Navigating the Estate and Gift Tax Maze

The estate and gift tax law is generally a complex labyrinth, and with the arrival of the new year there is an added degree of uncertainty that makes it even more perplexing.

Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the federal estate and generation skipping transfer taxes were repealed for one year starting January 1, 2010. The gift tax continues with a $1 million lifetime exemption and a top rate of 35%, which is down from the highest gift tax rate of 45% in effect in 2009. However, due to increasing budget deficits and the political dynamics of the current Congress, there is a good chance an estate and generation skipping transfer tax will be reinstated, along with reforms to the gift tax, perhaps retroactively to January 1, 2010.

Whether and when Congress will act is difficult to predict, which increases the number of balls in the air for those planning transfers. Even though there is broad consensus to enact tax legislation, issues such as healthcare, financial regulations, and job creation are undoubtedly higher on the political agenda. Despite the inherent unfairness to some, many legal scholars believe legislation could be drafted to apply retroactively to January 1, 2010 in a manner that does not violate the Constitution. Of course, such retroactive legislation will likely spur litigation, further clouding the state of the law. Alternatively, Congress might enact legislation effective as of the date of its introduction, enactment or some other date in 2010. It is impossible to know what final form any Congressional action would take but, based on recent proposals, the estate and generation skipping transfer tax may be reinstated with tax exemption amounts of $3.5 - $5 million with a top tax rate at 45% on all transfers, including gifts.

On the other hand, Congress could choose to take no action. Under the sunset provisions of EGTRRA, on January 1, 2011, the gift, estate, and generation skipping transfer tax provisions return to the pre-2002 law which imposed much more onerous taxes on transfers. Without Congressional action, in 2011 the gift, estate and generation skipping transfer tax exemption would be $1 million with the top tax rate of 55% (plus a surcharge of 5% on transfers between $10 million and $17,184,000).

Gifting in 2010

Although each individual’s circumstances are unique, many are reluctant to make gifts above the $1 million lifetime exemption amount to avoid paying any federal gift tax. However, the potential that the current 35% gift tax rate will not be retroactively changed to a higher rate may tempt some to consider making taxable gifts. This 35% tax rate is far below the 55% tax rate imposed in 2011 if Congress takes no action. The difficulty is that, at this point in time, it is impossible to know the exact tax implications of making taxable gifts. If Congress successfully enacts legislation that retroactively increases the tax rate, then the gift tax owed may be higher than anticipated at the time of the transfer. Additional tax implications arise if such a gift could retroactively be considered a generation skipping transfer. As such, there is the risk that making taxable gifts now could unnecessarily accelerate the payment of gift and generation skipping transfer taxes that could be reduced over time with other planning opportunities.

Estate Tax Law in 2010

As discussed above, if Congress takes no action then there is no estate tax in 2010, which could result in substantial tax savings for large estates. However, problems may arise since many wills and trusts contain sophisticated clauses that reference the estate tax that may not be in existence. These clauses may, for example, cause an unintentional over or underfunding of marital trusts, credit shelter trusts, generation skipping transfer trusts, and charitable bequests in a manner that does not conform to the estate owner’s true objectives. As such, wills and trust documents should be reviewed in light of the evolving tax law, particularly for those who are not in good health. Depending on the language in existing estate planning documents, it may be prudent to create a will codicil or amend revocable trusts to consider that there may be no federal estate tax or generation skipping transfer tax in 2010.

Carryover Basis

As part of the elimination of the estate tax, EGTRRA also added a twist on the income tax basis rules of inherited property. Prior to 2010, the income tax basis of property inherited was its fair market value on the decedent’s date of death (or 6 months after death if an alternate valuation election was made). If a decedent owned highly appreciated assets then prior to 2010 the appreciation that occurred prior to death would escape capital gains tax. The income tax basis of property inherited while the estate tax is repealed is generally the lesser of the adjusted basis of the property in the hands of the decedent or the fair market value at the date of death. The new carryover basis rules thus eliminate the ability to avoid income tax on the unrealized appreciation in assets held by the decedent.

Under the new carryover basis rules, executors may generally elect to increase the basis of estate property by up to $1.3 million for assets left to any designated beneficiaries, but not in excess of the fair market value of the property at the date of death. Also, executors may elect to increase the basis of up to $3 million for assets passing to a surviving spouse, but not in excess of the fair market value. In light of the ability to increase the basis by $1.3 million and $3 million, planning may need to be done to make sure each spouse has enough appreciated assets to take advantage of the basis adjustment.

Of course, compounding the complexity, if the estate tax is reinstated in 2010 then the new carryover basis rules would not be applicable, which, as discussed above, could be done retroactively. In addition to the federal estate tax, many states impose separate estate and inheritance taxes that can be substantial and need to be considered as part of any estate plan. WTAS is prepared to assist you in navigating the bewildering maze of the estate and gift tax law, as well as help you develop tax planning opportunities for these uncertain times.