Publications > C & A News Alert - January 2010

Death Tax Repeal!?

Many of our clients share with us their frustration about the amount of taxes they pay. After paying Federal and State income taxes and sales taxes for their whole lives, they become even more frustrated when they learn that when they pass away, their estates might be subject to an even more burdensome tax approaching 50% of the value of their accumulated wealth – in the form of the so called “death tax,” the technical name of which is the estate tax.

For many years, political efforts had been underway to reduce or eliminate this death tax. In fact, back in 2001, federal legislation was passed to eliminate the death tax (at least temporarily) by January 1, 2010. At that time Republican Congressional leaders promised to return to this issue and to make the death tax repeal permanent. For a variety of reasons, permanent repeal hasn’t happened. More recently, the political sands have shifted, and it was commonly believed that Congress would take action to prevent the temporary repeal of the death tax -- perhaps by freezing the death tax rules that existed during calendar year 2009.

The members of the Estate Planning and Wealth Transfer Group at Coman & Anderson, P.C. carefully monitored the United States Congress’s 2009 legislative activities as the deadline for estate tax repeal loomed. However, 2010 has dawned with no legislative action. As a result, as of January 1, 2010, the death tax is no more. Before you start celebrating though, please know that we do not expect the repeal to last for long.

How does this affect you?

We have been contacted by many of our clients in recent months wanting to understand how the new death tax regime will affect them. The short answer is that if we have not prepared or reviewed your will and trust documents with you in the last two years, we recommend that you contact us to review your situation in light of the new tax and political landscape.

We thought it an appropriate time to bring some perspective to this confusing arena. To understand where we are at right now, we need to briefly review the trajectory of the estate tax over the past decade, what changes have been wrought by recent Congressional inaction, and what steps you should consider taking now.

A Brief History of the Death Tax

As many of you may know, the United States has taxed the estates of deceased persons since 1916. In 1976 Congress linked taxes on estates, gifts made during life, and generation-skipping transfers (GST). Tax relief legislation passed in 2001 reduced all three taxes -- but only through 2010. That legislation gradually phased out the estate and GST taxes, and repealed both entirely beginning in 2010, leaving only the gift tax (at a reduced rate).

As a result of some arcane Congressional rules the 2001 law had a “sunset” provision. This meant that unless state tax repeal was later made permanent, after 2010 all three taxes automatically revert to their status before the 2001 legislation was enacted.

Here are some highlights of the law as it existed prior to January 1, 2010:

• The executor of an estate must file a federal estate tax return within nine months of a person’s death if that person’s gross estate exceeds the exempt amount (which was $3.5 million in 2009).
• The estate tax applies to the value of a decedent’s “gross estate.” This generally includes all of the decedent’s assets, both financial (such as stocks, bonds, CDs and mutual funds) and real (homes, land, and other tangible property). It also includes the decedent’s share of jointly owned assets as well as life insurance proceeds, IRA’s, Annuities and Qualified Plan assets.
• In computing the tax, estates are allowed to deduct from the value of the gross estate an unlimited amount for transfers to a surviving spouse and transfers to charity. Estates may also deduct debts, funeral expenses, legal and administrative fees, and estate taxes paid to states.
• The estate tax law provided a credit that effectively exempted a large portion of the estate: in 2009, the first $3.5 million was exempt from tax. In 2009, the estate tax rate of 45% was then applied to any amount over the effective exemption. Since 2001 the amount that is exempt from tax has increased, and the estate tax rate has decreased [see accompanying chart, data courtesy of the Tax Policy Center].
• For family-owned farms and closely-held businesses, special provisions may reduce the tax, or may spread out the payment of any estate tax over time.
• Congress enacted the companion gift tax in 1932 to prevent wealthy individuals from avoiding the estate tax by transferring their wealth to their heirs before they died.
• The gift tax provides a lifetime exemption of $1 million per donor which, when used, also reduces the estate tax exemption dollar for dollar. Beyond that exemption, donors must pay gift tax equal to 41% of the first $500,000 and 45% of any excess.
• Small annual gift amounts were also exempted from both the gift tax and the lifetime exemption. This exemption -- $13,000 in both 2009 and 2010 -- is indexed for inflation in $1,000 increments, and is granted separately for each recipient. For example, a married couple with three children could give their children a total of $78,000 each year ($13,000 from each parent to each child) without owing tax or having such gifts count against the lifetime or death time exemptions.
• The GST tax was enacted by Congress in 1976 to prevent families from avoiding the estate tax for one or more generations by making gifts or bequests directly to grandchildren or great-grandchildren rather than passing them through each generation. The GST tax effectively imposes a second layer of tax (using the exemption and the top tax rate under the estate tax) on wealth transfers to recipients who are two or more generations younger than the donor. During calendar year 2009, the first $3.5 million of generation skipping transfers was exempt from the GST tax.

