The 2010 federal estate tax repeal has been nine years in the making, yet we can honestly say that no one saw it coming. Virtually all estate planning professionals and politicos predicted that the repeal would never occur and that a tax-reform package would provide some certainty to the future of estate planning.  However, Congress did not act.  

The "repeal" of the federal estate tax in 2010 is one step in a larger scheme enacted by Congress in 2001 which gradually increased the estate tax and generation skipping transfer ("GST") tax exemption amounts from $1,000,000 in 2002 to $3,500,000 in 2009, and ultimately to an unlimited exemption in 2010. The federal gift tax continues for 2010, with the rules enacted in 2001 being effective.  In addition, assets included in the estates of decedents dying in 2010 will receive a limited adjustment in the income-tax basis of such assets to date of death value (i.e., the so-called carryover basis rules have taken effect).  Beginning in 2011, the estate tax and GST tax return, with the exemption for each returning to the $1,000,000 amount that existed in 2002.  Thus, rather than characterize this as a repeal, perhaps it is more accurate to simply state that the federal estate tax does not apply to estates of those who die in 2010.  While the elimination of the federal estate tax in 2010 may generally sound like a good thing for taxpayers, it very well may have some unintended consequences.

The most prominent problems could arise where bequests under estate planning documents are based upon the maximum allowable estate and GST tax exemptions.  In such circumstances, a taxpayer's spouse and/or children could be unintentionally disinherited.  Estate plans should be revisited to review tax planning provisions.  

While the federal estate and GST tax exemptions in 2010 are unlimited, the federal gift tax exemption remains at $1,000,000.  The gift tax rate, however, has decreased to 35%.  This rate decrease could offer certain taxpayers an incentive to make significant lifetime gifts.  

One of the trade-offs of the elimination of the federal estate tax in 2010 is the reduction of the step-up in basis of assets owned at death.  For decedents dying in 2009 and prior years, the appreciation on capital assets owned by a decedent was wiped out at death.  For decedents dying in 2010, this adjustment in basis to fair market value has been eliminated. Generally heirs and beneficiaries will receive the carryover basis of inherited assets, with two exceptions: (1) a decedent's executor can allocate up to $1,300,000 worth of "basis" to assets passing from the decedent to any person; and (2) the executor can allocate up to $3,000,000 worth of "basis" to assets passing from the decedent to the surviving spouse or to certain trusts for the benefit of the surviving spouse. Executors will be faced with difficult decisions about how to apportion this basis among assets and heirs.  

It is important to remember that the 2010 repeal only applies to federal estate taxes.  Although there is no state estate tax in Florida, the estate tax in states like Massachusetts, New York, New Jersey and Rhode Island is still alive and well.  The traditional planning to eliminate or defer state estate taxes remains of critical importance in saving state tax dollars, and estate plans should be reviewed to ensure that this planning is adequate.  

A great deal of analysis continues over whether Congress can and will pass a law in 2010 which reinstates the federal estate tax for estates of decedents dying in 2010.  Some in Congress have promised to take this matter up quickly this month and provide for retroactive re-enactment of these taxes.  President Obama has included a retroactive reinstatement of the estate tax to its 2009 limits in the recently released budget.  There has been some discussion of the possible challenge of a retroactively imposed tax based on Constitutional grounds. In August 1993, President Clinton signed a bill that extended an additional 5-percent surcharge to the federal estate and GST taxes and made the provision retroactive to January 1 of that year.  There was a Constitutional challenge to that provision that was ultimately denied, but the court's decision was based on the plaintiff's standing to bring the suit, not on the Constitutional issue.  Certainly, there have been and will be decedents' estates from deaths early this year that will become subject to a retroactive estate tax that would satisfy the standing requirements to bring a similar suit.  

There are several interesting scenarios which could play out with regard to the current status of the law:

Retroactive Re-enactment of the Estate Tax.  This result (assuming the Constitutional issue can be resolved) has the appeal of simplicity and providing certainty for estate planning.  The amount of the exemption and the maximum tax rate are certainly going to be subject to debate and the Senate will probably push for a higher exemption and lower maximum rate. There have been several alternatives proposed in the previous few years, with exemptions ranging from $2 to $5 million and rates from as low as 15 percent up to 55 percent in one proposal.  However, there are other potential modifications to the wealth transfer tax that might work their way into legislation, which are discussed below.

Reintroduction of Graduated Marginal Estate Tax Rates.  Due to the size of the exemption amount and the current rate table, the estate tax has been imposed at 45 percent for the last few years.  The effective rate actually paid is far lower due to the exemption and other estate-tax reduction planning techniques.  One recent proposal contained graduated rates above the exemption amount with the highest marginal rate of 55 percent effective for estate amounts over $10 million.  This type of proposal adds some complexity, but unless the deficit concerns become paramount in the eyes of the legislators, it is unlikely that the estate-tax rate will be increased above the 2009 level.

