By Daniel S. Rubin, J.D., LL.M.
Daniel S. Rubin, J.D., LL.M. (Taxation), is a partner in the New York City law firm of Moses & Singer LLP. He is a frequent author and lecturer on domestic and international estate planning and asset protection planning topics. He can be reached at (212) 554-7899 or email@example.com.
When the Economic Growth and Tax Relief and Reconciliation Act of 2001 (more commonly known by its acronym, EGTRRA), was signed into law by President George W. Bush on July 7, 2001, almost no one seriously thought that the law would ever be given its full effect-that is, most significantly, the ultimate repeal of the federal estate and generation-skipping transfer taxes in 2010. However, as of January 1, the federal estate and generation-skipping transfer taxes are, indeed, no more ... at least until January 1, 2011, when due to the "sunset" of EGTRRA, they are scheduled to be reinstated-with a mere $1 million exemption from the federal estate tax, and with a top rate of 55 percent.
In addition to the "repeal" of the federal estate tax, EGTRRA enacted § 1022 of the Internal Revenue Code relating to the basis of property acquired from a decedent after December 31, 2009. Under that section, and quite unlike prior law, the basis of most property acquired from a decedent is now the decedent's "carried over" basis, instead of a new basis that is "stepped up" to date of death values. In some cases this will cause the recognition of capital gain when the property is ultimately sold by the beneficiaries.
What EGTRRA did not do, however, was repeal the federal gift tax, most likely because the federal gift tax is thought to serve as a necessary back-stop, not only to the federal estate and generation-skipping transfer taxes, but also to the federal income tax. Indeed, the federal gift tax remains alive and well in 2010, and with the same $1 million exemption that was put in place back in 2001. There is, however, one significant difference between the federal gift tax that existed in 2009, and the federal gift tax that applies in 2010-the tax rate is reduced from its 2009 level of 45 percent to equate to the current maximum federal income tax rate of 35 percent. And, although the federal gift tax exemption is scheduled to remain at $1 million indefinitely, following the scheduled sunset of EGTRRA on December 31, 2010 the maximum federal gift tax rate will return to where it was pre-EGTRRA-to wit, 55 percent.
Notably, however, even a temporary one-year "repeal" of the federal estate and generation-skipping transfer taxes may well be untenable based upon current federal budget deficits and the fact that the federal estate tax alone is responsible for raising approximately 1 percent of all federal revenues. Therefore, a real possibility exists that sometime later this year a further federal tax law will be enacted that will serve to reinstate the federal estate and generation-skipping transfer taxes for the estates of decedents dying, and the generation-skipping transfer tax for gifts made in 2010. It is also very possible that such law will be given retroactive effect to January 1, 2010. These recent changes to the federal transfer tax laws, coupled with the prospect of a reversion of the law to its pre-EGTRRA state on January 1, 2011 (or a possible alternative tax law even prior to January 1, 2011), necessarily raises the question: What planning should advisers be recommending that their clients do in light of this situation? Here are some recommendations:
Review the Last Will and Testament or Revocable Living Trust Agreement
Although no two wills or revocable trust agreements are exactly the same, there are at least two common threads that run through most documents drafted with the goal of maximizing transfer tax efficiencies.
The first such thread provides that if the decedent is the first spouse to die (i.e., the decedent is survived by his or her spouse), the estate is to be divided into two separate shares-one that passes into a so-called "credit shelter trust" (sometimes referred to as a "by-pass trust" or a "family trust"), and a second that passes either outright to the surviving spouse or in a marital trust for the exclusive benefit of the surviving spouse (sometimes referred to as a "QTIP trust" or "qualified terminable interest property trust").
The division of the estate of the first spouse to die into these two shares is almost always defined by a formula that serves to pass the deceased spouse's remaining estate tax exemption (an amount that was $3.5 million in 2009), into the credit shelter trust, and any excess of the estate into the marital share. Inasmuch as there is generally permitted an unlimited marital deduction for property passing outright to a surviving spouse (or, alternatively, to a qualifying trust for the exclusive benefit of a surviving spouse), the division of the estate of the first spouse to die in this manner would negate any federal estate tax that otherwise would have been due upon the decedent's death.
A common iteration of this formula might provide that the amount passing to the surviving spouse is "the minimum amount necessary as the federal estate tax marital deduction in the decedent's estate to reduce the federal estate tax due to the lowest possible amount."
