Estate Planning in 2001

The first issue discussed at the University of Miami School of Law’s 35th Annual Heckerling Institute on Estate Planning at the Fontaintebleau a in January, which this writer attended (in down ski parka), was whether the President Bush would repeal the estate tax. The majority of the nearly 2,800 attorneys in attendance believed that no outright repeal would occur.

The estate tax received an extraordinary amount of legislative attention in 2000. The “Death Tax Elimination Act of 2000” (H.R. 8) was passed by the Senate by a vote of 59 to 39 on July 14, 2000, with nine Democrats voting in favor of repeal.

The bill would have phased out gift and estate taxes over nine years, with a complete elimination of gift, estate and GST taxes for transfers after December 31, 2009. The bill would also have changed the current credit to an exemption and eliminated the basis step up at death. [The credit imposes estate tax beginning at 37% if the taxable estate exceeds the exclusion amount and denies the use of the lower rates provided in IRC §2001(c); an exemption would permit all estates to enjoy the lower marginal rates which begin at 20%.]

President Clinton vetoed H.R. 8 on September 6, 2000, characterizing the bill as fiscally irresponsible in providing immense tax breaks for the wealthiest, while providing nothing for the vast majority of working families. Mr. Clinton also complained that the loss of revenue would total more than $50 billion annually, while benefiting only tens of thousands of families. Annual estate tax revenue has increased from $12.6 billion in 1993 to $27.8 billion in 1999, as estates have grown. Instead, Mr. Clinton supported “targeted and fiscally responsible legislation that provide[d] estate tax relief for small businesses, family farms, and principal residences.” The House, on September 7, 2000, voting 274 to 157, failed to override President Clinton’s veto.

The defeated bill had substantial flaws, even assuming one agreed with the elimination of the estate tax. Under the bill, $1.3 million of transfers to any decedents, and $3 million of transfers to a spouse would receive a basis step up. However, even with these exemptions, elimination of the basis step-up at death would likely resulted in an administrative nightmare. The last time Congress repealed the basis step-up at death, 1976, it was retroactively repealed two years later, as unworkable.

A Democratic alternative to full repeal of the estate tax was offered by Congressman Charles Rangel (D-NY), ranking Democrat on the House Ways and Means Committee. That proposal would have (i) reduced the maximum estate tax rate from 55% to 45%; (ii) created a $4 million exclusion for family and closely held businesses; and (iii) eliminated valuation discounts except to the extent they apply to active business assets. The House overwhelmingly rejected the Democratic proposal.

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Although President Bush appears to favor a complete repeal of the estate tax, it appears unlikely in the extreme that complete repeal will occur during his first term for a variety of reasons:

  • Nine Republican Senators voted in favor of repeal in 2000; eight of them did not return to the Senate;
  • Democrats could attempt to filibuster a bill to repeal the estate tax outright;
  • The loss in annual revenue to the government from an immediate repeal would be between $40 and $ 50 billion;
  • The nation appears to be entering a period of reduced economic growth. If the budget surplus is reduced, more pressure would be put on existing sources of revenue; and
  • If faced with a choice between reducing income tax rates and eliminating the estate tax, Mr. Bush might choose to expend political capital on income tax cuts.

The charged atmosphere in Washington may result in a compromise which would gradually phase out of the estate tax over the next seven to ten years, perhaps with an intermediate increase in the applicable exclusion amount to $1.3 million, and a substantial decrease in the rates of estate tax, which now climb to fifty-five percent. New legislation might also replace the present credit with an estate tax exemption. This would benefit large estates since the exemption would decrease the portion of the estate subject to the highest estate tax rates, while increasing the portion subject to the lowest rates.

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President Bush and Congress may well succeed phasing out the estate tax over the next decade. However, if the economy falters and budget surplus decrease, a future Congress could conceivably extend the period of the phaseout, or repeal it. This would generate immediate tax revenues. (By contrast, if Mr. Bush were successful in completely eliminating the estate tax, reintroduction would be extremely difficult, as this would require the enactment of a “new” tax. It should be noted that the current estate tax has been enacted and repealed three times.

One significant impediment to a rapid phase out of the estate tax may be the States:  No one would fare worse without an estate tax than would the States, which would stand to lose the state death tax credit. In New York, for example, 2.5 percent of the annual state budget derives from the estate tax credit “sop” tax. It appears unlikely in the extreme that new estate tax legislation could win passage in the States today. It is somewhat surprising that the States have not lobbied against estate tax repeal.

Another factor militating heavily against the outright repeal of the estate tax is the consequence such action would have on charitable giving. Notably, Even John J. DiIulio, Jr., Director of the new White House Office for Community Initiatives, which seeks to encourage more social services involvement by religious and charitable organizations, on February 9 warned against the elimination of the estate tax.

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If the gift tax is repealed or phased out, such action will probably not be retroactive. Therefore, given the current state of change, caution would counsel against a taxpayer making a taxable gift in 2001 that would result in the payment of gift tax. Once paid, those gift taxes would likely never be returned to the taxpayer. Conversely, it appears nearly certain that the present exclusion amount will almost certainly not be reduced. Therefore, leveraged or unleveraged gifts should be considered to utilize the credit of $675,000 in 2001, which will rise to $850,000 in 2004, and $1 million in 2006. One effective technique is the QPRT. (See “QPRTs”)

The phase out of the estate tax would elevate the importance of income tax planning. Income-shifting to lower bracket family members will become more important. For example, without a gift tax, transfers could be made to family members in states such as Florida or Texas which impose no income tax. Similarly, the use of  “dynasty” trusts could flourish in jurisdictions, such as South Dakota, which have eliminated the rule against perpetuities.

Although reduction of estate taxes may no longer be the focal point in estate planning, asset protection will still be an important element in estate planning.  Trusts, corporations and limited liability companies will still be required in estate planning to ensure that business assets are protected, and distributed to family members in an appropriate time and manner.

Estate planning will also continue to be important for traditional purposes. Wills and revocable trusts will be required to plan for incapacity or to avoid probate. Irrevocable trusts will be necessary for tax purposes and non-tax purposes to assist family members and minors. Grantor trusts to hold personal residence and income-producing assets will still be helpful to hedge against the possibility that the phase out will take longer than expected, or will be reversed by some future administration or Congress. Agreements for the succession of family businesses will still be required, as will prenuptial and postnuptial agreements. Pension planning will still be important, especially in light of recent changes (See “IRS Matters”).

When the dust settles, whether $236 billion will be returned to wealthiest estates appears doubtful. However, some significant changes in the estate tax regime appear likely. Therefore, vigilance and continuity in estate planning after estate tax legislation appears essential.

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