In the Twilight of the EGTRRA

When the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, PL 107-16) was enacted in 2001, almost no one seriously thought that one of its most important provisions would ever be given its full effect—the repeal of the federal estate and generation-skipping transfer (GST) taxes in 2010. However, as of Jan. 1, the federal estate and GST taxes are indeed no more. Unless Congress reinstates them sooner, they will remain repealed until Jan. 1, 2011, when, because of the sunset of the EGTRRA, they are scheduled to be reinstated—with a $1 million exemption and with a top rate of 55%, plus a 5% estate tax surcharge on portions of estates exceeding $10 million.

The EGTRRA also changed the basis treatment of property acquired from a decedent after Dec. 31, 2009. Under IRC § 1022, the basis of most property acquired from a decedent is now the lesser of fair market value or the decedent’s “carried over” adjusted cost basis, instead of, as under prior law, a basis that is “stepped up” to fair market value as of the date of death.

What the EGTRRA did not do, however, was repeal the federal gift tax. Indeed, it remains in 2010, with the same $1 million exemption as in 2001 but with one significant difference from 2009: The tax rate is reduced from 45% to 35%. And, although the exemption is scheduled to remain at $1 million indefinitely, following the scheduled sunset of the EGTRRA on Dec. 31, 2010, the tax rate will return to where it was pre-EGTRRA, 55%.

Notably, however, even the current one-year repeal of the estate and GST taxes may be considered untenable, considering federal budget deficits and revenue needs (see box, “Legislative Update,” below).

Legislative Update

On Dec. 3, 2009, the House passed a bill that would have retained 2009 estate tax provisions: a $3.5 million exclusion and a 45% top rate. A similar bill in the Senate did not leave committee. Senate Finance Committee Chairman Max Baucus, D-Mont., said in late December that the Senate in 2010 would take up the estate tax as part of broader tax reform and may reinstate it retroactively to the beginning of the year. Other legislators have expressed doubt whether a retroactive reinstatement is possible.     

In the meantime, tax and estate advisers have to consider what to recommend to their clients. While the fluidity of the situation renders specific recommendations vulnerable to becoming quickly outdated or moot, here are some points to consider:

REVIEW WILLS AND REVOCABLE LIVING TRUST AGREEMENTS

The customary division of the estate of the first spouse to die into a credit shelter trust and a marital share is almost always defined by a formula that passes the deceased spouse’s remaining estate tax exemption ($3.5 million in 2009) into the credit shelter trust and any remaining estate either outright to the surviving spouse or to a qualified terminable interest property (QTIP) trust for the exclusive benefit of the surviving spouse (see “Estate Planning: Time for a Tuneup”). A common version of this formula might provide that the amount passing to the surviving spouse is “the minimum amount necessary as the federal estate tax marital deduction in the decedent’s estate to reduce the federal estate tax due to the lowest possible amount.” Other versions of this formula might instead define the amount passing to the credit shelter trust as, for example, “an amount equal to the applicable exemption amount within the meaning of the Internal Revenue Code,” or “that amount which will generate the largest taxable estate for federal estate tax purposes without the estate paying any federal estate tax.”

GENERATION-SKIPPING TRANSFER TAX

Likewise, similar language typically has assured full use of the decedent’s exemption from the GST tax (see “The Generation-Skipping Transfer Tax: A Quick Guide,” JofA, Oct. 09, page 30). The formula dividing the decedent’s estate into a generation-skipping transfer tax exempt share and a generation-skipping transfer tax nonexempt share will often define the decedent’s “GST exemption” as the maximum amount of GST exemption allowed under the Internal Revenue Code at the time of death (reduced by any amount of GST exemption allocated during the decedent’s life or otherwise allocated by reason of the decedent’s death).

REFORMULATING THE FORMULAS

Now, however, the issue is: How do these formulas work where the estate and GST tax laws have (at least temporarily) been repealed?