Other iterations of this formula might instead serve to define the amount passing to the credit shelter trust; for example, as "an amount equal to the applicable exemption amount within the meaning of the Internal Revenue Code," or "that amount which will generate the largest taxable estate for federal estate tax purposes without the estate paying any federal estate tax."
The second such thread provides for the certain utilization of the decedent's full exemption from the generation-skipping transfer tax (the "GST exemption"). The generation-skipping transfer tax is a transfer tax in addition to the federal estate and gift taxes that applies to the transfer of property to persons more than one generation removed from the transferor (i.e., grandchildren or, alternatively, other individuals significantly younger than the transferor who are thus defined under the tax law as the equivalent of grandchildren or more remote descendants).
The manner in which the GST exemption is applied varies depending upon whether or not the decedent is the first spouse to die but, as a general matter, a formula clause will be used to carve the GST exemption amount away from the balance of the decedent's estate and will serve to pass the GST exemption amount into a separate trust that can ultimately pass to the decedent's grandchildren or more remote descendants (or, alternatively, other significantly younger beneficiaries). The formula dividing the decedent's estate into a generation-skipping transfer tax exempt share and a generation-skipping transfer tax non-exempt share will often define the decedent's "GST exemption" as the maximum amount of GST exemption allowed under the Internal Revenue Code at the time of death (reduced by any amount of GST exemption allocated during the decedent's life or otherwise allocated by reason of the decedent's death).
Beginning January 1, however, the issue is: How do the references in these formulas work where the federal estate or generation-skipping transfer tax laws have (at least temporarily) been repealed?
For example, under certain wills or revocable living trust agreements it would seem as though nothing would pass to the surviving spouse since there is no "minimum amount necessary as the federal estate tax marital deduction to reduce the federal estate tax due to the lowest possible amount." This might prove beneficial from a tax perspective if the federal estate tax later returns (since the marital share would most likely be includable in the surviving spouse's estate when the surviving spouse later dies), but may be problematic to the surviving spouse if, for example, he or she is not a beneficiary of the credit shelter trust or otherwise benefits from the credit shelter trust on more restrictive terms than would have been the case with regard to a marital trust or an outright marital share.
Alternatively, under documents that instead define the amount passing to the credit shelter trust as "the applicable credit amount within the meaning of the Internal Revenue Code," the issue becomes: What amount is that now that the section of the Internal Revenue Code that previously served to define the "applicable credit amount" no longer exists? And where the document defines the amount passing to the credit shelter trust as that amount that will cause "the largest taxable estate that the decedent can have for federal estate tax purposes without the estate paying any federal estate tax," the question must be asked: Is that amount zero (because there is no taxable estate), or is that amount the entire estate because irrespective of the amount of funding, there can necessarily be no federal estate tax?
And, of course, similar issues exist in connection with whether the decedent's GST exemption will be effectively utilized under documents with similar formula clause constructions.
Finally, beyond the inherent ambiguities that may exist under many wills and revocable living trust agreements, additional issues exist for taxpayers who reside in states that have a state level estate tax that is not tied to the federal estate tax system. For taxpayers who reside in those states, the funding of the credit shelter trust with the decedent's entire estate (if that is, in fact, the manner in which the formula division of the decedent's estate is ultimately held to operate), may cause significant state-level estate taxes to be incurred that might otherwise have been avoided.
The take away: Taxpayers should carefully review the terms of their will or revocable living trust agreement to determine whether any structural or definitional issues exist. In many cases, the existing formula clause language will need to be revised to better define the taxpayer's intent regarding the division of his or her estate in the event of his or her death at a time when no federal estate or generation-skipping transfer tax is in place.
Use a Marital Trust for the Surviving Spouse's Share in Lieu of an Outright Marital Bequest
Many taxpayers opt to provide for the surviving spouse via an outright marital share of the estate in lieu of a gift to a QTIP trust. This is because an outright marital share qualifies for the unlimited marital deduction just as well as does a gift to a QTIP trust (provided that the surviving spouse is a United States citizen), and is sometimes considered less burdensome on the surviving spouse than a QTIP trust.
Those taxpayers that instead find the use of a QTIP trust compelling sometimes are in a second marriage and want to ensure that the remainder of the marital share will pass pursuant to the deceased spouse's direction. Others are concerned about the surviving spouse's potential creditor situation, or about the possibility of the surviving spouse remarrying, and want to ensure that the marital share is protected from any claims by such third-party creditor or future spouse through the use of a trust. Finally, a few do not trust the financial abilities of their spouse and want to ensure appropriate financial management of the marital share through the use of trustees.
