Estate Planning in Times of Unprecedented Uncertainty

In December, 2009, the House of Representatives passed a bill to preserve the estate and gift tax rules in effect in 2009. (Under 2009 law, the top estate and GST tax rate was 45% and the exemption was $3,500,000.) The Senate failed to act. Hence, the estate and GST taxes expired. Some legislators have announced their intention to restore the estate and GST tax retroactive to January 1, 2010. It is possible, and perhaps likely, that someone affected by a retroactive reinstatement of the taxes may claim that it is unconstitutional for Congress to pass legislation with a retroactive effective date. However, the Supreme Court has given broad latitude to Congress to enact retroactive tax legislation. Therefore, it is unwise to implement a plan that relies on any such constitutional claim being successful.

The 2001 legislation repealed the rule that assets inherited from a decedent acquire a new income tax basis equal to the value of the assets acquired from the decedent, effective for persons dying after December 31, 2009. Instead, assets acquired from a decedent have the same basis the decedent had, with limited adjustments. This is referred to as “modified carryover basis.” Like the repeal of the estate and GST taxes, the modified carryover basis rule will be in effect only for one year unless Congress acts to extend the rule. Beginning January 1, 2010, the old basis rules will be restored as if the 2001 legislation had never been enacted.

The purpose of this Advisory is to advise you of steps you may need to take to protect your estate plan in light of the temporary repeal of the estate and GST taxes and implementation of the modified carryover basis regime and so that you may arrange to discuss with us possible planning opportunities during the one-year period these rules may be in effect (the “gap period”). We say “may be in effect” due to the possibility that the taxes will be restored this year, possibly retroactively to January 1, 2010.

Steps to Take to Protect Your Estate Plan
It is very common for wills and revocable trusts to define bequests by reference to the estate tax law. These definitions may not work as intended if a person dies when the estate tax is not in effect. For example, if a will leaves a surviving spouse the smallest amount necessary to reduce federal estate tax to a minimum, the spouse may receive nothing. If a will leaves a trust an amount equal to the applicable exclusion amount (the amount exempt from federal estate tax), the trust may receive nothing. If a will leaves grandchildren the largest amount that can pass to grandchildren without incurring GST tax, the grandchildren could take the entire estate. If a will leaves grandchildren an amount equal to the GST tax exemption in effect at the person’s death, that amount may be zero.

If your will or revocable trust contains an alternate disposition that is effective in the event the estate and GST tax is not in effect, then you may not need to change your estate planning documents. However, if your will and revocable trust do not plan for this state of affairs, you should have your estate planning documents reviewed as soon as possible.

A change to your estate plan may be necessary not only to make sure that the estate is allocated among beneficiaries as intended, but also to preserve the benefit of a $3,000,000 income tax basis adjustment. Effective for persons dying after January 1, 2010, assets inherited from a deceased person retain the decedent’s income tax basis with two adjustments. (Under the law in effect in prior years, assets acquire a basis equal to date of death value.) All decedents’ estates are allowed an adjustment up to the lesser of $1,300,000 or date of death value. (The $1,300,000 amount is increased for loss carryforwards and unrealized losses.) An additional $3,000,000 adjustment is allowed only for assets passing to a spouse or to a trust that gives a spouse a qualifying income interest for life. For example, if the entire estate passes to a trust for the surviving spouse and descendants, there may be no estate tax consequence but the additional basis adjustment will be lost. An amendment to your will or revocable trust could cure this problem by making sure that sufficient assets pass to your spouse or to a trust for your spouse to take advantage of this additional basis adjustment.

A change to your estate planning documents also may be necessary to avoid incurring state estate taxes. Some states no longer impose a state estate tax, but others do. For persons resident in states that do impose estate tax or who own real estate in states that impose estate tax, the state estate tax consequences of not having assets qualify for the marital deduction for state estate tax purposes should be evaluated.

Planning Opportunities
If you were planning to make a taxable gift, now is a good time to do so. The tax rate is 35% rather than 45%. It is possible that the rate will increase retroactively, but if you were planning to make a gift anyway, you may succeed in paying lower gift tax if you make the gift now.

A gift to a “skip person” (as defined under the GST tax law, such as a grandchild) will be taxed at the maximum rate of 35% if the GST tax does not apply. Under 2009 law, when the GST tax was in effect, the combined top rate of gift and GST tax was 65.25%. This is a huge savings. However, if the GST tax is restored retroactively, the higher tax rate will apply. In addition, the safest way to make a gift to a grandchild is outright and free of trust. A gift to a trust for one or more grandchildren presents a problem. Even if the gift to the trust would escape GST tax (because the tax was not restored retroactively), a distribution from the trust to a skip person will likely incur GST tax if that tax is restored before the distribution occurs.

A distribution from a trust to a skip person made when the GST tax was not in effect would avoid GST tax on such distributions. However, if the GST tax is restored retroactively, the distribution will be taxable.

One possible planning option is to make a gift to a trust for your spouse that qualifies for the marital deduction. The trust could provide that if the donee spouse disclaims the gift, the disclaimed assets pass to another person, including a skip person. A disclaimer will not have tax consequences if it is made within nine months of the trust’s creation. This allows the couple additional time to see what Congress will do about these taxes. However, there is some speculation that Congress may not act until after the midterm elections. If that happens, the decision about making a disclaimer may have to be made before the fate of the taxes is known. On the other hand, if the disclaimer is not made, there is no tax or other disadvantage, so it is a strategy that may be worthwhile trying.

If a married person is terminally ill and does not have assets with sufficient unrealized appreciation to take advantage of the basis adjustments allowed under the law in effect in 2010, his or her spouse may transfer such assets to the other spouse and the basis adjustment will be allowed. Even “deathbed” transfers between spouses will be effective.

Basis adjustments are allowed only for assets “owned by” the decedent. The “owned by” requirement is not satisfied where the decedent is the beneficial owner of assets owned by a trust. Therefore, distribution of appreciated assets from trusts may be necessary to take full advantage of basis adjustments. Trusts should be drafted to give trustees the authority to make such distributions to a beneficiary to allow basis adjustments upon a beneficiary’s death.

Most importantly, records need to be kept on the income tax basis of assets. After a person dies, it will be much more difficult to assemble the information needed to determine the income tax basis of a decedent’s assets. In addition, an executor’s decision on how to allocate basis adjustments could create controversy among heirs and it is advisable for a will or revocable trust to give guidance on this issue and exonerate the executor from liability for his or her decisions about allocations.

Restoration of Pre-2001 Law
If, as is currently slated, pre-2001 law is restored on January 1, 2011, there are a number of issues that will arise, particularly concerning the GST tax law. The 2001 legislation increased the GST tax exemption and adopted taxpayer-friendly rules for the allocation of that exemption. Those rules will be treated as never having come into effect unless Congress acts to change the law. This rule could adversely affect the taxation of trusts that benefit skip persons.

Interestingly, the restoration of pre-2001 law may also restore the basis adjustment to fair market value that is available for assets inherited from a decedent. Thus, it may be a good idea to postpone disposing of assets inherited from a person who died in 2010 until 2011. To avoid the risk of investment losses, the estate could enter into arrangements, such as covered calls, that are not taxable dispositions.

Conclusion
The problems discussed in this Advisory have the potential for creating severe dislocations in estate plans. Only a review of your particular situation will truly clarify if the new law changes the distribution of your estate in a way you do not intend, or if the new law creates ambiguities in your documents which could lead to court proceedings unless resolved now.

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