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By John J. Scroggin, AEP, J.D., LL.M.
When the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA")
was passed, most estate planners (and probably most Republicans) anticipated
that by 2011 there would either be an elimination of the federal estate tax or
the enactment of permanent transfer tax legislation that would create
permanently higher exemptions and lower rates than those under the pre-EGTRRA
tax laws.
It is increasingly possible that neither of these alternatives is going to
occur. First, it appears increasingly likely that the Democrats will gain
control of the House of Representatives in the 2006 mid-term elections. The
House Democratic leadership has made it clear that they are not open to the
higher federal estate tax exemptions and lower rates which have been proposed by
the Republicans. Second, even if the Democrats do not gain control of the House
of Representatives in 2006, they retain filibuster control in the Senate, with
the ability to stop any federal transfer tax legislation which they deem
unacceptable.
While the Republicans have had numerous opportunities to enact permanent
legislation, they have often chosen political postures (e.g., elimination of the
estate tax) instead of compromise legislation that could have adopted
permanently higher federal estate tax exemptions and lower rates. Now it appears
increasingly possible that the Democrats may decide to delay or prevent any
permanent legislation, with the idea that the higher exemptions accorded in 2006
through 2009 and the elimination of estate taxes for one year in 2010 are an
acceptable loss of tax revenue for the return of a one million dollar federal
estate tax exemption and higher transfer tax rates in 2011.
In fairness to opponents of an elimination of the estate tax, both the
impending budget impact of baby boomers drawing down social security benefits
and the need to fix the alternative minimum tax may leave little budgetary room
for permanent estate tax legislation. Moreover, there is certainly some merit to
Warren Buffett's argument that our society would be adversely impacted by the
total elimination of the estate tax, because it could create a class of
perpetually wealthy Americans.
The EGTRRA changes have both vastly reduced the number of estates subject to
an federal estate tax and caused a significant reduction in the federal estate
taxes in the remaining taxable estates (albeit while causing a counter-increase
in state estate taxes). By one estimate, less then one third of one percent of
all estates will be subject to a federal estate tax from 2006-2009. However,
without the adoption of permanent legislation by the end of 2010, on January 1,
2011, the payment of federal estate taxes will skyrocket.
In 2001, the estate exemption was $675,000. At an annual growth rate of just
over 4%, the 2001 exemption of $675,000 will equal the value of the $1.0 million
exemption in 2011. Because the estate exemption is not adjusted for inflation,
each year after 2011 the effective value of the exemption decreases.
For planners, all of this means we could be facing a horribly confusing
planning environment for the next four years. Let me provide a few examples.
Treatment of Insurance
Many of our clients have estates in the range of $1,000,000 to $2,000,000,
including life insurance. In many cases planners have told married couples that
with a federal estate tax exemption of $2,000,000 each ($4,000,000
collectively), it was unnecessary to place their life insurance into an
irrevocable life insurance trust to move it outside their federal taxable
estate, because the individual exemption and/or the joint exemption of the
married couple was more than sufficient to create a non-taxable estate. However,
if, in 2011, we return to the 2001 rules (with the return of a $1,000,000
federal estate tax exemption), the inclusion of the life insurance in the
federal estate tax computation may create a taxable estate to the client.
If a client is going to transfer an existing life insurance policy into a
life insurance trust, the three-year look back provisions of Internal Revenue
Code Section 2035(a) means that the transfer needs to occur at least three years
prior to the beginning of 2011 to effectively exclude the life insurance from
the insured's taxable estate. Thus, by the end of 2007, clients who do not
currently have a taxable estate (but who may have a taxable estate in 2011) will
be forced to consider the use of life insurance trusts or the transfer of
insurance policies to heirs.
State Death Taxes
As a result of the elimination of the state estate tax credit (the so-called
"sponge tax") in 2005, roughly half of the states have state estate taxes which
are de-coupled from the computation of the federal estate tax. The return in
2011 of the state estate tax credit is going to add some interesting confusion.
First, in "decoupled" states, there will be confusion because state death taxes
will not relate directly to the federal estate tax credit and tax computations.
Second, the other half of the states which have not enacted a new state death
tax (and which effectively lost any revenue from the sponge tax in 2005), will
suddenly see an unexpected return of previously lost revenue.
Interestingly, the return of the state estate tax credit will serve as a
partial offset of the increased federal revenue from the estate tax. Without any
state legislation, this change will effectively return dollars to the states
which coupled their state estate tax to the federal credit. For example,
according to
www.FloridaTaxWatch.org, in 2006 Florida lost over $1.1 billion in revenue
from the elimination of the sponge tax. All that revenue could now return to the
state as an unexpected revenue windfall.
It may be that a number of the states which have decoupled themselves from
the federal estate tax rules will reattach themselves to the federal code, if
for no other reason then so they can effectively piggy-back off federal estate
tax audits. However, there may be some trepidation that Congress may once again
fiddle with the exemptions and the state death tax credit. Those states which
are concerned about that loss of revenue may decide it is better to adopt either
an estate tax system independent of the federal tax system or one which is tied
to the federal tax system, but with a decoupled state estate tax exemption.
