Amiel Z. Weinstock, Esq., K&L Gates LLP
Back in 1789, Benjamin Franklin wrote that “in this world nothing is certain but death and taxes”. This timeless adage rings true even today, and is especially relevant in light of the uncertainty surrounding the future of the estate tax.
Last year, many (if not most) estate planning practitioners (myself included) predicted that by the end of the year Congress would have acted to preserve the estate and generation-skipping transfer tax regime in the same basic form that existed in 2009 (including a $3,500,000 estate tax exemption, 45% tax rate and basis step-up provisions). We all talked to our clients and assured them that their planning was not for nothing, that Congress would do the right thing and eliminate all the impending uncertainty. But alas, December 31, 2009 came and went and we were left standing in the doorway of 2010 like a high school senior abandoned by a prom date.
Despite Congress’ failure to act, many of those same practitioners held on tightly to the belief that Congress would act in early 2010 and make any necessary changes retroactive to January 1, 2010. We believed, perhaps naively, that the estate tax was important to our government, that it would be pushed to the front of the line ahead of such issues like the economy and healthcare reform. The sharpest minds in our field were out there discussing the constitutional issues of a retroactive change in the tax law, analyzing the impact of the carry-over basis rules and instructing everyone to scrutinize their existing plans to make sure that a formula clause that has worked for decades didn’t suddenly distort all of the existing planning.
But summer is almost upon us and Congress has still not taken any concrete measures to address the estate tax issue. Prom is over and our date is not showing up. The Democrats and Republicans cannot agree on the time of day, and now they are faced with a confirmation hearing to replace Justice Stevens. Surely the estate tax will again be relegated to the backseat. Both parties will blame each other for failing to reach a compromise and each will point to their respective 2009 proposals as being the “right” answer. In fact, I suspect that many in Congress will be pleased that no deal has been struck and will be happy to see the estate tax regime revert to pre-EGTRRA levels on January 1, 2011 (when a lower estate tax exemption and higher rates will mean more tax revenue), the result of which will be an increase in revenue for the Federal government.
So where does that leave us as practitioners? What do we tell our clients today?
We tell them that nothing is certain but death and taxes and to stop sitting around waiting for Congress to do something. We are all going to die one day, and there will be a tax impact at death – whether some form of transfer tax (i.e., gift, estate or generation-skipping) or income tax. Be proactive about the many opportunities that exist today to accomplish effective estate planning, notwithstanding the uncertainty of the laws. Remember, estate planning is only partially about estate taxes and transfers at death. It is also about efficient wealth transfer and asset protection through the use of trusts, income tax planning and charitable goals and about transfers made during lifetime to enhance the lives of children and grandchildren.
Estate planning clients can be broadly classified into two types, those whose focus is wealth preservation and those whose focus is wealth transfer. The classification (which may change over time) depends on many factors, including current net wealth, age, family demographics and health, and spending habits. For example, a husband and wife in their mid-50s, in good health, with three kids, having $10,000,000 of net wealth, are most likely in wealth preservation mode – they help their children as needed, are looking to retire in the near future and want to have plenty of liquid net wealth available for their expected 30+ remaining years. Take the same net wealth held by an 85 year old widow and the client is probably in wealth transfer mode – her reasonable care and comfort could be more than adequately managed with half of those assets, life expectancy is relatively short and she has no major expenses on the horizon.
Regardless of what type of client you are working with, effective planning strategies are available in spite of the uncertainty in the estate planning laws.
A. Wealth Preservation
While timing and amount are uncertain, we can reasonably anticipate that there will be some estate tax exemption amount fixed by Congress. As I mentioned above, if Congress does not act in 2010, the law will revert to the pre-EGTRRA laws with a $1,000,000 exemption and a 55% tax rate. At those levels, even modestly wealthy clients need to think about how they are going to account for the estate tax impact. If the exemption goes back to $3,500,000 (or more), there will be less of an impact on our sample clients above, but only if proper planning is done to make sure they maximize their use of the exemption (for example, by balancing the assets between husband and wife).
But even if we look to the other extreme, a world in which there is no estate tax, all clients need to consider how they intend to transfer their wealth to their children and/or more remote descendants. Will an outright distribution in accordance with the laws of intestacy suffice? Most likely not. So a simple estate plan directing the disposition of wealth over time (and perhaps in different proportions) is needed. Does the client have minor children? Have they thought about guardianship issues? Do any of the children have “special needs” for which they are entitled to government benefits? Are they adequately insured in the event that death occurs when (if) the estate tax exemption is low?
