Summer 2011 Status Wealth Transfer Taxes

By Mike Hoffman. Esq., CPA

The 2010 Compromise Act changes everything in the estate planning arena.  The $5,000,000 exclusion level was adopted for 2011 and 2012.  The last time Congress reduced an exclusion was in 1936, and only once before that, in 1932.  It is estimated that the estate tax will now only apply to 1.4 decedents in a 1000 (1/7 of 1%).*

How important was the November 2010 election?  Huge.

The Obama Administration had campaigned for a $3,500,000 exemption and a 45% tax rate.  The November 2010 elections had a huge and immediate impact.  On December 6, 2010, President Obama announced that he and Congressional leaders had agreed on the “framework of a deal” to permit the so-called “Bush tax cuts” to be extended for 2 years, a 1-year 2% payroll tax reduction, a 13-month extension of employment benefits, and an extension of the estate tax for 2 years with a $5,000,000 exemption and a 35% tax rate.  On December 9, 2010 the Senate released the text of its version of the agreement announced by President Obama as an amendment to other unrelated legislation.  It also included the opportunity for executors to elect out of the estate tax and into the carryover basis rules for 2010, increase of the GST exemption to $5,000,000 beginning January 1, 2010, a GST tax rate of 0% for 2010 and 35% beginning in 2011, indexing the $5,000,000 exemption and basic exclusion amounts for inflation beginning in 2012 and portability.  There was no mention of GRATS, consistent basis, relief for farm or timber real estate, valuation discounts, and permanent removal of the shadows of “sunset” from all of these areas.  On December 15^th the Senate approved the Reid-McConnell Amendment.  On December 16^th and 17^th the House approved the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.  Obama signed the Act on December 17^th.

The Basics

Now the estate tax basic exclusion amount (“BEA”), the gift tax basic exclusion amount and the generation-skipping transfer tax exemption are reunified at $5,000,000.  The tax rate has likewise been unified at 35%.

In calculating the credit for gift tax paid on transfers during life, the rate of a tax that applies at the taxpayer’s death is used, rather than the rate that was actually paid. This language diminishes most “clawback” concerns that have arisen in light of the 2-year existence of the $5,000,000 BEA.  Planners are always concerned with who pays the estate tax attributable to any lifetime gifts, and that is what is known as a tax apportionment issue, like it is for any other phantom asset that increases the estate tax liability at death.  The credit is granted as if any gift had been taxable and the tax was paid inter vivos.  Remember, it’s not that the transfer was tax free, rather the unified credit is tantamount to having a tax bill that is paid by using the credit available.  Since it is not an exemption or deduction, it does not actually make any transfer “tax free.”  So, if a $5,000,000 lifetime gift is made, with no tax actually paid, and a $1,000,000 BEA is applicable at death, there is no clawback because the tax on the $5,000,000 gift is a credit against the tax at death.  The fact that no gift tax was actually paid is irrelevant, so the benefit provided by the unified credit during life is not retracted at death.

The 2010 Act also adopts portability for transfers made after 2010 and a new term: “Deceased Spousal Unused Exclusion Amount” or “DSUEA.”

Portability does not apply for generation-skipping transfer tax purposes, just for estate tax purposes.

An election is required and the predeceased spouse’s estate must file an estate tax return to capture the portability option.

Estates for decedents who died in 2010 can elect to apply either the estate tax with a $5,000,000 BEA and 35% rate or carryover basis with no estate tax.  Carryover basis will be preferable for many large estates because the current capital gain tax rate is significantly lower than the 35% federal estate tax rate and   the taxes are deferred until a recognition event that may never be realized.

The estate of any decedent dying before December 17, 2010 (date of enactment) has a nine month period for filing any returns (including carryover basis Form 8939 for estates electing the alternative), paying any tax, and making disclaimers.

The 2010 Act clarifies that the generation-skipping transfer tax was applicable in 2010, but the rate was zero.  Note that if one elects carryover basis for a 2010 estate, a direct skip is not possible because there was no estate tax, which impacts where GST exemption is allocated as well as other matters such as splitting trusts and calculating inclusion ratios.

Estate planning is relevant, alive and well!

