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2010 – A Challenging Year For Estate Planning (to the financial professional…)

We have known since 2001 that the federal estate tax and generation-skipping transfer tax (GSTT) was scheduled for a one-year repeal beginning January 1, 2010, but few of us thought we would see that repeal actually take effect. Although most experts were confident that Congress would act to prevent the law from playing out, they failed to do so and estate and GSTT repeal, at least temporarily, is upon us.

 In 2001, President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) into law. EGTRRA was designed to provide significant tax relief, including “permanent” relief from the federal estate tax (with its then $675,000 exemption and maximum 55% tax rate). The new law steadily lowered the maximum estate tax and GSTT rate to 45%, while increasing the exemption amounts to $3.5 million in 2009 and eliminating federal estate tax and GSTT altogether in 2010. But because of a special Senate rule that limits budget deficits, EGTRRA was enacted with a “sunset” provision. Under this sunset provision, on January 1, 2011 the law will revert back to pre-EGTRRA law. This means that the federal estate and gift tax exemptions will be unified at $1 million (the unified credit was scheduled to increase under prior law) and the GSTT exemption will be $1 million, adjusted for inflation. The maximum tax rate will be 55%.

What Will Congress Do Now?

No one knows with certainty what Congress will do.   Several leading Congressional members stated publicly that they would attempt to pass estate tax legislation early in 2010. One of them, Senator Max Baucus, Chairman of the Senate Finance Committee, said that swift action is necessary to prevent “massive, massive confusion.”

But it is already mid-year, and the question now is will Congress act in any fashion in 2010. Some on both sides of the political aisle are fully committed to either the complete repeal of the estate tax or to a tax-raising plan rooting the estate tax at the 2011, $1,000,000 exemption level. Yet others see this as a perfect vehicle for campaign contributions for the 2010 election. Moreover there is great debate of whether any action that might purport to “repeal the repeal” retroactively can be accomplished constitutionally. There will no doubt be numerous wealthy individuals who will die during the period where the estate tax has been repealed. If Congress attempts a retroactive repeal this issue is likely to be resolved in the years to come by the US Supreme Court.

 Modified Carryover Basis

Before January 1 of this year, subject to some exceptions, assets owned at death received a basis “step-up” to the asset’s fair market value at date of death. That means that if a client dies owning publicly-traded securities that he or she bought many years ago, the beneficiaries could sell the stock after the client’s death and pay little or no income tax. The only tax the beneficiaries would have to pay would be on the difference between the sale price and the fair market value on the date of death. (Of course, the stock would also be included in the client’s gross estate for estate tax purposes.)

Under EGTRRA, in 2010 a beneficiary who receives property from a deceased person receives that property with an adjusted basis equal to the lesser of the decedent’s basis or the asset’s fair market value on the decedent’s date of death. Thus, EGTRRA eliminates the automatic “step-up” to the date-of-death value but retains a “step-down” for depreciating assets. Significantly, this modified carryover basis system will impact far more people than the estate tax ever would!

To offset this loss of the step-up in basis, EGTRRA provides that the person in charge of the property may allocate a $1.3 million “aggregate basis increase” on an asset-by-asset basis up to the particular asset’s fair market value at the date of the decedent’s death. Assets left to a spouse may receive an additional $3 million “spousal property basis increase,” also asset-by-asset, up to the particular asset’s fair market value at the date of the decedent’s death.

To be eligible for either step-up, the property must be owned by the decedent. And for purposes of the $3 million spousal property basis increase, the property must be left to the surviving spouse alone, either outright or in a special trust known as a “QTIP” (Qualified Terminable Interest Property) trust. Thus, absent modification to meet these requirements, many marital trusts in existence will not qualify and will waste $3 million of basis increase. Alternatively, assets that are left outright to the surviving spouse can frustrate clients’ estate planning objectives, accidentally disinherit children from prior marriages, and leave the assets exposed to the surviving spouse’s creditors.

Marital Formula Funding Clauses

For married couples, living trusts and wills typically use a formula to divide the decedent’s property into the credit-shelter trust (also referred to as the “bypass” or “Family” trust) and a marital trust, so as to maximize the amount that will pass free of estate tax. If clients created their estate plan when the federal exemption was significantly lower, this common estate planning language will force the trustee to put more assets into the credit-shelter trust than is necessary, leaving the marital trust relatively empty and not taking advantage of the special basis adjustment options under the modified carryover basis rules, discussed above.

Where the family and marital trusts contain identical beneficiaries and dispositive provisions, this will have no significance. However, if the family and marital trusts contain different beneficiaries or different dispositive provisions (such as in second marriage situations, especially where there are children from a prior marriage), this may cause dire consequences to the surviving spouse – potentially disinheriting the surviving spouse if death occurs in 2010!

What Should Clients Do Now?

Since most advisors did not anticipate EGTRRA playing out into 2010, virtually all clients’ estate plans fail to take into consideration the lack of estate tax and its replacement, the modified carryover basis rules. Many clients who understand that the estate tax is repealed will automatically assume that the result for them and their families will be a positive or neutral. Unless forewarned by you as their key advisor, they would little suspect that not only is it possible that without revising their estate plans more tax will be paid after their death, but that the amount and nature of the assets that they expected to go to spouse, family, friends and charity may substantially different than they had planned.

As the above discussion illustrates, the key is flexibility and ensuring that clients’ estate plans contain enough flexibility to accomplish clients’ goals under changing circumstances. Therefore, I strongly encourage clients to have their estate plans reviewed to ensure they continue to meet their objectives while minimizing all tax.

Anthony G. Celaya, Esq.

AmCan Law


[1] See Estate-Tax Repeal Means Some Spouses Are Left Out, January 2, 2010 Wall Street Journal and A Bizarre Year for the Estate Tax Will Require Extra Planning, January 8, 2010 New York Times.

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