The Estate Tax Is Dead; Long Live the Estate Tax

By Jan P. Myskowski
This article originally appeared in the New Hampshire Bar News, March 19, 2010

Topics in this update:

  • New Hampshire and other State-level Estate Taxes
  • Impact on Modest Estates
  • Impact on Existing Estate Plans

Federal Estate Tax Update

Well, it happened. The New Year has arrived without any Congressional action on federal estate tax reform. Now what?

The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) has a ten year life span. 2010 is the tenth year. Most people are by now well-educated on what EGTRRA provided during the first nine years of its life, but not many thought we would get to the tenth year without further action by Congress. Very briefly, the law at this moment is as follows:

There is no federal estate tax imposed on estates of decedent’s dying in 2010;

  • There is no automatic step-up in basis on assets passing on death in 2010 (instead, the decedent’s basis will “carry over” to the recipient(s) of the assets);

To mitigate the increase in capital gains tax that will result from elimination of the automatic basis step-up, a decedent’s executor may allocate up to $1,300,000 in “floating” basis to assets that pass on death in 2010 (regardless of who inherits them), and may allocate an additional $3,000,000 in “floating” basis to assets that pass to a surviving spouse;

The federal gift tax is not repealed (but the top gift tax rate is reduced to 35% for 2010), and for gifts in 2010 the annual exclusion remains at $13,000, and the lifetime exemption remains at $1,000,000;

  • There is no generation-skipping transfer tax on generation-skipping transfers taking effect in 2010.

I used the phrase “at this moment” above because Congress may act during calendar year 2010 to change the law applicable to the estates of decedents dying in calendar year 2010. Here is the range of possibilities:

Congress may pass legislation later in 2010 that would reinstate the estate tax retroactive to January 1, 2010. We do not know for sure what form this new estate tax would take, but most commentators predict that it would look identical to what was in effect for calendar year 2009, meaning a $3,500,000 exemption and automatic basis step-up. Because there is no estate tax at this moment, this legislation would have the effect of imposing a new tax retroactively, which would almost certainly face constitutional challenge by the executors of estates of decedents who died during the period when no estate tax was in effect;

Congress may pass legislation later in 2010 that would reinstate the estate tax but only for deaths in 2010 that occur after the date of enactment.

Most likely, either type of legislation (retroactive, or prospective only) would be a permanent fix, meaning that whatever is passed would also apply to years after 2010;

  • Congress may take no action yet again, and EGTRRA will simply expire. In that event, the law in effect at this moment will apply to all deaths that occur in 2010, and deaths that occur in 2011 will be subject to the law that was in effect in 2001 prior to EGTRRA’s enactment (a federal estate tax with an exemption of $1,000,000).

New Hampshire and Other State-Level Estate Taxes

What about state-level estate taxes? Here is the state of affairs and range of possibilities there:

New Hampshire has a sponge tax on the books. A sponge tax is a state-level estate tax that collects at the state level whatever the federal government allows as a state death tax credit for federal estate tax purposes. EGTRRA eliminated the federal credit for state death taxes and effectively nullified New Hampshire’s sponge tax. This means that at this moment, for deaths in 2010, there is no New Hampshire estate tax. If Congress allows EGTRRA to expire, for deaths in 2011 there will be a federal credit for state death taxes, and New Hampshire’s sponge tax statute will be revived automatically. If Congress passes legislation during calendar year 2010, we will have to watch closely whether that legislation includes a credit for state death taxes at the federal level and whether that legislation is retroactive. Interestingly, while a federal statute’s retroactive effect may be subject to constitutional challenge for federal estate tax purposes, its potential retroactive effect for New Hampshire estate tax purposes may not be subject to similar challenge since the sponge tax is technically in existence right now.

All of our neighboring states responded to EGTRRA by enacting “decoupled” state-level estate taxes. The status of the federal credit for state death taxes has no bearing on those states’ statutes. Those states will impose a state-level estate tax on the estates of decedents dying in calendar year 2010 and in later years regardless of what happens at the federal level (and assuming no state-level legislative changes). Some of those states also had sponge taxes prior to EGTRRA’s enactment, and those statutes may still be on the books in those states, as well. It is possible that those states will have two estate tax schemes in effect if changes at the federal level result in the reinstatement of a federal credit for state death taxes, in which case those states will have to decide which tax regime will govern for deaths occurring after the effective date of the federal legislation.

Impact on Modest Estates

Probably most pernicious of all is the fact that the switch to a carryover basis regime has the greatest impact on moderate estates. Under the federal law in effect through 2009, estates worth less than the federal estate tax exemption paid no estate tax, but they did get the automatic step-up in basis. This meant that the heirs of moderate estates were relieved of the capital gains tax burden associated with unrealized capital gains even though they did not bear the burden of an estate tax. Under the carryover basis regime currently applicable to the estates of decedents dying in 2010, those moderate estates will no longer get an automatic step-up in basis, and the capital gains tax burden on these estates will increase dramatically. Planning to make effective use of the $1,300,000 and $3,000,000 floating basis allocations will be particularly important in these modest estates.

Impact on Existing Estate Plans

For the estate of a decedent who dies in 2010, particularly early in 2010, things are very uncertain. That estate: (a) may be subject to federal estate tax (if one is enacted retroactively) at an unknown exemption level, (b) may instead be subject to carryover basis, (c) may be subject to New Hampshire estate tax (if federal law is enacted retroactively), and (d) will be subject to state-level estate tax if the decedent owned property in a state with a decoupled state-level estate tax (and/or with a sponge tax on its books).

Despite the tremendous uncertainty with respect to the law that will apply to the estates of decedents who die in calendar year 2010, we do not see any cause for panic. First and foremost, for any clients whose estate planning documents were drafted consistently with the estate tax laws in effect in 2009, those documents should also be consistent with the law that will apply in 2011. Barring a tremendous surprise, as of 2011, we will likely have a federal estate tax based on an exemption system similar to the one in effect in 2009, the only real uncertainty being the size of the exemption and the top marginal rate.

That means documents drafted for such a system should function well again as of 2011, since most documents of that type use formula clauses that self-adjust when exemptions change. Review and revision of documents is most urgent for clients with known health problems that may lead to their death in calendar year 2010. Many estate planning documents drafted prior to 2010 will be out of sync with the law as it exists at this moment. Our expectation is that a number of post-mortem planning techniques could be used to address provisions in documents that result in unintended tax consequences or an unintended dispositive scheme. Documentation is even more important when it comes to taxes, due to the amount of trouble a client can get into if their taxes are not documented properly, software company similar Digital WarRoom provide e-discovery software that could be helpful with document management.

For clients who do not have serious health problems, the availability of such post-mortem planning reduces the urgency of having their estate plans reviewed in 2010, assuming their documents were otherwise up to date for the 2009 laws. However, post-mortem planning is both expensive and less reliable than prospective planning. Therefore, we do not recommend that clients with serious health problems rely on it. Those clients should have their plans reviewed as soon as possible (which is always good practice when serious health concerns arise).

One final caveat. Even up-to-date documents will lead to undesirable outcomes if assets are not appropriately allocated to trusts. This will be especially true for deaths occurring in 2010 since the allocation of unrealized capital gains adds a new dimension to the asset allocation question. However, all clients whose asset allocations have not been reviewed recently should revisit those allocations.

2010 is likely to be a tumultuous year for estate planning.

IRS CIRCULAR 230 NOTICE – To ensure compliance with IRS requirements, we inform you that any tax advice contained in this communication (or in any attachment included as part of this communication) 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 addressed herein.