- FEDERAL ESTATE TAX REPEALED . . . MAYBE
- July 12, 2010
- Law Firm: Norris McLaughlin Marcus P.A. A Professional Corporation - Bridgewater Office
FEDERAL ESTATE TAX REPEALED . . . MAYBE
On January 1, 2010, the federal estate and generation-skipping transfer (“GST”) taxes were repealed ¿ temporarily ¿ leaving taxpayers in a state of confusion and aggravation. As a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (the “Act”), under the law as it stands today, the federal estate and GST taxes will not apply to the estate of any individual who dies during 2010, regardless of the size of the estate.
However, it is not all good news, since new income tax rules come into play that generally eliminate the benefit of the “step-up” in tax basis that otherwise applied at death. The new carryover basis rules are complicated and might cost some taxpayers more than they would have paid if the federal estate tax still existed in 2010! Moreover, there is no repeal of state estate taxes in many states, including New Jersey and New York.
Notwithstanding the temporary repeal of the federal estate and GST taxes, lifetime gifts are still limited, since the federal gift tax laws remain in place, and the lifetime gift tax exemption amount is frozen at its current level of $1 million. Further, the temporary federal estate and GST tax repeal is for 2010 only, and unless Congress enacts new legislation, the federal estate, gift and GST tax laws will be fully reinstated in 2011 and will revert to the significantly lower exemption thresholds and higher tax rates that applied in 2001.
Confused? Well, you are not alone. To help you better understand some of these changes, we have summarized below the past, current and possible future estate, gift and GST tax laws and described briefly how these changing laws might affect you and your family.
PRIOR LAW DURING 2009.
In 2009, each individual had a federal estate tax exemption amount of $3.5 million and the maximum federal estate tax rate was 45%. Estate assets were entitled to a basis “step-up” or “step-down” at death to the asset’s fair market value, which served to limit capital gains tax if estate assets were sold after death. The GST tax exemption amount was also $3.5 million in 2009. Each individual had a lifetime gift tax exemption amount of $1 million in 2009 and the maximum federal gift tax rate was 45%.
CURRENT LAW DURING 2010 (MAYBE).
Under the law as it exists now, there is no federal estate tax or GST tax during 2010. (But, as described below, it is possible, and even likely, that Congress will address this area during 2010 and enact further changes that might affect taxpayers dying in 2010 or thereafter.) However, for income tax purposes, estate assets are no longer entitled to a basis “step-up” at death, which effectively eliminated any income taxes on pre-death gain. Instead, assets passing at death during 2010 will generally retain a “carryover” basis, which means that the beneficiaries will need to know what the decedent might have paid for an asset acquired during his or her lifetime, perhaps decades before death. To ease the predictable administrative nightmare, the new law allows a $1.3 million aggregate basis increase which the estate’s personal representative (previously called an executor) may allocate to any estate assets passing to any person and allows the personal representative to allocate an additional $3 million basis increase to assets passing to a spouse or in some cases, to a trust for a spouse. However, basis may not be increased above an asset’s fair market value at date of death.
The federal gift tax rules remain basically unchanged -- each individual still has a lifetime gift tax exemption amount of $1 million in 2010; however, the maximum federal gift tax rate in 2010 is cut from 45% to 35% (which is equal to the maximum income tax rate).
THE LAW AFTER 2010.
If no new legislation is passed, on January 1, 2011, the estate and GST taxes are scheduled to be fully reinstated ¿ but at the 2001 tax rates and thresholds of taxation! Thus, each individual will have a federal estate tax exemption amount of only $1 million, and the maximum federal estate tax rate will return to 55%. Estate assets will again be entitled to a basis “step-up” at death. The GST tax exemption will also be reduced to a $1 million exemption amount, indexed for inflation from 1998 forward, which will result in a GST tax exemption of approximately $1,350,000 in 2011. Each individual will still have a lifetime gift tax exemption amount of $1 million in 2011, and the maximum federal gift tax rate will similarly return to 55%.
HOW DID THIS HAPPEN AND WHAT ARE THE OPTIONS?
When the Act was first passed in 2001, Congressional budget rules discouraged any changes beyond a 10-year period. Therefore, it was widely anticipated that additional legislation would be enacted before 2010 that would reset the estate, gift and GST tax rules and pre-empt the one-year repeal in 2010. Various Congressional Representatives and Senators made attempts to address this issue over the years, and while numerous bills were proposed to reform the estate, gift and GST tax laws in any number of ways, no agreement was reached and none of the bills were enacted, to the surprise of many tax and political professionals.
