• April 2010

As laws change, legal expert Stephan Nicholas explains how you can adapt

By Stefan C. Nicholas
Logan H. Winn and Jedediah R. Bodger, Jackson & Campbell, P.C.

For the past few years, the joke among estate planning practitioners and their clients had been that 2010 would be a good year to die.

The one-year “death” of the estate tax, however, has been greatly exaggerated. The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) actually put in place a much more complex and burdensome estate and gift tax system that will impact more taxpayers than the traditional estate tax and has caused so much uncertainty that 2010 may be anything but a good year to go gently into the quiet night.

The current state of affairs has made many, including many members of Congress, yearn for the simpler days of the estate tax.

Key issues

The key issue at hand involves a provision that “repealed” the estate tax for only one year – this year, 2010 – although the estate tax may be retroactively reinstated at any time. Yes, it’s really that confusing. Congress failed to act prior to the end of 2009 to extend the estate tax, despite repeated promises to do so.

Moreover, if Congress fails to act prior to the end of 2010, the estate tax will return in 2011, but not as it was in 2009, rather as it was prior to 2001. Did you follow all of that? This state of confusion and uncertainty is the unintended, and unwanted, legacy of EGTRRA. What, if anything, should you do about it?

The State of the Law

Prior to January 1, 2010, each U.S. person could have given away during their lifetime up to $1 million free of gift tax during life, or at death a total of $3.5 million worth of property free of estate tax. Gifts and inheritances over those amounts were taxed at 45 percent.

Additionally, prior federal tax law provided for an unlimited marital deduction. This meant that each U.S. person could have transferred an unlimited amount of property between spouses without incurring any federal estate taxes. Combining the $3.5 million exemption with the unlimited marital deduction meant that a married couple could have a combined estate of $7 million, which passed tax-free (for federal purposes) at the death of the second spouse to die.

In 2010, there is currently no estate tax and the top marginal rate for the gift tax is 35 percent. Without further action, in 2011, there will be a reduced estate tax exemption of $1 million per person and a top marginal rate of 55 percent (with an additional 5 percent surtax for certain large estates).

And there’s more.

• The federal gift tax exemption will remain fixed at $1 million, but gifts over that amount will be taxed at an increased rate of 55 percent rate beginning in 2011.

• In addition to the repeal of the estate tax, new “basis” rules are in effect for estates inherited in 2010. Prior to 2010, assets transferred at death were transferred with a basis equal to the assets’ fair market value at the date of the decedent’s death.

• Any appreciation realized by the donor was essentially forgiven and passed tax-free. This “step up” in basis has been repealed and replaced with “modified carryover” basis rules.

In short, for the year 2010, any property owned by a decedent is transferred to the recipient with the decedent’s basis (i.e., the original purchase price).

Therefore, although exempt from estate and gift tax, the assets received may be exposed to capital gains taxes when the inherited property is sold by the recipient, to the extent that the gain exceeds $3 million for assets transferred to a spouse and $1.3 million for assets transferred to anyone else, such as children, with gains calculated from the assets’ original purchase price.

This switch to “modified carryover” basis rules from “stepped-up” basis rules is one of the major changes to be aware of for 2010. In 2011, the “step-up” in basis rules will return along with the estate tax.

How do these changes impact you and your current or anticipated estate planning?

As noted, no one expected such legislative inaction and estate planning practitioners are now trying to grapple with the unintended consequences of EGTRRA. Congress is looking at ways to fix the problem, including the possibility of retroactive legislation.

This solution will almost certainly lead to litigation, which will only lengthen the current state of confusion. Fear not, there may be some concrete steps you can take now.

Planning in light of the 2010 laws:

  • 1. Make gifts, especially gifts to grandchildren.* The generation-skipping transfer (“GST”) tax is a federal tax that may apply to gifts or bequests that “skip” a generation. A typical example of a generation-skipping transfer is a gift to a grandchild.

Under current law, as with the estate tax, the GST tax has been repealed, and the gift tax has been lowered to 35%. This means gifts that would have previously triggered a GST tax will now avoid such tax, and be taxed at a lower gift tax rate.

For example, a testamentary transfer of $5 million in 2009 to a grandchild would have been subject to $675,000 of GST tax ($5 million minus $3.5 million exemption = $1.5 million x 45% tax rate), as well as a gift tax of $1.8 million ($5 million minus $1 million exemption x 45% tax rate) for a total of $2.475 million in taxes to Uncle Sam.

In 2010, the same gift would be subject to only the gift tax, and the tax on the transfer would be only 35%. So the same gift the year has a tax of only $1.4 million. This provides a tax savings of $1.075 million. Not bad.

