Congressional Inaction on Estate Tax May Require Attention

What Didn’t Happen?

Estate planning professionals across the country are amazed that Congress adjourned in December without resolving a serious tax problem due to occur on January 1, 2010. Under a tax bill passed in 2001, the estate and generation skipping transfer (GST) taxes will be repealed in 2010, and then re-enacted in 2011 at higher rates with lower exemptions than under current law. With this comes a companion one year change in the income tax basis rules applicable to property passing at death, leading to higher income tax on subsequent sales of inherited assets than in the past. The federal gift tax remains in place, with the top rate declining, only to go much higher in 2011.

It was widely expected that Congress would not leave Americans with this confusing state of affairs, and would act to continue the estate, gift and generation-skipping transfer tax system through 2010. The complexities of these new income tax “carryover basis” rules are viewed by tax professionals as so unworkable that few expected Congress would let them ever become effective. However, although the House passed a bill in December that would have resolved this situation, the Senate did not take action before adjournment, and the 2001 legislation takes effect on January 1.

What does the law provide for 2010?

The key features of the new law are, in general:

• No estate tax applies to estates of those who die in 2010.
• No GST tax applies to GST transfers in 2010.
• Gift tax applies to gifts made in 2010, with a 35% top rate and a $1 million lifetime credit.
• Assets in an estate of a person dying in 2010 get no new income tax basis equal to their value at death, as under current law. The decedent’s own basis carries over to the recipients. Estate executors can allocate up to $1.3 million to assets to reduce the impact of the rule, and another $3 million to assets left to spouses.
• In 2011, the estate and GST taxes return at a top rate of 55%, with a 5% estate tax surcharge on estates between $10 – 17.2 million, and a $1 million exemption. The current system of granting a new basis equal to date of death value (often a helpful “step-up”) returns to replace the carry-over basis regime. The top gift tax rate goes to 55%, with a $1 million exemption.

Most estate planning professionals think that Congress will act early in 2010 to continue the current estate and GST tax system, repeal the temporary carryover basis rules, and prevent the higher rates and lower exemptions from becoming effective in 2011. Some members of Congress stated late in December that they would work toward legislation to do this. However, there is no guarantee that Congress will so act, or whether it would make any re-enactment of the system retroactive to January 1. If Congress does act to make a re-enactment retroactive, there almost certainly will be litigation challenging its validity.

What to do?

Since there will be a period of time in 2010 when these new rules will apply, before there is congressional action (if any), we are suggesting to all of our clients that they do the following:

• Individuals and their estate planning attorneys should review the individual’s current estate planning documents to ensure that the division of assets to beneficiaries will in fact occur as intended were a death to occur in 2010 subject to these new tax rules. Some documents, particularly (but not exclusively) in the case of married couples, may refer to estate and GST tax provisions that will not exist in 2010. This creates the risk that these documents may not operate as intended.
• With the advice of their estate planning attorneys, individuals should consider whether to take advantage of the $1.3 and $3 million basis increase allocation rules to reduce the negative impact of the new carryover basis regime.
• Consider whether these new rules may offer tax planning opportunities while they remain in effect; for example, whether an individual can take advantage of the new, lower 35% top gift tax rate and the repeal of the GST tax.

We are closely monitoring this situation. We are recommending that our firm’s estate planning clients contact us and ask that we review their estate planning documents to determine whether there is now a risk that they do not accomplish the client’s objectives. We will be advising those clients whether they are at risk if their documents are not amended. Also, we are prepared to advise our clients who would like us to consider the potential planning opportunities. Since it is unknown how long these rules will stay in place next year, quick action may be needed.

In summary, these changes create the risk that current estate planning documents may not carry out an individual’s objectives beginning in 2010. We recommend that individuals contact their estate planning attorneys as soon as possible and request that documents be reviewed to determine whether they are at risk without amendment. If so, documents can be amended to make changes appropriate to an individual’s circumstances and given the current uncertainty in the law.

This publication is for informational purposes only and is not intended to provide legal or tax advice, or to create an attorney-client relationship.

Pursuant to IRS Circular 230, unless expressly stated to the contrary, any tax advice is not intended and cannot be used to (i) avoid penalties under the Internal Revenue Code or (ii) promote, market or recommend any transaction or matter to another party.