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Certain monumental changes have been made to the federal estate tax law in recent times. First and foremost, both the federal estate tax and the generation-skipping transfer tax (which arises with respect to assets given to those two or more generations below the donor) were repealed on December 31, 2009. Therefore, effective January 1, 2010, there is no federal estate tax and no federal generation-skipping transfer tax. In addition, prior to January 1, 2010, a beneficiary received a step-up in basis with respect to the value of the assets inherited. The basis received by the beneficiary was the value of the assets at the decedent's date of death (or six months thereafter if an election to value at the “alternate valuation date” was made on the decedent's estate tax return). The law as it currently stands provides that the basis of property acquired from a decedent, subject to limited exceptions, is the lesser of the fair market value at the date of acquisition or the decedent's basis in the property. The executor of the estate, however, is empowered to increase $1,300,000 of appreciated gain to the basis of assets passing to non-spouse beneficiaries and $3,000,000 in basis increase to qualified property passing to the decedent's spouse. Notwithstanding the foregoing permissible increases, the basis step-up allocated to an asset by the executor may not increase the basis of that asset above the then fair market value.
The current law, therefore, is vastly different from the law in effect on December 31, 2009. Most notably, be-fore January 1, 2010, there was an unlimited marital deduction. Therefore, anything passing to a spouse passed free of estate tax with the spouse receiving a step-up in basis in the assets received. Now, however, as discussed above, the executor may allocate $3 million in appreciated gain, and the spouse takes the balance at the carryover basis level.
In addition, the tax rates for inter vivos (lifetime gifts) have changed. The highest bracket for gift tax (which was previously at a 45 percent rate) has been reduced to a 35 percent rate.
Although we are clearly in uncharted territory, it is important for clients to review their current estate plans and estate planning documents with their attorneys to determine whether their documents, as currently drafted, reflect their intentions for the disposition of their property, as well as accomplish the proper tax planning. At our firms, we sent tax alerts to our clients and held speaking engagements and seminars our clients were invited to attend.
Key Issues for Clients
There are a number of issues that clients have to address in light of the new estate tax laws. First, it is very im-portant to consider how a client's current will is drafted. The prior law provided that up to $3.5 million could pass free of federal estate tax from the decedent's estate to the beneficiaries of the decedent's estate by virtue of a credit against the estate tax on $3,500,000, and the balance would be taxed at a high tax rate. Also, prior to this year, as previously noted, a spouse received an unlimited marital deduction. For example, if a wife had assets valued at $3.5 million and her husband had assets valued at $3.5 million, the wife could leave $3.5 million to her husband under her will, and there would be no tax. However, if the husband died without depleting his estate, he would leave an estate worth $7 million. After credit for the $3.5 million exemption, the balance in his estate was subject to a 50-55 percent tax. Had the wife provided in her will that the “maximum amount that could pass free of federal estate tax at her death” should remain in trust for her husband, and then on his death pass to their children, the wife's $3.5 million and its appreciation would ultimately pass to the children free of federal estate tax, and the husband's $3.5 million would pass to the children free of federal estate tax. Consequently, the children would end up with $7 million versus $5.2 million if the wife bequeathed all of her assets to her husband as initially discussed above.
However, this year, the entire estate may pass to the beneficiaries of the decedent's estate free of federal estate tax. Therefore, using the language quoted above, instead of placing $3.5 million into a trust, the wife would have unintentionally bequeathed her entire estate in trust, and that result could prove catastrophic depending on the family situation. For example, if your client had wanted to ensure that her children from her first marriage received $3.5 million tax-free upon her death, with the remainder of her estate passing to, perhaps, her second husband, under the new law she has now bequeathed her entire estate to her children, leaving nothing for her husband under her will. Therefore, when reviewing clients' estate plans, you must look closely at your clients' estate planning documents and each family situation to determine whether the repeal of the federal estate tax law may have unintentionally changed your clients' estate plans.
A second problematic issue that has arisen due to the change in the federal estate tax law relates to the new basis requirements. If your client received stock from his or her aunt, which his or her aunt received from her father, you could be tracing basis from over fifty years ago. In 1976, there was a period when carryover basis was included in the federal estate tax law. However, that law provided a mechanism for determining basis when basis was not available. The current law provides us with no guidance as to determining basis when your client has no records to support or substantiate basis. In addition, if your client were to inherit valuable jewelry from an aunt dying this year and you do not know the basis of the client's aunt in the jewelry, your client would still be required to use his or her aunt's basis should he or she ever sell that jewelry--a situation seemingly not contemplated when the change in the law was passed.
