What Now? Estate Tax Planning in an Uncertain World
Jonathan M. Forster and Jennifer M. Smith
Under current law, the federal estate tax will disappear next year (2010) but reappear in 2011 with a much lower exemption amount and a much higher tax rate. Congressional action could avoid this situation, but the timing and content of any new tax legislation remain unclear. Accordingly, individuals and their advisors should implement key planning strategies now that will ensure a flexible and tax-efficient estate plan in the face of an uncertain future.
The Estate Tax Rollercoaster
Estate planning in the current environment is difficult due to the unsettled nature of existing law. Without Congressional intervention, the federal estate tax laws will change rapidly and significantly over the next few years:
• 2009. As passed by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the current maximum federal estate, gift and generation skipping transfer (GST) tax rate is 45 percent, the estate and GST tax exemptions are $3.5 million, and the gift tax exemption is $1 million.
•2010. Both the federal estate and GST taxes will be repealed. Inherited assets will retain a carry-over basis for income tax purposes, rather than receiving a step-up in basis to fair market value. EGTRRA will allow estates to allocate a $1.3 million credit to increase the basis of assets generally, with an additional $3 million credit for assets received by a surviving spouse as “qualified spousal property.” The gift tax will remain in effect, with a $1 million exemption and a maximum tax rate of 35 percent.
•2011. The federal estate, gift and GST taxes will return at pre-EGTRRA levels, with a maximum estate and gift tax rate of 55 percent (including a 5 percent surcharge on estates over $10 million), a unified gift and estate tax credit of $1 million, a flat GST tax rate of 55 percent and a GST tax exemption of $1,120,000 (indexed for inflation).
Expectations for Reform
To eliminate the uncertainty caused by current law, many expect Congress to pass estate tax legislation that prevents the 2010 estate tax repeal. President Obama has voiced support for freezing 2009 estate tax rates and exemption levels, a position that key Congressional members may support, such as Senate Finance Committee Chairman Max Baucus (D-Montana) and House Ways and Means Committee member Rep. Earl Pomeroy (D-North Dakota).1 New reform legislation, however, may impose other changes that dramatically affect current estate planning options, including:
• Providing Exemption Portability. With married couples, a portion of one spouse’s exemption amount may be lost without proper planning. For example, a spouse who dies in 2009 owning only $2 million of assets would potentially waste $1.5 million of federal estate tax exemption. “Portability” of the exemption would avoid this result by allowing the unused exemption to pass to the surviving spouse, for use at the surviving spouse’s death.
• Limiting Valuation Discounts. Family entities, like family limited partnerships, have become popular in estate planning because they provide an opportunity to transfer wealth to beneficiaries at a “discount.” Transfers of limited partnerships interests in these entities may receive discounts from fair market value to reflect the interests’ lack of marketability and/or control over the entity. Thus, the beneficiaries receive more wealth at a lower estate or gift tax cost.
Some reform proposals would severely restrict the availability of these valuation discounts. For example, House bill H.R. 436 (“Certain Estate Tax Relief Act of 2009”) limits valuation discounts on transfers of interests in non-actively traded entities that hold “nonbusiness assets” (e.g., passive investments) and prohibits minority discounts if the transferor and his or her family have control of the entity.
• Restricting Withdrawal Powers. Each individual is entitled to an annual exclusion from the federal gift tax for gifts of a “present interest” ($13,000 per individual recipient in 2009). A contribution to a trust is not a gift of a present interest unless a beneficiary has the immediate right to benefit from the contribution, typically provided by giving the beneficiary a withdrawal power over the contribution (i.e., a “crummey power”). Certain proposals would allow these withdrawal powers to qualify trust contributions for the annual exclusion only if they are held by a beneficiary with a vested (as opposed to contingent) interest in the trust.
• Eliminating Favorable Planning Techniques. The Internal Revenue Code statutorily sanctions certain estate planning techniques, such as qualified personal residence trusts (QPRTs) and grantor retained annuity trusts (GRATs). QPRTs allow individuals to transfer to their beneficiaries a portion of the appreciation in their principal residence, estate and gift-tax free. With a GRAT, an individual can transfer assets to a trust, retaining an annuity interest for a set term and transferring the assets remaining at the end of the term to his or her beneficiaries, again, gift and estate tax-free. Under current law, an individual can establish a GRAT without incurring gift tax by making the present value of the annuity payments equal the present value of the remainder interest (i.e., “zeroing-out” the GRAT).