Family Businesses
Perhaps one of the most complicated pieces of federal estate tax legislation
ever enacted, the family business deduction (code section 2057) will be restored
in 2011, albeit at a total benefit of only $300,000 per decedent. Nevertheless,
planners and drafters of documents will have to anticipate the possibility of
the benefit of the business deduction and the passage of a family business to
family members. The planning will need to include planning for the ambiguity of
section 2057 and the potential recapture of the tax benefits of the deduction.
Higher Tax Rates
The federal estate tax rate in 2001 capped out at 55% for estates above
$3,000,000, but with an additional 5% surtax on estates over $10,000,000. These
higher tax rates will return in 2011 creating new and greater liquidity problems
for many clients. Many of the previous estate tax reduction techniques which had
been moth balled for a majority of our clients will be restored.
Given the possibility not only that the top federal estate tax rate could
return to 60%, planners should evaluate whether or not to purposely create an
estate tax at the death of the first spouse of a married couple during the years
from 2006-2009 when the tax rates will be lower.
Having assets taxable in the estate of the first-to-die spouse could
potentially not only reduce the top tax bracket, but it would also remove future
appreciation on those assets for being taxed at the higher rate for deaths after
2010. The off-set to this calculation would be the long term cost of the
prepayment of the estate tax. If both couples are elderly and in relatively poor
health, that concern may be minimized.
For example, assume a married couple has a combined estate of $15 million,
with each spouse having $7.5 million in their estate. Both clients are in their
eighties and their assets grow at 5% per year. One of the clients dies in 2009,
while the other dies in 2011. Purposely paying an estate tax in 2009 on the
entire estate of the first to die spouse could save the family over $500,000.
Federal Tax Liquidity
Given the increasing likelihood of a return to lower exemptions and higher
tax rates, clients with illiquid, potentially taxable estates should begin
immediately to consider increasing their current life insurance coverage. In
particular, clients with a history of health problems or family health problems
should begin now to consider how the potential new higher estate taxes in 2011
will affect the liquidity of their estate and the source of payment for the new
higher taxes. Consider the tragedy of a married client with an illiquid estate
who assumes the presence of higher exemptions and lower tax rates, only to die
while uninsurable after 2011.
Clients who decide to buy additional insurance should consider placing the
insurance in an irrevocable life insurance trust to keep it outside their
taxable estate. Because of the current legislative uncertainty, it may be
appropriate to adopt contingency formulas in the insurance trust to provide for
how the passage of assets will occur in various scenarios. For example, if
insurance is held in an irrevocable life insurance trust, but is unnecessary to
provide estate tax or liquidity to the estate, a formula provision in the
insurance trust could pass those assets on to the donor's favorite charity.
Flexibility should also include the use of limited powers of appointment in
virtually every insurance trust.
Shifting Fundamental Goals
With so few estates being taxable, planners have noted that tax planning is
no longer driving most of the estate planning decisions of most clients.
Unfortunately, the combination of return of lower exemptions and higher tax
rates and the accumulation of assets by clients since 2001 will mean that
clients will be increasingly driven back to the necessity of planning their
estate to minimize the imposition of a confiscatory federal estate tax.
IRS Estate and Gift Staff
In July of this year the Internal Revenue Service announced that they were
laying off roughly half of the attorneys (157 out of 345) who worked in the
Estate and Gift Tax Division of the Internal Revenue Service. The primary reason
was that the number of taxable estates was going down dramatically and the need
for auditors was being concomitantly reduced.
However, with the return of the 2001 rules and especially given the expected
significant increase in the number of taxable estates (e.g., see the above
appreciation impact on $675,000 from 2001), it should be expected that the IRS
will be back in a hiring and auditing mode, particularly when the top tax
bracket could equal 60%. However, how long will it take for them to gear up and
train so many new hires?
Try to Die in 2010?
There is one last wrinkle that compounds the confusion in planning: Roughly
2.3 million Americans die each year. For those Americans who die in 2010, they
and their heirs will have to deal with some unique opportunities and traps. For
example:
- In 2010 there will be no federal estate tax. What happens if a wealthy
disabled parent is lingering too long as they near 2011? Be careful who holds
that medical power of attorney.
- In 2010, the generation skipping tax is eliminated. For the appropriate
client, it would be possible to create a dynasty trust without regard to the
limited generation-skipping tax exemptions and rules that existed before 2010.
- Only a partial step-up in basis will be permitted in 2010. Particularly in
blended families and dysfunctional families, there are bound to be conflicts
over the allocation of the partial step-up permitted by the Act.
Unfortunately, we as drafters will have to anticipate how to deal with one
year's worth of no estate tax and a partial step-up in our planning documents.
Start getting prepared for the confusion of a quickly changing landscape:
three years of high exemptions and lower rates, one year of no estate tax (and a
loss of step-up) and then a return to higher tax rates and lower exemptions.
Virtually every single estate plan will have to be reexamined to account for not
only the return of the pre-EGTRRA rules, but, perhaps more importantly, the
possibility that the client dies in 2010.
Who benefits from a return to 2001? Four groups will reap the greatest
rewards: The Insurance industry should see substantial increases in life
insurance sales to fund increased estate taxes. Estate attorneys will be covered
up with work. CPAs will have more tax returns to file. And politicians will see
increased contributions to their campaigns from people on both sides of the
debate. And the client/taxpayer? He'll be paying the cost of all of it.
John J. Scroggin, AEP, J.D., LL.M. is a graduate of the University of
Florida and is a nationally recognized speaker and author of over 300 published
articles, outlines and books.
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