ARTICLE

The 2010 Estate and Gift Tax Law Presents Challenges – and Maybe a Few Opportunities

     As you may know, this year we find ourselves in an unprecedented situation in the 95-year history of the federal estate tax. The law could hardly be more uncertain than it is at the moment, primarily because we continue to await a long-anticipated and now belated Congressional revision of the estate and gift tax law, which revision, conceivably at this point, might not occur at all.

      Key Provisions of the Law Applicable This Year. Under the provisions of the 2001 Tax Act, which are in effect at the moment, the rules applicable for this year only are as follows:

     Estate and Generation-Skipping Transfer Tax. The estate tax is completely inapplicable to the estate of anyone who dies during 2010. [1] The generation-skipping transfer tax (GSTT) is also inapplicable to gifts made this year that are classified as “direct skips” – that is, outright gifts rather than gifts in trust.

     Income Tax Basis Adjustment Rules. However, the usual rule allowing an adjustment in income tax basis of assets owned at death to their then fair market value is also inapplicable to estates of decedents dying in 2010. This means that recipients of gifts made by decedents who die this year will generally have to take the decedent's cost basis in the assets, which in most cases will result in greater capital gain if and when those assets are later disposed of.

The law in effect this year allows for a limited adjustment in income tax basis at death. Under these rules, up to $1.3 million of accumulated gain can be sheltered from future income tax by means of a step-up in basis. For gifts to a surviving spouse, an additional $3 million of accumulated gain can be sheltered, for a maximum total step-up of $4.3 million.
 

A gift in trust for the lifetime benefit of a spouse can qualify for the additional $3 million basis adjustment so long as the trust that would have qualified for the estate tax marital deduction were the estate tax still in effect. This means that the trust must provide for distribution of all of its net income to the surviving spouse at least annually and that no one other than the surviving spouse can be the beneficiary of either income or principal of the trust so long as the surviving spouse is living.

For some people who die this year, the current law could actually saddle their successors with a greater tax burden than they would have suffered had the decedent died last year, when the estate tax was still in effect but subject to a $3.5 million exemption amount. This negative overall tax result could apply, for example, in the case of an unmarried decedent with $3.5 million in non-retirement assets, of which over $1.3 million consists of unrealized appreciation.

      Gift Tax Rate Reduction. The lifetime gift tax exemption amount remains $1,000,000 this year. However, the maximum gift tax rate applicable to gifts made this year is just 35%, down from the 45% maximum rate that applied last year.

     Effect of This Year's Law on Existing Wills and Trusts. The difficult issues presented by this year's law generally relate to married couples rather than unmarried individuals. This is because married couples commonly provide in their wills or trusts that when the first of them dies, the decedent's estate will be divided between two (or perhaps more) sub-trusts according to a marital deduction formula clause (referred to in this article simply as a “formula clause”) that is designed to allow for optimal utilization of the estate tax exemption available to the deceased spouse. When the estate tax exemption is unlimited, as it is right now, such formula clauses may not operate as intended.

      Formula Clauses May Produce Unintended Results. The typical formula clause in a married couple's trust or wills requires the trustee to allocate to the Nonmarital Share as much of the decedent's property as possible without triggering any estate tax. The balance of the decedent's property, if any, over and above the estate tax exempt amount is typically allocated to some form of marital trust (referred to in this article as the “Marital Trust”) that is designed to qualify for the estate tax marital deduction, thereby deferring all estate tax on that share until the surviving spouse's death. The Nonmarital Share is then typically allocated to a trust for the lifetime benefit of the surviving spouse, and perhaps for children or other family members as well. That trust is frequently labeled the Bypass Trust (but is also sometimes referred to as the Credit Shelter Trust, the Exemption Trust, or the Family Trust). [2] Less frequently, the Nonmarital Share is left directly to or in trust for children or others, to the exclusion of the surviving spouse.

If there is no estate tax in effect when the deceased spouse dies, and the governing instrument contains the typical formula clause, the decedent's entire estate will be allocated to the Nonmarital Share, regardless of how large that estate might be, and nothing will be allocated to the Marital Trust. In that event, the resulting benefit to the surviving spouse may be different (and perhaps dramatically less) than the deceased spouse intended. If the Nonmarital Share has been left to or for benefit of children or others, the surviving spouse will receive no benefit whatsoever from the deceased spouse's property! If, as in the more typical case, the Nonmarital Share passes to a Bypass Trust, the benefit conferred upon the surviving spouse will depend on the terms of the Bypass Trust.

Many Bypass Trusts provide for distribution of all net income to the surviving spouse, plus whatever amount of principal he or she may need for health, support, and maintenance. In those cases, the benefit to the surviving spouse is virtually the same as that provided in the marital trust. However, in some cases, the Bypass Trust makes distributions of income as well as principal discretionary with the trustee, according to the surviving spouse's needs. In other cases, the Bypass Trust provides for a “sprinkling” of net income (and perhaps principal as well) among the surviving spouse and children. Sometimes spouses grant each other a limited power of appointment over the Marital Trust but not the Bypass Trust. [3] In such situations, if everything passes to the Bypass Trust, no assets whatsoever will be subject to the surviving spouse's power of appointment, regardless of the size of the estate. These results may not be what the deceased spouse intended.