For example, under certain wills or revocable living trust agreements, it would seem as though nothing would pass to the surviving spouse, since there is no “minimum amount necessary as the federal estate tax marital deduction to reduce the federal estate tax due to the lowest possible amount.” This might prove beneficial from a tax perspective if the federal estate tax later returns (since the marital share would most likely otherwise be includable in the surviving spouse’s estate when he or she dies), but may be problematic to the surviving spouse if, for example, he or she is not a beneficiary of the credit shelter trust or whose benefits from it are more restricted than they would have been from a QTIP trust or an outright marital share.

Alternatively, under documents that instead define the amount passing to the credit shelter trust as “the applicable credit amount within the meaning of the Internal Revenue Code,” the issue becomes: What amount is that, now that the “applicable credit amount” no longer exists? And a document that defines the amount passing to the credit shelter trust as that which will cause “the largest taxable estate that the decedent can have for federal estate tax purposes without the estate paying any federal estate tax,” raises the question: Is that amount zero (because there is no taxable estate), or the entire estate because, irrespective of the amount of funding, there can necessarily be no federal estate tax? Similar issues arise for the decedent’s GST exemption.

In addition, for taxpayers who reside in states with a state-level estate tax not tied to the federal estate tax system, funding the credit shelter trust with the decedent’s entire estate (if that is, in fact, how the formula division is ultimately held to operate) will likely incur state-level estate taxes that might otherwise have been avoided.

Practice point. Taxpayers should carefully review their will and/or revocable living trust agreement for any such structural or definitional issues and, if necessary, consult with an estate planning attorney or other transfer tax planning specialist. In many cases, the formula language should be revised to better define taxpayers’ intentions regarding dividing the estate if death occurs when no federal estate or GST tax is in place.

QTIP TRUST MAY BE BETTER CHOICE THAN OUTRIGHT BEQUEST

An outright bequest of a share of the estate to the surviving spouse is simpler than a transfer through a QTIP trust. However, taxpayers might opt for a QTIP trust if they are in a second marriage and want to ensure that the remainder of the marital share will pass according to their directions. They may also do so to ensure that the marital share is protected from the surviving spouse’s creditors, and a few do not trust their spouse’s financial abilities and want to ensure appropriate financial management by trustees.

Due to the changes in the law, though, taxpayers who normally would feel they do not want or need the nontax benefits of a QTIP trust may now find one to have tax benefits. A QTIP trust will generally be taxed as a part of the surviving spouse’s estate only if an election was made on the deceased spouse’s estate tax return to qualify it for the unlimited marital deduction. Absent such an election, no marital deduction will be afforded to the deceased spouse’s estate, and the QTIP trust generally will not be taxed as a part of the surviving spouse’s estate when the surviving spouse dies. In contrast, an outright bequest to the surviving spouse automatically qualifies for the unlimited marital deduction (assuming only that the surviving spouse is a U.S. citizen), and such property will also, of course, automatically be taxed as a part of the surviving spouse’s estate when the surviving spouse dies.

Thus, where the will or revocable living trust agreement provides for the marital share to pass to a QTIP trust, the executor or personal representative has flexibility to minimize estate taxes in light of then-current and anticipated provisions. For example, if the estate tax is reinstated on or before the deceased spouse’s death, a QTIP election would likely be made on the deceased spouse’s estate tax return to negate immediate federal estate tax (at the cost of causing the QTIP trust property to be taxed as a part of the surviving spouse’s estate when the surviving spouse later dies).

If, instead, there is no federal estate tax in effect at the death of the first spouse to die, no QTIP election need (or perhaps even could) be made. And, absent the election, the QTIP trust should not be taxed as a part of the surviving spouse’s estate upon the surviving spouse’s later death, even if the federal estate tax had since been reinstated.

However, a QTIP trust in lieu of an outright marital share may incur state estate taxes if the state has an estate tax independent of the federal one but does not permit a “state only” QTIP election. In such a situation, where the QTIP election is unavailable because of the repeal of the federal estate tax, only an outright marital share is certain to generate an unlimited marital deduction for state estate tax purposes. One solution to these seemingly irreconcilable issues would be to provide for the possibility of converting the QTIP trust share into an outright marital share through either very careful drafting or a disclaimer by the surviving spouse.