In 2009, there were 234,000 gift tax returns filed.  The Internal Revenue Service has announced their intention to review significantly more of these filings than they have in the past.  In an ex parte petition filed December 27, 2010, the IRS requested California property records to pursue gift tax evaders. The IRS has received voluntary disclosure of property transfer information from authorities in Connecticut, Florida, Hawaii, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Texas, Virginia, Washington, and Wisconsin.  This will become a pattern across the United States.

In 2001, there were 125,000 Estate Tax Return Form 706’s filed.  This number had dropped to 33,000 by 2009.  It is estimated that of this 33,000 filed in 2009, 6,000 were estates of less than $5,000,000 and 5,000 were estates of between $5,000,000 and $10,000,000. Query – what will this number be in 2011 with the basic exclusion amount being $5,000,000?  In Georgia, for 2007, there were 803 estate tax returns filed.  This number dropped to approximately 600 in 2009 and approximately 400 in 2010.  It is anticipated that this number will be closer to 200 for the year 2011.

During the last three years, we have been in a “perfect storm” for estate planning purposes.  We have remained under a cloud of uncertain legislation and rules.  The estate planning environment has been supported by four strong “legs to the stool.”  We have witnessed the largest, deepest recession in our lifetime and valuations will never be lower.  We are experiencing a historically low interest rate environment, which improves most of the estate planning techniques that we are able to implement.  We are in an environment where the budget crisis begs for increased revenue and therefore taxes in the future, coupled with a “tax the rich” mentality a significant number of our legislatures and our President.  Finally, we are in an era where valuation discounts are still acceptable when done properly and under the right circumstances.

For those with large estates, it is tantamount to irresponsibility to not be implementing favored estate planning techniques which include things like intra-family loans, annual gifting, family limited partnerships and family limited liability companies, preferred partnership freezes, installment sales to defective grantor trusts, and the like.  Planning techniques are extremely complicated and expensive to implement, but the tax savings and asset protection consequences alone are compelling.

In low interest rate environments, qualified personal residents trusts (“QPRT’s”), grantor retained annuity trusts (“GRAT’s”), and charitable lead trusts (“CLT’s”) may not be as popular as in times of higher interest rates.  This is because the IRS tables assume that the retained benefit is worth less because of the low interest rate environment, therefore, the remainder interest is worth more.  Therefore, the value of the gift is not reduced as much when current interest rates are low as compared to when interest rates are higher.  However, there are alternate techniques that can be used to transfer, discount or freeze the valuation of personal residences.  There are techniques to minimize or zero-out the value of GRAT remainder interest.  The charitable lead trust area has evolved using a technique referred to as the “Shark Fin CLT” which back loads a significant portion of the payment to charities, allowing growth and ultimately more property in the CLT to pass to remainder beneficiaries.

The estate planning environment is ripe and exciting.  For those who do not embrace the objectives, concepts, and techniques that are currently being implemented by taxpayers, opportunities squandered will be opportunities lost.

Recent history

The current estate tax was established by the Revenue Act on September 8, 1916, as the U.S. was on the brink of entering WWI.  Rates were 1% to 10% on taxable estates over $50,000.  In 1917, the rates were increased 50%, from 1.5% to 15%, and the Finance Committee acknowledged that such a tax was a “temporary emergency measure” in an area that is generally reserved to the States.  The Revenue Act of 1926 made a significant move towards repeal providing a state death tax credit of 80% of the basic tax.  The Senate version would have repealed the estate tax in its entirety.

Then came the Depression, WWII, post-war recovery, the Korean War, Viet Nam, the Civil Rights Movement, Social Security, Medicare, Medicaid, Welfare, food stamps, and unemployment benefits.

There was significant legislation in 1976, including carryover basis (which was repealed in 1980), reduction of the maximum rate from 77% to 70%, unification of the gift and estate tax rates, making both estate and gift taxes tax-inclusive for gifts made within 3 years of death, a single lifetime exemption, the abolition of “gifts in contemplation of death” rule, more explicit rules in governing disclaimers, liberalized extended payment of estate tax rules under §6166 and tax on generation-skipping transfers (repealed and replaced in 1986).