In the past, it was easy for a client to understand the value of doing estate planning and setting up life insurance trusts. And it was easy to create a trust that paid upon the second death, because if the client planned correctly, he or she did not have to worry about the step-up in basis. Now, however, we have to rethink our strategies based on what the law states. For example, if the client intends to leave $3 million or greater in his or her appreciated gain, the spouse will pay capital gains on a federal level.
Positive and Negative Impacts of the Estate Tax Law Changes
Of course, there are also some positive impacts of the estate tax law changes, depending on the situation. For example, if a client had bequeathed a $40,000 million taxable estate to his or her grandson in 2009, the estate would have paid approximately $20,000,000 in federal and state estate taxes, and the grandson's share would have been charged an additional 45 percent federal generation-skipping tax on the value of his bequest in excess of $3,500,000. However, if the client dies this year, in the same scenario, the estate will pay a New York state estate tax of ap-proximately $6,000,000. There will be no federal estate tax and no generation-skipping transfer tax assessed. This specific situation highlights the potential benefit in certain instances. The grandson will most certainly pay gains tax as he sells the property bequeathed to him. However, the net tax savings to the beneficiary in 2010 is clear.
Conversely, a surviving spouse in 2010 could suffer tremendous loss due to the repeal of the 2009 federal estate tax. The unlimited marital deduction was thought of by many as, in effect, a deferral of the federal estate taxes, as it provided the surviving spouse the assets that he or she had accumulated with his or her now-deceased spouse, while assessing a tax on the remaining assets at the survivor's death. Under the current law, the surviving spouse will be assessed tax on low basis assets sold that have not been allocated to the $3,000,000 increase exception on the de-ceased spouse's federal return.
Key Drivers of the Estate Law Change
The changes in the federal estate tax law of 2010 were put into motion ten years ago when Congress, under President George H.W. Bush, passed the Economic Growth and Tax Reconciliation Act, which included the 2010 repeal of the federal estate tax. Nearly every sophisticated practitioner believed Congress would do something to address the repeal of the federal estate by the end of 2009--i.e., they would either extend the $3.5 million exemption that was part of the law in 2009 or agree upon a new exemption, as was intended initially. Many believe that imple-menting an exemption in a fixed amount in the range of $2,500,000 to $5,000,000 was an equitable result. That way, estates of those dying at the end of one calendar year would not be taxed differently from those dying at the start of the following calendar year. However, neither of these occurred.
As a result, we were forced to take rapid action in January 2010 to disseminate information to our clients and make sure everyone was properly advised of the change in the estate tax law. Then we immediately began the proc-ess of formulating the necessary changes to our clients' estate planning documents to achieve our clients' intended goals. In January 2010, initial thoughts were that Congress would do something fairly quickly to institute a retroac-tive repeal of the federal estate tax. However, with each passing month, there is an increasing chance that if a retro-active repeal of the federal estate tax is enacted, it will certainly be subject to a constitutional challenge, and that challenge may end up under review by the Supreme Court.
Challenges of Estate Planning Under Current Law
It is important to point out that federal estate taxes have been eliminated in the past, only to be reinstated. Under the current tax law, if the year goes by without any changes, we revert back to 2001 tax law. We are concerned that legislators have not focused on the significance of this revision. Absent a new law, the federal estate tax in 2011 will return to the 2001 tax law.
Two aspects of the former estate tax law that have not been repealed are the $1 million lifetime exemption and the annual gift tax exclusion of $13,000 per donee. These exemptions, coupled with our low interest rate environ-ment and depressed asset values, provide many with interesting opportunities. Parents could gift a portion and sell the balance of depressed properties to their children. To the extent that the transaction constituted a sale, the children could give their parents promissory notes in the amount of the sale price. With interest rates at historically low num-bers, an avenue that was previously unrealistic may now be pursued.
It is interesting to note that, if the law does not change this year and then reverts to the 2001 law next year, the interaction between the income tax and the estate tax portions of the Internal Revenue Code would seem to indicate that a beneficiary could receive his or her bequest free of estate tax in 2010, hold the inherited assets until 2011, and then sell them in 2011 when, as literally interpreted, the law would provide a step-up in value in basis to the dece-dent's/transferor's date of death.
It is likely that this was an unanticipated result of the current law, and taking this position is not for the faint of heart. Furthermore, we believe this loophole will be resolved by a change of the law before 2011.
Revising Estate Planning Strategies
Last year we did not focus on redrafting client estate planning documents in light of the upcoming changes, be-cause we were hopeful that the law was going to be changed. However, when the law ultimately changed in January 2010, we knew our clients needed to meet with us to review their plans and goals. Consider the example above of the wife who wanted to make sure she would leave something for her children from her first marriage upon her de-mise, while still providing for her current husband. As discussed above, her will should be amended to provide that, if there is no federal estate tax law in effect at the client's death, the relevant provisions of her will should be inter-preted based upon the law at such time as there was an estate tax immediately preceding the client's death.
