Only Death is Certain but Don’t Hold Your Breath

R. Daniel Brady

Benjamin Franklin is often quoted as saying: “In this world, nothing can be said to be certain, except death and taxes.” Today it appears that the list has been trimmed down to death, at least where the two are co-incident.  The federal tax rules relating to transfers of property at death changed significantly as of January 1, 2010 and the estate tax is now repealed, but like the headlines say, don’t hold your breath.  The law could change again in 2011 unless Congress passes new legislation. Here is some insight into where the estate tax law is today, how we got to this point and what may happen going forward.

2001 Tax Reform. In 2001, Congress passed the “Bush Tax Cuts” which are formally known as The Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which phased in increases in the federal estate, gift and generation skipping tax (GST) exemptions and lowered tax rates.  By 2009, the exemptions had increased to $3.5 million per person and the tax rate had decreased from a maximum rate of 55% to a flat 45% for property passing to a non-spouse, non-charitable beneficiary. The 2001 tax reform further provided that the federal estate and GST taxes were repealed for one year, 2010, while the federal gift tax remains with a $1.0 million exemption and a 45% flat rate for gifts in excess of that $1.0 million plus aggregate annual exclusion ($13,000 each).   

To help pay for the repeal, in part, the step up in basis rule (which gave beneficiaries a new basis equal to date of death fair market value) was replaced with a new adjusted carry-over basis rule.  The new basis rule allows a step up in basis of up to $1.3 million, for property passing to non-spouse beneficiaries, plus an additional $3.0 million for property passing to a husband or wife.  Property with built-in gain in excess of these adjustment amounts passes to the beneficiary at the decedent’s basis.  While no estate tax is due at death, the alternate result is disappointing for beneficiaries of smaller estates, valued at less than $3.5 million who would have paid no estate tax and avoided capital gains with the new basis. Those previously untaxed estates may now face capital gains tax on up to $2.2 million of gain. Congress has indicated that in 2010 about 6,000 estates will benefit from the elimination of estate taxes, but over 70,000 heirs will pay higher income taxes because of the change in the income tax basis rules for assets received from decedents. [Just for the record, interestingly enough in 2008, there were approximately 2.4 million U.S. deaths with 15,731 estate tax returns filed with assets of more than $3.5 million, and 8,084 of those returns showing tax due. These estates with liability represent .34% (that’s one third of one percent) of all U.S. estates.]

On January 1, 2011, under the terms of EGTRRA, the “reform” sunsets meaning that in a one year time frame, you must plan for: A $3.5 million estate exemption and basis step up in 2009; no estate and GST tax (but carry over basis) in 2010; and a $1.0 million estate exemption, basis step up and tax rates up to 60% in 2011.

What Happened in 2009? The nerds, like me, who watch this stuff, your estate planning lawyer, accountant and financial planner, were baffled, caught off guard, and amazed.  Almost all, universally expected Congress to carry forward the 2009 estate tax rules ($3.5 million exemption and basis step up) at least through 2010.  However, unexpectedly in December the House failed to act on a one-year extension and instead sent the Senate a bill to make the 2009 rules permanent. The Senate was focused on health care and estate taxes were put on the back burner and no changes were made to the 2010 reform rules. Thus, here we are, effective as of January 1, 2010; there is no federal estate or GST tax.

Planning in Chaos. Estate planners continue to be amazed, some amused and most a little angered about Congress’s failure to adopt estate tax legislation in 2009.  There is a real possibility that changes will not be adopted during 2010.  If that happens, your estate planning considerations will change radically.  For example, the state and federal tax liability on a $3.5 million estate will go from $0 in 2009 to a combined state and federal tax of $955,000 in 2011.

