Articles

2010 Repeal of the Federal Estate Tax and Its Impact on Existing Estate Plans

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”). This act provided for the temporary repeal of the estate and generation-skipping transfer taxes to take effect on January 1, 2010, with the reversion, on January 1, 2011, to the transfer tax law in effect in 2002. Tax practitioners thought it was unimaginable that Congress would not deal with the pending repeal in 2009; however, they chose not to act and no one knows what Congress will do next. The unpredictable environment, due to the current combination of tax rates and transfer tax exemptions and exclusion amounts, and the uncertainty of whether Congress will enact new law, causes profound uncertainties for estate planning in 2010 and beyond; and most existing estate plans should be reviewed because of this.

Under the EGTTRA, Federal estate taxes have been repealed for the 2010 tax year; and the generation-skipping-transfer (“GST”) tax doesn’t apply during 2010, while the gift tax remains in place with a $1 million exemption and a 35% maximum rate. Also a new regime was implemented for the tax basis of property passing to heirs of a descendant, which is called “modified carryover basis.” This regime substantially limits “step-up” in the basis of appreciated assets for a decedent dying in 2010, causing higher income taxes for the heirs; and estate plans which fail to consider the new regime may not get the full benefit of even the limited amount of basis “step-up.”

The EGTTRA provides that it will “sunset” and no longer be applicable on December 31, 2010. It provides that the law reverts to the law on estate, gift and GST taxes that existed in 2002 when the EGTTRA became effective. Unless Congress acts to change this, on January 1, 2011, the law will revert and provide for the estate tax rate of 55% (with a 5% surcharge on estate or cumulative gifts between $10 million and $17.184 million), a $1 million applicable exclusion amount for lifetime and testamentary transfers, and a $1 million exemption from GST tax (as indexed for inflation since 1999).

In 2009 the applicable exclusion amount was $3.5 million for lifetime and testamentary transfers, a $3.5 million exemption for the GST tax, and a $1 million exemption from exclusion for lifetime transfers.

At this point in time, Congress has the following choices:

- Do nothing and allow the EGTTRA to “sunset,” thereby returning the law for the estate, gift and generation-skipping-transfer (“GST”) taxes to the law that would have been in effect in 2002 had the EGTTRA not been enacted.

- Enact new legislation which, if constitutional, would retroactively extend the law that existed in 2009 and eliminate the repeal and “sunset” provisions of the EGTTRA.

- Enact new legislation which, if constitutional, would retroactively modify the law that existed in 2009 and eliminate the repeal and “sunset” provisions of the EGTTRA.

- Enact new legislation, which would be effective sometime after January 1, 2010, in which event there would be a “repeal gap” where the repeal of the EGTTRA would be effective from January 1, 2010, up to the point that new legislation takes effect (this would eliminate the constitutional arguments of retroactive legislation).

- Enact new legislation which makes the repeal of the estate, gift and GST tax permanent.

Depending on the language and structure of a person’s trust (or a will with testamentary trust provisions), the trust may need to be modified to take into consideration the possible actions of Congress, particularly to avoid the adverse tax effects of the EGTTRA for 2010 if there is a “repeal gap,” a “sunset” or retroactive legislation is deemed unconstitutional.

For example, existing estate plans, which contemplate the higher applicable exclusion amounts in effect in 2009 ($3.5 million) than were in effect in 2002 ($1 million) and fail to properly utilize “A/B Trust” planning for a married couple, may well be caught in a tax trap due to the reversion of the estate tax structure that occurs at “sunset.”

Every existing estate plan where the taxpayer’s cumulative assets with his/her spouse exceeds $1 million should be reviewed for the possibility that Congress may do nothing, therefore, allowing the EGTTRA to “sunset.” Alternative provisions may need to be added in the trust to deal with the possible event that the estate may become taxable due to a law change.

Also, most existing estate plans need to be amended which provide for a formula division for charitable or “A/B Trusts” (the division on the death between a Marital Trust and a Credit Shelter trust, also sometimes called a “bypass trust” or “family trust”). Again, alternative provisions may need to be added in the trust to deal with the various changes that are possible in the law.

For example, formula provisions have customarily made reference to the Internal Revenue Code and use terminology tied to definitions and other provisions found in the Code. Those provisions no longer have meaning during any period of repeal of the estate tax because those concepts are no longer part of the transfer tax system while the repeal of those provisions of the Code exists. Many bequests or transfers under these trust documents are defined in terms of tax definitions of the Code. Common phrases such as “applicable credit exemption” or “maximum marital deduction” or “minimum amount to reduce the federal estate tax to zero” are among those that no longer have meaning; and formulas using those terms won’t work while repeal of the estate tax exists. This can lead to disaster.

It becomes important because the estate of a decedent dying in 2010 may not fund the Credit Shelter or Bypass Trust, which would otherwise pass estate tax free, thereby allocating all of the decedent’s estate to the Marital Trust of the surviving spouse. The Marital Trust would then be added to the estate of the surviving spouse when he or she dies. If the surviving spouse dies after 2010, when the estate tax reverts, his or her estate will be aggregated with the decedent’s estate compounding the estate tax consequences of the surviving spouse.

