The Repeal of the Estate Tax and Its Chaotic Aftermath

The estate tax is dead, for now. Congress failed to extend the current estate tax regime of 2009, or any estate tax regime, to 2010. Consequently, on January 1, 2010, there will be no estate or generation-skipping tax. If Congress again fails to act during 2010, the estate and gift taxes, like Lazarus, will reappear on January 1, 2011 – not as they were in 2009 – but as they existed in 2001. At that time, there will be a reduced exemption of $1 million, not $3.5 million as existed in 2009, and a top marginal rate of 55 percent, not 45 percent as existed in 2009.

Few expected this level of legislative inaction that leaves existing estate plans vulnerable to unintended consequences. Many expect Congress to respond in the next session with the enactment of an estate and generation-skipping tax law, but will Congress make the new law retroactive to January 1, 2010? While this is a solution that many have proposed, it is uncertain whether retroactivity is constitutional. This uncertainty foreshadows protracted litigation on the point and prolonged confusion.

Planning in 2010

Although there will be continued uncertainty until Congress addresses the reinstatement of estate and generation-skipping taxes, existing plans should be reviewed to determine the effects of the repeal, and to consider planning opportunities.

• Check your existing plan. The repeal may unexpectedly impact taxable estates that utilize a formula to allocate between the amount exempt from estate tax and the residue of the estate going to the surviving spouse or to charity. If the formula first allocates the maximum amount that is exempt from the tax to an exempt trust and then allocates the residue to the marital share or charity, severe unintended consequences could ensue. Since there is no estate tax, the language literally could compel the fiduciary to transfer all of the estate to the exempt trust leaving nothing to allocate to the surviving spouse’s share or to charity.
• Transfers to grantor trusts (a trust where the grantor pays income taxes on trust income) are deemed not to be taxable gifts. This provision, which was largely ignored until now, will become effective in 2010 when the estate tax disappears. It may provide planning opportunities in 2010 even if Congress ultimately reinstitutes the estate tax in some form.
• Sales to grantor trusts. The use of sales to grantor trusts has always been an effective mechanism to transfer assets, particularly closely-held entity assets, at a discount to future generations. The use of such a technique remains effective, and may be more attractive now given the uncertainty about the 2010 transfer tax regime.
• Make taxable gifts in 2010. The highest marginal gift tax rate in 2010 is 35 percent, so there may be an advantage to making taxable gifts in 2010 before any enactment of new transfer tax legislation (unless there is an effective retroactive rate change enacted).
• Review state inheritance taxes. Many states have modified their estate tax laws since federal law eliminated a credit for state inheritance taxes paid. Most states decoupled the tax and the state inheritance tax will still apply, even if the federal estate tax does not. Any drafting changes to existing estate plans should consider the inheritance tax laws of the state of residency to avoid unintended consequences.

Your Holland & Knight Private Wealth Services lawyer is available to answer your questions as we wait to see what approach Congress will take to the re-establishment of the estate and generation-skipping tax.