A bold new era began on January 1st for estate planning attorneys and their clients.  Despite December efforts in Congress to pass legislation amending the estate tax to either permanently reform the system or provide a short term patch, the Senate failed to agree on and pass any legislation regarding the estate tax whatever.  Consequently, on January 1st, the post-2009 provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) are in effect, and for the first time since 1915, our country has no estate tax.  What does this mean?    

For starters, here is what we do know.  First, effective January 1, 2010, under current law, the federal estate tax is repealed for any person dying on or after 12:01 a.m., on that day, or any time in the next twelve months.  In theory, this means that any amount can be transferred to beneficiaries at death as long as death occurs in 2010.     

Second, the federal generation-skipping transfer tax (GSTT) also is repealed for one year, effective the same day.  So it should make no difference whether inherited wealth is left to children, grandchildren, great-children, great-nieces or nephews, etc.  The law will no longer penalize those who die and by will or trust provisions effective at death skip one or more generations and benefit younger family members, either by direct outright bequests or by creating long-term trusts.    

Third, the federal gift tax is NOT repealed.  The lifetime gift tax exemption will continue to be limited to $1 million, but the top gift tax rate will drop from 45 to 35%.  This seems to be an intentional effort by Congress to attempt to limit the amount that wealthy individuals will give away in 2010.    

Fourth, the stepped-up basis rules are repealed for 2010 and replaced with a modified carryover basis regime.  Before 2010, the income tax basis of property received by inheritance was “stepped up” to the fair market value of the property on the day the decedent died.  Under the new rule, the basis of property acquired from a decedent is the lesser of the decedent’s adjusted basis or the fair market value of the property on the date of the decedent’s death, whichever is lower.  There will be two exceptions to the new rule:  (1) the executor under a decedent’s will can allocate up to $1.3 million to increase the basis of assets received from the decedent; and (2) the executor also will be able to increase the basis of additional assets passing to the surviving spouse, either by outright bequest or in a particular type of trust for the benefit of the spouse (QTIP trust).  Remember that the $1.3 and $3 million amounts refer NOT to asset values, but to the amount of permitted basis increase that can be allocated.     

The effect of carryover basis is an income tax increase for wealthier families.  The rules for allocation will be complicated, and we will deal with that process in a separate article.  The bottom line to remember here is that identifying and preserving tax basis records will become extraordinarily important.  For the first time in recent memory, a beneficiary may have to substantiate the decedent’s basis in inherited property.    

Under the current law, all of these changes are scheduled to come to an end on January 1, 2011.  Effective on that date, under the “sunset provisions” of EGTRRA, the federal estate and generation-skipping transfer taxes both come back into existence with exemptions of only $1 million and a 55% top tax rate (with an additional 5% surtax for some large estates).  The federal gift tax continues with the same $1 million exemption and a 55% top rate, meaning all three taxes (estate, GSTT and gift) are again united.  Carryover basis is repealed and the stepped-up basis is reinstated.    

So what does this all mean and what should our clients be doing? No one expected the scheduled estate tax repeal to occur. As late as December 1st and after, commentators in the legal world and Washington fully expected Congress to pass either permanent estate tax reform or a temporary patch extending the 2009 exemptions and rates through at least part of 2010 to give Washington time to wade through health care reform and properly deliberate regarding the numerous issues involved with the estate tax.  Consequently, there is ”massive confusion” (in the words of Senate Finance Committee Chairman, Max Baucus) regarding what Congress will ultimately do and the best course of action for estate planning clients now that the unthinkable repeal has occurred.    

Basically, in 2010, one of four things will occur:  (1)  Congress will act to reenact the estate tax (and GSTT), retroactive to January 1st.  This would seem to be the most likely scenario, but it may be very difficult for Congress to pull together the necessary votes.  Neither Republicans nor Democrats will  relish the thought of restoring an unpopular tax in an election year.  Also, if the tax is reenacted retroactively, there are certain to be constitutional challenges.  The Chief Tax Counsel to the House Ways and Means Committee, John Buckley, has announced his opinion that reenacting the estate tax and GSTT retroactively would be unconstitutional.  (2) Congress will reenact both taxes in 2010, but will not attempt to make them retroactive.  This likely will depend upon how early in the year the matter can be brought to a successful vote.  Action in the first couple months almost certainly will date back to January 1st, whereas if the estate tax becomes a political football and action is delayed until late in the year, the possibility of a retroactive application decreases.   (3)  Congress will take no action, allowing the repeal to stand for 2010, with a return to the prohibitive tax rates and low exemptions scheduled as part of EGTRRA for 2011.  (4) Congress will not succeed in reenacting the estate tax and GSTT for 2010, but will act shortly to repeal carryover basis and restore the stepped-up basis.     

