Adrienne M. Penta, Esq., Brown Brothers Harriman & Co.
The federal estate tax is gone (for now), but not forgotten. Congress failed to take action before the end of 2009, resulting in the “sunset” of the estate tax in 2010. Currently, there is no federal estate tax for decedents dying in 2010, and no federal generation-skipping transfer (“GST”) tax for GST transactions completed in 2010. The gift tax, however, remains in place at a rate of 35%. This sunset was enacted as part of tax legislation passed in 2001.
If Congress does not address transfer taxes before the end of the year, the federal estate tax will come back with a vengeance in 2011. The federal estate tax exemption amount will be $1,000,000—a significant reduction from the 2009 exemption amount of $3,500,000—and the top marginal rate will escalate to 55%—10% higher than the 2009 rate of 45%. In addition, there will be a 5% surcharge on estates exceeding $10,000,000. The GST tax will also return in 2011 with a $1,000,000 exemption amount and a rate of 55%, and the gift tax rate will revert to 45%. Many practitioners believe that Congress will enact estate and GST taxes for 2010 and make them retroactive to January 1, but right now, in the words of Senate Finance Committee Chairman Max Baucus, there is “massive, massive confusion.”
Although there are no readily available answers, to help sort through the confusion there are five issues listed below that estate planners should keep in mind when drafting and reviewing estate planning documents.
1. Formula Clauses. If no estate tax is enacted for 2010, many current estate plans may not accomplish the clients’ desired goals. Most plans for married couples written in prior years allocate as much property as can pass free of estate tax (i.e., the exemption amount) to the family or “credit shelter” trust and the remaining property to the marital trust. Under some formula clauses, in a no-tax environment, all of the estate’s assets may pass to the family trust. If the surviving spouse is not a beneficiary of the family trust, the decedent could unintentionally disinherit her spouse. The plans at greatest risk are likely those drafted for clients with children from a prior marriage and for individuals living in states with no state estate tax. Formula clauses determining bequests to charity should also be reexamined as they may not function as the client would desire if there is no federal estate tax.
2. Carry-Over Basis Regime. If Congress does not act, the current law imposes a carryover basis regime on decedents dying in 2010. Under the carry-over basis system, the basis of assets transferred at death will be the lower of (a) the decedent’s tax basis and (b) the fair market value of the asset on the date of death. For example, if a share of stock was bought by Dad in 1945 for $1, inherited by Daughter at a value of $75 and then sold for $100, the Daughter’s tax basis would be $1, and she would realize a capital gain of $99. This system requires everyone to track the cost basis of all assets. Further cost basis complications beyond the scope of this article may arise for decedents in states that impose a state estate tax.
3. Allocation of Basis Adjustment. Under the 2010 carry-over basis regime, each estate will receive a limited step-up in basis equal to $1,300,000. This “exemption” may be used to increase the basis of the estate’s assets to their fair market value, but no higher. In addition, $3,000,000 will be available to each estate to increase the cost basis of assets passing to the surviving spouse. To qualify for the spousal step-up in basis, however, the property must be either held in a marital trust that that meets the requirements for a QTIP or transferred outright to the spouse from the decedent. Many estate plans drafted in 2009 and prior years do not take this new carryover basis system into consideration, and if all of the decedent’s property is distributed to a family trust, the $3,000,000 spousal basis adjustment will be wasted. In addition, executors are required to allocate the basis adjustment on an asset-by-asset basis. Any person named as an executor should ask about the testator’s intent with respect to which assets and which beneficiaries should reap the reward of a stepped-up basis.
4. Taxable Gifts. Currently, the gift tax rate is 35%, reduced from 45% in 2009. If a client makes a taxable gift this year, he may pay gift tax at a rate of only 35%. It is possible, however, that Congress will raise the gift tax rate to 45% and apply that rate retroactively to all gifts made in 2010. Therefore, clients should be advised of the significant risk of relying on a 35% gift tax rate.
5. Gifts to Crummey Trusts. Finally, if Congress takes no action in 2010, grantors may be unable to allocate GST exemption to Crummey gifts made this year to insurance trusts and other irrevocable Crummey trusts that are intended to be wholly GST exempt. Although the GST tax treatment of these gifts is unclear when the GST tax returns in 2011, one possibility is that the trust would have an inclusion ratio between zero and one due to the non-exempt 2010 Crummey gifts. If so, the grantor would have to make a late allocation of GST exemption to make the trust wholly GST exempt. Alternatively, for an insurance trust, the grantor could lend the trust enough assets to make the premium payments in 2010 and avoid the GST issue; however, the grantor may not have enough annual exclusion gifts in the following year both to (i) pay that year’s insurance premiums and (ii) repay the loan.