Estate Tax Chaos Presents Problems, Opportunities

By Glenn M. Karisch
The Karisch Law Firm, PLLC
7200 North MoPac, Suite 300
Austin, Texas  78731
(512) 328-6346
karisch@texasprobate.net

Congress unexpectedly failed to extend the federal estate tax, but leaders say legislation reinstating the tax will be passed early in 2010.  In the meantime, the federal estate tax expired December 31, 2009, so the estates of persons dying on or after January 1, 2010, will not be subject to the estate tax (or the related generation-skipping transfer tax) – unless Congress retroactively reinstates the tax.  This presents short-term planning opportunities for persons who are likely to be subject to the soon-to-be-reinstated estate tax, since it may be possible to make gifts now with substantially less taxes due.  It also presents problems which may require changes to wills and trusts  for persons holding assets with unrealized capital gains totaling more than $1,300,000, since those gains may be taxed for persons dying on or after January 1, 2010.

The 2001 Legislation

The Economic Growth and Tax Relief Reconciliation Act of 2001 increased the amount that individuals could pass free of estate taxes from $1,000,000 (under prior law) to $3,500,000 (for persons dying in 2009).  For married couples with properly drafted estate plans, these amounts effectively could be doubled by use of a “bypass trust.”  This legislation also repealed the estate tax for persons dying in 2010, but it also ended the unlimited step-up in income tax basis that occurred at death under the old law.  (The new law provides limited basis adjustments for persons dying in 2010 which are discussed below.)  However, the repeal of the estate tax expires December 31, 2010, and the old scheme returns for persons dying in 2011 or later – with tax-free amounts reverting back to $1,000,000.

The Train Wreck

This created a train-wreck scenario – estate taxes are repealed and a complicated new carryover basis scheme is enacted for one year, followed by a return to the old scheme with a substantially reduced tax-free amount.  Virtually all estate planning professionals believed that Congress would act before December 31, 2009, either to temporarily extend the current scheme or to enact a new, permanent scheme.  Only by doing so could citizens with potentially taxable estates plan their affairs in a logical, predictable manner.  However, Congress waited too long to make a change, and last-minute political wrangling in the Senate made it impossible to address this problem prior to January 1, 2010.

Repeal of the Estate Tax Brings Loss of Basis Step-Up

At first blush, it seems like people who paid lawyers to draft tax-planned documents would rejoice at the repeal of the estate tax.  That may be true for individuals with estates substantially greater than $3,500,000 and married couples with estates substantially greater than $7,000,000.  However, for estates below these amounts, more tax may be due after repeal of the estate tax since there will be no step-up in basis to date-of-death values.   Here’s an example:

• Husband and Wife have an estate worth $6,000,000 (all community property) consisting of $1,000,000 in cash and other basis-neutral assets and $5,000,000 in appreciated assets having a basis of $1,000,000.  Their wills create a typical “bypass trust” to hold assets of the first spouse to die in order to take advantage of the $3,500,000 tax-free amount in effect under the old law.
• Under the law which expired December 31, 2009, no estate or income taxes would be due at or following Husband’s death and Wife’s death, since the $3,500,000 tax-free amount would shelter all $6,000,000 of assets from tax and since the persons receiving this property after the deaths of Husband and Wife would take these assets with a basis equal to the date of death values.  This “free” step-up in basis at death would keep all unrealized capital gains from being taxed.
• Under the law becoming effective January 1, 2010, assuming Husband and Wife make no change to their estate planning documents, there could be $405,000 of income taxes due if the appreciated property is sold after the death of the first spouse to die or $210,000 in taxes if the appreciated property is sold after the death of both spouses.  Since the repeal of the estate tax is coupled with a loss of the “free” basis step-up, unrealized gain which previously would have escaped taxation could be subject to tax.

The new law provides $1,300,000 in basis adjustment for each person dying on or after January 1, 2010, so the problem only arises if the decedent owned property at death with unrealized gain in excess of this amount.  The new law permits an additional $3,000,000 of basis adjustment for gifts to spouses – if the gift is made free of trust or is made to a “qualified terminable interest property,” or “QTIP,” trust.  Unfortunately, most tax-planned wills under the old law created “bypass trusts” which do not meet the QTIP rules, so a well-drafted, tax-planned will or trust drafted under the old law may not permit the surviving spouse to take advantage of the additional $3,000,000 in basis adjustment.  Persons with tax-planned wills and trusts should check with their estate planning attorneys to see if any adjustments to their plans are necessary in light of the tax law changes – especially if death is imminent.

Repeal of the Generation-Skipping Transfer Tax; Reduction of Gift Tax Rate

For persons who are very likely to have taxable estates even if the old scheme is reinstated, a short-term planning opportunity began January 1, 2010.  Not only does the 2001 tax law repeal the estate tax effective January 1, 2010, it also repeals the generation-skipping transfer tax (GST) and reduces the gift tax rate to 35%.  This makes it possible for these wealthy individuals to make gifts in trust for their grandchildren and more remote descendants and owe “only” 35% in taxes (after the $1,300,000 lifetime gift tax exemption is exhausted).  Since several states permit perpetual trusts, wealthy individuals willing to pay 35% in taxes now may be able to lock away millions of dollars for their descendants in perpetuity with no further estate, gift or GST tax due.  Please note that this window is likely to close quickly – legislation reinstating the prior tax scheme could be enacted by February 1, 2010 – and that Democratic leaders say they intend to make the reinstatement retroactive.  (The constitutionality of making the change retroactive is unclear.)  The use of a formula clause that adjusts the gift downward if the tax is reinstated may limit the risk.  There are a number of possible gifting strategies (such as the use of grantor retained annuity trusts, or GRATs), but only for a very limited time.  Wealthy individuals should check with their estate planning attorneys immediately to make implementing these strategies possible, since the old law may be reinstated early in 2010.

No Immediate Effect on Persons With Estates of Less than $1,300,000 – But Wait for 2011

These changes have no impact now on persons whose estates hold assets worth less than $1,300,000, since those estates were not subject to the estate tax for persons dying in 2009 and will not be affected by the loss of the step-up in basis for persons dying in 2010.  However, if Congress takes no further action, the 2001 tax law provides that the estate tax returns for persons dying on or after January 1, 2011, and it will apply to estates of $1,000,000 or more.  (The tax-free amount is subject to inflation adjustments, so actual amount may be slightly more than $1,000,000.)  Most estate planning professionals think that Congress will act before then to increase the tax-free amount to $3,500,000 or more, but those are the same professionals who thought there was no way Congress would allow the estate tax to lapse on December 31, 2009, an that’s exactly what Congress did.

For more information, contact The Karisch Law Firm, PLLC, at (512) 328-6346 or karisch@texasprobate.net.