Fewer Taxable Estates Will Create Profound Planning Changes

There is little question that the number of taxpayers subject to an federal estate or gift tax is rapidly diminishing. One study reports that less than 1% of all estates will be taxable in 2004. This reduction in the potential imposition of federal estate taxes will create significant changes in how clients approach their estate planning.

Among the changes:

Income Tax Avoidance. The reduction in the number of estates subject to a federal estate tax will cause a shift in tax planning from transfer tax avoidance to income tax avoidance. For example:

–The vast majority of estates will be exempt from federal estate taxes. Because of the step-up in basis that occurs at death, valuation strategies for nontaxable estates will shift to increasing the fair market value of an estates assets. If the decedents estate is not taxable, obtaining a higher valuation (but below the taxable point) will provide heirs a higher step-up in basis. The higher basis can reduce the taxes paid on post-death asset sales and increase the depreciation deduction for depreciable inherited assets. Perhaps those brilliant valuation arguments of the Internal Revenue Service were simply misunderstood and should now be adopted but only for taxpayers who are not subject to a federal estate tax.

–This change will create an interesting problem for the IRS. Previously the Services attention was focused on whether taxpayers purposely had undervalued assets (i.e., to avoid transfer taxes). Now they also will have to focus on whether taxpayers purposely are overvaluing assets to obtain a higher basis (i.e., to avoid income taxes).

–A pivotal issue in establishing the proper basis will be the proper documentation of the value of nonmarketable assets. Because there is no statute of limitations on the computation of the basis of assets in nontaxable estates (i.e., no estate tax return is filed) appraisals will be necessary to establish the income tax basis of nonmarketable assets, even when the estate is not taxable.

–While the increase in the value of assets may make sense from a federal estate tax basis, the potential imposition of higher state death taxes may serve as a counterbalancing detriment.

–According to the IRS there are more trust and estate income tax returns being filed than C corporation returns. Given the 20% difference in rates between capital gain taxes and ordinary income taxes, fiduciaries will come under increasing pressure to invest in investments that are tax efficient. For example, fiduciaries will be more prone to invest in tax efficient mutual funds and capital gain investments. Such investments can reduce both the taxable income of a trust and its beneficiaries. Moreover, unlike most ordinary income investments (e.g., interest and rents) which are paid annually, fiduciaries may defer the tax on capital gain investments until it is necessary to distribute benefits, with the beneficiaries being taxed at a preferred capital gain rate.

–Instead of deducting estate costs on federal estate tax returns, clients increasingly will use them to reduce income taxes. More executors will waive fiduciary fees. Wills may be drafted which provide special bequests to executors in lieu of their taxable executors fees.

–Trusts increasingly will provide for discretionary “spray” powers. Such powers will give trustees broad discretion in allocating trust income to taxpayers in lower income tax brackets. For example, having a “spray” power may allow the trustee to pay income directly to a college-attending heir who is in a 10% income tax bracket instead of paying it to the heirs parent who is in a 35% income tax bracket.

State Death Taxes. Federal transfer taxes rapidly are diminishing, but increases in state death taxes will offset a part of the reduction. As a part of the 2001 tax bill, Congress replaced the state death tax credit with a federal estate tax deduction. Thirty-eight states were using the federal credit as their state estate tax. Its elimination will require them to revise the states death tax laws–an unpleasant political act. There has been pressure from the states to reinstate the pre-2001 federal state death tax credit. However, even if the state death credit is restored, the higher federal exemptions would still wipe out considerable state revenue. If a federal estate tax is not due, a state death tax will not be due to the states who use the maximum federal credit.

As a result of these changes:

–The states that were using the federal estate tax law as the basis of their state death tax will have to revise their statutes or face a serious loss of revenue. For example, Florida in 1999 received almost $650 million from the credit. Unless other sources of revenue are located, Florida (which has no income tax) could be facing severe budgetary problems.

–Some states will freeze their state death tax at the pre-2001 federal credit, resulting in a top effective state tax rate of 16% (i.e., the top rate for the state death tax credit in 2001).

–Some states will ignore the higher federal exemption amounts, creating a state death tax when no federal estate tax is due. For example, assume the state has a 10% state inheritance tax and allows a $750,000 exemption. A decedent dies with a $1.8 million estate in 2006 (when the federal exemption is $2.0 million). No federal estate tax liability is due. However, the estate could owe the state a death tax of $105,000.

–Some states may restore state inheritance taxes, with the tax rate being determined by the relationship of the decedent to the heir (i.e., the more remote the heir, the higher the tax rate).

–Like the federal government did in 1924, more states will adopt a state gift tax to stop the loss of transfer tax revenue through lifetime gifts. Currently only Connecticut, Louisiana, North Carolina, Tennessee, and Puerto Rico have a state gift tax.

–The lack of uniformity in state death taxes will add complexity to estate plans. For example, if a person owns real property in more than one state, the avoidance of the cost and taxes of ancillary probate may become a greater part of the estate plan.

–The pressure to “forum shop” will increase as taxpayers attempt to move their tax domicile to a less costly state like Florida, which cannot amend its state estate tax without a constitutional amendment (an unlikely event given the number of retirees in south Florida). Clients with principal residences in two states should take measures to assure they are treated as a resident of the state with the lowest death tax.

Transfer Tax Changes. The higher exemptions will also change how planners and their clients address the imposition of federal transfer taxes. Among the probable changes are:

–With the federal estate tax exemption increasing and the federal estate tax rate decreasing, the country effectively will have a flat federal estate tax. In 2006, the combination of a higher exemption and lower rate will create a flat estate tax rate of 46%. In 2007 the rate will drop one more point to 45%. With a flat rate, it will be relatively easy to compute the federal estate tax cost of any estate tax transfer.

–The benefit of prepaying estate or gift taxes is substantially reduced. The existence of a flat tax rate generally increases the benefit of deferring transfer taxes as long as possible. However, if an asset is expected to grow rapidly, it may still make sense to move it out of a taxable estate before the appreciation occurs.

–The transfer tax benefit of equalizing estates of a married couple to use the lower marginal transfer tax brackets of each spouse is reduced and may be effectively eliminated by a flat estate tax. Planners should to make sure each estate has enough assets to fully fund each individuals unified credit and, if used, generation skipping exemption.

–As the unified credit exemption approaches $2 million in 2006 (i.e., $4 million for a married couple who properly plan), the IRS probably will reduce its focus on estate and gift tax issues for most taxpayers.

–In 2004, the estate tax exemption and generation skipping exemption will both be $1.5 million (increasing to $2 million in 2006). The gift tax exemption will remain $1 million. This difference will create new planning ideas. For example, assume in 2006 a wealthy client has a spouse who is less wealthy. The client might create a lifetime unified credit/generation skipping trust for the benefit of children from a prior marriage. The gift uses both of the couples $1 million gift tax (i.e., by agreeing to gift splitting, the less wealthy spouse will be deemed to have funded half of the gift). As a consequence, the wealthy spouse provides a $1 million bequest to the less wealthy spouses children. Both families benefit. The wealthier family picks up a large generation skipping exemption at an earlier time. The less wealthy family receives a $1 million bequest from a stepparent.

Estate planning is undergoing a revolution. As in any revolution, those who recognize its impact will be able to react and take advantage of the changes. Those who do not may serve as its victims.

John J. Scroggin, J.D., LL.M., is an estate planning attorney in Roswell, Ga., and author of “The Family Incentive Trust,” published by The National Underwriter Company. He can be reached via e-mail at jeff@scrogginlaw.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, January 2, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.