The IRS is unrolling a major compliance initiative targeting transfers of real estate between family members for less than full consideration.  The goal is to identify taxpayers who failed to file a Form 709 (gift tax return) to report the gift.  If the amount of the gift exceeds the annual exclusion (currently $13,000), gift tax returns are required even if the gift itself would not be taxable.

The initiative is focusing on transfer records in 15 states for evidence of property transfers to family members.  The current roster of states includes Connecticut, Florida, Hawaii, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Texas, Virginia, Washington, and Wisconsin.  It is expected that the program will expand to other states soon.  The IRS is being aggressive with this initiative (it went to court to force the California Board of Equalization to disclose transfer data).  Those involved in preparing estate and gift tax returns should counsel their clients of the need to file a Form 709 for intrafamily transfers of real estate for less than full consideration.

After the relative calm following the enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010), we are beginning to see signs of turbulence in the estate tax arena.  (Note:  See my Guide to the New Estate Tax Law for an overview of TRA 2010.)

President Obama’s 2012 Budget

When President Obama reached a compromise with top-ranking Republicans in 2010 to raise the Federal estate tax exemption to $5 million with rates of 35 percent, he warned that this “generous treatment” would only be temporary.  The President’s 2012 budget seeks to follow through on that warning.

Estate and Gift Tax Exemptions and Rates

President Obama’s 2012 budget, which was released in mid-February, would return the Federal estate exemption to its 2009 level of $3.5 million.  The gift and generation-skipping transfer (GST) tax exemption would be set at $1 million.  A 45 percent tax rate would apply for all transfer taxes.

Portability of Deceased Spouse’s Unused Exemption

Portability allows a surviving spouse to take advantage of the unused exemption of a predeceased spouse.  Under TRA 2010, spouses of individuals who die after December 31, 2010, but before January 1, 2013, can increase their exclusion amount by the amount of the exemption that was unused by their predeceased spouse.   President Obama’s budget would make portability permanent (it is currently set to expire at the end of 2012).

Restrictions on the Use of Grantor Retained Annuity Trusts (GRATs)

The President’s 2012 budget would curb the use of GRATs to arbitrage the applicable Federal interest rate.  In a low-interest rate environment, GRATs are used to transfer wealth between family members at a reduced gift tax cost if the grantor survives the term of the GRAT (for a more detailed explanation of GRATs, see my article on Making Good Use of GRATs in 2010). This has resulted in the widespread use of short-term, “zeroed out” GRATs as a tax planning technique.  The President’s budget would curb this technique by requiring a 10-year minimum term and a remainder value that is greater than zero.

Restrictions on Valuation Discounts

Valuation discounts are often used in estates that are worth more than the Federal estate tax exemption.  These discounts are especially appropriate in family-owned businesses, where the value of the business is likely to be impaired by lack of marketability to the general public.  It is not uncommon for valuation discounts to reach 30 to 40 percent, resulting in a substantial tax savings.

The IRS is aware of these techniques and has litigated a string of family limited partnership cases, with mixed success in the courts.  President Obama’s budget creates a new class of tax restrictions that would prevent the use of valuation discounts in some family-controlled companies.

Curbing the Use of Dynasty Trusts

Dynasty trusts are funded with assets that pass free of the GST tax exemption. These trusts are typically created in a jurisdiction that does not follow the common law rule against perpetuities, allowing the trusts to continue indefinitely.  This allows the trust assets to be sheltered from transfer taxes throughout the term of the trust over many generations.  The Obama administration would curb this benefit by placing a 90-year maximum term on new dynasty trusts or money added to existing dynasty trusts.

Discussions Beginning in Congress

In early June, the New York Post reported that Senate Republicans are retreating from their push for an all-out repeal of the estate tax.

According to the Post, both sides of the aisle are comfortable with a $5 million exemption amount.  But there is disagreement about the tax rates that should apply.  Democrats are pushing for a 45 percent tax rate; Republicans prefer the current 35 percent rate.

