Estate Tax Bill Becomes Law
– Retroactive Reinstatement with Higher Exemptions and Lower Rates –

Late last night after delays and much debate, House members voted 277-148 to pass the Senate’s version of the H.R. 4853 tax bill and send it to President Obama. Earlier, House members voted 194-233 to block efforts to add an estate tax amendment proposed by Rep. Earl Pomeroy, D-N.D., to the bill.  In addition to extending President Bush’s income tax cuts, the bill addresses the estate, gift and generation-skipping transfer (GST) tax laws for 2010, 2011 and 2012.   President Obama is scheduled to sign the bill into law at 3:50pm today.

Below is a summary of the estate, gift and GST tax provisions of the bill, and related planning points. An income tax summary will be provided on a later date. Some of these suggestions would need to be implemented prior to the end of the year.

Retroactive Reinstatement of the Estate Tax with Choice in 2010

For decedents dying in 2010, the estate tax applies. There is a $5 million estate tax exemption and a 35% top rate. The estate tax exemption will be indexed for inflation after 2011 (with rounding to the nearest $10,000). A full cost basis step-up applies. Estate tax returns for estates of decedents dying in 2010 will be due within 9 months after the bill is enacted (December 17, 2010).

Choice:  Executors of estates of decedents dying in 2010 can elect out of the estate tax regime so that no estate tax is due. If such an election is made, the basis step-up rule will be limited to $1.3 million for non-spousal beneficiaries and $3 million for spousal beneficiaries and qualifying trusts. The IRS will publish rules on when and how the election is to be made. The Senate’s earlier version of the law would have done the same but only for decedent’s dying before December 2, 2010, and thankfully a partial year effective date was not enacted.

Election: If the value of the decedent’s estate is $5 million or less (including gifts made during life in excess of annual exclusion gifts), an executor would not elect out of the application of the estate tax. No tax will be due, and a full basis step-up will be permitted.

If the value of the decedent’s estate is over $5 million, the executor should generally opt out.  The benefits of the additional basis step-up will generally be outweighed by the estate tax, but in estates just over the exemption threshold, with substantial unrealized gains, this may not be advisable.  An analysis will be needed to determine whether incurring an estate tax is justified to secure the benefits of a full step-up in basis.

Recoupling – Gift Tax Exemption is $5 Million

For gifts made after 2010 and before 2013, both the gift and estate tax exemption is set at $5 million. Any exemption used prior to 2010 “eats into” the $5 million exemption available under the new law. The exemption is adjusted for inflation after 2011 (with rounding to the nearest $10,000).

Estate Tax Reduction Planning: The gift tax exemption has been increased by $4 million, which as reported in our recent Client Update newsletter opens-up tremendous estate tax reduction planning for client’s possessing larger taxable estates.  Clients should consider postponing until January 1, 2011 year-end taxable gifts (above annual exclusion gifts) that would cause gift tax. Gifts next year will be sheltered from tax to the extent of the increased gift tax exemption.

GST Tax Exemption is Increased to $5 Million for 2010

The amount of GST tax imposed on generation-skipping transfers in 2010 is zero, but a $5 million GST exemption applies for allocations to trusts.  The total exemption (zero tax) only applies to direct skips in 2010 and does not mean that gifts in trust occurring in 2010 will be exempt when distributions to grandchildren or more remote issue are later made.  Rather, for gifts in trust there is a $5 million GST exemption for 2010 and the automatic allocation rules apply.  As under the law prior to 2010, the taxpayer can opt out of the application of the automatic allocation rules. The GST tax exemption is indexed for inflation after 2011 (with rounding to the nearest $10,000).

Planning Points:
Clients can consider making outright gifts to grandchildren in 2010, as such gifts will not be subject to GST tax. There are ways of doing this without control being in the hands of grandchildren. The law is somewhat unclear on gifts in trust.  If a client makes a gift to a trust for grandchildren in 2010 (as opposed to an outright gift), there will be no immediate imposition of GST tax. With respect to whether distributions in a later year from these trusts to grandchildren will be subject to the GST tax at that time, the way the law is written, the result appears to be as follows:

•             The preferred answer seems to be that because of a rule in the Internal Revenue Code known as the “move down” rule,  once the gift is made the new “transferor” of that trust is deemed to be the grandchild’s parent. Thus, the grandchild is not a “skip person” – so that distributions from the trust to the grandchild should not cause GST to be imposed. This seems to be the correct interpretation but there is no guidance on this issue at this time.
•             When the grandchild dies, and assets pass to great-grandchildren, that will be a transfer to a “skip person” and GST tax will be imposed at that time.  This result can be mitigated if the assets of the trust are included in the grandchild’s estate for estate tax purposes. Note: this seems to be a fair result  – it allows gifts to adult and minor grandchildren to be treated in the same fashion.
•             In order to achieve this result, however, it is critical the donor elects out of the automatic allocation rules. Otherwise, the donor’s GST tax exemption will be automatically allocated to the gift. By electing out of the automatic allocation rules, GST tax exemption is preserved for gifts after 2010 when this special situation will not apply.

Direct skip bequests at death to trusts for grandchildren should be treated the same way – even if the executor opts out of the application of the estate tax. However, this is not clear. There are some commentators who believe that if there is no estate tax, there is no transferor, and as a result there would never be GST tax imposed on distributions from that trust. The bill states that the identity of the transferor will not change regardless of whether an executor elects estate tax or carryover basis.

Although above we recommended that gifts be postponed until 2011, that recommendation does not extend to gifts to grandchildren (or to trusts for their benefit). The ability to avoid GST tax for gifts made outright in 2010 remains an important opportunity, and we recommend that such gifts be completed before the end of 2010 to the extent possible.

Interesting planning will likely occur by gifting to grandchildren in ways that will permit them to gift back and up to their parents, using various trust mechanisms.

 The Law Does Not Eliminate Traditional Estate Tax Reduction Techniques

In prior versions of estate tax reform, and the Treasury’s “Greenbook,” GRATs, family partnerships, and QPRTs would have either been curtailed or eliminated.  The bill does not address these or any other traditional estate tax reduction techniques, leaving historically used estate tax reduction planning intact.

Planning Points:
The benefits of short term, rolling GRATs, qualified personal residence trusts, sales to defective trusts, and family partnerships have survived reform. Therefore, the “rush” to implement planning prior to 2011 has eased. However, now is still the best time to implement advanced planning because many work best in low interest rate environments, and we are currently in a historically low interest rate environment.

Portability of Estate Tax Exemption

If a decedent who died in 2010 leaves a surviving spouse who dies thereafter, to the extent the first spouse to die fails to use his or her estate tax exemption, the surviving spouse can use the unused portion. The surviving spouse’s executor has to make an election to accomplish this result, which creates a burden that can otherwise be avoided by using traditional credit shelter trust planning and not relying on portability.

Only the unused estate tax exemption of the “last” deceased spouse of the surviving spouse can be used. This rule is intended to avoid “serial marriages” to accumulate unused credits.  Note:  the “last spouse to die” may not be the spouse to whom the decedent is last married – the Elizabeth Taylor rule!

Planning Points:

Creating exempt, credit shelter, trusts on the first spouse’s death will remain the recommendation for all but the rare client.  The sooner wealth can become exempt, the better. The most important reason to do so is protection from “unfriendly hands” (e.g., creditor protection) by holding assets in trust.  Furthermore, funding an exempt or  credit shelter trust on the first spouse’s death allows any increased value of the trust assets that occurs between the first death and the second death to avoid estate tax. Using the portability rule will not allow that increase between deaths to avoid estate tax.  In addition, in most cases, both spouses want to use their GST tax exemptions ($5 million per spouse, and indexed for inflation beginning in 2012). Unfortunately, the GST tax exemption is not portable. Thus, in order for the estate of the first deceased spouse to use the GST tax exemption, a credit shelter trust should be used.

It is important to recognize though, that when a spouse dies first without sufficient assets to use his or her entire estate tax exemption, portability will be of great benefit.  This will eliminate the need to create lifetime QTIPs for the “poorer” spouse, or the need to give assets to the “poorer” spouse to allow him or her to use the estate tax exemption at the first death, assuming that the executor of the estate of first spouse to die elects to pass on unused exemption. However, the need to “equalize” estates between a “richer” spouse and a “poorer” spouse will still persist with regard to GST tax planning because the GST tax exemption is not portable.

No Limits on Discounts

As alluded to above, valuation discounts are used with various estate planning techniques (i.e., family limited partnerships) to reduce estate and gift tax exposure. As the Treasury proposed in their “Greenbook” it had been rumored that the new tax bill would include limits on the ability to discount the value of assets in estate planning transactions. The bill as enacted does not include such limits.

Planning Points:

Valuation discount planning continues to be an effective way to reduce estate and gift taxes. It is one of the best strategies, particularly if coupled with other available estate planning measures.

What To Know- Summary

The above rules apply for two years and expire after 2012.  In two years we will again be where we have been- wondering what Congress will do.  Nevertheless, we finally have answers and the guidance that is needed now, but with a few lingering questions that should be answered soon with Treasury regulations.  Client’s who have died during 2010 with large estates have passed without estate tax.  Significant reporting is however required to elect out of estate tax and to comply with the carry over basis rules. Failure to do so results in material penalties.

Gifting large amounts to grandchildren is the main opportunity for the rest of 2010, since no generation skipping tax will apply. Nevertheless, large gifts to grandchildren is not a common objective. Unique planning may use this opportunity in conjunction with trust mechanisms to allow children to benefit.  Going forward into 2011, significant opportunities exist for estate tax reduction planning.  Increasing the gift tax exemption from $1 million to $5 million is a huge opportunity, particularly since traditional estate tax reduction techniques, like GRATs, QPRTs, family partnerships, sales to defective trusts, and others have been left intact.

Merry Christmas, Happy Holidays and All The Best For The New Year,

Joe Kempe

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