Originally published December 2009
On January 1, 2010, significant changes will occur to the federal transfer tax system. Three important changes are discussed in this article. First, both the federal estate tax and generation-skipping transfer (GST) tax will be repealed. Second, although the gift tax exemption amount will remain at $1 million, the top gift tax rate will be reduced to 35%. Third, the "step up" in basis rules will be eliminated so a decedent's basis in property will "carryover" to the beneficiaries of the decedent's estate.
Repeal Of Estate And GST Taxes
In the 2001 Tax Act known as EGTRRA, Congress created a transfer tax system that gradually decreased the top tax rates and increased the exemption amounts for estate and GST taxes. In 2009, the estate and GST tax exemption amounts are $3.5 million and the top tax rate is 45%. Under the provisions of EGTRRA, the transfer tax system changes dramatically in 2010 and 2011. On January 1, 2010, the estate and GST taxes are repealed. However, the repeal is only effective for one year because EGTRRA is subject to a "sunset" provision that eliminates all of the changes at the end of 2010. Without congressional action, numerous tax provisions will be restored in 2011 as they were before EGTRRA including estate and GST tax exemption amounts of $1 million and top tax rates of 55% (60% on certain transfers).
The future of the estate and GST taxes is uncertain. Although there is strong support in the House of Representatives for a permanent repeal of the estate and GST taxes (as evidenced by its passage of a bill to do that this year), similar support is lacking in the Senate. While most practitioners do not believe that a permanent repeal of these taxes is likely, it is unclear what exemption amounts and tax rates will apply if the estate and GST taxes are reinstated. There is further uncertainty regarding whether any changes to the estate and GST taxes would be retroactive and whether such retroactivity would be held constitutional.
Gift Tax Continues
The gift tax annual exclusion amount ($13,000) and the gift tax exemption amount ($1 million) remain unchanged in 2010. However, the top gift tax rate is reduced from 45% to the top income tax rate (currently 35%). Under the provisions of EGTRRA, the top gift tax rate will be increased to 55% in 2011.
New Carryover Basis Provisions
Another important change involves the basis of property acquired from a decedent dying after December 31, 2009. In such cases, the basis of property will be the lesser of the decedent's adjusted basis and the fair market value of the property on the decedent's death. Note that this does not allow the basis of property to be "stepped-up," but it does allow the basis to be "stepped-down" at a decedent's death. There are two exceptions from the carryover basis provisions. First, the personal representative may allocate up to $1.3 million to increase the basis of assets in the decedent's estate. Second, the personal representative may also allocate up to $3 million to increase the basis of assets passing to the decedent's surviving spouse or to a trust for the surviving spouse's benefit.
The carryover basis system will likely impact many estates that would not have been subject to federal estate tax if the current $3.5 million exemption amount had been extended. The carryover basis system will also complicate estate administration. The personal representative of a decedent's estate will have the difficult tasks of determining the decedent's basis in property and allocating the increase in basis among the decedent's assets. The carryover basis provisions will not apply in 2011 when the estate tax returns.
Division Of Property
Many married people divide their estates into two portions: one portion equal to the individual's unused estate tax exemption typically passing to a trust for the benefit of the surviving spouse and descendants and the other portion passing to the surviving spouse or a trust for the spouse's benefit. In some cases, an individual also allocates a portion of his or her estate equal to his or her unused GST tax exemption to a trust for the benefit of his or her grandchildren or more remote descendants. If there is no estate or GST tax in 2010, the use of exemption amounts to define the division of a decedent's estate may not lead to the desired result.
Planning Opportunities
- Gifts Individuals should consider gifts to grandchildren and more remote descendants in 2010 when there is no GST tax. In addition, individuals who are considering making large gifts should make them in 2010 when the top tax rate is reduced to 35%. There is a risk that additional tax may be due if Congress enacts legislation to apply retroactively.
- Grantor Retained Annuity Trusts (GRATs) There is a possibility that grantor retained annuity trusts (GRATs) funded in 2010 when there is no GST tax will not be subject to the tax in the future. If so, the GRAT and any continuing trusts at the end of the GRAT term will not be subject to GST tax. Thus, the remainder interest could continue in trust for the grantor's grandchildren or more remote descendants without the imposition of GST tax. There is no certainty that these GRATs would be "grandfathered" if the GST tax is reinstated, but provisions may be included in the trust instrument to provide for an alternate distribution at the end of the initial GRAT term in the event the GRAT is subject to GST tax.
- GST Trusts Individuals should consider funding long-term trusts for their descendants. Because the trusts would be funded in 2010 when there is no GST tax, the trusts may be "grandfathered" if the GST tax is reinstituted. If the trusts are not grandfathered for GST purposes, most practitioners believe that individuals will be allowed to make a late allocation of GST exemption to the trusts. For individuals with unused GST exemption, the risk of GST exposure seems minimal if the gift is within the available exemption (currently $3.5 million) even if the GST tax is reinstated retroactively. Any such gift would still be subject to gift tax to the extent that it exceeds the donor's $1 million lifetime exemption remaining at the time of the gift.
- Other Planning Opportunities Currently, if a trust makes a distribution or terminates and assets pass to a beneficiary two or more generations below the original donor, the transfer is taxable for GST purposes. When the GST tax is repealed in 2010, there may be an opportunity to make distributions from or terminate such trusts. Again, there is a risk that additional tax may be due if the GST tax is reinstated retroactively.
Finally, when Congress tackles the transfer tax issues, it may also consider other issues that impact estate planning. There is a possibility that GRATs, qualified personal residence trusts (QPRTs) and valuation discounts will be impacted. Thus, individuals should consider whether to take advantage of these planning opportunities.
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.