However, even for those taxpayers who to this point have not found the many non-tax benefits of a QTIP trust compelling, the current state of uncertainty in the estate and generation-skipping transfer tax laws provides a potential tax benefit to the use of a QTIP trust. This is because the QTIP trust will generally only be taxed as a part of the surviving spouse's estate if an election was made on the deceased spouse's estate tax return to qualify it for the unlimited marital deduction. Absent such an election, no marital deduction will be afforded to the deceased spouse's estate (meaning that the QTIP property will be taxed as a part of the deceased spouse's estate), and the QTIP trust generally will not be taxed as a part of the surviving spouse's estate when the surviving spouse later dies.
In contrast, an outright bequest to the surviving spouse automatically qualifies for the unlimited marital deduction (assuming only that the surviving spouse is a United States citizen) and such property will also, of course, automatically be taxed as a part of the surviving spouse's estate when the surviving spouse later dies.
Thus, where the will or revocable living trust agreement provides for the marital share to pass to a QTIP trust, the executor has flexibility to minimize estate taxes depending upon the then current and anticipated future state of the federal estate tax. For example, if the federal estate tax has been reinstated on or before the deceased spouse's death, a QTIP election would likely be made on the deceased spouse's estate tax return in order to negate immediate federal estate tax (at the cost of causing the QTIP trust property to be taxed as a part of the surviving spouse's estate when the surviving spouse later dies).
If instead, there is no federal estate tax in effect at the death of the first spouse to die, no QTIP election need (or perhaps even could) be made. And, absent the election, the QTIP trust should not be taxed as a part of the surviving spouse's estate upon the surviving spouse's later death even if the federal estate tax had since been reinstated.
Conversely, the use of a QTIP trust in lieu of an outright marital share may present issues for state estate tax purposes if the state has an estate tax system independent of the federal estate tax, but does not permit a so-called "state only" QTIP election. In such a situation, where the QTIP election is unavailable because of the repeal of the federal estate tax, only an outright marital share is absolutely certain to generate an unlimited marital deduction for state estate tax purposes. One solution to these seemingly irreconcilable issues would be to provide for the possibility of converting the QTIP trust share into an outright marital share through either very careful drafting or, alternatively, the possibility of a disclaimer by the surviving spouse.
The take away: Married taxpayers whose will or revocable living trust agreement currently provides for an outright bequest of the marital share to a surviving spouse should consider having the document revised to instead provide for the marital share to pass to a QTIP trust.
Revise the Last Will and Testament or Revocable Living Trust Agreement to Account for the New Carry Over Basis Regime
As noted, a stepped up basis is no longer applied to property acquired from a decedent. Instead, the income tax basis of property acquired from a decedent is generally the lesser of the property's fair market value at the date of the decedent's death or the decedent's adjusted basis in such property.
There are, however, two exceptions to the generality of this carry over basis regime. The first exception permits the decedent's executor or personal representative to allocate up to $1.3 million to increase the basis of selected assets (but not beyond date of death values). The second exception allows the decedent's executor or personal representative to allocate up to an additional $3 million to increase the basis of selected assets passing outright to a surviving spouse or, alternatively, in a QTIP trust for the benefit of a surviving spouse (but, again, not beyond date of death values).
In order to ensure full flexibility to allocate basis increases in a manner most appropriate to the circumstances existing at the time of the decedent's death, the authority of the decedent's executor or personal representative pursuant to these two exceptions must be broadly defined in the decedent's will. For example, the decedent's executor or personal representative should be given discretion to make such allocations to non-probate property. In addition, consideration should be given to the appropriateness of a conflict waiver concerning possible allocations of basis adjustment to property passing to the decedent's executor or personal representative.
Separately, the decedent's will or revocable trust agreement should ensure that property with at least $3 million of unrecognized gain, if available, passes to the decedent's surviving spouse (or, alternatively, to a QTIP trust for the surviving spouse's benefit). Notably, this is quite likely a very different amount of property than would be the case where the will or revocable living trust agreement directs that $3 million in value passes to the surviving spouse (or to a QTIP trust for the surviving spouse's benefit). Moreover, the possible reinstatement of the federal estate tax either through the enactment of legislation with retroactive effect during 2010, or EGTRRA's scheduled sunset on December 31, 2010, requires a careful coordination relating to the amount of these potential bequests so as not to cause the estate to incur more estate tax than necessary under such circumstances.
