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  First, effective January 1, 2010, under current law, the federal estate tax is repealed for any person dying on or after 12:01 a.m., on that day, or any time in the next twelve months.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Second, the federal generation-skipping transfer tax (GSTT) also is repealed for one year, effective the same day.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Third, the federal gift tax is NOT repealed.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Fourth, the stepped-up basis rules are repealed for 2010 and replaced with a modified carryover basis regime.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!

The Wall Street Journal reports that Exxon-Mobil’s recent $31 billion purchase of natural gas exploration firm XTO Energy confirms a recovery of merger and acquisition activity over the past 2 months. It reports that November and December had the most M&A activity since the summer of 2008, with values 4 times greater than a year ago. Also leading this charge were Warren Buffet’s largest ever $26 billion investment in the railroad industry, and the $4.6 billion merger of Stanley Works and Black & Decker. November alone saw the announcement of 41 U.S. deals worth a combined total of approximately $47.5 billion, benefiting mostly large Wall Street banks and boutique financial firms. Sources within the chemical industry also expect a 2010 rally in the number of deals.

Many experts believe these increases in M&A activity signal good news for the health of the broader economy in 2010. Indeed, the recent surge seems to be the result of increased access to capital markets, the stagnation of which has been cited repeatedly as the cause of the continued lagging of a broader recovery. Accompanying these positive indicators are the apparent stabilizing of economies world-wide, financing becoming more available in the broader spectrum, and the narrowing of the gap in price expectations between buyers and sellers. Consistently, a large regional bank representative recently said at a lunch meeting that their bankers have been directed to increase lending dramatically in 2010 as underwriters loosen standards for loan approval.

Until recently, any positive indicators of recovery always have seemed to accompany at least as many negative ones. As 2009 ends, however, the negative indicators appear to be waning strongly in favor of the positive. Also, while many experts claim, perhaps too definitively, that this recession is over, others hinge their disagreement mostly on lagging unemployment data. Yet unemployment typically is the last area to improve after a recession as companies tend to wait until they clearly are understaffed before resuming hiring. Moreover, early 2010 should provide great opportunities for companies to contact their previously obstinate bankers again to seek (or refinance) lines of credit and other financing.

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.

One of the few perks that a taxpayer can bestow upon his or her beneficiaries is the so called “step up” in basis under Section 1014 of the Internal Revenue Code. This Section generally permits the tax basis of property owned by the decedent to take a tax basis equal to fair market value as of the date of death of the decedent.  This Code provision is usually very helpful for taxpayers, particularly those who may have held appreciated securities or real estate for many years.  Depending upon the size of a person’s estates (taxable or not) the ability to step up the tax basis of assets may be outweighed by the ability to transfer the assets out of the taxable estate and avoid the usually greater marginal estate tax rate.

The recent carnage in the markets however, has left taxpayers with the unpalatable prospect of a step down in basis.  Section 1014 merely specifies that the basis of property acquired from the decedent is valued at fair market value as of date of death, independent of whether the fair market value is greater or less than basis.

For example, say Mr. G. owns 1,000 shares of AIG, which he purchased for $100 per share way back in October, 2000.  If Mr. G sells the AIG shares for $1, he incurs a long term capital loss of $99,000 ($100,000 - $99,000).  If he dies owning the shares, the tax basis of the shares plummets to $1,000.

What is a planner to do?  The first alternative is for the client to sell the property prior to death, thereby recognizing the loss.  The second alternative, if the client is married, would be to transfer the property to the healthier spouse so that he or she would have the opportunity to time the sale of the asset before his or her later death.  Section 1041(b)(2) of the Code provides that a spouse takes the donor’s basis in the transferred property.  The result is not the same however, if the donee is not the donor’s spouse.  In that case, it is a heads I win, tails you lose for the IRS.  If the fair market value of the property is less than the donor’s basis, then for purposes of recognizing any loss, the donee takes as his or her basis the fair market value of the property rather than the donor’s basis.

Example 2:  Assume Mr. G gives the AIG stock to his son, Junior.  Junior later sells the shares for $1.  He does not recognize any gain or loss because his basis is now $1.  He will later recognize gain or loss to the extent that the sales price of the shares is more or less than $1.

The above examples illustrate that the devastating meltdown in financial and real estate assets is turning some transitional estate planning on its head.

Congress continues with efforts at permanent estate tax reform. In January, Harry Mitchell (D) of Arizona introduced a bill that would reform the estate and gift taxes permanently.

