Congress proves nothing is certain about taxes anymore
According to the familiar adage, nothing is certain but death and taxes. While death remains a certainty, a congressional stalemate at the end of 2009 has left the federal estate tax in doubt for at least part of 2010.
More specifically, the Democratic majority in the House of Representatives voted to permanently extend the 2009 estate tax rates and exclusion amounts. The more closely divided Senate, however, became preoccupied with health-care legislation, and failed to act amid disagreement over the proper level for the tax. As a result, the estate tax expired Jan. 1 for a one-year period. In response, Democratic Senate leaders vowed to retroactively restore the 2009 estate tax rules sometime in 2010.
This impasse began in 2001 when Republicans (and some Democrats) in Congress enacted the Economic Growth and Tax Relief Reconciliation Act. As illustrated in the table below, the Act gradually raised the tax's exemption ceiling while cutting the tax rate over a 10-year period. The Act then called for a one-year repeal of the tax in the 10th year, which began Jan. 1, 2010. Barring any agreement to extend or change the 2001 law, the estate tax is scheduled to resurface in 2011 at a rate of 55 percent on estates that exceed $1 million.
This uncertainty is sure to cause a quandary for estate planning advisers, especially attorneys, who for years have drafted wills and trusts under the assumption that the estate tax would remain in force. As a result, countless married couples currently have estate planning documents that include formula clauses (with specific references to the estate tax) designed to preserve the estate tax exemption of the first spouse to die. That could prove problematic for married couples.
For example, an individual with a $6 million estate may direct in his documents for his children to receive the "exemption" amount with his spouse receiving the balance. If the husband died in 2009, the spouse would have received $2.5 million and the children would have received the exemption amount, i.e., $3.5 million. Now, however, if the husband dies in 2010, that same formula would result in the entire $6 million being transferred to the children, thereby disinheriting his spouse.
Thus, the big question is what Congress will do next and how estate planning advisers and their clients should react to these developments.
Congress may respond in one of four ways. First, Congress may restore the estate tax retroactively before the first estate tax returns become due in October, i.e., nine months after a decedent's date of death. Second, Congress may restore the estate tax prospectively and let a relative few transfers escape tax free. Third, Congress may do nothing and allow the 2001 estate tax to return in 2011. Finally, Congress may take up meaningful tax reform in 2010.
Realistically, the Democrats in Congress may wait to gauge the political winds blowing from the economy, health care reform, and two ongoing wars before they predict the midterm elections, let alone pursue estate tax reform.
In the meantime, you should consult your advisers to determine whether your estate plan needs to be modified. They can also explore gifting opportunities with you in response to two other changes that took effect Jan. 1. First, the gift tax rate dropped from 45 percent to 35 percent. Second, the generation-skipping transfer tax expired.
Consulting your advisers will give you the perfect opportunity to revisit more basic goals, as well. Perhaps you created your documents years ago but have since experienced changes to your family or finances. Are your current goals clearly and accurately reflected in those documents? Are you comfortable with the person you chose to administer your estate? Have you become more charitably inclined? Perhaps you are in a better position to assess your children's maturity level and want to modify when and how your children receive their share of your estate. Is your business succession plan fully incorporated into your estate plan?
The worst thing you could do is let the uncertainty concerning the estate tax be yet another excuse to avoid the hard choices, difficult conversations and expenses related to family wealth transfer planning. The unwillingness to deal with these issues can prove devastating, not only to family wealth but to family relationships, as well.
Other changes: What's not getting enough attention is another law that became effective Jan. 1.
Prior to Jan. 1, inherited property (excluding retirement accounts) received a stepped-up basis for tax purposes. In other words, the value of the property on the date of death was considered the heir's "cost" basis for determining capital gain upon a future sale. For example, if a parent paid $500,000 for a home, and its value on the date of the parent's death was $2 million, then the child's cost basis was $2 million. If the child then sold the home for $2 million, the child would not incur any capital gains tax.
As of Jan.1, the stepped-up basis rules changed, but only for 2010. A total basis increase of $1.3 million may be applied to assets transferred to any beneficiary. After the $1.3 million in step-up is applied, the remaining assets receive the decedent's cost-basis with one exception. A surviving spouse can increase the basis of assets he or she receives by an additional $3 million. That could create a taxing situation for thousands of moderately well-off families in 2010 that would have been tax neutral in 2009.
By failing to act at the end of 2009, Congress created a significant mess that took effect Jan. 1. At this point, it remains unclear how Congress will respond. What is clear, however, is that you're best served to consult your estate planning advisers to ensure your estate plan meets your current goals and also contains flexibility to efficiently transfer wealth under the estate tax and carryover basis rules.
Christopher M. Brown is a partner with Miller Johnson who specializes in estate planning. Bruce A. Vandermeulen is a senior director with BDO who specializes in estate planning.
Estate Tax Exemption
Top Estate Tax Rate