Practice point. A married taxpayer whose will or revocable living trust agreement provides for an outright bequest of the marital share to a surviving spouse should consider having it revised to pass to a QTIP trust.

RECKONING WITH THE NEW CARRYOVER BASIS REGIME

As noted earlier, a stepped-up basis no longer applies to property acquired from a decedent (at least in 2010). Instead, the income tax basis of property acquired from a decedent is generally the lesser of the property’s fair market value at the date of the decedent’s death or the decedent’s adjusted basis in such property, with two exceptions:

• Section 1022(b) permits the decedent’s executor or personal representative to allocate up to $1.3 million to increase the basis of selected assets (but not beyond date-of-death values, and the allocation is reduced to $60,000 in the case of a nonresident alien decedent).
• Section 1022(c) allows the decedent’s executor or personal representative to allocate up to an additional $3 million to increase the basis of selected assets passing outright to a surviving spouse or a QTIP trust for the benefit of a surviving spouse (but, again, not beyond date-of-death values).

To ensure full flexibility to allocate basis increases most appropriately, the will must define the executor’s or personal representative’s authority broadly. For example, the executor or personal representative should have discretion to make such allocations to nonprobate property. In addition, planners should consider including a conflict waiver for basis allocations to property passing to the decedent’s executor or personal representative.

Separately, the will or revocable trust agreement should ensure that property with at least $3 million of unrecognized gain, if available, passes to the decedent’s surviving spouse (or, alternatively, to a QTIP trust for the surviving spouse’s benefit). Notably, this is likely a very different amount of property than $3 million in estate value. Moreover, the EGTRRA’s scheduled sunset on Dec. 31, 2010, and the possibility of reinstatement of the estate tax during 2010 require planners to carefully coordinate the amount of these potential bequests so as not to incur more estate tax than necessary. Section 1022 is also scheduled to sunset on Dec. 31, 2010. If it winds up being extended, the allocation amounts are indexed for inflation.

Practice point. Taxpayers should revise their wills to provide flexibility, where appropriate, for an executor or personal representative to allocate basis adjustments under the new carryover basis regime.

A TIME TO GIVE?

Even though the federal estate and gift taxes historically have been imposed at the same rate, the gift tax was effectively less expensive (at least before this year), because the estate tax was imposed on a tax-inclusive basis and the gift tax on a tax-exclusive basis. Now that the gift tax is imposed at a reduced rate of 35%, however, the tax benefit of making a taxable gift is even greater (assuming, of course, (1) that the federal estate tax is later reinstated before the donor’s death; (2) the federal estate tax rate in effect at the time of the donor’s death exceeds 35%; and (3) that the donor survives three years from the date of the gift, so as to avoid inclusion in the decedent’s estate of the gift tax paid, pursuant to section 2035(b)).

In addition, since at least for now there is no GST tax, taxpayers might consider making gifts or trust distributions to skip persons that under prior law were inappropriate because of adverse tax consequences. However, since the GST tax could be retroactively reinstated, taxpayers who are extremely risk-averse should do so only in an amount less than or equal to the transferor’s otherwise unused GST exemption as of Jan. 1, 2011. Any retroactive reinstatement would likely provide the same exemption amount as under prior law.

Practice point. Taxpayers who can afford to make substantial gifts should carefully consider doing so this year, preferably as early as possible.

EXECUTIVE SUMMARY

Daniel S. Rubin (drubin@mosessinger.com) is a partner in the Trusts and Estates and Wealth Preservation practice of Moses & Singer LLP in New York City.

AICPA RESOURCES

PFP Member Section and PFS credential

Membership in the Personal Financial Planning (PFP) Section provides access to specialized resources in the area of personal financial planning, including complimentary access to Forefield Advisor. Visit the PFP Center at aicpa.org/PFP. Members with a specialization in personal financial planning may be interested in applying for the Personal Financial Specialist (PFS) credential. Information about the PFS credential is also available at aicpa.org/PFP. The PFP Center also contains a page of Estate Planning Resources.