Understanding Estate and Gift Tax

Estate Tax Repealed (for a while?)

This article is written January 2, 2010. It replaces the previous one, "Understanding Estate and Gift Tax," as it is uncertain that today anyone fully understands the estate tax situation. Yesterday, January 1st, the estate tax which has been law since 1916 was repealed, but only for one year. Leaders of the tax writing committee in the Senate have indicated Congress will bring back the law in effect in 2009 by a retroactive extension, but nothing is certain.

In mid-2001 the Economic Growth and Tax Relief Reconciliation Act of 2001 became law. It gradually increased the amount which passed free of the estate tax to $.,5 million in 2009 and which repealed the estate tax in 2010. For budgetary reasons, that law reinstated the estate tax with a $1 million tax free amount in 2011. For several years the consensus had been that repeal would not happen. However, as reported in the January 2ndWall Street Journal, "Instead, amid disagreement over the proper level for the tax and preoccupied with healthcare legislation, lawmakers punted and the tax disappeared."

This is not the first time the estate tax has been repealed. There were temporary death taxes during the presidency of John Adams (to finance naval expansion), and during the civil war and, the Spanish-American War.

The question today is how to proceed. Unfortunately, although there are obvious problems there are no clear answers.

THE ESTATE TAX is repealed for one year, but Congress will probably try to reinstate it. It is uncertain whether or not a retroactive reinstatement is possible. In the past the Supreme Court has ok'd a retroactive increase in the estate tax rate, but it was looking at an adjustment to an existing tax. A retroactive reinstatement would not merely adjust a tax rate, it would impose a new tax on an event (a death) which has already occurred and cannot be altered. If Congress acts quickly, this question may be of importance only for the estates of individuals who die after December 31, 2009 and before any reinstatement.

The repeal, however, creates a great deal of uncertainty for many estate plans where executors or trustees are directed to set aside an amount equal to what can pass free of federal estate tax. Intending to shelter only the tax-free amount with the balance going directly to or in trust for a surviving spouse, the "tax free" set aside will now swallow the entire estate. In the past, such adjustments have caused state legislatures to enact "savings" provisions, but as no one anticipated this situation such savings provisions none yet exist.

The repeal does not affect state inheritance and estate tax. This fact is of no importance in Virginia, as it repealed its estate tax in 2007. A number of states still have their own estate taxes. Maryland and the District of Columbia tax estates of more than $1 million.

Without estate tax, the "stepped up" basis rule which had existed for decades is gone. Generally, that rule caused assets in an estate to take a basis for capital gains purposes equal to value on the date of death. Now, an estate is allowed to step-up $1.3 million of assets (more if there is a surviving spouse), but the estate may have to pick and choose among assets and file a return where none was necessary in the past. For estates with assets worth less than the amount that can be stepped-up there is no problem choosing, but for others the original basis of assets (some of which may have been held for decades) will have to be determined.

THE GIFT TAX continues, but as before there is a credit which allows a total of $1 million of lifetime gifts to be made without tax. Importantly for most individuals, there is an exemption that keeps certain transfers from being counted against that $1 million credit. The transfers which are ignored, or in the terminology of tax lawyers and accountants "annual exclusion" gifts, are gifts of up to $13,000 which can be made to any number of individuals. Additionally, gifts for the benefit of an individual for medical or educational expenses are exempt if paid to the service provide, not to the individual.

There is a new, lower maximum gift tax rate of 35%. This lower rate could be beneficial to those contemplating making total gifts of more than $1 million, but such gifts run the risk of being subject to any retroactive reinstatement of the 2009 law with its 45% rate.

The repeal of the estate tax was coupled with the repeal of the Generation-Skipping Transfer Tax. That was a tax on certain gifts to grandchildren and others defined as two or more generations below the person making the gifts. A large gift to a trust which benefits such persons, helpfully called "skip persons" in the old terminology, might avoid the generation-skipping tax if the courts find a retroactive reinstatement is impermissible. The 2009 law had a $3.5 million per person generation-skipping tax exclusion, so attempting to avoid generation-skipping tax prior to any new legislation would make sense only if the transfers to the trust exceed $4 million per person or $8 million per couple.

WHAT TO DO NOW? As a general rule, estate plans should be reviewed every five to seven years, and whenever there is a major tax change. However, if the repeal appears likely to be followed by new legislation within a few months, individuals who did not have estate tax problems under the old law can probably wait to do a review until the law is settled.

Couples, however, who have estate plans which call for a division of assets and the setting aside of the "tax free" amount at the first death should review their plans now. The increase in the tax free amount to $3.5 million had already meant that many such plans drafted in the 1990's and early 2000's will result in unnecessary administrative burdens without any offsetting tax savings. Now, the repeal of estate tax means it is possible that a trust or children would take the bulk of the assets and leave the survivor with limited means. Often state law allows a surviving spouse to claim a minimum portion of an estate, but making such a claim can be time consuming and expensive.

Individuals who contemplate gifts to children and grandchildren of $13,000 or less or who pay tuition for children or grandchildren can continue as before.

Individuals with substantial assets who would like to consider making gifts in excess of the old generation- shipping tax limits need to act quickly, but with the understanding that there will be some risk.