Uncertainty as to whether there will be an estate tax this year (and whether it will be imposed retroactively) has created some possible planning opportunities. However, it has also called into question whether current estate planning documents and techniques will work as intended. This is a very serious problem that must be considered on a case by case basis.
It is well publicized that since January 1, 2010 there is no federal estate tax or generation-skipping transfer (“GST”) tax. This is a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) which provided for a phase out and ultimate repeal of these taxes effective January 1, 2010. However, due to budgetary complexities, this tax break, like many other tax cuts under the 2001 legislation, was not permanent. As a result, the law today reinstates the estate tax and the GST tax at their pre-EGTRRA levels ($1 million of exemption for both estate tax and GST tax and higher rates) beginning January 1, 2011.
We have been dealing with an unprecedented level of confusion in estate planning since the passage of EGTRRA. It was widely believed that Congress would act before the end of 2009 so the estate tax and GST tax would not lapse at the end of 2009. Many wills and trusts drafted in recent years assumed that such taxes would continue. At this point, it is unclear whether Congress will act to reinstate the estate tax and the GST tax in the coming months and if so, whether such action will be retroactive to the beginning of the year.
Of particular concern are those wills and trusts which were prepared based on formulas geared to estate tax and GST tax provisions of the Internal Revenue Code. In view of the temporary lapse of these taxes, these formulas may not work as intended. For example, a typical formula used in wills could result in an entire estate passing to the so called “by-pass trust” with nothing passing to the surviving spouse; or in the case of another typical formula, everything passes to the spouse and nothing to other family members. Similarly, a formula bequest based on the exemption from the GST tax could result in an entire fund passing to grandchildren and more remote descendants, with nothing going to the children, or vice versa.
Because of the confusion caused by the lapse of these taxes, family conflict will inevitably result over the meaning of provisions in wills and trusts. Legislation has been proposed in some states, including New York, to address how these clauses are to be construed in the absence of Congressional action. However, there is no assurance at this point that such legislation would be enacted in New York. Moreover, even if such legislation became law, it may be of little comfort in determining how newly ambiguous estate planning documents will be interpreted. It is problematic that the New York Legislature would be able to accurately divine a family member’s intent.
It is regrettable, but necessary, that one’s principal estate planning documents be reviewed at this time to determine what should be done to address these uncertainties. Also, it will be necessary for people to reconsider how they would like their assets to pass in the absence of an estate tax or a GST tax.
Celebration of the current absence of the estate tax should be tempered by the fact that the basis step-up of assets owned at death is also severely curtailed. This year, the basis step-up on death is limited to $1.3 million for bequests generally, plus an additional $3 million for bequests to surviving spouses. Planning is necessary to assure that the will or trust provisions for the surviving spouse properly allocate the $3 million of basis for the assets passing to him or her in trust.
The fact is that for many taxpayers, notwithstanding the lack of an estate tax, there is an actual tax increase due to the limitation on the basis step-up. For example, the estate tax exemption for 2009 was $3.5 million for each person. An estate of a person dying with $3.5 million of assets would have been entitled to a basis step-up of up to $3.5 million even though no estate tax would have been payable. In such case, the estate could have disposed of these assets without incurring an income tax. That is no longer the case. For many taxpayers, the lack of an estate tax, coupled with a limited basis step-up, results in a tax increase.
Limitations on the basis step-up has other serious adverse consequences as well. Most heirs do not have the records available to determine the bases of inherited assets. Also, for estates of holders of low basis leveraged real estate and interests in low basis leveraged real estate partnerships, the lack of a basis step-up will ultimately result in substantial capital gains taxes on phantom gain that can exceed cash proceeds from a disposition of these assets.
It is our recommendation that all of the principal estate planning documents, and the estate plans in general, be reevaluated and, possibly, modified in light of the current state of the law. We realize this is burdensome, and that it may have to be revisited again in the coming months depending upon if, when and how, Congress acts with respect to the estate tax and GST tax.
Lastly, once Congress does act, it is likely there will be significant reforms to the system that may make it more difficult to achieve beneficial results. Proposals under consideration include limitations upon valuation discounts and short term planning with grantor retained annuity trusts. This may be the last chance to take advantage of these and other techniques that are available under current law. Once Congress does act, estate planning in general may become radically different from what it is today.
In light of the foregoing, our best advice is that you should engage us to review your documents and your estate plan.
*IRS Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.