Are We Headed Back To 2001?

When the Economic Growth and Tax Relief Reconciliation Act of 2001 passed, most estate planners (and probably most Republicans and a few Democrats) expected that before 2011, Congress would enact some form of permanent transfer tax legislation to replace the sunsetting provisions of EGTRRA.

The November 7 election has put that assumption at serious risk. Increasingly, it is possible that permanent transfer tax legislation will not occur. Among the reasons supporting this possibility are:

- The Democrats will control Congress at least through 2008. The House Democratic leadership has not shown a desire to permit permanent transfer tax legislation. If the House Democratic leadership can prevent a tax bill from coming out of the Ways and Means Committee, then giving up 3 years of large exemptions from 2007-2009 (and an estate tax elimination in 2010) may be of minimal consequence compared to the revenue to be raised when the estate exemption drops to $1 million and the top tax rate rises to 60% in 2011.

- Even if the Republicans succeed in taking back control of Congress in the 2008 election, the Democrats will probably retain filibuster control in the Senate. No one reasonably expects the Republicans to control 60 Senate seats anytime in the near future. The Democrats do not have to act; all they have to say is “No” and 2001 will return in 2011.

- Polls indicate most Americans want to eliminate the estate tax. But, according to a number of studies, few estates are subject to the tax. The estate tax has a limited impact on the general population and potential elimination could be traded away for broader-based tax reform, like an overdue reform of the Alternative Minimum Tax.

Because the AMT system impacts more Americans, its reform will have broader support than elimination of the estate tax.

- Although estate taxes made up only 1.1% to 1.3% of the federal revenue during the 1990s, this percentage is expected to grow rapidly as the single wealthiest generation that has ever lived dies and passes trillions of dollars to its heirs. A study by Boston College estimates that between $41 and $136 trillion will pass by the year 2050. Given the concern that many elderly Americans have taken more out of Social Security and Medicare than they put into the systems, some in Congress may view the estate tax as a generational repayment of these distributions.

- Warren Buffett, George Soros, William H. Gates Sr. and over 300 hundred of America’s wealthiest citizens publicly oppose elimination of the estate tax. They believe that the primary purpose of the tax should not be the raising of revenue. Instead, it should be to avoid creating a multi-generational class of perpetually wealthy in America. Increasingly, the debate has shifted to the taxation of the super-wealthy as a social issue. A column by William H. Gates Sr. describing why the estate tax is a societal necessity can be found in the Feb. 16, 2001, edition of the Washington Post. It makes interesting reading.

The reality is that the Republicans have had numerous opportunities to enact permanent legislation, but have often chosen political postures (e.g., elimination of the estate tax) instead of compromise legislation that could have adopted permanently higher federal estate tax exemptions and lower rates.

Without the adoption of permanent legislation by the end of 2010, on Jan. 1, 2011, the payment of federal estate taxes will skyrocket. Look at the impact of inflation: In 2001, the estate exemption was $675,000. At an annual growth rate of just over 4% (barely above inflation), the 2001 exemption of $675,000 will roughly equal the value of the $1 million exemption in 2011.

Because the estate exemption is not adjusted for inflation, each year after 2011 the effective value of the estate exemption decreases.

We could be facing a horribly confusing planning environment for the next 4 years.

Here are a few examples.

Treatment of Insurance. Many clients have estates in the range of $1 million to $2 million, including life insurance. Many planners have advised married couples that with a federal estate tax exemption of $2 million each ($4 million collectively), they did not need to place their life insurance into an irrevocable life insurance trust, because the individual exemption and/or the joint exemption of the married couple would produce a non-taxable estate.

However, a return to a $1 million estate tax exemption could mean that many clients will have a taxable estate, with the result that 41% to 60% (the applicable tax brackets over $1 million) of the insurance proceeds could be lost to an estate tax.

If a client is going to move an existing life insurance policy out of his or her taxable estate by 2011, the 3-year look back provisions of Internal Revenue Code Section 2035(a) mean that the transfer should occur at least 3 years prior to the beginning of 2011. Thus, by the end of 2007, clients who do not currently have a taxable estate (but who may have one in 2011) will be forced to consider the use of life insurance trusts or the transfer of insurance policies to heirs.

Higher Tax Rates. The federal estate tax rate in 2001 capped out at 55% for estates above $3 million, but with an additional 5% surtax on estates over $10 million. These higher tax rates will return in 2011, creating significant liquidity problems for many clients. Planners may want to start raising the liquidity issues with their clients today, in case the client becomes uninsurable before 2011.

Clients who decide to buy additional insurance should consider placing the insurance in an irrevocable life insurance trust to keep the death proceeds outside their taxable estate. Because of the current legislative uncertainty, it may be appropriate to adopt contingency formulas in the insurance trust to provide for how the passage of assets will occur in various scenarios.

For example, if insurance is held in an irrevocable life insurance trust, but is unnecessary to provide estate tax liquidity to the estate, a formula provision in the insurance trust could pass those assets on to the donor’s favorite charity. Flexibility should also include the use of limited powers of appointment in virtually every insurance trust. The trust may provide mechanisms for the early termination of the trust and the distribution of the policy to someone other than the insured/grantor.

State Estate Taxes. Roughly half of the states have state estate taxes which are de-coupled from the computation of the federal estate tax. The return in 2011 of the state estate tax credit is going to create some confusion. First, in “decoupled” states, there will be confusion because state estate taxes will not relate directly to the federal estate tax credit and tax computations (e.g., many decoupled states have lower estate exemptions).

Second, the other half of the states that have not enacted a new state estate tax (and which effectively lost any revenue from the estate tax in 2005), will suddenly see an unexpected return of previously lost revenue. This change will effectively return dollars to the states that had not revoked their state statutes that coupled their state estate tax to the federal credit. For example, according to one source, Florida lost over $1.1 billion in revenue in 2006 from the elimination of the state estate tax credit. That lost revenue could now return to the state as an unexpected revenue windfall.

Family Businesses. Planners and drafters of documents will have to deal with the return of the business deduction for businesses that pass to family members. Perhaps one of the most complicated pieces of federal estate tax legislation ever enacted, the family business deduction (code section 2057) will be restored in 2011, albeit at a total benefit of only $300,000 per decedent.