The key parts of the bill would:   

•  Make the estate and generation skipping taxes  permanent;

•  Increase the applicable exclusion amount to  $5 million, phased in as follows:

          •  For calendar year 2010, $3,750,000
          •  For calendar year 2011, $4,000,000
          •  For calendar year 2012, $4,250,000
          •  For calendar year 2013, $4,500,000
          •  For calendar year 2014, $4,750,000
          •  For calendar year 2015 and thereafter, $5,000,000;

•  Index the applicable exclusion amount for inflation, beginning in 2016; 

•  Reunify  the gift tax exemption to the estate tax applicable exclusion amount;

•  Limit  the top estate and gift tax rate to the maximum capital gains rate for taxable estates of up to $25 million, and double that rate for estates over $25 million;

•  Index the $25 million threshold for the higher rate for inflation after 2014;

•  Repeal the estate tax deduction for state death taxes;

•  Retain the present rules that provide for a step up in the income tax basis of assets at death;  and

•  Allow the unused applicable exclusion amount of the first spouse to die for use by the surviving spouse.

It will be interesting to see how Congress “fixes” the estate tax. We are now less than 10 months from a one year repeal  and all of the interesting subplots that would bring.

If a seller of a business receives a substantial payment for a non-compete agreement, can that be characterized as income subject to capital gains tax?

Not according to the First Circuit Court of Appeals which strongly denounced the efforts of one Irwin Muskat.

The case arose out of the sale of Muskat’s business, Jac Pac Foods (based in Manchester, New Hampshire). It seems beyond dispute Muskat was highly successful at growing the family business, whose signature line was the distribution of meat products to restaurant chains. In 1998, Corporate Brand Foods America bought Jac Pac’s assets for $34,000,000. Above the purchase price, CBFA paid Muskat nearly $4,000,000 for a covenant not to compete. About one-quarter of that was paid up front.

Muskat filed his 1998 tax return and listed the payment as ordinary income, paying income and self-employment taxes accordingly. However, he had a change of heart and filed an amended return for 1998, seeking to recharacterize the income as a capital gain. Because of the lower rate for capital gains income, he sought a tax refund of $203,434.

After the Internal Revenue Service denied the request, Muskat filed suit.

The First Circuit affirmed the trial court’s judgment in favor of the United States. In its holding, the court made a number of important findings that business sellers will want to keep in mind:

(1) payments received in exchange for a non-compete are usually taxed as ordinary income;

(2) payments received for the sale of goodwill are usually taxed as capital gains;

(3) when a party seeks to vary a written allocation of income, that party bears the burden of submitting “strong proof” that the contracting parties actually intended the payments to compensate for something different; and

(4) the “strong proof” rule is analogous to the clear and convincing evidence standard familiar to litigants.

Applying these precepts to the IRS’ ruling, Muskat was doomed. Muskat negotiated the sale of business documents - including his own employment and non-compete agreements - and those agreements clearly said the money paid to Muskat was to protect Jac Pac’s (not Muskat’s goodwill) and to prevent Muskat from competing with CBFA after the closing.

Muskat could not muster up any evidence that the payments were intended for something different, i.e., his personal goodwill. Exactly what Muskat argued in support of this proposition is not at all clear. In fact, the sale documents showed CBFA paid $16,000,000 for Jac Pac’s goodwill, making any separate goodwill payment to Muskat “implausible.”

On October 1st, the Internal Revenue Service amended Section 382 of the Internal Revenue Code to facilitate bank mergers and acquisitions.  IRS Notice 2008-83 reads:

“For purposes of Code Sec. 382(h), any deduction properly allowed after an ownership change of a corporation that is a bank with respect to losses on loans or bad debts, including any deduction for a reasonable addition to a reserve for bad debts, shall not be treated as a built-in loss or a deduction attributable to periods before the change date. This guidance does not affect the application of any provision of the IRC except Code Sec. 382. Banks may rely on this guidance until further guidance is issued.”

The effect?  Two days later, Wells Fargo swooped in to buy Wachovia for $15 Billion Dollars.  Citibank had previously been offering a mere $2 Billion and had depended on the FDIC to backstop potential losses. 

Under United States tax law, Section 382 limits the scope to which operating and “built-in” tax losses can be used to offset an acquirer’s income after an ownership change.  Prior to October 1, only a small portion of a bank’s losses from distressed loans were available to offset income in future tax years. 

IRS Notice 2008-83 substantively change’s the effect of Section 382.  Now, Section 382 is does not apply if loan losses are recognized for tax purpose after an ownership change.  In effect, a bank may acquire a target, write-down the fair value of the loan portfolio, and apply the losses against its future income. In this case, Wells Fargo was able to write-down $74 Billion dollars in losses arising from Wachovia’s plagued loan portfolio. According to the Associated Press, this loss generated $19.4 Billion dollars in tax savings for Wells Fargo.  In effect, Wells Fargo was paid $4 Billion dollars to buy Wachovia.

This example illustrates a clear lesson to banks:  Sec. 382 can have powerful rewards for local financial institutions contemplating a merger or acquisition.