Finally! A New Estate Tax Law…Now What?

(Adapted from Leimberg Information Services Inc., #1743, December 22, 2010)

Charlie Douglas, JD, CFP®, AEP®, Editor
Email: editor@naepcjournal.org
Phone: 404.279.7890

“We believe the estate tax in the bill is a bridge too far.” 
Speaker of the House Nancy Pelosi/December, 2010

“There is never a perfect bipartisan bill in the eyes of a partisan.” 
President Bill Clinton/December, 2010

“If you had to pay estate tax and you had to die, this was the year.”
Morbid joke of 2010

EXECUTIVE SUMMARY:

With the signing of “The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” ( “TRA 2010”) into law by President Obama on December 17, 2010, clients and their advisors alike are no longer in the dark as to how to plan (at least for the next two years). At long last, one can begin to take some action without fear as to whether the estate tax law will be changed retroactively for 2010 or prospectively for 2011.

While in the weeks and months to come there will surely be much written about TRA 2010, with much greater detail and with further clarity, the following passages underscore some of the more pertinent aspects of TRA 2010, and provide some planning pointers to consider.

Political Drama to the Passage of the 2010 Act

The supposed “lame-duck” session of 2010 may have been a lot of things, but it was not lame. There was plenty of political theater to be had. President Obama, who actively campaigned against extending the Bush tax cuts for the wealthy, suddenly broke ranks with many in the Democratic Party and yielded to the Republicans new-found political capital.

By most all accounts, the most controversial parts threatening passage of TRA 2010 were the provisions relating to the often overlooked estate tax. Many Democrats argued that the estate tax was a costly tax break for the rich. Republicans countered (and without much empirical evidence), that a higher “death tax” would unduly burden farmers and small businesses.

In the end, “just say no” in the House Democratic Caucus gave way to “no tax hikes for working-class Americans.” Ultimately, with final resolution came the most favorable wealth transfer planning provisions in modern time. Ironically, TRA 2010’s generous provisions regarding the transfer taxes had virtually no chance of making its way through either House of Congress, until they became welded together with Obama’s pledge to protect the unemployed and working-class Americans.

A few years from now, if we have not taken overt action to address the unsustainable fiscal path that we are on, we may look back with some remorse for not combining passage of this estimated $858 billion tax deal (which offers slim hopes for cutting the deficit) with a phased-in reduction of the deficit over the longer term. The costs for the more openhanded transfer tax provisions in TRA 2010 are estimated by some experts to be $68 billion and $300 billion over a two and ten year period respectively. But in the political moment, it is easier to have “compromise” on spending matters that make deficits bigger than it is to have “compromise” on spending restraints that bring deficits down.

Two Roads Regarding Death in 2010

The new law allows the executor of the estate for a decedent who died in 2010 to choose between two roads in administering the estate. One road, which is automatic unless the executor elects out of it, subjects the estate to estate tax, a $5 million estate tax exemption, a 35% estate tax rate and a stepped-up income tax basis for appreciated assets.

The other road available by election of the executor would be to provide for no estate tax, but with appreciated assets “owned by the decedent” receiving only a modified carryover basis ($1.3 million for non-spousal beneficiaries and $3 million for spousal beneficiaries).

While the choice is clear for estates under $5 million not to elect out of the first road and to “pay estate tax,” considerable analysis may need to be done to decide which road to choose for the lowest overall tax consequences for estates above $5 million.

Planning Pointer: According to Robert S. Keebler, CPA, MST, AEP� (Distinguished), partner with Keebler & Associates, large estates in excess of $30 million will likely choose to opt out of the automatic estate tax. However, for estates ranging between $5 and $30 million, the estate tax cost will necessarily need to be weighed against the income tax cost. Keep in mind that the income tax calculation may likely be more than a simple capital gains analysis. For example, more complicated calculations regarding depreciation recapture for fully depreciated real estate are apt to be more challenging. Still, for estates in excess of $5 million, paying an estate tax within nine months of the date of death at 35% should likely be more costly than paying a capital gains tax at some later point in time, unless the estate tax is very small and the decedent had assets with a low basis.

