Congress dropped the ball, and the federal estate tax vanished for 2010. So what happens now?
If you're planning to die wealthy, 2010 is the year to do it-at least from a financial perspective. That's because Congress, to the amazement of estate lawyers and financial planners, allowed the federal estate tax to expire-for one year only-at midnight last New Year's Eve.
The temporary expiration was legislated almost a decade ago by the Economic Growth and Tax Relief Reconciliation Act of 2001, which estate planners now wryly call the "throw Momma from the train" law. As in, "Gee, look how much richer I'd be if Momma stopped breathing in 2010."
So far, no Ohioans have been charged with tax-stimulated matricide (or patricide), but there's no doubt that heirs are likely to inherit considerably more if a wealthy parent dies this year than if the same parent had died in 2009-or survives until 2011.
Indeed, it's what may happen in 2011 and subsequent years that really worries the pros who earn their livings by advising rich folks. If 2010 is a great year to die rich, dying in 2011 could cost your heirs a bundle. Unless Congress sends President Barack Obama a new estate tax bill this year, the "old" federal estate tax will return with a vengeance in 2011. The individual exemption will be just $1 million ($2 million for couples who've executed the necessary trusts). And the marginal estate tax rate will increase to 55 percent, plus a 5 percent surtax on estates in excess of $10 million.
In 2009, the federal estate tax rate was 45 percent with a $3.5 million individual asset exemption ($7 million for married couples). Most experts predicted Congress would fix the muddle by scrapping the 2010 estate tax hiatus and keeping the 2009 rates and exclusions. But Congress was too busy arguing about health care. "My sense is that people are still shocked that Congress didn't do anything last year about this and seems to be in no hurry to anything about it this year," says Joe Popp, an attorney with Rea & Associates, a regional accounting firm.
"Financial planners have been dealing with a moving target for a decade, because the exemptions and tax rates kept changing," says Diane Armstrong, an accountant and certified financial planner who's managing director of financial planning at WealthStone.
If the estate tax does return in 2011 with an exclusion of just $1 million, things could get noisy. "At $1 million, the estate tax will affect a lot more people. If there were complaints before, there'll be more about a $1 million exemption at a higher tax rate next year," says accountant Jim Valderrama, tax director at RSM McGladrey. The IRS estimates the estate tax affects just the wealthiest of Americans, but those fortunate folks have the resources to make their voices heard.
How will your own estate planning documents hold up? Can your wishes regarding asset distribution be honored if you die this year? Will your heirs take a hit if the estate tax comes back in 2011? Columbus C.E.O. asked a sampling of professionals how they're advising clients in an uncertain time.
Matters of Trust
Historically, estate planners have advised married clients to protect the maximum amount from estate taxation by establishing credit sheltered trusts that divert the estate tax exemption of the first to die spouse away from the surviving spouse, for the benefit of children or other beneficiaries. Wills and other estate planning documents incorporate time frames and formulas to fund credit sheltered trusts and marital trusts, commonly known as A-B trusts.
"The formula usually directs the maximum estate tax exemption amount into the credit sheltered trust," says attorney Ron Rowland, a partner at Vorys, Sater, Seymour and Pease. "It's zero today, so there's no exemption to fund that trust. All of the money then goes into the marital trust."
If you don't want everything to pass into your marital trust, there's a simple remedy for 2010: a spousal disclaimer. "Think of it as a legal ‘No, thank you,' " says attorney Sharon Miller, a shareholder at Blaugrund, Herbert & Martin. "A disclaimer sidesteps having all of the assets flow to the marital trust, because the spouse can direct them to the family [credit sheltered] trust. This year we have to navigate a different course to get the assets where they would've gone in 2009."
Disclaimers, which can be executed up to nine months after a spouse's death, often direct money to a trust for the benefit of children. "Say Dad died this year. Without an exemption amount to be directed into the credit sheltered trust, it's conceivable that the children could get nothing," Rowland says. "All of the money would flow into the marital trust for the surviving spouse. That's not reflective of Dad's intention. If he died last year [the children] would've received $3.5 million."
Without a disclaimer, there's potential for big trouble if, say, a stepmother inherits the $3.5 million that Dad intended to leave to his kids from a previous marriage. Updated documents could prevent this scenario-and any accompaning attorney. "If you use now-repealed tax concepts and formulas to divide assets among multiple beneficiaries, you can really harm yourself," says John Schuman, an accountant, attorney and financial planner who's a principal at Budros, Ruhlin & Roe, a fee-only financial planning firm. "If the kids are to get what's in the credit sheltered trust and the surviving spouse gets what's in the marital trust, in this year of repeal, it's winner-take-all."
The temporary elimination of the estate tax in 2010 doesn't mean heirs get to keep the whole bundle. They'll pay capital gains taxes on the difference between what Dad paid for an asset and what it's worth on the day it's sold. "Managing long-term capital gains is the new estate planning wrinkle," says financial planner Paul Gydosh, managing director of Kensington Wealth Partners.