The take away: Taxpayers should revise their will to provide flexibility, where appropriate, for the executor or personal representative to allocate basis adjustments under the new carry over basis regime.
Consider Whether More Proactive Planning is Warranted
It has been long recognized that even though the federal estate and gift taxes were historically imposed at the same rate, the federal gift tax was (at least prior to January 1, 2010), effectively less expensive than the federal estate tax. This was the case because the federal estate tax was imposed on a tax inclusive basis, and the federal gift tax was imposed on a tax exclusive basis (assuming only that the donor survived three years from the date of the gift).
The fact that the federal gift tax was (at least prior to January 1, 2010), effectively less expensive than the federal estate tax is best understood by example. Therefore, imagine a scenario in which a decedent died in 2009, without any remaining estate tax exemption, with a $10 million estate that passed in its entirety to a non-spouse beneficiary. The federal estate tax would have been $4.5 million ($10 million x 45% = $4.5 million), and the beneficiary would have received the remaining $5.5 million of the decedent's estate ($10 million - $4.5 million = $5.5 million). If however, the decedent had instead made a gift prior to death (without any remaining gift tax exemption), from the same $10 million the beneficiary would have received $6,896,552 and the tax due would have been $3,103,448 instead of $4.5 million. In other words, a gift of $6,896,552 multiplied by a 45 percent tax rate on the amount gifted generates a tax in the amount of $3,103,448; the same $10,000,000 is split between the beneficiary and the government ($6,896,552 + $3,103,448 = $10 million), except that with a gift the beneficiary receives more and the government receives less.
If, however, the gift tax is imposed at a rate of only 35 percent, as is the case this year, the tax benefit of making a taxable gift is even greater-assuming, of course, that the federal estate tax is later reinstated with a rate is excess of 35 percent (and that some higher gift tax rate is not later enacted with retroactive application).
In addition, since there is no longer any federal generation-skipping transfer tax, lifetime or testamentary transfers need not be constrained to children (or others assigned by the tax law to the generational level of a child). Instead, unlimited amounts can be gifted or bequeathed, either outright or in trust, to grandchildren or more remote descendants (or to others assigned by the tax law to the generational level of a grandchild or more remote descendant), or to a trust for their benefit. Of course, gift tax would apply to the extent the value of the gifted property exceeds the donor's remaining gift tax exemption. Similarly, distributions might now be made to such persons, or to a trust for their benefit, from existing trusts that were previously subject to potential generation-skipping transfer taxation by reason of having an inclusion ratio in excess of zero (by reason of having been allocated an amount of GST exemption less than the value of property given to the trust).
Although the generation-skipping transfer tax may be reinstated on January 1, 2011, gifts, bequests or trust distributions made at a time when there is no generation-skipping transfer tax in existence will, of course, not be subject to such tax unless there is a retroactive reinstatement of the generation-skipping transfer tax. Even if there is a retroactive reinstatement of the generation-skipping transfer tax, however, gifts made in an amount less than or equal to what would be the transferor's GST exemption as of January 1, 2011, should still avoid any tax risk because it would seem unlikely that a generation-skipping transfer tax would be enacted on a retroactive basis with an exemption less than the GST exemption that is schedule to take effect on January 1, 2011. Alternatively, gifts made via a formula drafted to negate the imposition of generation-skipping transfer tax (i.e., "so much of my interest in ABC LLC as can pass to my grandchildren free of generation-skipping transfer tax") should also provide a safe harbor from the subsequent enactment of a generation-skipping transfer tax with retroactive effect.
The take away: Taxpayers who can afford to make substantial gifts should give careful consideration to making such gifts this year, and to doing so as early as possible this year.
Although almost no one seriously thought that those provisions of EGTRRA that were back-loaded to January 1, 2010, would ever be allowed to come into effect, the new year heralded their arrival and they must now be addressed in almost every estate plan.
Appropriate action includes (i) reviewing the will or revocable living trust agreement to determine whether any structural or definitional issues exist, (ii) revising the will or revocable living trust agreement, if necessary, to provide for the surviving spouse's share to pass via a QTIP trust, (iii) revising the will or revocable living trust agreement to provide the executor or personal representative appropriate flexibility to properly allocate basis adjustments pursuant to the new carry over basis regime, and finally (iv) if appropriate, making substantial gifts as early as possible this year.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.