Planning Pointer: Unless an executor elects not to have the estate tax apply, the 706 estate tax return must be filed by the later of: (i) 9 months after the date of death; or (ii) 9 months after the date of enactment (December 17, 2010) which is Saturday, September 17, 2011 and therefore should give one until Monday, September 19, 2011. Further, the IRS in December of 2010 posted another official draft of Form 8939, “Allocation of Increase in Basis for Property Acquired from a Decedent.” The deadline for filing the form according to a recent conversation with a senior IRS official is “that it will be extended at least until 10/15/2011.” See LISI Estate Planning Newsletter # 1759 (January 14, 2011) by Vince Lackner @ leimbergservices.com

Planning Pointer: QTIPs, QPRTS, and GRATs normally are entitled to receive a step-up in basis under IRC 1014. However, under IRC 1022 the property is not considered “owned by the decedent” and therefore is not entitled to either the $1.3 million or the $3 million step-up in basis.

Favorable GST Tax Transfers for 2010

TRA 2010 established a $5 million GST tax exemption and a GST tax rate of 35% for gifts made and decedents dying after January 1, 2010. However, GST transfers made in 2010 were subject to a zero GST tax rate under IRC 2641(a).

With a zero GST tax rate, there were no GST taxes on GST transfers (direct skips, taxable distributions or taxable terminations) in 2010. Nevertheless, does this mean that all transfers to trusts in 2010 have an inclusion ratio of zero and therefore are exempt from the GST tax in future years?

Fiduciary Counsel Steve R. Akers, JD, AEP� (Distinguished) of Bessemer Trust Company, N.A. pointed out generally at the time that TRA 2010 was enacted that the Joint Committee on Taxation Technical Explanation says the inclusion ratio is not zero: “…the generation skipping transfer tax rate for transfers made during 2010 is zero percent. The generation skipping transfer tax rate for transfers made after 2010 is equal to the highest estate and gift tax rate in effect for such year (35 percent for 2011 and 2012).”

Shortly after the enactment of TRA 2010 prominent commentators specifically noted that creating and funding a trust in 2010 exclusively for skip persons was a direct skip under IRC 2612(c), a type of generation-skipping transfer, which makes it subject to GST tax, but with a tax rate of zero for 2010. As such, future distributions from trusts established and funded exclusively for grandchildren in 2010 should not attract any GST tax because of the application of the “step-down” rule under IRC 2653 (a). (See LISI Estate Planning Newsletter #1735 (December 18, 2010) by Jonathan G. Blattmachr, Esq., AEP� (Distinguished), Diana Zadel and Mitch Gans and LISI Estate Planning Newsletter #1736 (December 18, 2010) by David Pratt and George Karibjanian @ leimbergservices.com.)

Be that as it may, any transfers to grandchildren (outright direct skips or in trust) were subject to gift tax at a 35% rate in 2010 for amounts over the $1,000,000 gift tax exemption. Therefore, a careful analysis should have been given before making gifts to grandchildren in 2010. On the one hand, was it better to make the gift in 2010 and pay gift tax, but avoid using any GST exemption? Or on the other hand, is it preferable to wait until 2011 to take advantage of the larger gift tax exemption and then allocate GST exemption to the transfer?

Planning Pointer: The absence of the GST tax in 2010 created a golden opportunity to make GST tax-free distributions from non-exempt generation-skipping trusts before the end of the year. After 2010, distributions to grandchildren or more remote descendants from a non-exempt trust will likely be subject to a GST tax.

Planning Pointer: If a transfer in 2010 to grandchildren resulted in a gift tax, lower basis assets should likely have been used to increase the basis under IRC 1015 by the amount of gift taxes paid. Conversely, in 2011, gifts of higher basis assets may make more sense since the new gift tax exemption of $5 million may well cover any gift tax.

