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Guide to the New Estate Tax Law

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.

IRS Releases Estate Tax Statistics for 2001-2009

I’ve been looking over the data from the IRS Estate Tax Statistics for decedents dying between 2001 and 2009.  The data was collected as part of the annual estate tax study.  A few interesting points about the 2009 statistics:

  • Due to the higher exemption amounts (which increased from $675,000 in 2001 to $3.5 million for 2009 – more on that here), the number estate tax tax returns decreased from over 108,000 in 2001 to under 34,000 in 2009.  In other words, only 34,000 of individuals who died in 2009 had taxable estates when the exemption amount was $3.5 million.  I would be curious to know what the number would drop to if the proposed $5 million exemption amount were enacted.
  • Those estates that were taxable in 2009 had over $194 billion in assets.  The primary assets were stock and real estate, coming in at 30 percent and 22 percent, respectively.  Cash (11%), bonds (13%), pensions and 401(k)s (7%), and miscellaneous other assets (17%) made up the rest.
  • Just under half of the decedents with taxable estates were married and another 38 percent were widowed.  And, not surprisingly, over 97 percent of those who were married claimed a marital deduction.  Only 10 percent of estates of married decedents owed estate tax.  This indicates that most of these folks had done at least some estate planning, and I suspect the majority of them had also used a credit shelter bequest.  This is a strong policy reason for making the unified credit portable (meaning that the second spouse to die could take advantage of any unused portion of the predeceased spouse’s unified credit).
  • Less than half of those filing owed estate taxes!  Again, this indicates that most folks with taxable estates are doing some sort of estate planning, including marital and charitable bequests to avoid taxes at the death of the first spouse.
  • Bad news for us guys.  Almost 58 percent of the decedents with taxable estates were males.  This, combined with the statistics indicating heavy use of the marital deduction, indicates that the men are dying first and leaving the estate to their wives, using the marital deduction to zero out the estate taxes at the first death.
  • Approximately 19 percent of the estates claimed a charitable deduction, for a total of $16 billion in charitable deductions claimed.  But the ultra-rich appear to be the ones making the biggest donations.  Over 58 percent of the donations were made by estates with $20 million or more in gross assets, notwithstanding that these estates represented only 3 percent of filers.

It will be interesting to see how these numbers influence the policy arguments over estate tax repeal or a permanent estate tax fix.

IRS Clarifies 2010 Basis Rules for Revocable Trusts

New FAQs indicate that property held in a revocable trust should qualify for allocations of basis increase

The IRS has published a webpage on FAQs about the New Tax Rules for Executors for 2010 (Update: the original IRS webpage has been taken down; most of this information is now contained in Publication 559).  While most of these rules are not groundbreaking (Q: Is the estate tax repealed for decedents dying in 2010? A: Yes.), they do provide guidance about how the IRS will apply the 2010 basis rules to property held in revocable trusts.

The lapse of the estate tax for 2010 was accompanied by a new set of basis rules that replaced the taxpayer-friendly “stepped-up” basis rules with a modified carryover basis regime.  Generally, for the estates of decedents who die in 2010, the basis of assets acquired from the decedent is the lesser of the decedent’s adjusted basis (carryover basis) or the fair market value of the property on the date of the decedent’s death.

There are two “coupons” that taxpayers can apply to reduce the harsh consequences of the new carryover basis system.  First, the executor can allocate up to $1.3 million (increased by unused losses and loss carryovers) to increase the basis of assets left to anyone.  Second, the executor can allocate an additional $3 million to increase the basis of assets passing to a surviving spouse, either outright or in a Qualified Terminable Interest Property (“QTIP”) trust.

The 2010 basis rules, which are found in IRC § 1022, apply to property “treated as owned” by the decedent and “acquired from the decedent.”  There has been some discussion about whether property owned by a revocable trust would qualify.  Two views have emerged.  The more conservative view is that since IRC §  1022 deals with what is or isn’t owned by the decedent for purposes of basis allocation and does not mention revocable trusts, revocable trusts do not qualify for the basis increase.  In other words, because IRC § 1022 does not reference the grantor trust rules, property owned by a grantor trust is not “treated as owned” by the decedent and is therefore ineligible for basis increase.

