2010: An Estate Tax Odyssey

Congress is in the midst of one of its most challenging periods in history. On its agenda are health care reform, wars in Afghanistan and Iraq, job creation and other economic stimulus efforts, regulation of the financial services industry, and solvency of Social Security and Medicare. Facing unsustainable fiscal deficits, Congress must find ways to raise additional sources of revenue without stalling a fragile economic recovery.

Against this backdrop, it is understandable that legislators have been unable to reach a consensus on the shape and form of the estate tax. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the federal estate tax exemption increased during the past decade from $1 million to its present level of $3.5 million and the maximum rate decreased from 55 percent to 45 percent. In 2010, EGTRRA would provide the ultimate relief from the estate tax – a full repeal. This relief would be short-lived, however, as the estate tax is to be reinstated in 2011 and it returns with a vengeance given that the exemption is scheduled to revert to $1 million. While commentators have been hesitant to predict what action Congress may take on the estate tax, almost all have agreed that the repeal of 2010 will not be allowed to go into effect.

The Estate Tax Debate

Despite the many crises facing Congress, there has been considerable debate over the estate tax.

Those against the estate tax argue that:

• it unduly endangers many family-owned businesses and farms considered the backbone of the U.S. economy
• it creates a disincentive in the form of double taxation to entrepreneurs
• it is an extremely inefficient mechanism for raising revenues

Those in favor of the estate tax contend that:

• inherited wealth stifles the incentive of future generations to become economically productive members of society
• those who have benefited most from our economy should bear a disproportionate share of the tax burden
• the estate tax serves as an offset to some of the more regressive forms of taxation such as sales taxes and payroll taxes

Both sides of this debate have some merit and some folly.

The rhetoric of debate has been translated into several bills that are before Congress. (A chart is included at the end of this article summarizing some of the more significant provisions of each bill.) These bills provide a range of exemptions from a minimum of $2 million to a maximum of $5 million – with most bills indexed for inflation. The maximum rates at which the estate tax is imposed range up to 55 percent. Most bills provide for a reunification of the estate and gift tax exemptions. Currently, the gift tax exemption is limited to $1 million while the estate tax exemption is $3.5 million.

Portability: A Benefit for Affluent Couples

Several of the bills before Congress provide for a feature referred to as “portability.” Under current law, in order for a married couple to ensure that they obtain the full benefit of their combined estate tax exemptions, they must engage in traditional estate planning involving the establishment and funding of a bypass trust to which the exemption of the first spouse to die is applied. The funds held in the bypass trust are not included in the gross estate of the surviving spouse. Legislation providing for portability of exemptions between spouses would allow any unused exemption in the estate of the first spouse to die to be passed along to the surviving spouse.

For wealthy clients whose estates exceed the value of their available exemptions, several reforms are under consideration which are designed to decrease the utilization of selected wealth transfer techniques. For instance, discounts previously claimed for lack of marketability or minority interests in certain assets, such as family limited partnerships or LLCs, may be reduced or eliminated.

GRATs: Longer Term May Be Required

In addition, consideration has been given to requiring a minimum term of 10 years for Grantor Retained Annuity Trusts (GRATs). GRATs have been a very effective mechanism for families to transfer substantial appreciation in accumulated wealth downstream to the next generation using little, if any, gift tax exemption. Given that a GRAT’s effectiveness is dependent upon the trust’s total return outperforming specified rates established by the IRS, it is easier to capture such gains during shorter intervals in the market. The longer a GRAT must be in existence, the greater the likelihood that its total return will revert to the hurdle rate established by the IRS and its effectiveness will be limited.

Extension of Current Exemption Is Likely Short-Term Patch

With 2010 just around the corner, time has run out for Congress to work through the many competing considerations involved in defining a new estate tax law. Consequently, House Ways and Means Committee Chairman Charles Rangel is drafting legislation which will effectively grant Congress an extension by retaining the current exemption of $3.5 million and maximum rate of 45 percent until an appropriate compromise can be reached. The cost of continuing with these provisions over the next 10 years as compared to the $1 million exemption under EGTRRA is estimated at $609 billion.

As a practical matter, despite all the debate and proposed legislation, the impact of the estate tax remains to a large degree unchanged. Truly wealthy individuals with estates in excess of $10 million continue to face the prospect of losing a significant portion of their assets to estate taxes unless they actively engage in advanced estate planning. Wealthy individuals that have stayed the course have benefited greatly during the past year in which uncommonly low rates of interest and depressed market values have created an ideal environment for wealth transfer techniques including GRATs, sales to Intentionally Defective Grantor Trusts (IDGTs) and Qualified Personal Residence Trusts (QPRTs).

Affluent individuals with estates ranging in size from $2 million to $10 million are still well advised to establish a solid estate plan, which may include the creation of a bypass trust to utilize their estate tax exemption, the creation of an Irrevocable Life Insurance Trust (ILIT) to hold any significant life insurance policies, and the implementation of lifetime gifting programs to take advantage of their gift and generation-skipping transfer tax exclusions. The upper middle class with estates of up to $2 million should also consult with an attorney to avoid unintended state estate tax consequences and provide for an orderly disposition of their estates. Of course, all individuals should engage in planning to protect themselves and their families from difficult situations brought on by incapacity and end-of-life medical decisions.