Planning Pointer: For direct skip transfers in 2010, one should consider opting out of the automatic allocation of GST exemption under IRC 2632 (b) (3) on the 709 gift tax return, thereby preserving their 2010 GST exemption. In other GST matters, where transfers were made to trusts in 2010, but where the inclusion ratio was not zero, one may want to consider allocating up to $5,000,000 of their GST tax exemption available in order to avoid a taxable distribution to the grandchildren’s descendants and/or taxable termination upon the death of the grandchildren who are beneficiaries of the trust. Note, allocation of the GST tax exemption for transfers made in 2010 and before December 17, 2010 can still be made within nine months of the date of enactment.

Planning Pointer: For GST tax purposes, consider that a Qualified Disclaimer under IRC 2518 can still likely be made in 2011 with respect to a bequest from a decedent who died in 2010, as long as the disclaimer is filed by the later of: (i) 9 months after the date of death; or (ii) 9 months after the date of enactment. Furthermore, be sure to check applicable state law for making a disclaimer later than nine months from the date of death.

Planning Pointer: Some advisors may have clients who made taxable gifts in 2010 when the gift tax exemption was $1 million at a 35% tax rate and who now wish that they had not done so because of the gift tax exemption increasing by $4 million in 2011. In such cases, the advisor may want to explore having the donees make a disclaimer if there has not been “acceptance” and it makes sense under applicable state law. In the alternative, there is an argument for rescission under state law based on mistake of law and/or mistake of fact.

Credit Shelter Trusts and Spousal Portability

Beginning in 2011, executors are now able to transfer to the surviving spouse any unused estate tax exemption ($5,000,000) from the first spouse’s death. The Deceased Spousal Unused Exclusion Amount (“DSUEA”) under IRC 303 (a)(2) can be used for lifetime gifts and/or for transfers at death. That makes it possible for a married couple to transfer up to $10 million free of estate and gift taxes to their intended beneficiaries without a tax planning estate plan.

As such, there may be a chilling effect on the perceived need to do comprehensive estate planning since married couples may conclude that there is no longer a compelling need to do a “A”/”B” tax planning trust because they no longer have a “tax problem.” After all, the ability to pass on $10 million free of estate taxes through portability for at least the next two years should result in more than 99% of the estates in America remaining untaxed. Unfortunately, “I Love You” wills may become that much more prevalent as many families possibly will forgo the considerable non-tax benefits of using credit shelter and other types of trusts that provide asset, creditor and divorce protection to their loved ones.

In addition to the compelling non-tax reasons for trusts, there are also sound tax reasons to have trusts like the credit shelter trust. For example, funding a credit shelter trust on the first spouse’s death allows any increase in value in the assets of the trust to avoid estate taxation at the death of the surviving spouse. Further, because the GST tax exemption is not portable, the estate of the first spouse to die for wealthier clients should likely incorporate a credit shelter trust where the deceased spouse’s GST exemption can be applied. Finally, a credit shelter trust can utilize a portion of the first spouse’s to die state estate tax exemption in the twenty one states which have a separate estate tax like New York. One argument in favor of portability and against using a credit shelter trust, however, is that portability preserves the full step-up in basis for appreciated assets in the surviving spouse’s estate.

Fleshing out the numerous possibilities regarding portability may be challenging as The Joint Committee Report contained only three portability examples as set forth below:

Example 1. Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1’s estate tax return to permit Wife to use Husband 1’s deceased spousal unused exclusion amount. As of Husband 1’s death, Wife has made no taxable gifts. Thereafter, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.

Example 2. Assume the same facts as in Example 1, except that Wife subsequently marries Husband 2. Husband 2 also predeceases Wife, having made $4 million in taxable transfers and having no taxable estate. An election is made on Husband 2’s estate tax return to permit Wife to use Husband 2’s deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2’s $1 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse of the surviving spouse (here, Husband 2’s $1 million unused exclusion). Therefore, Wife’s applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.

Example 3. Assume the same facts as in Examples 1 and 2, except that Wife predeceases Husband 2. Following Husband 1’s death, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1). Wife made no taxable transfers and has a taxable estate of $3 million. An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion amount, which is $4 million (Wife’s $7 million applicable exclusion amount less her $3 million taxable estate). Under the provision, Husband 2’s applicable exclusion amount is increased by $4 million, i.e., the amount of deceased spousal unused exclusion amount of Wife.