So, what happens now? While it is impossible to predict with any reasonable degree of certainty, we nevertheless still hold out hope that Congress will appreciate the Byzantine complexity that the current law presents for taxpayers and will promptly enact legislation to dispel the confusion. Of course, the beneficiaries of those unfortunate persons who die during 2010 might prefer the current state of affairs. However, as each day passes with no relief, more potential problems and ambiguities come to light as a result of the current law.
If Congress does take action, a variety of scenarios for such legislation are conceivable, all of which make definitive predictions and planning at this point a daunting challenge. Congress might decide to change the 2010 interim law either prospectively or retroactively. Any such change for 2010 or beyond might entail extending the application of the tax law as it existed in 2009 or might include an entirely new set of tax rates and thresholds. Of course, any attempt at a retroactive enactment is certain to be challenged, on Constitutional grounds, by those who are adversely affected. However, the outcome of such challenges is far from certain. Support can be found in prior court cases both for and against such retroactive application. It is also possible that Congress will do nothing to change the estate, gift and GST tax laws during 2010 and instead wait for reinstatement of the estate and GST taxes in 2011, based on the law as it was in 2001. It remains to be seen what Congress will do to fix this mess.
WHAT DOES THIS MEAN FOR YOU?
For some of you, the repeal of the federal estate and GST tax laws will cause unintended consequences for your estate plans. For others, your plans will still work as intended, despite the uncertainty caused by the new rules. There may be new estate planning opportunities for some clients, depending on their particular circumstances and tolerance for risks associated with the possibility of a retroactive further change in the law. Some of these potential estate planning concerns and opportunities are discussed below.
POTENTIAL ESTATE PLANNING CONCERNS.
1. Bequests Based on Formulas. It is common for sophisticated estate planning attorneys to use flexible “formula” bequests that self-adjust to maximize certain opportunities available under tax laws in effect at date of death. These bequests are generally used in two situations (i) funding a trust (or direct bequest) to take advantage of any unused federal estate tax exemption, and (ii) funding a trust (or direct bequest) to take advantage of any unused GST tax exemption. Since the estate and GST taxes technically no longer exist for the calendar year 2010, the application of these formulas might have unintended consequences for your estate plan. The outcome is not necessarily adverse or undesirable, but in some cases, the relative interests of the beneficiaries might be materially altered. For example, if you are married and your will or trust provides for a formula bequest to your descendants equal to the maximum amount of your assets that can pass free of any federal estate tax upon your death and for the balance of your assets to pass to your spouse, such a formula bequest could unintentionally disinherit your spouse if you die in 2010!
Most states have laws that protect a spouse from being disinherited entirely; however, this could require estate litigation and family turmoil, which would be a costly and unfortunate result of Congress’ inaction. Further, if your documents provide for a formula bequest of your remaining GST tax exemption amount to your grandchildren or more remote descendants, in 2010, the amount of that bequest could be $0.
If your estate planning documents contain such a formula bequest, particularly a bequest to your descendants equal to the maximum amount that can pass free of any federal estate tax upon your death, we recommend that you contact us to discuss reviewing the application of these provisions to ensure that your estate would still pass in an acceptable manner should you die in 2010.
We recommend that you consider revising your estate planning documents to include language authorizing your estate representative to allocate the new 2010 basis increase amounts among your estate assets. In addition, we recommend that you review your financial records and assemble and keep basis information records for your assets, to the extent basis can be determined. Such basis records will be particularly important for your heirs if the step-up basis rules are eliminated permanently.
Despite the current temporary repeal of the federal estate tax, it is important to remember that tax-free lifetime gifts are still subject to limitations, since the federal gift tax regime remains in place. The only significant difference is that the federal gift tax rate is currently reduced to 35% for 2010. Each individual still has a $1 million lifetime federal gift tax exemption amount. Unfortunately, unlike the periodic adjustments dictated by law over the past 10 years, the $1 million gift tax exemption amount is not scheduled to change automatically in future years.
Despite the current repeal of the federal estate tax, it is also important to remember that the state estate tax regime remains in place for many states throughout 2010. For example, New Jersey’s and New York’s estate tax regimes remain in place. Pennsylvania’s estate tax is repealed under the current law; however, Pennsylvania still imposes a separate inheritance tax on assets passing to beneficiaries other than a spouse or charity.