Also, for decedents with large estates dying during a period of repeal, an opportunity exists (if the transfer tax law is not enacted retroactively) to pass the entire estate without estate taxes. Under previous planning techniques, the formula “A/B” Trust resulted in the intentional exposure of portions of the decedent’s estate to estate taxes, which would be offset by the Federal credit exemption ($3.5 million in 2009). For large estates this would also result in an allocation of a portion of the decedent’s estate to the marital trust portion, which eventually would be added to the taxable estate of the surviving spouse at his or her death. This would result in a postponement of the taxes of that portion. By contrast, during repeal of the estate tax it is possible that the decedent’s entire estate could be set aside because it will not be subject to estate tax, and nothing would be allocated to the marital trust portion. That would result in the entire estate bypassing the surviving spouse’s estate and lowering the eventual estate tax effects of the surviving spouse’s estate. For large estates this tax savings could be enormous.

The GST tax is treated differently by the EGTTRA than the estate tax, in that the GST tax has not been repealed. Its applicability has only been suspended for transfers made in 2010 but not with respect to assets that were transferred before 2010 or which may be transferred after 2010.

The EGTTRA, as present law (unless changed by Congress) says, “this chapter [meaning Chapter 13 which contains the GST tax sections] shall not apply to generation-skipping transfers after December 31, 2009.” However, with the EGTTRA “sunset” in 2011, the law regarding the GST tax will revert to the 2002 law after December 31, 2009. The effect is that in 2010 the identity of persons and the determination of their generational level that are critical to the application of the GST tax and GST tax exemptions cannot be determined.

For example, you cannot identify the “transferor” in the GST tax setting because no one during 2010 meets the definition of “transferor” under the Code. A “transferor” is the individual with respect to whom property was most recently subject to Federal estate or gift tax. However, in 2010 with the death of a decedent there would be no “transferor” because there is no estate tax. Transferees and their generational level are defined relative to the “transferor.” In 2010, trusts containing property that was not subject to estate tax at the death of the decedent (but that would have been subject to estate tax had the estate tax been applicable) will give rise to GST taxes after 2010 when the “sunset” applies or after a “repeal gap” when the GST tax will again apply. Therefore, trust planning requires consideration of these issues in their structure and language and may necessitate modifications of existing trust instruments.

Further, in the case of large estates, in 2010 the EGTTRA may have the effect of losing the opportunity for the best use of the GST tax exemption after December 31, 2010. In the above example where the formula provision is ineffective and the Credit Shelter Trust isn’t funded for a spouse who dies in 2010, and then the surviving spouse dies after “sunset” or after the reestablishment of the GST tax, then any benefit that might be derived from the temporary inapplicability of the GST tax during 2010 will be lost (again assuming Congress doesn’t retroactively reinstate the GST tax for 2010). Trust language should consider this, and existing trusts may need to be amended to do so.

The modified carryover basis rules implemented by the EGTTRA are also problematic and may require existing trust instruments to be amended. Before 2010, the tax basis of property passing to beneficiaries was the value on the date of death. If the value was less than the decedent’s tax basis, then the tax basis of the beneficiaries will be reduced below that of the decedent. But, where there is unrealized appreciation of the asset at the date of death, this appreciation was not taxed because the asset acquired a new tax basis equal to the value at the date of death. These same rules will be in effect if there is a “sunset” after December 31, 2009.

Under the modified carryover basis regime of the EGTTRA, to the extent that the unrealized appreciation exceeds certain limits or does not meet certain requirements, the unrealized appreciation of the assets will be subject to capital gains taxes. This is a new tax that was intended by Congress to somewhat offset the elimination of the estate tax. Estate planning and trust modifications in 2010 need to consider these factors and implement appropriate provisions to take advantage of the limited amount of step-up in basis that continues to be allowed as an exception to carryover basis rules.

The limited step-up in basis that remains under the EGTTRA for 2010 is an amount equal to $1.3 million of unrealized appreciation which the executor or trustee may allocate to specific assets in the general estate. There is another $3.0 million of unrealized appreciation for assets passing to a surviving spouse, either outright or in certain kinds of trusts (but not all trusts which benefit the spouse). If the estate plan is not properly structured, the benefit of these limited exceptions to the carryover basis regime may be lost, exposing the unrealized appreciation to capital gains taxes.

In the example above where the formula provisions of an “A/B Trust” references terminology tied to definitions of the Code which have been repealed for 2010, the loss of one of the limited benefits of the modified carryover basis regime may be lost. If the formula doesn’t work, there may be the loss of either the $1.3 million step-up in the Credit Shelter Trust or the $3.0 million step-up in the Marital Trust.

No one is certain what Congress will do next, leaving existing trusts and planning new trusts in 2010 fraught with uncertainties and possibly some opportunities. This will require that the language of a trust include alternative provisions depending on what transfer tax law may become applicable to the decedent’s estate. Each taxpayer’s circumstances may dictate a different strategy to accomplish the taxpayer’s objectives; and existing estate plans should be reviewed to determine the effects of the EGTTRA, and, if necessary, modified to provide for alternate dispositions to deal with those effects and uncertainties as best as is possible.