the minimum rate is 0.57  percent.) The child’s income and appreciation on the investment (net of the low interest payments) would belong to the child, free of gift or estate tax. This method is a particularly useful way to assist a child in purchasing a home at today’s reduced prices.

Incurring a Gift Tax in 2010.  The gift tax rate has dropped to 35 percent starting in 2010 including a lifetime gift exemption amount of $1 million. A taxpayer may want to consider incurring a taxable gift in 2010 (and paying tax at a 35 percent tax rate) instead of the potential of having the gift being subject to future estate tax (and paying tax at a rate up to 55 percent). Also, the tax efficiency of the transfer has been increased because unlike the estate tax, the gift tax is computed on a tax-exclusive basis, i.e. the tax is paid from other assets of the donor’s estate thus further reducing the donor’s potential taxable estate.

Taxable gifts in 2010 should be made as early as possible. In the worst case (Congress retroactively reinstates the 2009 law), the taxable gift would be taxed at a 45 percent rate. In the best case (Congress does nothing), the taxable gift would be taxed at a 35 percent rate.

Non-Taxable Gifts. The annual exclusion for gift tax purposes has been increased to $13,000 per recipient (or $26,000 for married couples who are “gift-splitting). Annual exclusion gifts remain among the most advantageous estate planning opportunities as they remove from the client’s taxable estate not only the amounts of the gifts, but also any post-gift income and appreciation on the property. Such gifts could be utilized to transfer a family business or other interests that have declined in value. Gifts to pay tuition and medical expenses can be made in unlimited amounts if paid directly to the educational or medical institution. The special annual exclusion for gifts to non-citizen spouses has increased to $133,000 for 2009 and $134,000 for 2010, up from $128,000 in 2008.

Life Insurance Trusts. Life insurance continues to be a uniquely favored asset for estate tax purposes. If insurance on a client’s life is acquired by a properly drafted and administered life insurance trust (or an existing policy is transferred to such a trust and the client survives another three years), it is possible for the insurance proceeds to be excluded from the client’s taxable estate. A life insurance trust is especially useful for a client who is property rich and cash poor, as it can provide the family with a cash flow to pay for estate taxes and administration expenses. Clients considering the purchase of significant life insurance policies, or already having them in place, may wish to consider creating life insurance trusts.

Most transfers in trust for grandchildren and younger generations should be considered early in 2010 before Congress acts.

Family Limited Partnerships. The IRS continues to attack the use of family limited partnerships and similar entities (such as limited liability companies) to transfer assets to family members at discounted values. Additionally, Congress is reviewing proposals to eliminate intra-family minority discounts on transfers of family businesses, but taxpayers had some court victories in 2008. These cases are very fact-specified but have some common elements. To note a few, an entity is more likely to be respected for favorable tax treatment if:

• There were legitimate non-tax purposes for forming the entity;
• There is an ability to document active management of the entity’s assets;
• The client refrains from the use of an entity as a “pocketbook” for personal expenses; and
• Sufficient assets are maintained outside the entity to provide for the client’s support and the payment of estate taxes on the client’s death.

Clients with family limited partnerships or similar entities in existence should ensure, in consultation with counsel and other advisors, that all necessary legal formalities (e.g., tax filings, periodic meetings, etc.) are being observed. Again, this is an area that Congress is taking a very close look at as is evident in the current budget resolution, where the president has also proposed severely curtailing discounts for lack of control.

Carryover Basis. Under Internal Revenue Code Section 1022, the income tax basis of assets acquired from an individual who dies in 2010 will not equal their estate tax values. Instead, the basis of his or her assets will “carryover” to those who inherit the property. There are two “exceptions” to the carryover basis rule, which will provide some relief to the beneficiaries who receive these assets.

The first exemption permits the decedent’s executor (or personal representative) to allocate up to $1.3 million to increase the basis of assets. This increase, however, may not increase the basis above the fair market value of the asset on the date of death. In addition to the $1.3 million step-up in basis, the decedent’s executor (or personal representative) can also allocate up to $3 million to increase the basis of assets that the surviving spouse receives outright or through a QTIP trust (called “qualified spousal property”).

These 2010 carryover basis rules will place additional record keeping burdens on estates and beneficiaries and their representatives.

General Housekeeping

As always, we recommend a review of your estate plan whenever there is a significant change in your family situation, your financial circumstance or the tax law. We also continue to recommend the periodic review of all of your estate planning documents, including your living wills, health care proxies, powers of attorney, and beneficiary designations for life insurance policies and retirement plans. Periodic reviews of life insurance coverage are also recommended in appropriate circumstances to assess whether existing coverage is adequate.

We hope you find this information helpful. If you have any questions about any of these concepts or developments discussed in this letter, we would be happy to review them with you.

Contact the authors with questions or comments by calling 814.454.4008 or via email at wfinnecy@malinbergquist.com and aisacks@malinbergquist.com, respectively.

The Malin Bergquist Tax Group: