Estate Planning in 2010

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I. Period of Uncertainty

The federal estate tax was repealed midnight, December 31, 2009. If Congress fails to act in 2010, the estate of every decedent who dies this year will owe no federal estate tax. This could complicate existing wills. As it now stands, the estate tax will return on January 1, 2011, and the exemption amount will be reset at pre-2001 levels. This means the applicable exclusion amount will be $1 million, and the highest estate tax rate will be 55%.

This “default” scenario could change if Congress passes legislation later this year (retroactive legislative action after 2010 would likely raise constitutional problems) which President Obama signs. The House passed a bill in December that would have permanently extended the $3.5 million exemption and the 45% top estate tax rate in effect in 2009. However, the Senate failed to act, with Republicans and conservative Democrats favoring a higher exemption amount of $5 million. Mr. Obama favors a $3.5 million exemption amount and a top estate tax rate of 45%.

Given fiscal considerations, Congress may reinstate the estate tax retroactively to January 1, 2010. Most believe that the longer Congress takes to act, the less likely it is that reinstatement of the estate tax will be retroactive. However, if accomplished within the next few months, retroactive reinstatement would probably not be unconstitutional. The Supreme Court, in U.S. v. Carlton, 512 U.S. 26 (1994), held that Congress may validly impose retroactive legislation concerning an estate tax deduction. The Court remarked: “The amendment at issue here certainly is not properly characterized as a `wholly new tax,’ and its period of retroactive effect is limited.”

If Congress waits past the summer to reinstate the estate tax, Congress may decide to forego retroactivity. This, despite the significant loss in tax revenues. If Congress does elect to reinstate the estate tax retroactively any time this year, the Supreme Court will more than likely be called upon to decide the constitutionality of the measure.

Note: New York still imposes an estate tax on taxable estates in excess of $1 million. Therefore, it may be prudent for a New York testator to leave at least that amount outright or to a credit shelter trust to make use of the $1 million New York exemption amount.

II. Carryover Basis

Prior to 2010, property acquired from a decedent by bequest, devise or inheritance generally received a stepped-up basis under IRC § 1014. The purpose of the statute is to avoid the double taxation that would result if the asset were first subject to estate tax at the death of the decedent, and then to income tax when the beneficiary sold the asset after the decedent’s death. Since the estate tax has, for the time being at least, been repealed, no double taxation would result from the loss of the step-up in basis at death.

For decedents dying after December 31, 2009, the basis of property acquired from a decedent is the lesser of (i) the decedent’s adjusted basis or (ii) the fair market value of the property at the decedent’s death. IRC § 1022(a)(2). Many estates that would not have been subject to estate tax at the $3.5 million applicable exclusion amount threshold will be subject to the new carryover basis regime.

To temper the harshness of the new rule, Congress provided that the executor may allocate (i) up to $1.3 million to increase the basis of assets, and (ii) up to $3 million to increase the basis of assets passing to a surviving spouse, either outright or in a QTIP trust. Although constitutional arguments could be made against the retroactive repeal of the new carryover basis provisions, few would likely object, since it is difficult to envision a situation in which the new carryover basis provision could benefit an estate.

If Congress does not retroactively repeal the carryover basis provisions in 2010, failure to either make an outright bequest to a spouse, or failure to fund a QTIP trust might waste the $3 million basis allocation that could be made to the QTIP trust. (An income interest in a credit shelter trust given to a surviving spouse would not qualify for the $3 million spousal allocation of basis.)

III. Transfers to Trusts

IRC §2511(c) treats transfers to trusts made after December 31, 2009 as taxable gifts unless the trust is a wholly grantor trust under IRC §§ 671-679. The statute is intended to prevent the donor from making a transfer complete for income tax purposes but incomplete for transfer tax purposes, thereby shifting income tax responsibility without incurring gift tax.

IV. GST Tax Uncertainties in 2010

Although technically not repealed in 2010, the generation-skipping transfer (GST) tax will have no application in 2010, as there is no estate tax. This also means that transferors will not be able to allocate any GST exemption to transfers made in 2010. As is the case with the estate tax, the GST tax will “spring back” into life on January 1, 2011.

However, by reason of the language in the sunset provision in the 2001 Tax Act, i.e., “the the Internal Revenue Code of 1986 shall be applied . . . as if the provisions [in the 2001 Tax Act] had never been enacted,” various uncertainties arise in the application of the GST tax. For example, will GST exemptions allocated trusts after 2001 but before 2010 be allowed? Also, will decedents who die in 2010 with testamentary trusts be treated as transferors for GST purposes? Since transfers to trusts will not be subject to estate tax in 2010, such decedents might not be considered “transferors” within the meaning of IRC § 2652(a).

A number of GST provisions are also scheduled to sunset in 2011 without further legislation. Among those are the allowance of a retroactive allocation of GST exemption under certain circumstances, and a late election to allocate the GST exemption.

V. Review of Existing Documents

Wills for testators at risk of death in 2010 should be reviewed. Existing wills may contain a formula provision allocating the maximum amount which can pass free of estate tax to a credit shelter trust. Since there is no estate tax in 2010, the amount called for in the formula could consume the decedent’s entire estate. Most testators who included this formula provision were motivated by a desire to avoid burdening the estate of the surviving spouse with unnecessary estate tax liability, not a desire to disinherit the spouse. However, if no estate tax exists, then this could result. Similarly, a bequest to a QTIP trust of the maximum amount qualifying for the estate tax deduction may be difficult to interpret if there is no estate tax for which a deduction could be claimed.

A client, even an elderly one at risk of death in 2010, may resist drafting a new will which might be effective only for only one year, since it is remote that estate tax reprieve will more than temporary. A simple codicil may provide an effective solution. The codicil could provide that (i) should the client die at a time when the estate and GST tax do not apply, and (ii) if the estate tax and GST tax are not retroactively reinstated, then (iii) notwithstanding any contrary provisions in the will, for purposes of all formula computations, it would be conclusively presumed that the estate tax laws in effect on December 31, 2009 would be applicable at the client’s death. This would prevent the overfunding of the credit shelter trust. The language of such a codicil could read:

Article [ ]

Intent if No Federal Estate Tax

“For purposes of gifts made under this Will, if at the time of my death there is no federal estate tax, and it appears to my Executor that retroactive reinstatement by Congress of the federal estate tax is unlikely to occur, it is my intention that all dispositive provisions under my Will be given the same force and effect as if I had died in 2009, and that all dispositive provisions in my Will be interpreted according to the federal tax law as it existed in 2009, regardless of the federal tax law in effect at the time of my death.”

VI. Planning for Married Persons

It appears likely that the estate tax will be reinstated no later than 2011, and that the exemption amount could be between $3.5 million and $5 million. As seen, under many current wills, if either spouse were to die in 2010 at a time when there is no estate tax, the credit shelter trust could be overfunded. Overfunding of the credit shelter trust could also result in unintended (and costly) New York state estate tax consequences, since the New York state estate tax exemption amount is only $1 million.

One interesting approach discussed at the University of Miami Heckerling Institute on Estate Planning in Orlando during the week of January 25th, 2010, which seeks to exploit the uncertainty in the estate tax in 2010, is to maximize dispositions to QTIP trusts.

Assets in a QTIP trust with respect to which no estate tax marital deduction is allowed at the death of the first spouse will not be includible in the estate of the surviving spouse under IRC § 2044. If no estate tax exists at the death of the first spouse in 2010, and all of the estate is left to a QTIP trust, no QTIP election will be necessary to save estate taxes on the first spouse to die. If no QTIP election is made, none of the assets in the QTIP trust will be included in the estate of the surviving spouse, even if the estate tax is reenacted prior to the death of the surviving spouse.

[Note: The rights accorded to a surviving spouse in a QTIP trust are insufficient to pull the QTIP trust assets back into the her estate under §2036. QTIP assets are includable only if the executor of the first spouse to die makes a QTIP election and deducts the value of the assets from the gross estate of the first spouse. By making the election, the executor is agreeing to include the value of the assets in the estate of the second spouse (at their fair market value at the death of the surviving spouse). If no election is made, QTIP trust assets will not be included in the estate of the surviving spouse. Inclusion arises by virtue of the QTIP election, not by virtue of the QTIP trust being funded. If no election is made, no inclusion in the estate of the surviving spouse will result even if the QTIP trust was funded.]

In contrast, if all of the assets are instead left outright to the surviving spouse, those assets would be included in the estate of the surviving spouse if the estate tax were reenacted prior to the death of the suriviving spouse. Therefore, a QTIP trust may effectively shield the estate of the surviving spouse from potential estate tax liability. The QTIP trust may also impart a significant degree of asset protection into the inherited assets, when compared to an outright bequest. Another advantage to funding the QTIP trust is to ensure that the $3 million spousal basis adjustment can be utilized, if needed. By inserting a disclaimer provision in the will, the surviving spouse could decide whether to disclaim amounts not needed for the $3 million spousal basis adjustment.