Despite the current repeal of the federal GST tax, it is important to remember that absent further legislation, the GST tax is scheduled to be reinstated in 2011. The GST tax generally applies to lifetime or testamentary gifts you make to grandchildren or more remote descendants, either directly or in trust. If you created a GST protected trust prior to 2010, we recommend that you continue to file a federal gift and GST tax return (Form 709) for each year in which transfers were made to the trust and properly report the allocation of a portion of your GST exemption amount to such transfers. In addition, if in prior years you failed to file federal gift tax returns and properly report the allocation of your GST tax exemption to gifts to a trust that is intended to be “GST protected”, due to recent changes in the law, there are new options available to fix such GST non-allocation issues.
More importantly, if after January 1, 2001 you create and make gifts to an irrevocable trust that does not incorporate GST planning (such as certain life insurance trusts), unless you make an election on a timely filed federal gift tax return, generally a portion of your GST exemption will be automatically allocated to any gifts you make to that trust, even though you may not intend to GST protect that trust. Since the GST tax is slated to return in 2011 (and maybe in 2010, depending on any new legislation) your GST exemption is still a potentially valuable tax benefit that likely would be wasted to the extent allocated to such a trust. You can avoid such automatic allocations by making a one-time election on a timely filed federal gift tax return to “opt out” of the automatic allocation rule. If, in prior years you inadvertently failed to file a federal gift tax return to opt out of the automatic allocation rule for a trust that is not intended to be “GST protected”, due to recent changes in the law, there are new options available to retroactively fix that GST allocation issue. If you have any questions or concerns about the GST exempt status of any trust you created, we recommend that you contact us to review the status and discuss your options.
POTENTIAL ESTATE PLANNING OPPORTUNITIES.
1. Lifetime Tax-Free Gifts
. During 2010 you may still make “annual exclusion” gifts to any number of persons of up to $13,000 per person without imposition of a federal gift tax. If you are married and your spouse consents to “split gifts”, you may continue to give a total of $26,000 gift-tax-free to any number of persons. The $13,000 annual exclusion amount is scheduled to be indexed for inflation in future years. You are also still able to use your annual exclusion gifts to fund a Section 529 plan to provide for future educational expenses for your descendants or other beneficiaries. In 2010, you may make a gift to a Section 529 plan equal to up to five years of annual exclusion gifts for each person, for a total of $65,000 (or $130,000 if you are married and elect to split gifts). In addition to the annual exclusion, you may still make unlimited gift-tax-free gifts to any person for payment of that person’s tuition or medical expenses (including health insurance premiums). However, to qualify as a tax-free gift the payment must be made directly to the educational institution or health care provider.
Lifetime Taxable Gifts. Currently, the gift tax rate is reduced to 35% for 2010. Under the Act, gift and estate tax rates in 2011 are scheduled (subject to further Congressional action) to return to a maximum of 55%, which was the highest rate applicable in 2001. Thus, depending on your situation, you may wish to take advantage of the current low 35% gift tax rate to make significant taxable gifts to your descendants during 2010 in excess of your $1 million lifetime federal gift tax exemption amount. Depressed asset values may also work in your favor for making tax efficient gifts. Current low asset values may enable you to deflect more future appreciation at a lower gift tax cost (or by using less of your lifetime gift tax exemption amount). Note, however, that if legislation is enacted effective retroactively to January 1, 2010, the gift tax rate may revert to 45% or higher.
If your current estate plan does not fully address your retirement benefits, you should consider contacting us to review the disposition of those retirement assets and discuss whether it is appropriate to have those retirement assets pass to a trust upon your death.