Reform proposals may eliminate QPRTs entirely and/or change the rules to require that a GRAT’s remainder interest equal at least 10% of the initial trust contribution (effectively requiring a taxable gift upon the GRAT’s creation).
Whether Congress will pass any of these proposals is uncertain, and the cost of enacting the recent economic stimulus package will certainly affect the debate. Thus, Congress may opt for a one-year “patch” that keeps 2009 rates and exemptions in place for 2010. This patch would buy Congress time to revisit the issue next year, when it must address other expiring tax cuts under EGTRRA, including the expiration of the favorable dividend and capital gain tax rates.
Don’t Forget About the States
Apart from federal tax law uncertainties, individuals face new complexities in determining their potential state death tax exposure. Prior to EGTRRA, most states had a "pickup" tax, which provided that the state death tax equaled the "state death tax credit" provided under federal estate tax law. Due to this link, if an estate had no federal estate tax liability, it generally had no state death tax liability. For married couples, estate plans typically eliminated federal tax liability (and thus state death tax liability) at the death of the first spouse by using a formula clause. The formula placed the deceased spouse’s federal exemption in a “credit shelter” trust and gave the balance of the estate to the surviving spouse in a form that qualified for the unlimited federal estate tax marital deduction.
EGTRRA, however, repealed the state death tax credit in 2005, replacing it with a state death tax deduction. This change effectively eliminated the estate tax for states that retained a pickup tax tied to the credit. Some states, however, decoupled their death tax calculations from EGTRRA, either tying them to federal estate tax rules under pre-EGTRRA law or imposing stand-alone state death tax systems.2 Accordingly, many states have estate tax exemptions below the current federal estate tax exemption of $3.5 million.3
The resulting discrepancy means that estate plans using the typical credit shelter formula could cause a state death tax liability at the death of the first spouse. For example, assume that a married New York resident dies in 2009 with a credit shelter formula plan that funds a credit shelter trust with the federal exemption amount ($3.5 million) and a marital trust with the balance of the estate. The New York estate tax exemption, however, is only $1 million. Thus, placing $3.5 million in the credit shelter trust reduces the federal estate tax to zero, but results in a New York estate tax of approximately $229,200.
This potential state death tax exposure remains an issue even if reform legislation freezes the federal estate tax at 2009 levels. If the reform includes exemption portability, however, married couples in decoupled states could use it to manage their state death tax exposure at the death of the first spouse. For example, a credit shelter trust could be funded to the extent of the state death tax exemption, with the unused federal estate tax exemption applied at the surviving spouse’s death.
How to Plan Now
To deal with the current uncertainty and anticipate future changes, individuals should review, update and implement their estate plans now, giving consideration to the following planning alternatives:
• Be Ready for a New Tax Regime. The one-year estate tax repeal could take effect if Congress fails to pass reform legislation. Most estate planning documents, however, contain formulas that accommodate the increasing exemptions under EGTRRA. With the estate tax repeal, these formula clauses will no longer apply, because the concepts of a federal taxable estate and estate tax exemption will not exist. Accordingly, estate planning documents should include provisions that become effective only upon repeal of the estate tax. For example, the documents could provide that the estate passes to a trust that prevents inclusion of the assets in the surviving spouse's estate and qualifies for the $3 million basis increase for qualified spousal property.
• Address Decoupling. Planning for spouses in decoupled states should address the potential state death tax exposure at the first spouse’s death. Options include using a formula clause that limits the funding of a credit shelter trust to an amount that generates neither a federal nor a state estate tax. This plan, however, may waste part of the deceased spouse’s federal tax exemption. Alternatively, the surviving spouse (through a disclaimer power) or the executor (through various tax elections and fiduciary powers) could have the ability to decide whether to fund a credit shelter trust with the federal exemption and incur state death taxes, depending on the circumstances existing at the first spouse’s death.
