End of the estate tax reprieve looms

Issue December 2010 By Lisa M. Rico

In 2010, we experienced an unprecedented reprieve from federal estate and generation-skipping transfer (GST) taxes. How did we get here? In 2001, Congress enacted the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which, in part, provided that the federal estate and GST tax laws would not apply to the estates of decedents dying, or transfers occurring, after Dec. 31, 2009.

Estate planning practitioners never thought, even up until December 2009, that the federal estate and GST taxes would be "repealed," but the reprieve did materialize due to Congress' inaction. This reprieve potentially provides substantial savings for applicable heirs. For example, the estate of a Massachusetts' decedent dying in 2010 with a $10 million taxable estate will only pay the Massachusetts estate tax. The decedent's heirs will receive $8,932,400, instead of $6,487,820 had the decedent died in 2009.

The reprieve, however, has not been a complete reprieve; the estate and GST tax repeal brought with it the modified carryover basis system. Under the modified carryover basis system, excepting a $1.3 million basis increase and a $3 million spousal basis increase, the assets retain the decedent's basis. Accordingly, when the inherited assets are sold, the heirs will recognize a gain totaling the difference between proceeds received and the carryover basis.

On Jan. 1, 2011, this estate tax reprieve ends. With the sunset of the EGTRRA provisions, the estate tax laws are brought back to their status prior to 2001. That is, unless Congress acts to make a change. What does this mean for clients? The federal estate and GST exemption amounts, which have been to a high of $3.5 million; federal estate and GST tax rates, which have been to a low of 45 percent; and the federal gift tax rates, which are at a low of 35 percent, will return to their pre-2001 levels. The federal estate and GST tax exemption amounts decrease to $1 million and approximately $1.34 million, respectively. The federal gift tax exemption rate remains at $1 million. The highest gift, estate and GST tax rates increase to 55 percent.

In addition, the step-up in basis system returns. In the example above, the heirs will only receive $5,205,000 after the paying federal and state death taxes if the decedent dies in 2011 or thereafter.

What should we expect in 2011? There appears to be three possible outcomes:

First, Congress retroactively reinstates the estate and GST tax laws. Given that we are now in November 2010, retroactive reinstatement of the estate and GST laws seems unlikely. Instead, Congress may enact legislation providing estates of decedent's dying in 2010 with an option to pay either a federal estate tax at 2009 levels with the estate's assets receiving a stepped basis or pay no federal estate tax with the estate remaining subject to the modified carryover basis system.

Second, Congress does nothing. In this case, the estate, gift and GST taxes will return to pre-2001 levels, as described above.

Third, Congress enacts legislation effective for tax years beginning Jan. 1, 2011, reinstating the estate, gift and GST taxes to 2009 levels, or to different rates and exemption amounts.

Of course, we have no way of knowing what Congress will do, but we hope, at the very least, that Congress will address some uncertainties that EGTRRA's sunset will cause. For example, what happens with the GST exemptions deemed allocated during tax years 2001 through 2009? Or, if the GST exemption has been allocated in an amount above the pre-EGTRRA GST exemption amount, will such allocation still be considered to have been made?

As the reprieve year is ending, there are planning opportunities that clients should consider to reduce their overall estate, gift and GST tax burdens.

  • Make federally taxable gifts subject to the 35 percent gift tax rate. As retroactive reinstatement is unlikely, and the gift tax rate is as low as it will ever likely be, wealthy clients who are most likely to be subject to federal estate taxes on death have an opportunity to transfer assets to the next generation at the low gift tax rate, if done before the end of 2010.
  • Make outright gifts to grandchildren and/or great-grandchildren. Again, there will be an overall savings by paying a low gift tax rate now as opposed to a higher estate tax rate in the future. Additionally, the donor can skip one or more generations without incurring the GST tax, thereby completely escaping one or more transfer tax levels.
  • Trustees of trusts that are not exempt from the GST tax should consider making beneficiary distributions to beneficiaries two or more generations below the trust's donor, thereby eliminating a future GST tax.
  • Personal representatives of estates of decedents dying in 2010 who left a surviving spouse should fund QTIP trusts with as many of the assets passing the surviving spouse as possible. The QTIP trusts' assets will not be subject to the federal estate tax upon the surviving spouse's death, thereby escaping the federal estate tax on both the decedent's and surviving spouse's death.

The estate tax reprieve's end brings more transfer tax planning uncertainty, but provides some opportunities - which may never be available again - for wealthy clients if they act quickly before year's end.

Lisa M. Rico is a partner at Gilmore, Rees & Carlson PC in Wellesley. She concentrates her practice on estate, gift, generation-skipping transfer and income tax planning for high net worth individuals, estate and trust administration, and the representation of nonprofit organizations and charitable trusts. In addition, she provides tax advice to partnerships and other pass through entities. She is currently the chair of the MBA's Taxation Law Section, as well as the co-chair of the Estate Planning and Administration for Business Owners, Farmers and Ranchers Committee of the American Bar Association's Real Property, Trust and Estate Law Section.