Feb 12, 2009

No Estate Tax in 2010? Not Necessarily a Good Thing!

The terms of The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) provided for a lapse in the federal estate tax for the 2010 calendar year. In other words, under the current regime, individuals who die in 2010 can pass an unlimited amount of assets to named beneficiaries.

Many assumed Congress would enact a permanent revision to the federal estate tax, however no such law has been passed. The House of Representatives and Senate continue to argue over the specifics of the law, in addition to several other critical issues which are taking priority. Therefore, it is crucial for estate plan documents to take current laws into consideration.

At first blush, the ability to pass an unlimited amount of assets sounds great. However, as is often the case with legislation, taxpayers would be well advised to read the fine print first!

Critical issues associated with the 2010 Estate Tax Regime may include the following:

NO ASSETS will to pass to your surviving spouse.Significant INCOME TAX consequencesBequests to grandchildren may be DISREGARDED.

These issues are very complex and must be examined in the context of your personal asset portfolio and your existing estate plan. The purpose of the summary below is to highlight some of the most critical issues associated with the 2010 Estate Tax Regime. But, don't worry – these issues can be addressed by reviewing and updating your existing estate plan.

Do you intend for NOTHING to pass to your surviving spouse?

For a married couple, assets are typically divided into two separate trusts upon the death of the first spouse. Traditionally, the "Family Trust" (or Residuary Trust) is funded with the federal estate tax exemption (the maximum amount that would pass estate tax free). In 2009, for example, the federal estate tax exemption was $3.5 million. Therefore, for individuals who died in 2009, the Family Trust was funded with $3.5 million. Any assets in excess of the exemption were used to fund the "Marital Trust" (which is solely for the benefit of the surviving spouse during his/her lifetime).

However, in 2010 the exemption is unlimited. Therefore, the "maximum amount that would pass estate tax free" would be the entire estate, and the Marital Trust would never be funded. That is not necessarily problematic, UNLESS the terms of the trust do not allow the surviving spouse access to the Family Trust. Some trust documents provide that the surviving spouse is only a beneficiary of the Marital Trust (and not the Family Trust). As such, under the current regime the surviving spouse may be disinherited.

Furthermore, regardless of whether the surviving spouse is a beneficiary of the Family Trust, failure to fund a Marital Trust can create unintentional income tax consequences associated with basis (see "Basis Shmasis" below).

Basis Shmasis!

Basis is an important aspect of income tax. Essentially, basis is the "cost" of a particular asset against which taxable gain is calculated. With regard to bequests/gifts made pursuant to an estate plan, Internal Revenue Code Section 1022 provides that for years PRIOR to 2010, upon death, assets passing to beneficiaries get a "step-up" in basis. For example, if Uncle Jerry purchased a home in 1970 for $100,000 that was now valued at $1 million, upon Uncle Jerry's death in 2009, the beneficiaries would get a "step-up" in basis to the $1 million fair market value. Subsequently, upon the sale of Uncle Jerry's home for $1 million, the beneficiaries would realize no gain on sale for income tax purposes.

Under the current 2010 regime, for individuals dying in 2010, beneficiaries are required to take the decedent's "carry-over basis," subject to certain exceptions. Thus, Uncle Jerry's $100,000 basis would "carry-over" to the beneficiaries, and if the property was sold for $1 million, they would recognize tax on the $900,000 gain ($1 million minus $100,000).

To complicate matters, there are two exceptions to the carryover basis provisions:

The executor can allocate up to $1.3 million (increased by unused losses and loss carryovers) to increase the basis of assets; and the executor can also allocate up to $3 million to increase the basis of assets passing to a surviving spouse.

However, in true legislative style, there are exceptions to the exceptions!

First, these allocations may not increase the basis of an asset above its fair market value as of the decedent's date of death. Second, in order for assets passing to the surviving spouse to qualify, the decedent must have provided that the assets go to the spouse either outright or in a Qualified Terminable Interest Property (QTIP) trust (i.e., a special trust solely for the benefit of the surviving spouse during his/her lifetime, such as a Marital Trust). Thus, if no Marital Trust was created (discussed above), even if the surviving spouse was a beneficiary of the Family Trust, assets allocated to him/her from this trust would not be eligible for the $3 million basis increase.

Generation Skipping Transfer Tax – Skips Right Out of the Picture!

The generation skipping transfer tax (GST Tax) refers to the tax imposed on outright gifts and transfers in trust to beneficiaries who are a "skip person" (i.e., gifts or transfers to related persons more than one generation away from the decedent; for example, money that passes to an individual's grandchildren, skipping his/her children). The EGTRRA also provided for the GST Tax to disappear in 2010.

The issue is, some documents may provide a gift to grandchildren where the amount is calculated based solely on the GST Tax Exemption. However, such language may be interpreted so that NOTHING passes to the intended beneficiary!

The Magic Eight Ball Dilemma – "Not Sure, Ask Again Later"

Congress has intimated several different and even conflicting courses of action, none of which are guaranteed to come to fruition in the near future. If Congress fails to take ANY action, EGTRRA provides that starting in 2011, the federal estate tax exemption amount plummets to $1 million, and the maximum estate tax rate increases to 60 percent. This would dramatically increase the number of estates subject to estate tax and the amount of tax due.

Another idea set forth is that Congress may pass legislation to "freeze" the 2009 estate tax regime. This would mean the exemption level would be set at $3.5 million with a maximum federal estate tax rate of 45 percent. An additional issue is whether such legislation would be in effect on a going-forward basis, or whether Congress would call for such legislation to be retroactive with an effective date of January 1, 2010. If the latter, then none of the 2010 issues would apply. However, the constitutionality of retroactive legislation is questionable.

Yet another option is for Congress to enact an entirely new estate tax regime, either on a going-forward basis or retroactively.

Bottom Line

Have your existing documents reviewed to ensure they provide flexibility to deal with the uncertainties of 2010 and beyond.