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Estate Planning For 2010 And Beyond

Almost no one believed it would happen, but here we are: For the first time since 1915, the United States has no federal estate tax.

Congressional action nine years ago created the potential for this situation, and congressional inaction last year made it happen. At the 44th annual Heckerling Institute on Estate Planning, which I recently attended, many of the planners present were worried about their jobs. Not us. The failure of Congress to act before the estate tax was repealed for this year creates as much confusion, opportunity and planning work as the tax itself did.

Because Congress before the end of 2009 did not address the “sunset” provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the estate tax and generation-skipping transfer (GST) tax were allowed to lapse for this year. Next year, unless legislation changes things, the provisions of EGTRRA will expire and we will return to the transfer tax laws (generally, estate, gift and GST taxes) of pre-2002.

So in 2011, the rules would revert to a $1 million applicable exclusion for the gift and estate taxes, and a higher 55 percent tax rate, compared with the $3.5 million estate tax exemption and the 45 percent rate of 2009. The applicable exclusion is the sum of lifetime transfers plus assets passing at death that an individual can transfer without being subject to estate tax. The following table summarizes the transfer tax situation.

Estate Tax Chart

What does this mean for high-net-worth families? Currently, not much. This is because no one knows whether Congress will impose a tax this year retroactive to Jan. 1, effectively keeping the transfer tax laws consistent with those of last year. If lawmakers did pass such a tax, would it withstand a constitutional challenge? The answer is unknowable. This article will not discuss the myriad “what-ifs” of potential gift and estate tax legislation, but instead will focus on ways to deal with the uncertainty and to take advantage of the possible tax holiday.

The massive uncertainty created by Congress’s inaction has many planners and their clients paralyzed by confusion. For the most part, this is fine, because unless an individual is in poor health and likely to pass away before the end of the year, this temporary situation will have little impact. By Jan. 1, 2011, we will know what the estate tax looks like. For young and healthy clients, a “wait-and-see” approach is adequate, if not ideal.

However, there are some important actions clients and their advisors should take now. Even though most people were aware of the sunset provisions of EGTRRA, few built language into their estate-planning documents, including wills and trusts, to account for a situation in which there would be no estate tax. Therefore, planners and individuals should look at those documents to ensure that in the event of an untimely passing in 2010, assets won’t be disposed of in a way contrary to the individual’s intent.

An example of this can be found in the use of formula clauses included in many wills. Such language may read, “My executor is to fund the Mr. Smith Family Trust with the largest value that can pass free of federal estate tax by reason of the applicable exclusion amount” with the remainder going to the spouse outright. In 2010, the term “applicable exclusion amount” does not exist in the tax code. Therefore, in this scenario, the Mr. Smith Family Trust would receive no assets and all assets would pass to the surviving spouse.

The reverse could also occur. The language funding the trust might read, “...fund the Mr. Smith Family Trust with the maximum amount that can pass free of federal estate tax.” In this scenario, all the assets could pass into the trust without estate tax, leaving the surviving spouse out in the cold. If your spouse’s will currently says this, you may want to start being really nice to your kids.

A solution to the formula clause problem used by many practitioners is to add a simple codicil, or amendment, to the will stating something to the effect of “If the federal estate tax is not in effect at my death, then I intend all provisions of this Will to be given the same force and effect as if I had died in 2009, and to be interpreted under the law as it existed in 2009.” It is up to the executor, the trustees and the courts to decide how the dispositive provisions of the will are to be read. Such a codicil will clarify the decedent’s intent.

Another way to protect against one class of beneficiaries being completely excluded upon a 2010 death is the use of qualified disclaimers. The Internal Revenue Service provides that if a beneficiary takes no possession or use of the inherited property, he or she can disclaim the right to own it. When a beneficiary executes a qualified disclaimer within nine months of the decedent’s date of death, the assets pass to the contingent beneficiary. In the first example, where the surviving spouse inherits all of the assets and the children get nothing, the spouse could disclaim an amount that would then pass to the family trust. This strategy may not work for everyone, though, because among the requirements of a qualified disclaimer is that the beneficiary have no say in directing where the disclaimed assets go. The executor or trustee must look to the provisions of the governing document.

So far, this is a pretty cautionary picture of the estate-planning environment in 2010. However, whenever there are drastic changes, there is also opportunity. For clients looking to transfer wealth to younger generations, the possibility of making gifts in 2010 is enticing. Such gifts may be taxed at the current 35 percent rate, rather than the 45 percent many expect in future legislation or the 55 percent that will kick in next year without further legislative developments. Only individuals who are not risk-averse should use this strategy, because, as mentioned above, Congress could impose a retroactive tax this year. Only those willing to accept a 45 percent tax, should one be enacted, should make gifts now to capitalize on the current lower rate.

Quite possibly the largest opportunity presented in this last year of the Bush-era legislation is the absence of a GST tax in 2010. Previously, gifts made to individuals two or more generations below the donor, or more than 37.5 years younger for unrelated individuals, were not only subject to the regular gift tax, but also to the GST tax. Such gifts are called “direct skips.” The GST lifetime exemption was $3.5 million in 2009, allowing donors to make such gifts up to that amount without paying any tax in cash. In 2010, for this one year, none of these issues exists, and this could be a once-in-a-lifetime chance for wealthy donors to make gifts to their grandkids free of generation-skipping tax.

This strategy is also quite risky. The same issue as with planning for the gift tax arises. If Congress retroactively reinstates the GST, generation-skipping gifts made with the intent of being tax-free could now be taxed at whatever GST rate is enacted. However, there may be more opportunities to protect against this risk this year. One planning technique to prevent the unintentional triggering of a GST tax would be to make gifts to a trust for the benefit of grandchildren, and include a provision that the amount of the gift is however much can pass free of GST tax. In the event the GST is reinstated, there would be no gift.

All of the strategies described above are highly complex and subject to far more technical tax issues than can be fully explored here. Any changes to existing documents or creation of new plans should be overseen by an experienced estate planner.

The failure of Congress to act before the end of 2009 created a great deal of confusion and uncertainty. However, rather than giving in to paralysis, advisors and their clients should view the change as a reminder to ensure that their plans properly address the environment. The changes in the law also present opportunities to reap significant tax savings with prudent planning.

Vice President Eric Meeermann, who is based in our Stamford, Connecticut office, is the author of several chapters in our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 11, "Social Security And Medicare"; Chapter 18, "Philanthropy"; and Chapter 19, "A Second Act: Starting A New Venture." He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.