     Trust Terms May Limit Basis Step-Up. As noted above, a gift in trust for the benefit of a surviving spouse must meet certain conditions in order to take advantage of the additional $3 million of capital gain shelter that is available for gifts to spouses. If the decedent's entire estate passes to a Bypass Trust that does not meet these criteria, a potentially valuable increase in income tax basis may be lost. The types of disqualifying provisions that are commonly found in Bypass Trusts include the following:
  •  A provision making income distributions to the surviving spouse discretionary with the trustee (even if the trustee is the surviving spouse himself or herself); and
  •  A provision authorizing the trustee to sprinkle income or principal among the surviving spouse and others.

The terms of any Bypass Trust should be reviewed if your estate includes $1 million or more in unrealized appreciation.

     What If Congress Retroactively Reinstates the Estate Tax? Many believe that if Congress addresses the estate tax anytime this year, they will make their changes retroactive to the beginning of this year. If Congress retroactively reinstates the estate tax for 2010 (and along with it, the step-up in income tax basis at death), the potential problems described above will become moot.

In order to allow for the possibility (the probably, many would say) of retroactive reinstatement of the estate tax and avoid having to further amend your documents in that event to reverse whatever amendment you make at this time, we suggest that any amendment you now make to your governing document be conditional and include its own “sunset” clause, so that it automatically lapses upon the earlier of (a) the end of 2010, or (b) the effective date of reinstatement of the estate tax by the federal government.

      Does the Current Law Present Any Planning Opportunities? In very limited circumstances, the current law may offer planning opportunities. However, in order to take advantage of these opportunities, you would need to be prepared to have your actions subjected to taxation under a different, and currently unknown, set of rules in the event Congress reinstates the estate tax and the GSTT retroactively.

The following are several planning opportunities presented by current law:

  • You may wish to make outright gifts to grandchildren or more remote issue this year. If the GSTT is not retroactively reinstated, such gifts will not consume any part of your lifetime GSTT exemption. However, the gift tax will still apply to such transfers, subject to the annual gift tax exclusion (now $13,000 per donee) and the $1 million lifetime gift tax exemption.
  • You may wish to make gifts that exceed your $1 million lifetime gift tax exemption and trigger gift tax on the excess, on the theory that the present rate of 35% will likely be increased next year to 45% or more. The risk of making gifts in excess of the $1 million exemption, and paying the resulting gift tax, is that Congress will act next year or shortly thereafter to increase the lifetime gift tax exemption. In that event, you will have paid gift tax that could have been avoided had you waited for the change in the law.
  • If you anticipate that either spouse will not survive until 2011, you may want to consider transferring the entire estate to that spouse. [4] If your trust calls for the estate of the first spouse to die to pass to a Bypass Trust for the survivor's lifetime benefit, any assets allocated to that trust will not be included in the survivor's taxable estate. If one spouse does in fact die this year, and if Congress does not reinstate the estate tax for 2010, then the entire estate will fall into the Bypass Trust and will ultimately pass to the next generation free of estate tax. This tactic has obvious risks and disadvantages, the most important being that the ill spouse has complete control, however temporarily, of how the entire estate is distributed, and the surviving spouse will never have outright control over even his or her former share of the estate.

As we advised you in our previous Alert, if and when Congress gets around to revising the estate tax law, they are expected to include in the new law some new provisions that limit certain tax planning techniques that have been popular in recent years. Those techniques include valuation discounting for gifts of interests in family limited partnerships and other family business entities and short-term grantor-retained annuity trusts. Any such limitations, if enacted, will not likely be retroactive. Therefore, if you want to take advantage of any of these planning techniques before they become unavailable, you should act now.

Recommendation: If you are married and have some form of formula clause in your trust or wills, we recommend that you have us review your documents to confirm whether they will operate properly if one of you happens to die this year. If you believe that your assets include unrealized appreciate of over $1 million, it is especially important that you have your documents reviewed. If a revision is required, a brief amendment or codicil may suffice.

[1] The estate tax is scheduled to return (with a vengeance) in 2011, with a marginal rate of 55% and an exemption of only $1 million.

[2] In the balance of this article, we will refer to such a trust as “the Bypass Trust.”

[3] A limited power of appointment is a power, generally exercisable by will at death, to designate who will receive distribution of the trust to which the power applies, in what proportions, and in what manner (i.e., outright or in trust). Typically, the power is exercisable in favor of the issue of the deceased spouse, although the permissible appointees could be any limited set of people or organizations.

[4] Such a transfer will not be a taxable gift, regardless how large, because gifts between spouses in any amount qualify for the gift tax marital deduction.