Despite the alluring federal estate tax consequences of generously funding a QTIP trust in 2010, a dark cloud in the form of New York state estate tax liability may appear, since New York does not recognize a “state-only” QTIP election. That is, if no QTIP election is made on the 706 (and no election will be made since none is needed to eliminate the federal tax in 2010, no separate New York QTIP election would also likely be possible, since New York does not appear to allow a QTIP election if no federal QTIP election is made.

This means that if all assets are transferred to a QTIP trust, the cost of obtaining no federal estate tax bill on the death of the first spouse (by reason of there being no estate tax) or on the death of the second spouse (by reason of there having been no QTIP election, meaning that while a transfer to a QTIP trust was made, no election was made to deduct the amounts transferred, and therefore no obligation to include those assets at fair market value on the 706 of the surviving spouse arose) may be a New York state estate tax on the size of the entire estate, less $1 million (the QTIP trust would qualify for New York’s $1 million lifetime exemption amount, since it would be treated for New York estate tax purposes as a garden variety credit shelter trust.)

Although the New York state estate tax could be avoided — and no increase in federal estate tax would arise — by making an outright disposition to the surviving spouse in 2010, this would result an avalanche of potential future federal estate tax on the death of the surviving spouse, unless of course, the surviving spouse also dies before 2011, or consumes or gifts the entire amount before her death.

Another peculiar disadvantage to funding the QTIP trust with all of the estate assets, rather than leaving assets directly to the children, is that the surviving spouse will incur taxable gifts if lifetime transfers to children are desired. That is, the surviving spouse may not wish to wait until her will takes effect to transfer wealth to children. Recall that although the estate tax has been repealed, the gift tax exemption remains at $1 million in 2010. (The rate of tax applied to gifts has been reduced, however, from 45% to 35%.)

Although a disclaimer creates post-mortem flexibility, a significant disadvantage to disclaimers is that the surviving spouse must actually disclaim. Some surviving spouses may not disclaim, even if sensible from a tax standpoint. If this is a concern, the surviving spouse may instead be given more rights and powers over assets funding the credit shelter trust. For example, (i) the spouse might be named co-trustee of the trust; (ii) the spouse might be given a testamentary limited power of appointment over the credit shelter trust; (iii) the trustee might be directed to make greater distributions to the surviving spouse; or (iv) the trustee or “trust protector” might be given authority to make discretionary distributions to the spouse of as much of the income or principal of the trust as the trustee or trust protector believes is in the best interest of the spouse. The credit shelter trust could also provide that the spouse would no longer be a beneficiary if the spouse were to remarry.

Giving the spouse more rights in a credit shelter trust (as would transfers to a QTIP trust where no QTIP election is made) may eliminate the need to rely on a disclaimer. However, this solution would result in significantly less flexibility, and would almost certainly result in New York state estate tax on the death of the first spouse. (Again, the only way to avoid New York estate tax on the death of the first spouse is to make a transfer qualifying for the New York state estate tax deduction. This type of transfer could be (i) an outright transfer to the surviving spouse; (ii) a QTIP transfer for which a QTIP election is made on the 706; or (iii) a general power of appointment trust. A final disadvantage to foregoing the QTIP in favor of a credit shelter trust is that as indicated above, only outright transfers or transfers for a QTIP trust are eligible for the $3 million basis allocation at the death of the first spouse.

VII. Transfer Planning in 2010

Many clients wish to transfer assets to their children during their lifetimes rather than at their death. Therefore, lifetime transfer planning remains important for reasons wholly independent from the fate of the estate tax. While the $1 million lifetime gift tax exclusion amount is a hindrance to large gratuitous transfers, gifts of interests in discounted family entities, installment sales to grantor trusts, and transfers to annuity trusts can significantly leverage the $1 million gift tax exclusion amount.

The federal gift tax (New York has no gift tax) has not been repealed, although the tax rate for gifts in 2010 is 35%, down from 45%. Although the 35% rate is not scheduled to increase in 2011, Congress has historically imposed the same rate of tax on both gifts and estates. Since the 35% tax rate may be only temporary, large gifts of $1 million or more made in 2010 may be considerably less expensive than the same gifts would be in 2011. Another important reason to consider transfer planning in 2010 is that President Obama seeks to curtail valuation discounts, either by means of new legislation, or by issuing regulations under IRC §2704. This prospect, in combination with the historically low gift tax rates now in effect, makes transfer planning in 2010 particularly attractive.

¶ Although Congress is contemplating requiring a minimum 10-year period for GRATs, this would not effect the client’s ability to utilize a “zeroed-out” GRAT, which would result in little or no current taxable gift.

¶ The gift tax annual exclusion amount remains for 2010 remains at $13,000. Much wealth can be transferred without gift or estate tax consequences by prudent use of annual exclusion gifts, either outright or in trusts providing Crummey powers.