We are living with an unpredictable planning environment, tied to the inability of Congress to do anything but belly ache, point and flip fingers, and nothing constructive.  Looking ahead, and 2010 being an election year, Congress may just continue to do nothing, in which case for people who die in 2010 there heirs will work with the adjusted carryover basis, and no state or federal estate. Will you die in 2010? Let’s hope not but given the frailty of this worldly time we share, you should plan flexibly, assuming you will die tomorrow.  Depending on your testamentary documents, not planning for these changes, if you do die, your death could be disastrous. For example:  

§                                   Fractional shares and formula clauses (provisions that allocate or distribute the “greatest amount that can pass free of estate tax” or your “applicable exemption amount” or “the maximum generation shipping amount” to specified non spouse beneficiaries or to a “by-pass”, “credit shelter” or “family” trust) may disinherit your husband or wife other heirs, most likely in favor of children resulting in conflicts among family members, (particularly blended families) litigating your real intent as to how your documents should be interpreted, or a spousal claim against the documents for his or her “elective share”.

§                                   Conflicts may arise among your heirs and fiduciaries on the allocation of the limited basis step up or the distribution of assets with higher basis that may be, or appear to be unfair.

§                                   Passing assets directly to your surviving spouse may result in higher estate taxes after 2010.

§                     Congress may adopt legislation to carry the 2009 rules over to 2010, retroactive to January 1, 2010, but a retroactive tax leaves constitutional questions that neither you nor your estate want to litigate. If Congress acts in 2010 to address the estate tax issues, it may:

Ø       Adopt permanent estate tax exemption, beginning in 2010 or 2011. (If that happens, most of us who watch this stuff anticipate estate tax exemptions to fall between $2-5.0 million and tax rates 35% to 45%. (I have read that the projected 10-year revenue loss of adopting a $3.5 million exemption as compared to the scheduled $1.0 million is estimated to be $290 billion.)

Ø       Adopt a temporary higher estate exemption.

Ø       Adopt rules to limit or eliminate planning tools such as valuation discounts for family partnerships or zero valued gifts using a Grantor Retained Annuity Trust (GRAT).

As a side note, in what is seen as an immediate reaction to the President’s call for the restoration of “pay as you go” budget restraint, the Senate on January 28 and the House on February 5 passed legislation (H.J. Res. 45) that would establish statutory pay as you go rules, a pet issue of the fiscally conservative. This will move on the President and will likely be signed. Under statutory pay-as you go rules, spending must be cut if legislation adds to the deficit. This pay-go measure contains several exemptions, including a two-year continuation of the estate tax at 2009 levels and the permanent extension of Bush tax cuts for middle income taxpayers that are otherwise scheduled to expire at the end of 2010. The waivers represent a first look at what Congress intends to do with the estate tax and other sun setting tax laws, but we are not there yet.

Unless Congress enacts new legislation in 2010, then on January 1, 2011, the sunset of the Bush Tax Cuts, (or Bush Tax Increases for the beneficiaries of smaller estates as a result of the carry over basis rules) automatic changes occur to the federal tax code, including:

§                                 The estate tax exemption drops to $1.0 million per decedent.

§                                 The estate tax rates increase (55% above $3.0 million and 60% above $10 million).

§                                 Some states, including North Carolina, will have their state death taxes restored, as the federal “state death tax credit” will apply as it did in 2000.

§                                   The step up in basis to date of death fair market value returns for assets passing from a decedent.

With no new legislation, in 2010 the estate tax rules rollercoaster our families and each of us from where they were in 2009, and then again in 2011. Uncertainty makes it difficult to plan, but waiting to see what happens next is not a good idea. The earlier you can implement flexible tax and estate planning to respond to these changes the better.

So what’s the problem?  In my humble and admittedly cynical opinion, as long as the members of Congress have someone else to blame for the tax, those cards, letters contributions and “Bunny Money” from the .34% of individuals with estates over $3.5 million, keep on rolling. 

For now, the best advice is: DON’T DIE!

R. Daniel Brady is an attorney, CPA and is certified by the NC State Bar as a Specialist in Estate Planning and Probate Law.  He can be reached in Raleigh at 919-573-1416 or dan@danbrady.com