5. GRATs. Another wealth transfer technique you might wish to consider is a Grantor Retained Annuity Trust (“GRAT”). A GRAT is an irrevocable trust to which you transfer assets but retain the right to receive an annuity payment for a fixed term of years. If you survive the term of years selected, at the end of the term, any assets remaining in the GRAT pass to your intended beneficiaries (e.g., your descendants), outright or in trust, at little or no gift tax cost. Current depressed asset values and low interest rates make this a good time for a tax efficient transfer to a GRAT and under current law, a GRAT can be structured to result in a gift that is close to zero (a “zeroed-out GRAT”). Since the tax benefits of creating a GRAT are lost if you do not survive the term, many individuals choose to use a series of short term zeroed-out GRATs, commonly referred to as “rolling GRATs”. Under the current gift and estate tax laws, there is little risk in transferring a portion of your assets to a “zeroed-out GRAT”. If the GRAT performs well, you pass appreciation on the assets to your beneficiaries using almost no lifetime gift tax exemption. Even if the GRAT does not perform well (i.e., the value of the assets does not grow as anticipated), you still would not have used any significant portion of your lifetime gift tax exemption. However,the GRAT technique may not be viable in future years and the tax laws may change in the future, possibly even during 2010. Tax legislation has been introduced to repeal the ability to create a “zeroed-out GRAT” and instead require a remainder gift of some significant amount (such as 10% of the assets initially transferred to the GRAT) making a GRAT much less appealing for you in the future. A GRAT with a term of less than 10 years may also be disallowed in the future, increasing the chance that if you create a GRAT, you may not survive the term. There is current proposed legislation imposing limitations on GRATs, but as proposed, the limitations would only apply to a GRAT created after the new law is enacted. Thus, early in 2010 may be your last chance to create a zeroed-out GRAT and/or a GRAT for a term of less than 10 years. Further, generally a GRAT is not a good vehicle for generation-skipping transfers. Although the issue is unclear, with the current repeal of the GST tax, it may be possible to create a GST tax protected perpetual trust for your descendants at the end of the initial GRAT term. Depending on your situation, if you are considering transferring significant wealth to your descendants, we recommend that you contact us to discuss the pros and cons of funding a GRAT in early 2010.
6. IDGTs, QPRTs and CLATs. Finally, there are other techniques that you may wish to consider using to transfer a portion of your assets to trusts for the benefit of your descendants to take advantage of the low interest rates, currently depressed asset values, and the low 35% gift tax rate.
For example, you might consider a part gift and part installment sale to an intentionally defective grantor trust (“IDGT”) for the benefit of your descendants. Low interest rates and depressed asset values make this a tax efficient wealth transfer technique. You might also consider transferring real property to a Qualified Personal Residence Trust (“QPRT”) for the ultimate benefit of your descendants. A QPRT is an irrevocable trust to which you transfer an interest in real property but retain the right to use the property for a fixed term of years. Like a GRAT, in order to achieve all the intended tax savings, you must survive the term of years selected. If you survive, at the end of the term, any assets remaining in the QPRT pass to your beneficiaries (e.g., your descendants).
While the low interest rates do not help with the QPRT technique, the 35% gift tax rate and historically low real property values may enable you to transfer wealth to your descendants at a significantly reduced gift tax cost. If you are charitably inclined, you may also wish to consider a gift to a Charitable Lead Annuity Trust (“CLAT”). The low interest rates and depressed asset values make this a good time for a gift to a CLAT. A CLAT is a trust that makes annual annuity payments to one or more charities for a fixed period of time. At the end of the fixed period, the trust remainder is distributed to one or more non-charitable beneficiaries, such as your descendants. Under the current law, if properly structured, a CLAT can make a deferred gift to your descendants at little or no gift or estate tax cost. Like GRATs, it is possible that new tax legislation may be passed that will disallow some or all of these techniques in the future, and quite possibly during 2010. Depending on your situation, some of these techniques may be of interest to you.
With all the possible variables, it is difficult to determine what the outcome will be for the federal estate, gift and GST tax laws. The temporary repeal of the federal estate tax and the other changes in the federal tax laws might create problems and/or opportunities for your estate plan, or when the dust settles, there might be minimal change necessary for your estate plan. While no one has a crystal ball, ignoring the issue does nothing to eliminate the uncertainty and you might be overlooking possible estate planning opportunities, which we would be happy to discuss with you. Therefore, we recommend that you take this time to review your overall estate plan, assets and family situation to see if your estate plan needs to be revised, either for tax reasons or for any non-tax change in your circumstances. If you would like to discuss how these changes affect you and what, if anything, you need to do, please contact one of the Norris McLaughlin & Marcus, P.A. tax professionals listed below.
NORRIS MCLAUGHLIN & MARCUS TAX ATTORNEYS
Robert G. Tallman, Esq.
[email protected] ¿ x3226
Donald A. Zamborsky, Esq.
[email protected] ¿ x3215
Dolores A. Laputka, Esq.
[email protected] ¿ x3213
Judith A. Harris, Esq.
[email protected] ¿ x3284
R. Nicholas Nanovic, Esq.
[email protected] ¿ x2295
Avery E. Smith, Esq.