Even if estate tax planning is not high on the list of concerns for clients in wealth preservation mode, estate planning is important for so many other reasons, most of which can be addressed without waiting for Congress to tell us how much money they will let us save.
B. Wealth Transfer
Clients in the wealth transfer category are typically those who can “afford” to part with some portion of their net wealth without impacting the way they live their lives. Transfers can include outright gifts of cash or other liquid assets, as well as transfers of interests in intangible assets like real estate and/or corporate entities (like partnerships, LLCs or corporations). Alternatively, more creative strategies can be used to both maximize the transfer of wealth and limit access to the transferred funds by the recipients thereof.
The same issues raised above apply to clients in wealth transfer mode. They too should be concerned with how and when their assets are transferred to subsequent generations (whether or not reduced by taxes). In some respects these issues are magnified because the dollars are bigger (i.e., more money for that perpetually indebted child who at age 55 still can’t hold a job, or for the 18 year old high school dropout with a substance abuse problem). In other respects the issues are less worrisome because even if reduced by taxes there will still be ample resources available for the family. No matter what the concern, proper estate planning adds major value to the family for multiple generations.
There are a variety of lifetime planning techniques that can be effective no matter what the estate tax exemption is (or even if the estate tax has been repealed in its entirety). For example, simple GRATs that are funded with publicly traded stock are a very low risk proposition with an extreme upside. Other than the cost associated with establishing the trust, the GRAT is a “heads I win, tails I don’t lose” structure. In other words, if the asset contributed to the GRAT appreciates over the term of the GRAT, most of that appreciation will inure to the benefit of the trust remainder beneficiaries and will not be included in the grantor’s estate at death. If, on the other hand, the asset contributed to the GRAT does not appreciate (or in fact depreciates), the GRAT will terminate when the last annuity payment is made to the grantor and the grantor will be in the same financial position as if he/she had simply held the asset in his/her portfolio for the duration of the GRAT.
Another very effective technique that is available to your clients is the sale of assets to an intentionally defective grantor trust. This technique is a bit more complicated than a GRAT, but with the right asset can have an even better upside. Like the GRAT, this strategy is a so-called “estate freeze” technique, the goal of which is to transfer all appreciation in value to the next generation without any transfer taxes. Because of the extremely low interest rate environment today, these sales are very effective with income producing property (like commercial real estate or flow through entities like S corporations or partnerships).
For those clients in the ultra high net worth category (i.e., $50,000,000 or more in liquid net wealth), private premium financing arrangements with life insurance can also be very exciting because of the low interest rate environment.
There is no reason for our clients to wait to employ these strategies. Nothing will be gained by waiting for a new estate tax law to be enacted by Congress. If anything, some of these strategies may become less effective under a new law because of their well-recognized effectiveness and appeal to the upper class. For example, there is a current legislative proposal which will require GRATs to have a minimum 10 year term. Our clients should take advantage now of the strategies that we know will work no matter what the estate tax law looks like in the future.
It is our job as advisors to explain to them the value of proper planning and to offer them opportunities to achieve their goals in a tax-efficient and coherent fashion. For all of our clients who have enough wealth to be worried about the uncertainty of the estate tax, they have enough wealth to be doing something about it right now.
 Note that “portability” of the estate tax exemption amounts has been raised as part of a compromise solution to the estate tax uncertainty. Portability might obviate the need for balancing assets between spouses, but the details of its application are uncertain at this time.
 The only risk is that the cost to prepare and fund the GRAT will exceed the performance of the stock placed in the GRAT. Note that GRATs funded with assets other than publicly traded stock are also very beneficial but have higher costs to implement because of the necessity to get a formal valuation of the asset at the time of contribution to the GRAT as well as on each annuity date.
 If a grantor does not survive the term of a GRAT the entire value of the trust property (including all appreciation) will be included in the grantor’s estate at death. Thus, the longer the term of the GRAT, the greater the mortality risk. For younger clients this is not a significant concern, but for clients who are older and/or who may have health issues, a short-term GRAT (i.e., for 2 years) is more appealing.