In view of the above, it should be noted that a surviving spouse who has DSUEA, or any individual for that matter, essentially has an intangible asset (Basic Exclusion Amount-$5 million) whether or not he or she has any other financial assets. As such, one could marry another solely for the purpose of gaining access to existing DSUEA or to DSUEA which would become available upon the new spouse’s death regarding their unused Basic Exclusion Amount.

Be that as it may, there is no “stacking” of deceased spouses’ unused estate tax exemptions and therefore no incentive to enter into “serial marriages” because only the most current spouse’s unused exemption can be used by the executor. As a matter of practice, a prior transfer of unused estate tax exemption by the death of a previous spouse is cancelled out and replaced by the death of the most current spouse and their unused estate tax exemption.

Planning Pointer: For many families, the use of disclaimer trusts will likely become much more prevalent during 2011 and 2012. Although there may be no estate tax concerns over the next two years for most people, providing flexibility for the surviving spouse or a QTIP trust for surviving spouse to disclaim assets to a credit shelter trust, especially with a potential $1 million estate tax exemption beginning in 2013, is an important consideration. The simplicity and planning flexibility of disclaimer trusts makes them particularly appealing. Be that as it may, disclaimer trusts come with their own concerns regarding the surviving spouse and giving up control.

For example, even if it makes estate tax sense to disclaim it may not be easy for the surviving spouse to do so, especially in making a large disclaimer to a credit shelter trust, given the recent financial turmoil and the economic uncertainty that still exists. Further, the surviving spouse should not likely be in control of the credit shelter trust and serve as the sole trustee if he/she retains a discretionary power to direct the enjoyment of the disclaimed interest under IRC 25.2518-2(d)(2) and/or there is not clear ascertainable standards language under IRC 2041 for making distributions.

Having someone else other than the surviving spouse serve as the trustee or a co-trustee may be important in that broader language (ie.”best interests”) may be desired within the credit shelter trust so that low basis assets could be distributed back to the surviving spouse for step-up in basis purposes. Finally, further control is relinquished by the surviving spouse when making a disclaimer to a credit shelter trust as the surviving spouse cannot retain a limited power of appointment under IRC 2518.

Planning Pointer: Instead of endorsing only a disclaimer trust approach, planners may want to also recommend other flexible post-mortem planning techniques such as the One-Lung Marital Trust (“OLMT”) and/or the Clayton Marital Trust (“CMT”). In a OLMT the decedent’s entire estate will be left to a marital trust where the executor can then make a partial QTIP election. Thereafter, there will be two identical trusts: one qualifying for the marital deduction and the other not qualifying for the marital deduction. Unfortunately in each trust, the surviving spouse must be the sole beneficiary to the exclusion of the children.

A CMT like a OLMT also leaves the decedent’s entire estate to a single marital trust, where the executor once again can make a partial QTIP election. With a CMT, however, any property that does not qualify for the marital deduction will pass to a separate bypass trust, where the terms and beneficiaries can be different from the QTIP trust and therefore can include the children. Note, that in both the OLMT and CMT the QTIP election does not need to be made until 15 months (9 months plus a 6 month automatic extension) after the decedent’s death. In reality, the OLMT and CMT may be somewhat more flexible than a disclaimer trust which must be made within 9 months of the decedent’s death.

Planning Pointer: Portability is only effective for decedents dying and gifts made after December 31, 2010. Moreover, in order to claim DSUEA a timely 706 estate tax return must be filed, where the DSUEA available is calculated and an irrevocable election is made by the executor. Query: What is the likelihood of a 706 Estate Tax Return getting filed for an estate with little or no assets? Finally, as the law is currently written, both spouses must die before 2013 for the portability provisions to apply under TRA 2010.

Planning Pointer: Although the need to equalize assets between “rich” spouse and “poor” spouse is lessened with portability, the need to balance wealth between two affluent spouses still exists, particularly if the goal is to maximize each spouses GST tax exemption. The GST tax exemption is not portable.