For states that provide a marital deduction for property held in a qualified terminable interest property (QTIP) trust,4 another option is to fund a credit shelter trust with the amount that is exempted from both federal and state estate taxes, and then fund a separate QTIP trust with the excess federal applicable exclusion amount and making a state QTIP election. This should avoid federal and state estate taxes at the death of the first spouse. Even if the federal tax law is repealed, spouses will want to consider placing the state tax exemption amount in trust to ensure that it is sheltered from state estate tax at the death of the surviving spouse.
Note that individuals who do not reside in decoupled states may still have state death tax exposure if they own real property in a decoupled state. These individuals could place such property into a LLC, partnership or other entity in which the ownership interests constitute intangible property. Since state death taxes generally are levied only on real property and tangible property situated in a state, if the character of the property is changed into intangible property, it no longer should be subject to the decoupled state’s estate tax.
• Use Exclusions Now. Individuals should make transfers now that use their current exclusion amounts in order to ensure tax-free benefits. These gifts may provide specific benefits in decoupled states by decreasing the size of a decedent’s estate for state death tax purposes. Certain states may not impose a gift tax on lifetime transfers, which allows more property to pass to the beneficiary, tax-free.
• Don’t Miss Current Opportunities. Individuals should consider using available exclusions in combination with planning techniques that may disappear or become less favorable if certain tax law changes are implemented, such as GRATs, QPRTs and family entities.
• Take Advantage of Current Rates. Historically low interest rates and depressed asset values make this an opportune time to implement estate planning techniques that provide an arbitrage between actual investment returns and federally set interest rates, such as GRATs and installment sales. Growth in excess of the federal rates will pass estate and gift tax-free to the designated beneficiaries.
• Provide for Liquidity. A key feature of the recent financial crisis has been the tightening of credit availability and a slump in the stock and real estate markets. Thus, individuals may have limited access to liquidity, either because they cannot borrow funds or cannot sell assets to raise capital. A reversion to pre-EGTRRA estate tax levels, however, will expose more individuals to an increased estate tax liability. Accordingly, individuals should implement plans that ensure their estates will have access to sufficient liquid funds (such as through life insurance) to cover the increased exposure.
• Consider Valuation Issues. Planning documents should incorporate provisions that can adjust to a higher gift tax valuation and limit gift tax exposure if the IRS challenges the value of transferred property or disallows valuation discounts. For example, defined value formula clauses provide that, rather than transferring a fixed percentage or value of property, the only portion transferred is the amount that equals the available exemption amount, or, in the case of sale, the sales price. If the value of the property is higher than anticipated, the effect will be to reduce the fraction of the property that is transferred to the point where not gift is incurred.
Proper planning now will allow individuals to take maximum advantage of current tax planning opportunities while providing flexibility to adapt to future changes.
Jonathan M. Forster is Shareholder, National Chair of Wealth Management and Co-Chair of Insurance Transactions and Regulatory Groups, Greenberg Traurig, LLP and Jennifer M. Smith is an Associate with Greenberg Traurig, LLP.
1 See generally, Jay Heflin, “Baucus Drafting Bill to Freeze Estate Tax, Cut AMT,” CongressNow, Jan. 12, 2009;Peter Cohn, “Estate Tax Level Extension Eyed As an Attractive Offset Wednesday,” Congress Daily, Feb. 25, 2009. See, also, H.R. 436, “Certain Estate Tax Relief Act of 2009,” introduced in the House by Rep. Earl Pomeroy.
2 Approximately twenty-three states have decoupled or impose a separate state estate or inheritance tax. See, generally, Charles D. Fox, “State Death Tax Chart,” updated February 18, 2009, as prepared and maintained by Mr. Fox on behalf of the American College of Trust and Estate Counsel (www.ACTEC.org).
3 E.g., the District of Columbia, Maryland, Massachusetts, and New York provide only a $1 million state estate tax exemption, while Connecticut, Illinois provide a $2 million exemption.
4 States that provide a separate QTIP marital deduction include Indiana, Kansas, Kentucky, Maine, Maryland, Massachusetts, Oregon, Pennsylvania, Rhode Island and Tennessee. See Fox, at note 2.