What should our clients be doing now?  First and foremost, do not lose sleep over the estate tax situation.  We are monitoring the commentators and Washington sources very closely and will keep you informed.  If you are worried about your specific situation, do not hesitate to contact one of us to discuss your concerns.     

Second, we will be looking very closely at the unique planning opportunities that may be presentedby the temporary absence of the estate tax and GSTT and will be happy to make specific recommendations.  Depending on the likelihood of retroactive reenactment of the tax (which may or may not become easier to predict in the next couple weeks), this may be the ideal time to pursue aggressive gifting with payment of some gift tax at the reduced rate, use of discounts, and creation of grantor-retained annuity trusts (GRATs) and similar devices to take advantage of  the current law.  At the same time, we will advocate caution to ensure that a return of the tax does not cause undesirable consequences for transactions carried out early in the year.  We also will be reporting to you on how the federal law changes impact the Illinois estate tax (as well as other states’ estate taxes) and similar issues that may affect your planning.    

Third, regarding traditional estate planning, we are incorporating alternative language in our estate planning documents designed to provide the best tax consequences no matter whether the estate tax and/or carryover basis does or does not exist at the time of death.  For clients who already have documents in place, remember that we have been using “trust protector” provisions (providing for amendment of the document even after death by a third party) for a number of years.  The trust protector concept is specifically designed to protect and implement a client’s wishes regarding disposition of their assets even in the event of tax law or other changes that may unfavorably impact the planning a client put in place before death or mental disability made amendment by the client impractical. For the short-term, the trust protector provision could be implemented as needed if a client were to die with older out-dated planning in place. In the case of a decedent whose documents did not include a trust protector provision, a proceeding could be brought in state court to amend or “reform” the document.    

Finally, we will be contacting you at an appropriate time to suggest a meeting, as periodic updating of your estate plan is always a good idea, even in times not as tumultuous as these.  But do not hesitate to pick up the phone or send an e-mail to us at any time that you have thoughts or concerns that you would like us to address immediately. Your peace of mind is always our ultimate goal.  Have a happy and prosperous 2010 and stay tuned!

Washington Sources indicate that Congress finally may be getting serious about acting to amend the federal estate tax.  A House and Senate negotiating committee has been working to achieve a compromise among various bills proposed in the House and Senate, all aimed at preventing the scheduled repeal of the estate tax next year and replacing it with permanent reform.  The recent compromise would freeze an individual’s exemption at $3.5 million and the top tax rate at 45% (the current 2009 levels).  Based on the alternatives, this may be good news indeed.

Recent proposals would have set the tax rates on decedent’s estates considerably higher.  H.R. 2023 was offered by Democrat Jim McDermott.   That bill would have lowered the applicable exclusion amount available to an individual (the amount that would pass free of estate tax at the death of an individual if not utilized during lifetime for gifting) (the “exclusion”) from $3.5 million to $2 million.  It would have made the exclusion portable between spouses.  (Portability means that a surviving spouse would have the use of any remaining exclusion not utilized during life or at death by the first spouse to die — not currently permitted).  However, that would have limited a married couple to $4 million in total combined exclusion, down from the current $7 million. 

Worse, Representative McDermott’s proposal would have eliminated the current deduction for state death taxes.  An estate currently can take a deduction from the federal estate tax for estate taxes paid to any state.  Most states that have an estate tax still use similar systems based on the old credit from the estate tax for death taxes paid to a state.  This would have meant a substantial estate tax increase — combining the federal estate tax rate with an assumed rate equal to the old state death tax credit, taxable estates of $4,040,000 would have paid a combined tax rate of over 56%, with taxable estates exceeding $10,040,000 owing combined federal and state taxes at a rate of 71%! 

Other bills would have set the limits at far more sane levels.  A recent budget passed by the Senate would have increased the exclusion to $5 million per person and lowered the top estate tax rate to 35%.

Other related issues to watch with concern include what Congress will do with the current step-up in the income tax basis for assets passing from a decedent, the use of discounts in valuing lifetime gifts of closely-held stock and other property, and the lifetime gift tax exemption of $1million, to name a few.  Watching Congress attempt to reach final passage of a permanent amendment to the estate and gift tax portion of the Internal Revenue Code may well resemble a good NBA or NHL playoff game — unpredictable at best.  We will do our best to keep you informed.