The Reagan Administration had a low interest in total repeal of the estate tax and produced only a reduction of the top rate from 70% to 50% in a phased reduction that ultimately leveled off at 55% with a 60% rate applicable on amounts over $10,000,000, to eliminate the benefit of the lower brackets for larger estates.

The “Death Tax Elimination Act of 2000” was passed in 2000 by large majorities in Congress (including 59 Senators), but was vetoed by Clinton.  This legislation would have reduced rates, converted the unified credit to an exemption, eliminated the 5% surtax “bubble” on taxable estates larger than $10,000,000, repealed the estate, gift and generation-skipping transfer taxes for years beginning in 2010, and implemented a carryover basis regime.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) was subject to the Byrd Rule ten year sunset provisions.  The Byrd Rule makes “extraneous” provisions in a budget reconciliation subject to a point of order in the Senate.  “Extraneous’ is defined to include the reduction of net revenues in years beyond the period provided for in the budget resolution.  The 2001 budget resolution generally covered ten years and also a net reduction of taxes beyond ten years would have been ruled out of order.  This rule was added to The Congressional Budget Act of 1974 in 1985 and amended in 1990 in sponsorship of the late Senator Robert Byrd (D-WV).  A point of order under the Byrd Rule can be waived by a vote of 60 senators.  EGTRRA passed by a vote of 62-38, with a “sunset” provision in it.  Presumably the votes were not there to make permanent the estate tax repeal.

Efforts began in earnest in 2002 and continued in 2003 to repeal or reform the estate tax, but Republicans failed to achieve the 60 votes necessary to override the Byrd Rule.  The 2004 election brought four more Republican seats in the Senate, which now totaled fifty-five, and many were confident of total repeal, a centerpiece of President Bush’s domestic agenda.

Permanent repeal of the federal estate tax was passed in the House on April 13, 2005 and placed before the Senate.  At the end of July 2005, just before August recess, Senate Majority Leader Bill Frist (R-TN) filed a motion of “cloture”, basically a form of “calling the question”, when the Senate reconvened on September 6, 2005.  It was believed that full repeal lacked 60 votes, and compromise efforts needed to continue until Labor Day.  However, when Congress reconvened, the pressures of dealing with Hurricane Katrina became overwhelming and the estate tax vote was postponed, as it turned out, indefinitely.

In May of 2006, consensus started to build towards provisions that became identified with Senator Kyle (R-AZ), a compromise of a 15% rate and a $5,000,000 exemption (indexed for inflation), and a continued stepped-up basis for appreciated assets.  When the Senate took up the cloture motion on June 8, 2006, Senator Kyle had suggested that he would agree to a second rate of 30% imposed on taxable estates of over $30,000,000.  The Senate vote ended up 57-41 in favor of cloture, 3 votes short of the necessary 60.

During 2006, the House proposed two new estate tax compromise bills in an attempt to attract the support of 60 senators.  The “Permanent Estate Tax Relief Act of 2006” (“PETRA”) and the “Estate Tax and Extension of Tax Relief Act of 2006”  (“ETETRA”) were both submitted to the Senate, and on August 3, 2006, a cloture motion failed to attract the required 60 votes (56-42).

What would have happened just after Labor Day 2005 if Katrina had not intervened?  Republicans lost control of Congress to the Democrats in the 2006 election, and support for total repeal became more and more diluted by years of frustrating political maneuvering and the realization that carryover basis would be an unwelcome and messy substitute.  Our large budget deficits and the “tax the rich” mantra has taken estate tax repeal off the table.

Interim Changes and Adjustments

The annual exclusion remained at $13,000; the special use valuation reduction is increased for 2011 to $1,020,000; the non-citizen spouse annual exclusion is increased to $136,000; and an inflation index is applicable to the applicable exclusion amounts for estate and gift tax purposes and the GST exemption amounts (all $5,000,000) after 2011.