If your clients are a husband and wife who want to benefit the same beneficiaries, you can still do fluid and flexible post-mortem planning. For example, the clients could leave everything to the surviving spouse, and then within nine months of the death of the first spouse--the time period for filing renunciations--the surviving spouse could renounce his or her inheritance (or a portion thereof) to effectuate a different estate plan. For example, a new will could provide that the renounced portion would pass into a trust. Ultimately, this would enable the surviving spouse to create an exempt trust of what would have been $3.5 million last year on the back end, instead of on the front end. Essentially, the surviving spouse could look at what the law was on the date of his or her spouse's death, with nine months to do post-mortem tax planning.
We also aim to create customized solutions to people's issues to help them solve their liquidity problems. We find that life insurance trusts are still an excellent wealth management tool to create significant amounts of money; such a trust can buy assets from the decedent's estate to create liquidity. In addition, if you believe the estate tax is coming back, an insurance trust will benefit your client's heirs, because if structured correctly, the insurance will remain outside of your client's estate.
Looking to the Future
Going forward, we believe attorneys and advisors in this practice area need to reinforce to their clients the im-portance of determining basis and keeping records as carefully as possible, to the greatest extent possible. In addi-tion, clients should be reviewing their estate plans to confirm that documents containing so-called formulaic clauses (i.e., the “maximum amount that can pass free of federal estate tax”) still accomplish their goals. Fortunately, it is still possible to take advantage of some interesting techniques to transfer assets during 2010. For example, if your client is in a position to make gifts and has the ability to pay the gift tax, your client can remove appreciated assets out of his or her estate at a lower rate. In addition, as discussed above, to the extent possible, your clients should take advantage of the low interest rate environment coupled with depressed property asset values.
Additionally, life insurance trusts are another strategy attorneys are recommending to their clients. These trusts create liquidity, as the trust owns the policy. Upon a person's death, the trust can purchase the assets in the estate to provide the estate liquidity to pay federal or state estate tax or provide cash as needed. This is particularly a good strategy to ensure that, no matter what the federal estate tax is, there is a trust in place that is not subject to estate or income taxes and that can provide up to a 9 percent rate of return.
As an attorney in this practice area, you need to stay current on the law and look carefully at what you have done for your clients to ensure that your planning does not have any unintentionally adverse results. Critically im-portant in today's estate planning is flexibility--to make sure what your clients do today can be altered tomorrow, by providing “escape hatches” in their estate plans.
Fortunately, certain family situations enable you to plan for your clients with great flexibility; escape hatches may include post-mortem planning strategies such as renunciations, as previously discussed. Also, to the extent that your clients have high net worths, shifting assets at a small tax cost may be done for the overall benefit of their beneficiaries.
Final Thoughts
We recently met with a man who is worth approximately $30 million. We asked him what planning he had done, and he told us that he does not have a will or a form of estate plan. We explained that if he did not have an estate plan, his heirs would face potentially serious and costly problems. People tend to procrastinate in this area, and there is always an opportunity to do effective estate planning to impact the bottom line for a client's children and grandchildren.
In developing an estate plan, clients need to work with advisors at the forefront in this area. A client's advisors should address these issues and keep the client updated. Although it is difficult to do any concrete planning at the present time, not knowing what the law will be going forward, it is unlikely that there will be a permanent repeal of the estate tax. At the same time, there is opportunity for good planning in this low interest rate environment.
People should be updating their estate plans on a regular basis. Every time they experience a major life event, they need to reevaluate their current estate plan. Finally, it is important to create the right recordkeeping system and remind clients to keep their files organized.
Laurie Ruckel is a partner with Loeb & Loeb LLP. She concentrates her practice on estate planning, succession planning, estate and trust administration, and estate taxation. Her experience encompasses wills and trust agreements, estate and gift tax audits, succession planning for closely held businesses, and prenuptial agreements.
David Kleinhandler, CLU, CHFC, CASL, is managing partner of DKA and David Kleinhandler LLC. Prior to forming his own company, he held leadership positions at Equitable Insurance, Mass Mutual, and AIG. In 1997, he launched Quotemaster USA, providing life insurance solutions to select professionals nationwide. Mr. Kleinhan-dler provides strategic insurance planning to many of the country's prominent families and business owners. He also works with top estate and tax lawyers, certified public accountants, and investment professionals in helping their clients see insurance as a financial asset and putting it to work to create new wealth as well as protect assets for future generations.
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