2. Review current documents. Many Wills and Revocable Trusts are drafted with formula clauses, or other various types of contingency planning that were designed to provide flexibility in the event of changes to the tax law.

These clauses have become somewhat of a trap for the unprepared. With no federal estate tax “exemption amount,” (i.e., the amount that can pass free from federal estate tax) a clause in a Will requiring property to fund a “family trust” (generally a trust for the surviving spouse and children of the testator) to include assets of the estate over the exemption amount, with the balance passing to the surviving spouse could result in the creation of a family trust with $0 and all assets passing outright to the surviving spouse.

In such an example, the surviving spouse now faces a larger estate tax liability upon his or her subsequent death, and in addition, loses the creditor protection afforded the family trust.

The reverse can be true too, depending on how the clause is worded. The only way to prevent disastrous results of disinheriting either your spouse or your children, especially if you are in a second marriage, is to discuss the current structure with your advisor, and make sure that your estate plan is amended accordingly.

3. Sales to Grantor Trusts. An intentionally defective grantor trust is an irrevocable trust for the benefit of your descendants that is “defective” for income tax purposes but “effective” for estate tax purposes.

In other words, you would continue paying the income taxes of the trust but the assets would not be included in your taxable estate at death. Sales of assets to grantor trusts is a time tested method of transferring assets in a tax efficient manner that does not appear to be affected by the repeal of the estate and GST taxes.

Risks in light of the 2010 laws

  • Retroactive Legislation: As noted above, new legislation may be enacted at any time, and new legislation may invalidate any actions taken in the interim, even without an estate tax in place. The constitutionality of this legislation will almost certainly be litigated all the way to the Supreme Court. Because of this, uncertainty and risk remain with any action taken in 2010 not carefully reviewed with your advisor.
  • GST Planning: The reinstatement of the GST tax may be applicable to distributions from trusts in future years, even if the transfer into the trust is completed in 2010, and not subject to GST taxes today. Thus, a future distribution may be subject to a high rate of taxation when distributed to the beneficiary.
  • Carryover basis regime: As noted above, a new carryover basis regime has been put in place. Previously, an asset’s basis was determined at the transferor’s death, and was stepped up to the then fair market value of the asset. Currently, the value of an asset will be the basis of the asset at the transferor’s death, increased only by allowable basis allocation.

This is a complex system, and requires careful planning and asset allocation. Discussing how to allocate your assets and gain step-up should be a conversation between you, your attorney, your wealth planning advisor and your CPA.

The Bottom Line

Although we are faced with uncertainty until Congress finally attends to the estate tax, at a minimum your existing estate planning documents should be reviewed to ascertain the effects of the one year repeal on your individual plan.

Unfortunately, there is no one size that fits all “band-aid,” but your advisors can help you avoid any unintended estate and gift tax consequences in 2010, as well as take advantages of any of the benefits to you during the one year “repeal.”

About Stefan C. Nicholas

Stefan C. Nicholas is a Director and chair of Jackson & Campbell’s Estates and Trusts practice group and a member of the Business Law practice group. He has extensive experience in drafting wills, trusts and all ancillary documents in connection with estate and gift tax planning, as well as asset protection planning including both on- and off-shore asset protection trusts and the use of corporate entities. Stefan also has extensive experience with sophisticated wealth transfer techniques such as grantor retained interest trusts, qualified personal residence trusts and defective grantor trusts.

In addition, Stefan specializes in developing exit planning strategies for business owners, and has counseled clients on estate planning, business succession planning and asset protection planning with an emphasis on managing the tax impact that liquidity events have on a client’s personal assets. He has guided clients on completing mergers, acquisitions and divestitures and has negotiated partnership, management, shareholder, employment and confidentiality agreements on behalf of numerous clients.

Stefan earned his J.D. from the University of Virginia School of Law, where he was a member of the Moore Society of International Law and the Black Law Students Association. Before that, Stefan earned his Master in Foreign Affairs from the University of Virginia Wilson School of Foreign Affairs. He received a B.A. in International Relations from Georgetown University, which he followed with academic stints in Prague in the Czech Republic and Berlin, Germany, where he earned a Certificate of German Language and Culture from the Goethe Institute.

Stefan is admitted to practice in the District of Columbia and the State of New York.

Stefan is a member of the American Bar Association and the Estates and Trusts Bar of the District of Columbia. He is a member of the Wealth Counsel and the Business Enterprise Institute, and is currently Treasurer and a member of the Board of Directors for DC Vote and the Chairman of the Board of the Hilda & Charles Mason Charitable Foundation. Stefan also serves on the Advisory Board for Eagle Bank and the George Washington Cancer Institute, as well as the Alumni Board for Georgetown Day School.