[email protected] ¿ x2214
NEW JERSEY OFFICE
Thomas N. Torzewski, Esq.
[email protected] ¿ x4369
Jill Lebowitz, Esq.
[email protected] ¿ x4193
Melinda Fellner Bramwit, Esq.
[email protected] ¿ x4306
April Scott McCann, Esq.
[email protected] ¿ x4207
SPECIALIZING IN TRUSTS & ESTATES
Circular 230 Disclaimer:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter(s) addressed herein.
Tax Law Alert provides information to our clients and friends about current legal developments of general interest in the area of taxation. The information contained in this Alert should not be construed as legal advice, and readers should not act upon such without professional counsel. Copyright © 2010 Norris McLaughlin & Marcus, P.A.
3. Gifts to Grandchildren. With the temporary repeal of the GST tax in 2010, an additional technique for transferring assets in a tax efficient manner might be to give assets to your grandchildren, either directly or to one or more perpetual “dynasty trusts” for the benefit of your grandchildren or more remote descendants, utilizing your gift tax annual exclusion and/or lifetime gift tax exemption amount. A dynasty trust generally establishes perpetual lifetime trusts for your descendants. If administered properly, the tax-protected trust assets can pass from generation to generation without imposition of death taxes. You could make a gift-tax free transfer to such a dynasty trust using your gift tax annual exclusion and/or your $1 million lifetime gift tax exemption amount (which could be increased to $2 million if your spouse consents to “split gifts”), or you may wish to make taxable gifts exceeding your exemption, to take advantage of the low 35% gift tax rate. Note, however, that there is a risk that legislation could be enacted that retroactively imposes the GST tax, in which case if you make gifts in excess of the applicable GST exemption amount, you could incur GST tax on the excess transfers.
4. Retirement Benefits. There have been recent developments regarding retirement benefits law,which are still in effect. For example, previously, only a surviving spouse could “rollover” a retirement account, thereby allowing the surviving spouse to calculate and receive the required minimum distributions over the spouse’s lifetime and continue to defer income tax on the undistributed retirement assets. The law recently changed to allow a non-spousal beneficiary (such as a child or grandchild) to inherit a retirement account and “stretch out” the required minimum distributions over his or her lifetime. There is a significant benefit of using such a stretch out structure, in that the beneficiary is required to pay income tax only on the portion of the retirement account that is withdrawn each year, while the remaining portion of the account continues to grow on a tax-deferred basis.
A fairly typical retirement account beneficiary designation for a married couple with children is for each spouse to name the other spouse as primary beneficiary and to name their children or more remote descendants as contingent beneficiaries. Such a designation is fine if you do not wish to use any portion of those retirement assets to fund a trust for your spouse or descendants.
However, there are now many tax and non-tax reasons to use trusts as part of your estate plan,particularly if minor children are involved. Although there are drawbacks in some circumstances to using retirement assets to fund a trust, given the changes in the tax laws, it might be appropriate for you to use all or part of your retirement assets to fund a trust for your surviving family members.
Historically, the tax rules have been both unclear and problematic regarding the treatment of retirement benefits passing to trusts. However, recent Internal Revenue Service rulings provide specific guidance on the requirements for beneficiary designations and corresponding provisions for estate planning documents that enable a retirement asset to be paid to a trust for the benefit of a spouse or to separate trusts for children, and allow the retirement asset’s required minimum distributions to be stretched out over the lifetime of the trust beneficiary. As a result, if your estate plan directs that upon your death any retirement benefits might be paid to trusts for your spouse or descendants, your estate planning documents and retirement account beneficiary designation forms must contain certain language which allows your heirs to stretch out required minimum distribution payments over their lifetimes.
Prior to 2001, if you wanted to “GST protect” an irrevocable trust, you were required to file a federal gift tax return for each year in which transfers were made to the trust and affirmatively allocate a portion of your GST tax exemption amount to such transfers. However, since January 1, 2001, unless you elect otherwise, generally a portion of your GST exemption is automatically allocated to any gifts you make to such a trust.
5. Allocation of GST Tax Exemption.
4. State Estate Taxes.
3. Lifetime Gifts.
2. Carryover Basis. During 2010, any assets passing to beneficiaries as a result of an individual’s death will receive a modified carryover basis. Under the Act, an “aggregate basis increase” of $1.3 million may be allocated to any estate assets passing to any person and an additional $3 million basis increase may be allocated to any assets passing to a spouse.