"With ‘step-up' basis that was used in 2009, the assets go to the heirs based on the value at death," Gydosh says. In other words, if Dad paid $1 in 1960 for a share of stock that was worth $100 when he died in 2009, there's no tax on the $99 gain. "Now with ‘carryover' basis, the original asset value carries over to the heir, who's now responsible for all of the accumulated capital gains when the asset is sold."
"For some high-net-worth individuals with greatly appreciated assets, the beneficiaries aren't getting any favors with the repeal," Popp says. "It's possible they'll end up taking a bigger tax hit with capital gains if they sell the assets in 2010 than if they received and sold the assets in 2009 under the old rules."
Instead of exemptions, estate planners are working with ‘basis increases' in 2010. "Every estate [exempts from capital gains tax] a $1.3 million aggregate basis increase," Miller says. "Assets passing to a surviving spouse have an additional $3 million spousal property basis increase. These are totally new concepts. ... When the heir sells the asset, they won't have as much, if any, capital gains tax to pay."
For many heirs, calculating carryover basis can be a record-keeping nightmare. "How does a beneficiary reconstruct the value of a stock that his dad purchased decades ago?" Valderrama wonders. "How will the IRS handle this when the heir sells it and the tax is due? What if there's an audit?"
Gift and GST Taxes
The federal estate tax has disappeared for 2010, but there's still a tax on gifts of more than $1 million. "In 2001, the gift tax and estate tax were the same amount and called the unified credit. After 2001, the gift tax exemption stayed at $1 million even as the estate tax exemption increased incrementally," says attorney Bill Browning, a partner at Browning, Meyer & Ball.
Currently, anyone may give up to $13,000 per year to anyone else without declaring the gift for tax purposes. If you give more than $13,000 to a single recipient, you must file a gift tax form with the IRS, but there's no tax due unless your lifetime gifts exceed $1 million. If you exceed the limit, the gift tax rate in 2010 is 35 percent, down from 45 percent in 2009.
"Many people don't want to pay taxes any sooner than they have to, but it can make sense to gift assets in 2010 to take advantage of the 35 percent gift tax rate before it goes back up to 45 percent in 2011," says Inez Bowie, an accountant and tax manager for Rea & Associates. "The caveat is retroactive legislation. Who knows what Congress will do? Today's 35 percent taxable gift may end up being a 45 or 55 percent taxable gift after all."
Some of the same uncertainties apply to "generation skipping trusts," established for the benefit of grandchildren. Through 2009, there was a generation skipping tax (GST) payable when assets were transferred to the trust, but future appreciation in the value of those assets was exempt from federal estate taxes. In 2010, the generation skipping tax (GST) is repealed, along with the estate tax.
"Like the estate tax, the GST rate climbs to 55 percent next year from 45 percent in 2009 unless Congress acts," Schuman says. If you're willing to gamble that Congress won't reinstate the generation skipping tax retroactively, you can give, say, $10 million to your favorite grandchild in 2010, and pay only the 35 percent gift tax. If Congress does reinstate the GST retroactive to Jan. 1, 2010, you can join what's sure to be a long list of plaintiffs filing Constitutional challenges.
Will Congress Act?
The Obama administration's 2011 budget incorporates revenue from a 45 percent estate tax rate, but what actually will happen is anyone's guess. "The limbo is whether Congress will take the time amid its other legislative issues to address it this year," Schuman says.
In December, the U.S. House of Representatives passed a bill to make permanent the 2009 federal estate tax rate and exemption level. However, the Senate failed to pass legislation before 2009 ended.
In April 2009, Senators Blanche Lincoln (D-Arkansas) and Jon Kyl (R-Arizona), sponsored a measure setting a 35 percent tax rate and a $5 million individual exemption ($10 million per couple). That squeaked by in a 51-48 vote, but never made it into final legislation. Some business organizations that previously lobbied for permanent repeal of the estate tax now are backing the Lincoln-Kyl bill as a positive alternative to what's looming in 2011.
If Congress does address the issue, one big question is whether the new tax will be retroactive to Jan. 1, 2010. That would almost certainly trigger a Constitutional challenge that would wind up in the U.S. Supreme Court. "The Constitutional argument is that of due process," Schuman says. "Is it due process to die during a period of no tax and then have an estate tax applied afterward?"
For now, many wealthy folks are choosing to do nothing, assuming they'll survive until at least 2011. "If the client loses that bet and dies, under current law they can petition probate court for an interpretation of the documents," says Rowland. "I can't predict any outcome, but I have to believe that the court would be reasonable if the outcome in 2010 was significantly different than would have happened in 2009 under the old rules."
Estate planners know some clients are at more risk than others. "The red flag is if you're in poor health this year or advanced in age, see your lawyer. It's morbid, but it's the right advice," Browning says.
Attorneys and financial advisors don't like being in limbo, even when it means extra billable hours. "Because Congress didn't do their job in a timely manner, attorneys and others are doing work they shouldn't have to be doing and clients are paying for it," Rowland says.
Lisa Hooker is a freelance writer.
Reprinted from the May 2010 issue of Columbus C.E.O. Copyright © Columbus C.E.O.