Re-unification of the Estate and Gift Tax.  The 2009 level of exemption for estate was $3.5 million while lifetime taxable gifts are only exempt up to a cumulative total of $1 million.  There have been proposals to unify the exemption amount.  It seems unlikely that the estate-tax exemption will be lowered to as little as $1 million, even though current law would have the estate-tax exemption at this level in 2011 and thereafter.  It certainly would be helpful for the succession planning for the owners of family businesses and farms if the gift-tax exemption was increased commensurate with the estate-tax exemption.  However, it is also very difficult to forecast the revenue loss for this type of tax reduction.

Portability of Estate-Tax Exemption to a Surviving Spouse.  One proposal contained in some prior reform bills that did not pass would allow a surviving spouse to use the estate-tax exemption of a deceased spouse who did not use his or her full exemption at the time of death.  This provision would simplify the estate planning for some couples since it would eliminate the need to create a formula will or living trust that create an exemption trust at the first death.  It would also eliminate the need for some couples to re-title or separate assets from joint ownership.  For example, assume a married couple has $7 million (assume the exemption will be re-instated at $3.5 million) owned jointly with rights of survivorship. When the first spouse dies, the $3.5 million exemption amount of the decedent will not be used since the surviving spouse receives the whole estate by operation of law and the transfer is completely deductible as a result of the estate-tax marital deduction.  However, the surviving spouse would have a $7 million exemption at the second death.This type of change has merit, but will result in tax revenue loss because the current planning techniques to use both exemptions are often ignored or inappropriate in many scenarios.  

State Estate or Inheritance Taxes.  The state death tax credit was phased out in 2001.  In 2009, the state death taxes paid were allowable as a deduction from the federal estate tax base.  It seems unlikely that any reform will re-enact the state death tax credit because this would shift federal tax dollars directly to the states.  However, most of the prior attempts to reform the estate tax would have kept the deduction for state estate or inheritance tax paid by the estate.

Other Miscellaneous Reform Issues.  The Treasury generally is asked to produce items that are potential revenue raisers when reform is proposed. Hopefully, these items also coincide with goals of fairness and simplicity. It's worth mentioning a few changes that have been discussed by Congress. 

First, family limited partnerships (FLPs) could be limited in providing valuation discounts for gift or estate tax purposes.  The discussion has primarily focused on entities formed without any business activities where the entity holds only investment assets.

A second possibility is requiring a minimum time period (e.g., 10 years) for grantor-retained annuity trusts (GRATs).  Actuarial principles used to value the gift component of a GRAT combined with appropriate investment yield have resulted in transfer-tax free wealth transfers in some circumstances for short-term GRATs.  

Finally, reform might place a greater compliance burden on an estate's personal representative for reporting income-tax basis to heirs who inherit property.

No New Reform Legislation.  This would seem to make the least sense. For deaths in 2010, there would be no estate taxation.  However, the heirs would take property with a modified carryover basis.  The executor is allowed to add $1.3 million to the basis of estate assets.  An additional $3 million of basis can be added to the assets inherited by a surviving spouse. Certain assets, such as previously untaxed monies in retirement plans or IRAs, cannot receive any of the discretionary basis increase.  Hence, the wealth transfer tax is replaced by a long-term capital gain tax (currently imposed at no greater than 15 percent) and the tax is only imposed when the estate or the heirs sell the property.  The executor has the requirement to file a return, that has not yet been developed, to report the adjusted income-tax basis of estate assets to the IRS and the heirs. Under the current law, this carryover basis is gone after 2010 and, as we discussed above, the federal estate tax would return with rules from 2001.  This would limit the estate exemption to $1 million and have a maximum rate of 55 percent (with an additional 5 percent surcharge to some large estates).Obviously, having a new tax compliance requirement in place for one-year only followed by a substantial estate-tax increase would seem to be politically infeasible.  On the other hand, there have been greater surprises in the past.

Planning Implications

It will be very important moving forward to stay abreast of the legislative proposals and be prepared to react.  Professional advice is essential and it will be important to get this advice at the time any legislation appears headed to passage (or existing law seems certain due to inaction).  The taxes that might be imposed on an estate are potentially enormous and mistakes cannot be cured in many instances.  Here are a few pieces of advice we'd like to pass along:

●        Absent a deathbed scenario, do not rush to take action or unwind prior planning.

●        Estate planning goals should be the same regardless of tax burdens.  The dispositive goals should drive the plan and the estate owner should answer the "Who", "How", and "When" questions with the assistance of an advisory team.  The tax minimization techniques should be applied only after the primary goals have been determined.

●        Prior estate plans may be fine or may just require a small tune-up.  A good estate plan should have been designed to be valid for the indefinite future.  There may be great dispositive reasons to keep existing trust structures in place.  Trusts are formed for many reasons other than taxes.  Assets placed in irrevocable trusts, such as a life insurance policy, have investment and asset security value irrespective of the form of the wealth transfer tax.

●        Expect more change to taxation in the future.  The previous version of the wealth transfer tax began over 30 years ago.  It is unlikely with rapid shifts in the political climate and a large national debt that anything enacted this year will have the same stability.