In our last Private Client Alert (http://www.blankrome.com/index.cfm?contentID=37&itemID=2121), published in January, we reported on the repeal of the Federal estate and generation-skipping transfer ("GST") taxes effective January 1, 2010. Prior to that date, each tax was imposed separately at a 45% marginal tax rate, with an exemption of $3.5 million ($7 million for a married couple). The law currently provides that both taxes will spring back into life effective January 1, 2011, with a marginal tax rate of 55% (60% for very large estates) and an exemption of $1 million ($2 million for a married couple) for purposes of the Federal estate and GST taxes, with the GST exemption amount indexed for inflation.

Most tax professionals believed that Congress would have acted before the end of 2009 to reform the Federal transfer tax system and were surprised that it did not. Then most assumed Congress would quickly resurrect both taxes early in 2010, possibly with an effective date retroactive to January 1, 2010, and an exemption level of, or close to, $3.5 million. That has not yet come to pass, and appears unlikely to happen soon. At a February 4 news conference, Senate majority leader Harry Reid was quoted as saying that the estate tax will not be addressed "in the near future."

When or even if Congress will act is unclear. What is clear is that we cannot assume (a) that the estate and GST taxes will be reinstated in 2010, or (b) if reinstated, these taxes will be retroactive to the tax rates and exemption levels in effect during 2009. Most unsettling is the prospect that Congress may do nothing and allow these taxes to be revived as scheduled on January 1, 2011, both with a $1 million exemption and a 55% tax rate. For purposes of this Alert, we assume that these taxes will be not be reinstated this year but will become effective again as scheduled in 2011.

Despite these uncertainties, we believe that now is the time to review your estate plan. Some clients may be dramatically impacted by the one-year repeal and immediate action may be necessary to ensure that their intended plans will be implemented. Some clients may wish to consider "fine tuning" their plans at this time. The vast majority of our clients are not adversely impacted by the one-year repeal because of the flexibility we have already built into their estate planning documents.

Nonetheless, it is important that you at least consider whether to make changes to your estate plan at this time. In the balance of this Private Client Alert and in a Part 2 which will be published soon, we will highlight several common scenarios that may warrant immediate attention.

Scenario No. 1 – Married couple with a combined estate worth more than $2 million.

If this situation applies to you, you may have a so-called "disclaimer will," whereby each spouse leaves his or her entire estate to the survivor. The survivor would then have the ability to disclaim into a trust the full amount exempt from Federal estate tax at the first spouse's death (or, for clients residing in a state that imposes its own estate tax, an amount equal to the exemption from the state estate tax). If you have such a Will, no action is required at this time.

However, many clients in this scenario have a Will that at the death of the first spouse creates a "Credit Equivalent Trust" (sometimes referred to as a "bypass trust" or "exemption equivalent trust") via a formula clause that referred to the Federal estate tax exemption amount. Such a clause would have caused the trust to be funded with up to $3.5 million under the law in effect in 2009. In this scenario, the balance of the estate would have passed to the surviving spouse, either outright or in a trust for the exclusive benefit of the surviving spouse (a "Marital Trust"), which would have made a "QTIP" election at the first spouse's death, thereby postponing Federal estate taxation on the Marital Trust assets until the surviving spouse's death. At that time, the surviving spouse's own assets plus the Marital Trust assets would be taxable after taking into account the survivor's exemption from Federal estate tax. In contrast, the assets in the Credit Equivalent Trust would pass at the survivor's death to the couple's intended beneficiaries free of Federal estate tax, regardless of its value. Such a plan would permit the couple to transfer twice the Federal estate tax exemption, once at each death, or up to $7 million, free of Federal estate tax.

Problem: With a formula bequest such as the one just described, if the first spouse dies in 2010, nothing would pass into the Credit Equivalent Trust since (for the time being, at least) there is no Federal estate tax. Consequently, the entire estate would pass either outright to the surviving spouse or into a Marital Trust for the surviving spouse. This in itself is not problematic from a tax perspective at the first death in 2010, but when the surviving spouse dies, an outright disposition to the survivor would expose those assets to Federal estate taxation in 2011 or beyond. This problem would not occur if the assets passed into a Marital Trust, which would not make a QTIP election and therefore should not be subject to Federal estate tax at the survivor's death even if the tax is reinstated. A Marital Trust would have the added advantage of providing the creditor protection afforded by a properly drawn trust.

Solution: Change your Wills to eliminate an outright distribution to the surviving spouse and provide instead that the assets not passing to a Credit Equivalent Trust pass to a Marital Trust for the benefit of the surviving spouse. This change will provide the best potential to avoid Federal estate taxation at the second spouse's death if the tax is reinstated.

