Contrary to expectations of almost all experts and statements by various members of the Congress and President Obama, Congress failed to pass long-awaited legislation affecting the federal gift, estate, and generation-skipping transfer tax laws. The failure to act has resulted in uncertainty regarding the application of various transfer tax provisions and related tax planning in 2010 and thereafter.
Given these developments, we recommend clients contact us to review their plans—and to discuss any changes that may be advisable.
2001 Legislation (EGTRRA)
The situation stems from the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) passed in 2001, which made the following changes to the estate and gift tax laws:
- Increased the estate tax exemption amount gradually from $675,000 per person in 2002 to $3.5 million per person in 2009.
- Lowered the top gift and estate tax rate gradually from 55 percent to 45 percent.
Despite numerous proposals from 2001 through 2009, Congress failed to enact any permanent tax reform. Therefore, under EGTRRA, the following changes became effective on January 1, 2010:
- The estate tax is repealed for one year.
- The generation-skipping transfer tax is repealed for one year.
- The "step-up" in tax basis (to date-of-death value) of a deceased person's assets is repealed for one year and replaced with modified "carry-over" basis rules. In general, the heirs take the decedent's basis (usually the decedent's original cost), subject to certain exceptions. These exceptions generally allow for a total step-up of up to $1.3 million (over and above the decedent's basis). An additional step-up of $3.0 million is allowed for assets passing to a surviving spouse. The step-up is allocated on a tax return filed by the executor. Assets that are not stepped-up will pass to the beneficiaries at the decedent's (usually lower than fair market value) basis rather than a basis stepped-up to fair market value that applied under prior law. This change may result in higher capital gains taxes when the inherited property is sold and can present problems if detailed records were not maintained by the decedent to support the cost basis.
- The gift tax remains in place. However, the top gift tax rate is decreased from 45 percent to 35 percent.
These changes apply only for the calendar year 2010. On January 1, 2011, the gift, estate, and generation-skipping tax laws and the "step-up" tax basis rules will all be reinstated at the levels and under the rules that were in effect when EGTRRA was enacted in 2001.
The reinstatement will result in an estate tax exemption of $1.0 million per person, a generation-skipping transfer tax exemption amount of $1,340,000 per person (adjusted for inflation from August 2009 to August 2010), and a top marginal rate for gift, estate, and generation-skipping transfer taxes of 55 percent.
What Lies Ahead in 2010?
Various congressional leaders have stated they intend to act in 2010 to reinstate the estate and generation-skipping transfer tax and make the legislation retroactive to January 1, 2010. Yet, we are now midway through 2010 and no legislation has been passed, retroactive or otherwise.
Some also speculate that no legislation may be passed in 2010—and estate and gift tax provisions from 2001 may be reinstated in 2011, at far lower exemption levels. There are also questions about how to interpret some of the EGTRRA provisions in effect for 2010.
What Should You Do Now?
We suggest you review the allocation provisions of your estate plan to make certain your documents are consistent with your objectives in light of the changes for 2010. In particular, planning for married couples or plans that involve generation-skipping transfers should be reviewed.
For example, under prior law, it was common for married couples to allocate the maximum amount that could pass free from estate tax at the first spouse's death as a "credit shelter trust" for the benefit of a spouse and/or children, with the balance of the estate passing outright or in trust for the sole benefit of the spouse.
If a person dies in 2010, there is no longer a limit on the amount that can pass free from estate tax. Consequently, the entire estate may now be allocated to the credit trust, with no assets passing outright or in trust for the sole benefit of the spouse. Such an allocation provision may be acceptable if liberal distributions may be made to the spouse from the credit trust. However, if the spouse is not a beneficiary of the credit trust, or the distribution provisions under the credit trust are more restrictive, such an allocation provision may no longer be desirable. In this situation, it may be advisable to make immediate changes to your current plan.
In sum, the impact the one-year repeal of the estate and generation-skipping transfer tax may have on a particular individual or estate will vary from case to case.
State Estate Tax Laws
States like Minnesota, which have continued to impose a separate estate tax, may be affected by the changes in federal law. In Minnesota, the state estate tax remains in effect with the current exemption amount still at $1.0 million per person (and not scheduled to change). Other states that do not currently have a state estate tax as a result of changes in the federal law several years ago (the "decoupling" of the federal tax from state taxes) could have the state estate tax reinstated in 2011. Other effects caused by the references in state laws to the federal statutes are still being analyzed.