What We’ve Been Watching

With the prospect of the federal estate tax being repealed, planners have been anxiously waiting for guidance from Washington. The legislative uncertainty has challenged estate planners and their clients who labor to create workable and flexible plans. 

Anyone following the debate understands that there is a strong Republican desire to make the repeal of the estate tax permanent – or at least make a higher exemption amount permanent; the current budget problems facing Washington, however, suggest that permanent repeal is clearly off the table. We have seen a reprise of the debate over the efficiency and fairness of this system of taxation; while this is of historic and philosophical interest, we will not belabor it here.

At Coman & Anderson, P.C., we’ve been monitoring the progress of various proposals being considered by Congress. These proposals address a slew of issues designed to maintain the estate tax and to address numerous estate tax reforms that go beyond the size of the estate tax exemption. Some of these related issues include:

• Estate tax rates and how they should be applied.
• Consideration of reunifying the gift and estate taxes.
• The possible “portability” of estate tax exemption unused by a deceased spouse or spouses.
• Imposition of term limits on “grantor retained annuity trusts.”
• Curbing perceived abuses in valuation discounting.
• Regulation of so-called “Crummey” withdrawal powers.
• Revisiting state death tax credit and deduction issues.

In fact, over two dozen bills were introduced since 2008 to address these issues. While some of these carry minor implications, towards the end of last year there were four major bills likely to impact estate planners and their clients:  

• H.R. 4154 was introduced on November 19, 2009 by Earl Pomeroy (Dem., ND) and is largely similar to a bill he introduced earlier in 2009 (H.R. 436). This resolution, passed by the House on December 3, 2009, would permanently extend the current estate tax exemption amount ($3.5 million per person and $7 million total for a married couple) and includes a maximum estate tax rate of 45%.  It would also repeal the carryover basis provisions under the 2001 law that were scheduled to go into effect (discussed below).
• Senate Bill 722, introduced in late March 2009, would make the 2009 estate tax law permanent ($3.5 million estate-tax exemption and top tax rate of 45%), reunifies the gift-tax and estate-tax exemptions, indexes the exemption amount for inflation and allows for exemption portability (allows the transfer of a first-to-die spouse’s unused estate-tax exemption to his or her surviving spouse). Senate Bill 722 also included a special use valuation that benefits family farms and other real-estate heavy family businesses.
• House Bill 2023, has far more reach than the others because it drops the estate tax exemption level to $2 million and creates a tiered tax-rate structure starting at 45% for estates valued from $2- $5 million, 50% for estates valued at $5 to $10 million, and 55% for estates valued over $10 million, all indexed for inflation. Like S.B. 722, this Bill reunifies the estate and gift-tax exemption, allows for exemption portability and restores the state estate-tax credit in lieu of the current state estate tax deduction.
• House Bill 3905, labeled the “Estate Tax Relief Act of 2009,” was introduced by Shelley Berkely (Dem., NV) on October 22, 2009. This bill called for an increase in the estate tax exclusion amount of $150,000 a year each year from 2010 through 2019. At the same time the bill calls for a reduction in the effective top tax rate by 1% a year. In 2019 this results in an exemption amount of $5 million (indexed for inflation thereafter) and a top tax rate of 35%. In addition, the deduction for state estate taxes would go down 10% per year through 2019, when it would cease to exist.

What Did Congress Opt to Do?

Congress opted to take no action on any of the pending bills.

With this inaction, the sunset provisions of the 2001 law kicked in, and the Federal estate tax is now repealed. Estate tax repeal has long been the goal of many conservative tax watchdog groups, but as we said earlier, we think the time for their celebration is not quite at hand.

As we noted above, under the 2001 legislation, the estate tax is repealed for calendar year 2010 only. Thereafter, the estate tax regime, as it existed in 2001, comes back into full operation in 2011. This means that we need to understand what’s going on in 2010, and what happens in 2011 and thereafter.