Scenario No. 2 – Married couple with children from a prior marriage who are to receive a bequest at the first spouse's death.

If this situation applies to you, you may have a Will which, via a formula clause, gives your children (or perhaps grandchildren) from a prior marriage an amount equal to your remaining Federal estate tax exemption, either outright or in a Credit Equivalent Trust. In this scenario, the balance of your estate passes to your surviving spouse, either outright or in a Marital Trust.

Problem: Like Scenario No. 1, under the formula clause, a death in 2010 (or in any year in which there is no Federal estate tax) may cause the gift to the children (or grandchildren) from the prior marriage to fail and the entire estate to pass either outright to the surviving spouse or into a Marital Trust for the surviving spouse.

Solution: Change your Wills to provide for a bequest to the children (or grandchildren) of a specific dollar amount or a specific percentage or fraction of your estate should the first spouse die in 2010 (or a year in which there is no estate tax). In order to protect your assets from potential creditor claims after your death, a trust for your children (or grandchildren) is highly recommended. It is also recommended that you leave the balance of your assets to your spouse in a Marital Trust, which will reduce or avoid Federal estate tax at the survivor's death, as explained in Scenario 1, and ensure that the assets will be protected from potential creditor claims and will pass to your intended beneficiaries at the surviving spouse's death.

Scenario No. 3 – Married couple with substantial means who wish to leave some assets to the children (or grandchildren) of their own marriage at the first spouse's death.

This scenario may apply if you and your spouse have decided that together you have sufficient assets allowing you to leave some assets to your children (or grandchildren) either outright or in trust at the first spouse's death. Similar to Scenario 2, you may have a Will which via a formula clause, gives your children (or perhaps grandchildren) an amount equal to your remaining Federal estate tax exemption, either outright or in a Credit Equivalent Trust.

Problem: Like Scenario No. 2, under the formula clause, a death in 2010 (or in any year in which there is no Federal estate tax) may cause the gift to the children (or grandchildren) to fail.

Solution: Like Scenario No. 2, you could change your Wills to provide for a bequest to the children (or grandchildren) of a specific dollar amount or a specific percentage or fraction of your estate. Another solution is to provide in your Wills that if the surviving spouse disclaims, the disclaimed amount will pass into a trust for the children (or grandchildren). A disclaimer requires timely affirmative action by the surviving spouse, but is more likely to be made in this Scenario than in Scenario 2, where the surviving spouse was not the parent (or grandparent) of the intended beneficiaries. As in Scenario 2, in order to protect the assets from potential creditor claims, a trust for the children (or grandchildren) is highly recommended.

Scenario No. 4 – Your Will contains a "Maximum" or "Minimum" Formula Clause.

Many practitioners1 have drafted their Wills and related estate planning documents to include a formula clause which either (a) funds the Credit Equivalent Trust with the "maximum" amount that can be passed free of Federal estate tax, or (b) funds the marital portion of the estate (outright bequest to the surviving spouse or bequest to a Marital Trust) with the "minimum" amount necessary to reduce the Federal estate tax to zero. Although intended to have the same effect, a "maximum" or "minimum" formula clause is different from those previously described which reference the Federal estate tax exemption amount.

Problem: With no Federal estate tax in 2010, it is unclear how to interpret a "maximum" or "minimum" formula clause if the first spouse's death occurs in 2010 (or any year in which there is no estate tax). If this type of clause is used, we are left to speculate: Do all of the assets pass to the Credit Equivalent Trust? Or, do all of the assets pass to or in trust for the surviving spouse? If the Will provides that the Federal estate tax amount is to pass to children (or other beneficiaries), will they receive the entire estate? Or, will the surviving spouse (who may not be the parent of the children) or Marital Trust receive the entire estate?

Solution: While several states, including Virginia, are contemplating legislation which would seek to legislatively solve this question of interpretation, the enactment of such legislation is far from certain and even if enacted, may result in the disposition of your assets in a manner other that what you intended. Therefore, if you have a Will containing a "maximum" or "minimum" formula clause you should contact us so that we can recommend appropriate changes to your Wills as soon as possible.

This Alert provides a few common scenarios that may require consideration and perhaps action at this time. Several additional scenarios will be discussed in Part 2 of this Alert, to be published shortly. Unfortunately, there is no "one size fits all" solution for the uncertainty surrounding the current state of the Federal estate and GST tax laws. Each client's circumstances are unique and may lie outside the parameters of the scenarios we have highlighted.

Footnote

1. A small number of our clients residing in Maryland and the District of Columbia may have the type of formula clause described in Scenario 4.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.