Planning Pointer: One issue that makes portability planning particularly difficult in the context of a remarriage is that, depending on the order of deaths between the new couple, there is a risk that the original surviving spouse could lose some or all of the DSUEA of the original first spouse to die. As such, lifetime transfers may offer the best opportunity to utilize the DSUEA since it may not be available at the time of death or after 2012.

Review Formula Clauses & Family Liquidity Needs

Applying the new $5,000,000 estate, gift and GST tax exemptions to existing tax planning wills and trusts may result in unintended financial consequences to the surviving spouse or to the decedent’s heirs. Fractional share formulas and pecuniary formulas will likely produce dramatically different results, depending upon which one is used.

Formulas which provide for “the maximum amount that can pass free of estate tax,” should now be interpreted to mean $5.0 million, rather than the entire estate. Conversely, formulas that dictate that the “amount equal to federal estate tax exclusion amount” will presently mean $5.0 million rather than zero.

Carefully consider whether it will be the surviving spouse or the bypass trust that will receive the deceased spouse’s unused estate tax exemption. What about second marriages and the overfunding or underfunding ofa Q-tip trust? Now more than ever, estate planning practitioners must carefully review estate planning documents and tax plann ing formulas with their clients.

Similarly, the purpose for which a life insurance policy was purchased along with the policy itself ought to be reviewed. Was the policy for income replacement or to help pay for estate taxes?

Planning Pointer: With an increased estate tax exemption it may be tempting to cancel a second-to-die policy, for example, which is owned by an ILIT for an estate under $10 million. Keep in mind, however, that the increased estate tax exemption is not set in stone beyond 2012 and client insurability may be an issue. Moreover, life insurance is likely to remain taxed-favored and a good hedge if one does not live until their life expectancy, and as such, deserves a place in one’s overall asset allocation. It is also worth noting that using husband’s and wife’s gift and generation skipping tax exemptions by purchasing a second-to-die policy with $10 million of premium will likely solve a whole lot of estate tax issues.

Planning Pointer: If disclaimer trusts are not used, general tax formula clauses will likely need to be reviewed and adjusted regarding minimums and maximums to be passed on to various trusts as there could be widely different outcomes depending upon whether the estate tax exemption is $5 million (2011 & 2012) or $1 million as the case may be beginning in 2013.

A Windfall for Gifting

Just when you thought things could not get any better for transferring wealth during one’s lifetime they did. Barring any new restrictions, limitations or prohibitions, be they proactive or retroactive, the case for making significant wealth transfer between January 1, 2011 and December 31, 2012 is extraordinarily compelling.

Presently, conditions for gifting have never been better in modern times. Under the new tax law we have a $5 million unified estate, gift, and generation skipping tax exemption (indexed for inflation) and a 35% combined estate, gift and GST tax rate. Add to that, all-time low federal interest rates, relatively low asset values and no legislation at this time restricting the use of GRATs and/or valuation discounts on family controlled enterprises. Keep in mind that IRC 2704(b)(4), if enacted, will significantly reduce discounts for interests in partnerships and corporations so the discount clock may be ticking.

During this time, large gifts to Dynasty and Spousal Access trusts may become much more prevalent. Likewise, gifts and sales to Grantor Trusts, with easier seeding due to the increased gift tax exemption, have the potential to remove vast amounts of wealth. Even so, gifting does not remove the gifted assets from the base of calculating estate taxes. What gets removed is only the appreciation on the gifted assets and any gift taxes paid so long as one lives three years from the date of the gift. Furthermore, gift splitting between spouses ought to increasingly come into play as should business succession planning that was unavoidably delayed during the past few years of economic turmoil.

Still, making gifts is not without risks. Presently, donors should be warned on the potential recapture regarding making gifts in 2011 and 2012. Simply, Congress did not likely address the case where the estate tax exemption ($1 million in 2013) would be less than the $5 million of gift tax exemption in 2011 and 2012.