What can we look forward to?  Change

None of the potential changes revealed in Obama’s 2010 budget proposals were enacted.  Areas to keep an eye on are (1) a minimum ten year term for GRATS and requiring a remainder interest greater than zero, which by definition creates a future interest in GRAT transactions and requires the filing of a gift tax return on creation because the annual exclusion cannot apply; (2) the elimination of valuation discounts; (3) making portability permanent; (4) special interest provisions for farmers and small business owners; (5) amending the GST tax provisions to preclude perpetual tax free dynasty trusts; (6) preclude lapsing Crummey withdrawal rights; and (7) restoring the estate death tax credit.

Valuation discounts

It was during the Reagan years that the attacks on valuation discounts began to arise in earnest, appearing in a report by Treasury entitled “Tax Reformed for Fairness, Simplicity, Economic Growth” published on November 27, 1984.  Specifically, Treasury proposed that fractional interests of an asset be valued at their pro rata share of the value of the total asset owned or previously transferred by the transferor or the transferor’s spouse. By 1987, a rule valuing interests in family-entities at their pro rata share was proposed in the House but dropped by the time the Ominous Budget Reconciliation Act of 1987 became law.

The Clinton Administration’s budget proposals for 1999 would eliminate valuation discounts except as they apply to active businesses.  The budget proposals for 2000 and 2001 repeated this particular proposal, with slight modifications. Representative Charles Rangle (D-NY) proposed legislation in March of 2000 and in March of 2001 to eliminate valuation discounts on the valuation of non-business assets.  Representative Earl Pomeroy (D-SD) has introduced similar legislation in 2002, 2005, 2007 and 2009.

On January 27, 2005, the Staff of the Joint Committee on Taxation published a 430 page report entitled OPTIONS TO IMPROVE TAX COMPLIANCE AND REFORM TAX EXPENDITURES which presented 5 proposals estimated to raise between 4 and 5 billion dollars over 10 years…

First, perpetual dynasty trust would be eliminated.  Second, valuation discounts would be curved by applying aggregation rules and a look-through rule.  Third, lapsing Crummey powers would be curtailed by limiting Crummey withdrawal powers to those who are direct, non-contingent beneficiaries of a trust (to repudiate Cristofan 1991), limit Crummey powers to powers that never lapse, or limiting Crummey powers to cases where the exercise of which are not only possible but are a meaningful possibility that they will be exercised.  Fourth, providing consistent basis between the estate tax valuation and the basis in the hands of an heir, which would require the executor to report the tax basis of property to each recipient and to the IRS.  Finally, a fifth proposal would subject 529 Plans to transfer tax rules.

Portability

Having a predeceased spouse’s unused estate tax exemption (BEA) to carryover to the surviving spouse can simplify estate planning for some married couples.  However, our clients should not rely on portability.  A credit shelter trust still offers advantages, and other estate planning techniques will continue in importance, including equalization of ownership inter vivos, using an inter vivos or testamentary QTIP, considering a joint settlor revocable trust, and not relying on portability or post-mortem planning because of uncertainty, ignorance or disregard.

Trusts (whether inter vivos or testamentary) can introduce professional management.  Trusts should create asset protection during the beneficiary’s/surviving spouse’s life.  Assets in a trust can protect expectancies of children from diversion by the surviving spouse, especially in the cases of second marriages, blended families or remarriage by the surviving spouse.  The intervening appreciation and accumulated income of a credit shelter trust avoiding estate taxes is extremely valuable, particularly given the number of years a surviving spouse may outlive the testator/testatrix.  Preservation of the predeceased spouse’s exemption also survives conventional planning if the surviving spouse remarries and the exemption (BEA) is legislatively reduced or portability sunsets.

Portability does not apply to generation-skipping transfer tax.  Therefore, the use of the predeceased spouse’s GST exemption is a significant consideration.

Portability must be elected, so an estate tax return must be filed.  Avoiding the filing of an estate tax return for the predeceased spouse’s estate, if the estate is not so large as to otherwise require a return, will save significant administration and probate costs.

On the other hand, a second step-up in basis for appreciated assets and the avoidance of state estate tax on the first estate may be counterbalancing considerations.

Remember that the DSUEA is not indexed for inflation.  Also recognize that relying on portability eliminates the “bracket run” on the first $500,000 that is included in the predeceased spouse’s estate.  Portability planning may affect percentage ownership requirements under provisions such as Sections 303, 2032, 2032A, and 6166.