On January 1, 2010, highly unexpected changes to the Internal Revenue Code went into effect that may have adverse impacts on existing estate plans. This Client Alert provides an overview of those changes, discusses how those changes may adversely impact existing estate plans, and identifies planning opportunities that those changes have created.
Federal Estate, Gift and Generation-Skipping Transfer Taxes in 2010
Despite indications from Congressional leaders that they would address the issue before the holiday recess, the federal estate and generation-skipping transfer (“GST”) taxes were temporarily repealed on January 1, 2010. As a result, unless Congress enacts new legislation, no federal estate tax will be imposed on the estates of individuals dying in 2010 and no GST tax will be imposed on transfers made in 2010. Both taxes are only scheduled to be repealed for one year and, absent further Congressional action, will be reinstated on January 1, 2011.
While the repeal of the estate and GST taxes, even if temporary, may appear to be good news for taxpayers, the repeal of these taxes is not without consequences. For example, with certain exceptions, the income tax basis for property acquired from a decedent in 2010 will be the decedent’s adjusted basis or the fair market value of the property on the date of the decedent’s death, whichever is lower. This new provision, which is known as the “carryover” basis rule, replaces the “stepped-up” basis rule and may result in higher capital gains taxes being imposed when inherited property is sold. The “carryover” basis rule also permits a personal representative to allocate up to $1.3 million in increased basis to the decedent’s assets in general and, in certain circumstances, an additional $3 million in increased basis to assets passing to a surviving spouse who is a U.S. citizen.
The temporary repeal of the estate and GST taxes does not affect the federal gift tax, which will continue to be imposed on taxable gifts made in 2010 that are in excess of the $13,000 annual exclusion amount per beneficiary and the $1 million lifetime exemption. For 2010, the top marginal gift tax rate has been reduced to 35 percent. However, unless Congress enacts new legislation (which may apply retroactively to January 1, 2010), this rate reduction is only scheduled to be temporary and the top marginal gift tax rate will rise to 55 percent on January 1, 2011.
What This Means for Existing Estate Plans
The repeal of the federal estate and GST taxes may have adverse impacts on existing estate plans. For example, many estate plans use formulas to determine the division of assets between different beneficiaries. Many of these formulas are based on the amount of the federal estate and GST tax exemption available in a given year. Because the federal estate and GST taxes have been temporarily repealed, a decedent’s estate plan may not allocate the decedent’s assets as originally intended if the decedent dies in 2010.
The following examples illustrate the potential for adverse impacts caused by the temporary repeal of the federal estate and GST taxes:
- Many estate plans provide for the funding of a Decedent’s Trust (also known as a Credit Bypass Trust) with the maximum amount that can be placed in that trust without incurring any estate tax. Last year, that meant that this trust would be funded with $3,500,000 (assuming no part of the unified credit was used up on lifetime gifts), but this year it could mean that the trust is funded with the entire amount of the deceased spouse’s separate property and one-half of community property. This may produce a result that is not intended, particularly where the beneficiary of the Decedent’s Trust is children, and where the amount in excess of the $3,500,000 was intended to be used for the benefit of the surviving spouse.
- Some estate plans provide for the funding of trusts for grandchildren with an amount equal to the decedent’s GST tax exemption. Last year, that meant that such trusts would be funded with $3,500,000 (assuming no part of the decedent’s GST tax exemption was used up on lifetime transfers), but this year it could mean that such trusts will not be funded at all. This may produce a result that is not intended, particularly where grandchildren are not otherwise provided for in the decedent’s estate plan.
- Some estate plans provide for the funding of a Decedent’s Trust (also known as a Credit Bypass Trust) with the maximum amount that can be placed in trust without incurring any estate tax, with the residue of the deceased’s estate going to charity. Last year, that meant that the Decedent’s Trust would be funded with $3,500,000 (assuming no part of the unified credit was used up on lifetime gifts) and that the balance of the decedent’s estate would go to charity, but this year it could mean that the Decedent’s Trust is funded with the decedent’s entire estate. This may produce a result that is not intended, particularly where the decedent did not make any other charitable contributions in his or her estate plan. (Depending on how the formula allocation between individuals and charities is worded in the applicable trust agreement, the converse may also be true and a charity may receive more than intended.)
The repeal of the GST tax may also have adverse impacts on individuals who plan to make lifetime gifts to trusts created for the benefit of their grandchildren and great-grandchildren in 2010 and individuals who incorporated generation-skipping transfers into their existing estate plans (including their revocable living trusts).
Moreover, due to the temporary elimination of the “stepped-up” basis rule, all estate plans should be carefully reviewed to ensure that the new “carryover” basis rule does not produce unintended results. For example, estate plans should be reviewed to ensure that assets left to a surviving spouse in trust will qualify for the additional $3 million in increased basis available to assets passing to a surviving spouse who is a U.S. citizen. Estate plans should also be reviewed to ensure that personal representatives and trustees have the appropriate authority and discretion to make any necessary allocation of increased basis that is provided by the “carryover” basis rule.
Individuals who own real property in states that impose a state estate tax (Arizona does not currently impose such a tax) or who may otherwise be subject to a state estate tax that is separate from the federal estate tax should also carefully review their estate plans to ensure that the repeal of the federal estate and GST taxes does not produce unintended consequences.
Adding to the uncertainty created by the temporary repeal of the estate and GST taxes is the fact that Congressional leaders have stated their intention to reinstate both taxes at their earliest opportunity. Some of these Congressional leaders have also indicated their desire to make the reinstatement of both taxes retroactive to January 1, 2010. The constitutionality of a retroactive imposition of the estate and GST taxes is unclear. In spite of this uncertainty, the temporary repeal of the GST tax may present planning opportunities for certain risk-tolerant individuals. For example, the repeal of the GST tax, coupled with a relatively low gift tax rate (35 percent), may present a good opportunity for certain individuals to make gifts to grandchildren and other descendants.
Legislative uncertainty aside, this may also be a good time to consider certain lifetime giving strategies that are particularly effective in this climate of low interest rates and depressed market values, such as loans to family members, grantor retained annuity trusts and charitable lead annuity trusts.
We strongly encourage our clients with questions about how the 2010 laws may impact their existing estate plan to contact us to discuss those questions, as the impact of the current laws varies based on the specifics of each individual plan. If you would like to discuss whether or not this is a good time for you to take advantage of any potential transfer tax planning opportunities, please let us know.
** IRS Circular 230 Disclosure: To ensure compliance with Treasury Department regulations, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is addressed in this document.
This Client Alert has been prepared by Lewis and Roca LLP for informational purposes only and is not legal advice. Readers should seek professional legal advice on matters involving these issues.
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