Planning Pointer: Regarding possible clawbacks, note that the combined estate and gift tax base should not be greater than if no gift were made in the first place. Moreover, even with a clawback, one is typically better off making a gift from a transfer tax standpoint as long as the gifted asset appreciates.

Planning Pointer: Separate spousal access trusts which do not run afoul of the reciprocal trust doctrine under common law may be a great planning technique to use husband’s and wife’s $5 million gift tax and GST tax exemptions. Note, to avoid having the reciprocal trust doctrine apply consider setting up the trusts at different times, using different trustees, varying the beneficial interests of each spouse by giving one of the spouses the right to invade principal but not income, or a 5/5 power, or by giving one spouse a limited power of appointment in their trust. Simply, the more differences between the trusts the better. Additional potential concerns with spousal access trusts include divorce, death and having a spouse who consented to gift-splitting be a beneficiary of the trust which would produce adverse tax consequences.

Planning Pointer: IDGTs may become the preferred planning vehicle for transferring vast amounts of wealth. With up to $10 million worth of seeding presently available through using husband’s and wife’s gift and generation skipping tax exemptions, a $90 million installment note can now be taken back from a sale to the grantor trust. Moreover, a gift/sale to a IDGT can be done on tax advantaged GST basis. Conversely, a transfer of property to a GRAT or QPRT results in the grantor not being able to effectively allocate GST tax exemption to property transferred until the close of the estate tax inclusion period (ETIP) pursuant to Internal Revenue Code Section 2642(f)(1). While the case for an IDGT is compelling, a significant drawback is losing the seeded gift should the IDGT fail to outperform the AFR rate.

Planning Pointer: For more on the benefits of gifting, please see LISI Estate Planning Newsletter #1668 (July 1, 2010 by John J. Scroggin, JD, LL.M., AEP� and Charlie Douglas, JD, CFP�, AEP�; LISI Estate Planning Newsletter #1718 (November 29, 2010) by Jeffrey N. Pennell; and LISI Estate Planning Newsletter #1732 (December 15, 2010) by Robert S. Keebler, CPA, MST, AEP� (Distinguished) @ leimbergservices.com.

CONCLUSION:

Could things possibly get any better for wealth transfer planning? Well, with another election coming at the end of 2012 maybe Republicans will finally get their way and repeal the “death-tax” once and for all. At that point the minimal revenue from the estate tax portion of TRA 2010 may give Republicans all the leverage they need to put the final nail in the estate tax coffin. On the other hand, the need for fiscal responsibility and higher taxes of all kinds, including estate taxes, or a Democratic controlled Congress may rule the day.

Whatever the political climate may be, with so many predictions by so many in our wealth transfer planning community having turned out to be so wrong over the last few years, I doubt there will be many who will be definitive as to where things will ultimately stand come January 1, 2013. Without congressional action during the next two years, we will have many of the same transfer tax concerns that we had about 2011 going into 2013, as we prepare for the possibility of returning to the law in 2001. In the meantime, however, planning opportunities should be plentiful. Seize the day!

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Charlie Douglas, JD, CFP®, AEP® has practiced in the business, tax, estate and financial planning areas for over 25 years. He holds a J.D. from Case Western Reserve School of Law and possesses the Certified Financial Planner® and an Accredited Estate Planner® designation. As a senior vice president for a leading global wealth management institution, Charlie specializes in comprehensive planning solutions and trust fiduciary services for business owners, high net-worth individuals and their families. Charlie is a board member of the National Association of Estate Planners & Councils (“NAEPC”) and is the current editor of the NAEPC Journal of Estate & Tax Planning.

This information is provided for discussion purposes only and is not to be construed as providing legal, tax, investment or financial planning advice. Please consult all appropriate advisors prior to undertaking any of the strategies outlined in this article, many of which may involve complex legal, tax, investment and financial issues. This communication is not a Covered Opinion as defined by Circular 230 and is limited to the Federal tax issues addressed herein. Additional issues may exist that affect the Federal tax treatment of the transaction. The communication was not intended or written to be used, and cannot be used, or relied on, by the taxpayer, to avoid Federal tax penalties.