The other view, which I hold, is that property owned by a grantor trust under the rules of IRC §§ 671-678 are treated as wholly-owned by the grantor and therefore should qualify for the basis increase based on the plain language of the rules themselves.  The IRS appears to agree, although with some timidity.  The FAQs state:

All of the decedent’s property was held by a revocable (or living) trust.  Can the basis of that property be increased as well?
Probably yes. The decedent is treated as owning property transferred by the decedent during life to a qualified revocable trust (as defined in section 645(b)(1)).

While this language falls short of binding guidance on the issue, it should give taxpayers some comfort that property held in a revocable trust will be eligible for basis step-up under IRC § 1022.

Making Good Use of GRATs in 2010

With the scheduled reinstatement of the Federal estate tax less than 4 months away, many taxpayers are taking advantage of the current low-interest-rate environment to use estate freezing techniques.  Estate freezing strategies are designed to limit future estate tax value of an asset to its current value (“freeze” the value) and allow future growth to pass to the taxpayer’s beneficiaries free of gift or estate tax.

Estate freezing techniques are usually used to supplement and enhance a solid gifting strategy.  Although there is no estate tax in 2010, there is still a gift tax of 35 percent.  Taxpayers are allowed to make annual exclusion gifts of up to $13,000 per done (doubled to $26,000 for married couples) without incurring gift tax.  But gifts in excess of the annual exclusion will chip away at the taxpayer’s $1 million lifetime exclusion.

Grantor-retained annuity trusts (GRATs) are popular estate freezing techniques.  GRATs are irrevocable trusts in which the grantor retains an interest that is a “qualified” interest under the Internal Revenue Code.  The grantor transfers property into the trust, which provides that the grantor will receive a fixed annuity on at least an annual basis for a number of years.  At the end of the trust term, whatever is left in the trust after the annuity has been fully paid will go to the remainder beneficiaries.  The “gift” is the theoretical value of the remainder, which is calculated using a statutory interest rate known as the 7520 rate.

GRATs are appealing in a low-interest rate environment because the 7520 rate is correspondingly low.  The value of the grantor’s retained interest is “frozen” at the value of the contribution plus the 7520 rate.  If the assets in the trust out-perform the 7520 interest rate (2.4 percent for September), the excess will be transferred to the remainder beneficiaries free of gift tax when the trust term ends.

The most aggressive GRAT strategy—and one which may soon be limited—is the “zeroed-out” GRAT.  By manipulating the amount of the retained annuity and the term of the trust, it is possible to set the GRAT up so that the value of the retained interest is technically worth nothing.  If the assets outperform the 7520 rate, all of the assets remaining in the trust at termination will pass to the remainder beneficiaries free of gift or estate tax. If the asset does not out-perform the 7520 rate, the assets are simply returned to the grantor at the end of the trust term and the grantor is in no worse position than if the trust had not been established.  Because zeroed-out GRATs have little downside and can yield big tax savings, they have become increasingly popular in recent years.

Many fear that we may be nearing the end of the era of the GRAT as an estate-planning tool.  President Obama’s 2011 budget projects almost $3 billion in savings from restricting the use of GRATs, and the Joint Committee on Taxation believes that restrictions on GRATs could raise almost $4.5 billion over 10 years.

In the current political environment, some believe that Democrats will curb the use of GRATs in order to raise revenue for other tax breaks or for spending.  And we have seen recent proposals to do just that.  For example, the Small Business Tax Relief Act of 2010 proposed by Rep. Sander M. Levin (D-MI) on July 30, 2010, would require 10-year minimum term for GRATs (compared with the current 2-year term).  Since all of the GRATs assets are included in the grantor’s estate if he or she dies within the term, extending the term from 2 to 10 years would make it much more likely that the full value of the GRAT will be subject to estate tax.  This increased “mortality risk” could curb the use of GRATs for gift tax savings.  Other bills have proposed to limit the use of zeroed-out GRATs.

If the proposals to curb the use of GRATs are ultimately successful, changes would probably not be effective until the date the proposals are signed into law.  Many taxpayers are seizing the current opportunity to take advantage of the low 7520 rate and establish GRATs before the law changes.  Others are shifting assets from existing GRATs into new ones with lower interest rates.  Those who are concerned with the reinstatement of the estate tax in 2011 should consider incorporating GRATs into their estate planning strategy.