A Few Concluding Thoughts

This isn’t the first time we’ve seen what President Obama is proposing.  A similar bill (H.R. 4154, Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009) was passed by the House of Representatives in 2009.  No Republicans voted for the bill, and it died in the Senate.

Based on previous legislative attempts, it is not clear that a return to 2009 levels is a viable option.  It seems more likely that President Obama’s budget is intended to appease those in his party who were critical of the concessions at the end of 2010 while leaving himself room to compromise in return for concessions from top-ranking Republicans.

I see these recent developments as more of a starting point for discussions, preliminary volleys before the real fight begins.  With any luck, we won’t need to wait until December 2012 to see how it ends.

I recently completed a series of articles on Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312 (TRA 2010), which was signed into law by President Obama on December 17, 2010.  I have given a few presentations on this topic recently and decided to turn my materials into a series of articles.  The four articles are:

1. Introduction to the New Estate Tax Law – This article contains some of the background information and legislative history preceding the enactment of the new law.  I know you’ll want to skip ahead to the substance, but be warned: you can’t really understand the new Act unless you have a good grasp on what came before it and the situation we found ourselves in in 2010.
2. Estate Planning Under the New Estate Tax Law – This article discusses the substantive provisions of the act, including the new applicable exclusion amount (exemption) and tax rates, retroactive application of the Act, and a few planning pointers.
3. Portability Under the New Estate Tax Law – This article deals with a brand new feature of our estate tax laws–portability.  Portability allows the unused exemption of one spouse to be passed on to the surviving spouse.
4. Why Tax Planning Still Matters Under the New Estate Tax Law – This article explains why estate tax planning–including credit shelter/bypass planning–is as necessary now as ever.

TRA 2010 provides welcome relief from the uncertainty that plagued estate planners at the end of 2010.  But it is more of a patch than a fix.  Since TRA 2010 sunsets in 2012, we can expect these same issues to pop up again, along with more of the usual political wrangling over a permanent solution.  And if the past ten years are any indication, Congress will wait until the eleventh hour to provide any clarity.

If Congress fails to act by the end of 2012, the applicable exclusion will drop to $1 million and the estate tax rate will go up to 55 percent.  In my opinion, that is probably the least likely scenario.  It is more likely that the law will remain at current levels or drop to the $3.5 million exemption and 45 percent tax rate proposed by Senator Baucus and backed by many Democrats.  Of course, the possibility of another temporary fix of a different nature should not be ruled out.

Over the next two years, the higher applicable exclusion amount and lower transfer tax rates will slash the revenue from transfer taxes.  Outright repeal of the estate tax will be an easier sell in 2012, after revenue has dwindled enough to make it less of a hot-button issue.  Estate tax repeal is a more likely scenario than it has ever been and is likely to be re-proposed by the end of 2012.  Whether the modified carryover basis regime will also be reintroduced is anybody’s guess.

Note:  The higher exemption amounts will also mean much fewer tax returns will be filed.  Check out our post on the Estate Tax Stats for 2001-2009 to get  good idea of how drastic the decrease may be.  This means the IRS estate tax division will have some time on its hands. Expect high audit rates.

Given the continuing uncertainty, estate plans should not place undue reliance on the new Act or predictions about what Congress may or may not do before the end of 2012.  As we did in the years leading up to 2010, we must plan for the law as it is and try to build in as much flexibility as possible into the estate plan.

Tax planning still has an important role in most estate planning documents.  And in many ways, it will be more of a challenge over the next two years.  Estate plans must now be flexible enough to (1) adjust for fluctuations in the applicable exclusion amount, (2) plan for the possibility of estate tax repeal at the end of 2012 and reintroduction of modified carry-over basis regime, (3) plan for special elections, such as portability and basis adjustments; and (4) do all of this while meeting the client’s non-tax goals.