Here are more highlights:

• As we saw, the 2001 law incrementally increased the estate tax exemption all the way up to $3.5 million for persons passing away in 2009.  Under the “sunset” provisions of this law, the exemption amount will revert to $1 million for both estate and gift tax purposes starting in calendar year 2011.
• Under the 2001 law, the top estate and gift tax rate was also reduced incrementally - dropping to 45% for transfers made in 2009.  In 2010, there will be no estate tax and the top gift tax rate will be 35%.  The top estate and gift tax rates revert to 55% in 2011.
• Prior to 2010, beneficiaries received a “step up” in basis when they received inherited property. This means that when a beneficiary sold the inherited property, he or she computed gain or loss for capital gains purposes using the inherited property’s value as of the date of the decedent’s death. In calendar year 2010 only, those beneficiaries of decedents dying in 2010 will receive the inherited property at the decedent’s tax basis. This means that in the case of appreciated property, the beneficiary may owe substantial capital gains tax if the assets are later sold. Note that the law provides beneficiaries with the ability to minimize the capital gains by electing to increase the tax basis of inherited property – up to a certain amount.  For example, the basis of assets received from an individual dying in 2010 can be increased by $1.3 million and by an additional $3 million for property inherited by a surviving spouse.
• Under the “sunset rule,” when the estate tax kicks back in, the step-up in basis rules return.
• There are many other technical provisions of the 2001 law that also expire in 2010 (related to state death tax credits and deductions, family-owned businesses, and so forth) that come back into play in 2011.

So Will This Change Again?

Our prediction that Congress would act rationally and address this problem before the end of 2009 was clearly inaccurate and so we hesitate to prognosticate again. However, we have every expectation that estate tax reform will be addressed before long.

Any one of the Bills discussed above could be enacted, or some new proposal could be adopted. In fact, there is significant discussion that any coming legislative change could be made retroactive to January 1, 2010, however there are questions about the constitutionality of Congressional authority to levy retroactive taxes. What will happen to the estates of decedents who pass away between 01-01-2010 and the date of new legislation? Quite honestly, no one has a definitive answer.

What Should Clients Do Now?

For many of our clients, their planning structures anticipated fluctuating levels of estate tax exemption, and they may be well positioned in light of the new law. Others may wish to take action now.

Review Existing Plans

Some clients may wish to revisit their current planning structures to make sure that their planning is flexible enough to respond to exemption levels at $1 million, $3.5 million or higher, and to make sure that coordination with the Illinois estate tax has been addressed.

Some clients have simply not had their plans reviewed in a long time. Even for clients for whom estate tax minimization is not a critical component of their planning, periodic reviews make sense to address other important -- non-tax-motivated -- issues such as making sure that named executors and trustees remain appropriate, assuring that durable powers of attorney and health care representative appointments are current and appropriate, to consider whether ages for distributions to children need to be revisited, and so forth.

Many clients have simply been on the sidelines – taking a wait-and-see approach to their planning until Congress provides clearer direction. We find that view logical and understandable, but given the uncertainty of our own mortality combined with the uncertainty as to the timeline for legislative action, if you have not had us prepare or review your documents in the last two years, then we recommend that you contact us now to begin the dialogue about revisiting your planning needs.

Gifting/Asset Transfers

For some clients, continued use of the annual exemption from gift tax ($13,000 per person, per year) continues to be a simple and effective estate tax reduction strategy by removing value from the donor’s estate. This strategy will likely remain sound regardless of legislation in the estate tax arena.

Other popular wealth transfer tools will continue to have vitality – unless legislation changes the landscape. Such tools as grantor retained annuity trusts (GRAT), family limited partnerships (FLP), transfers of residential property to qualified personal residence trusts (QPRT), and intra-family loans, and other structures that take advantage of depressed asset values and a low interest rate environment continue to be effective. If a strategy like this has been on your radar, we urge to you to get in touch with us now to discuss whether the time is right to put such planning techniques to work to benefit you and your family.

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We will continue to monitor legislative activity in this area closely and will supplement our report as developments occur.

If there are any issues that you would like to explore further with us, we urge you to contact any of the members of the Coman & Anderson, P.C. Estate Planning and Wealth Transfer Group:

Daniel G. Coman
Mark D. Anderson
William J. Cotter
Lynn E. Cagney

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