United States: Increase In Estate Tax Exemption Highlights Changes For 2006

Effective January 1, 2006, each taxpayer’s federal estate tax (and generation skipping tax) exemption (sometimes referred to as the "unified credit") will increase from the current $1.5 million to $2 million. This is a result of the 2001 Tax Act, which provided for gradual increases in the exemption for a number of years. The next scheduled increase will be in 2009, when the exemption increases to $3.5 million. The estate tax is then scheduled to be repealed in 2010, but no provision has been made for its permanent repeal in 2011 and afterward. Although Congress came close to passing permanent repeal during 2005, the measure was tabled in the wake of Hurricane Katrina. The consensus among observers appears to be that permanent repeal is not likely to occur in the immediate future, if at all. While a total permanent repeal would obviously remove a major obstacle in estate planning, we will probably have to settle for legislation that would set the exemption at a definite amount (e.g., $3 - $5 million) with an inflation index. This would eliminate the continuing uncertainty that inhibits current planning.

While the federal estate tax exemption has increased, it is important to check individual states’ estate tax laws. Like the income tax system, states typically have their own estate or inheritance tax regimes and can have lower exemptions than the federal exemption. This needs to be examined on a state-by-state basis, depending on domicile and the location of property that is owned.

It should be noted that the continued increase in the federal estate tax exemption does not affect the maximum exemption for gift tax purposes, which remains at $1 million.

Also new for 2006 is a flat federal estate tax rate of 46%. Estate tax rates had previously been graduated, ranging from 45-47% in 2005 and 37-55% only a few years ago. This flat estate tax is scheduled to drop to 45% for 2007-2009. Because of the lower exemption for lifetime gifts, gift tax rates will continue to be graduated (41-46% in 2006).

It is also noteworthy that the annual gift tax exclusion will increase from the current $11,000 per donee per year ($22,000 for married persons who split their gifts) to $12,000 ($24,000 for married persons who split their gifts). This is a result of the inflation factor added to the annual exclusion amount in 2001.

In other current developments, during 2005 the IRS continued to score some successes in challenging family limited partnerships, especially in cases where a sufficient non-tax reason for creating the partnership was lacking. However, this technique continues to be a viable vehicle to accomplish many clients’ tax and non-tax goals when structured properly with the correct mix of assets.

Another general trend from 2005 continues to be the decreasing emphasis on estate tax planning as the exemption amount continues to increase, with a corresponding shift of focus toward non-tax issues. These issues include asset protection, proper selection of fiduciaries, investments and distributions by fiduciaries, and avoidance of probate and/or transfer tax in multiple states, especially if the client tends to migrate between jurisdictions.

In light of the increase in the estate tax exemption, for those taxpayers whose aggregate value of assets (including life insurance) is less than $2 million, estate taxes may no longer be a factor. In those cases, it may be appropriate to revise current Wills or other estate planning documents to remove reference to the credit shelter formula or similar estate tax planning language, particularly since those bequests tied to such formulas can result in drastically different results than those intended by the individual.

Taxpayers with a net worth in excess of $2 million will continue to face the possibility of federal estate tax. Married couples in this situation should focus on ensuring that their assets are divided in such a way as to take maximum advantage of the higher exemption amount, regardless of the order of their deaths.

Clients should contact their advisors for assistance in reviewing their estate planning documents and how their assets are titled in order to determine the best response to these beneficial changes.

This summary is intended only as an overview of recent significant estate tax developments. If you have any questions about how these changes may impact your estate planning, or if you would like specific advice regarding any of these issues, please contact our Trusts and Estates attorneys listed on the right.

This Client Alert is prepared by the Tax and Estate Planning Sections of Powell Goldstein LLP as a client service. The information discussed is general in nature and may not apply to your specific situation. Legal advice should be sought before taking action based on information discussed.