The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) provided some of the most significant estate tax changes in the last 30 years. However, the act had one of the most disturbing timebombs ever enacted in a major piece of tax legislation: The entire law dies on Jan. 1, 2011!
When EGTRRA passed, most estate planners expected that Congress would enact some form of permanent transfer tax legislation before 2011. However, as I pointed out in my article in National Underwriter on Nov. 20, 2006, it is growing more plausible that we will return to the 2001 rules in 2011. Consider this possible scenario:
o It is unlikely that new transfer tax legislation (if any is adopted) will not be seen until mid to late summer in 2007, at the earliest. Democrats will probably enact tax legislation containing provisions that are unpalatable to the president. The president must either sign the legislation or veto it and hope Congress enacts a more responsive bill after the November 2008 congressional and presidential elections.
o In 2008, based upon past political history, it is highly unlikely that any significant compromise tax legislation will be enacted; compromise legislation does not tend to happen during a presidential election year.
o In 2009, the country will have a new president and a new Congress. Every new president wants to make their mark with new tax legislation. Three overriding issues will probably be driving any tax reform legislation.
First, the tax code has reached such a degree of complexity that many experts believe it is effectively broken. Americans are increasingly demanding a simpler and fairer tax code. Any reform will naturally include a search for additional revenue sources.
Second, by 2009 there will be a huge need to fix the Alternative Minimum Tax (AMT) disaster. According to the Congressional Budget Office, about 2 million taxpayers paid AMT in 2002. Over 30 million taxpayers are expected to pay AMT in 2010. Under current law, in 2010 (the year of the AMT’s peak effect during CBO’s current baseline projection period), 66% of the 26 million taxpayers with adjusted gross income (AGI) between $50,000 and $100,000 will owe more tax as a result of the AMT. Among the 9 million taxpayers with AGI between $100,000 and $500,000, more than 85% will owe more tax.
Third, by 2009, the extent of the coming budgetary shortfall caused by entitlement programs for the baby boomers and their parents will be even more apparent and may start impacting the 5-year budget window of current planning.
o Each of these issues will require Congress and the president to find new sources of revenue. Could Washington decide that the revenue from an increased estate tax solves some of its revenue problems? The huge wealth transfer expected in the next 50 years could be an alluring source of “found money.”
The November 7 election effectively killed any serious possibility of a permanent elimination of the estate tax. Even the $3.5 million to $5 million exemptions that have been discussed are an increasingly unlikely event. Given the partisan wrangling that is tying up compromise legislation in Washington, there is an increasing possibility that Washington will fail to enact any permanent legislation, resulting in a return to the pre- EGTRRA rules on Jan. 1, 2011.
The unfortunate reality of this uncertain environment is that planners and their clients need to start planning now for the possibility of a return to 2001 in 2011. Planners need to consider the possibility that their clients will have become incapacitated by 2011 and will be unable to revise an estate plan that assumed the availability of a much larger estate exemption than that available after 2010. A return to the pre-EGTRRA rules would create a number of liquidity issues for estate planners and their clients.
Higher Taxes. Without the adoption of permanent legislation by the end of 2010, on Jan. 1, 2011, the payment of federal estate taxes will skyrocket for many estates. As pointed out in my previous article, at current inflation rates, the $675,000 exemption of 2001 will be roughly equivalent to the $1,000,000 estate exemption in 2011.
Wealthy decedents could be subject to both higher overall tax rates and lower exemptions. From 2007-2009, the federal estate tax rate will effectively be a flat 45%. The federal estate tax rate in 2001 capped out at 55% for estates above $3 million. Estates valued at over $10 million paid an additional 5% surtax (until the estate equals $17,184,000) designed to eliminate the benefit of the marginal tax rates below 55%.
The combination of a reduced estate exemption and a higher estate tax can have a significant impact on clients who have not planned on the higher cost. Let’s look at 3 separate scenarios. First, assume a single taxpayer has a $1.5 million estate in 2007, growing at an annual rate of 5%. Scenario 1 shows the federal estate tax cost to the client from 2007-2013.
Instead, assume the client had an estate of $3 million (see Scenario 2), growing at an annual rate of 5%. Note the combined impact of a lower exemption and higher tax bracket. From 2008 to 2011, the estate taxes to this client will more than double. The combined effect of a lower exemption and higher tax rates can have a much greater impact than either planners or their clients expect.
Last, assume the above client had an estate of $10 million. Scenario 3 shows the impact of the 2007-2011 changes. Note that the combined lower exemption and higher tax rate in 2 years (from 2009 to 2011) increased the estate taxes by over $2.7 million.
Perhaps the most important aspect of these 3 scenarios is the reducing percentage of the estate that will ultimately pass to heirs. For example, in the last 2 scenarios, the combined impact of a higher tax and lower exemption causes a 19%-36% increase in the effective tax rate in the 2 years from 2009 to 2011.
State estate taxes could drive the effective tax rate even higher. Prior to EGTRRA, the federal estate tax was offset by a dollar-for-dollar credit for state death taxes. Roughly 38 states used the amount of the credit as their state estate tax. However, pursuant to EGTRRA, in 2005 the state death tax credit was fully phased out and replaced with a deduction. States were forced to either lose the revenue they had received from the credit or “decouple” themselves from the federal estate tax and impose new state estate taxes. Today, roughly half of the states have state estate taxes which are decoupled from the computation of the federal estate tax. Many decoupled states have lower estate exemptions than the federal exemption. For example, New Jersey has a $675,000 exemption. In many of these states, the combined state and federal estate taxes could exceed 60% because state estate taxes will exceed the federal state death tax credit.
ira and Retirement Assets. With the higher exemptions and new rules permitting heirs to make withdrawals from inherited IRAs over their lifetimes, many estate plans have provided that the retirement plan will pass to younger families members (to take advantage of the longer life expectancy) while passing other assets to a surviving spouse. However, these plans could create a number of problems if we return to the lower estate tax exemptions in the pre- EGTRRA rules.
For example, assume a client in a second marriage had a $1.5 million IRA and $2 million in other assets. Under his current planning, the IRA passes by trust to his young children from a prior marriage while the $2 million is held in a QTIP trust for the second wife. At the current exemptions, no estate tax would be due at the client’s death, assuming his spouse survives him. However, if the client dies after 2010, there could be a federal estate tax of approximately $210,000 on the IRA transfer to the children. If the trustee reaches into the IRA to pay the $210,000 in estate taxes, the trustee will create taxable income of $210,000. If the trustee then reaches back into the IRA to pay the income taxes, they incur additional income taxes. Each withdrawal from the IRA to pay tax will create a new tax. The plan should be revised to either:
–reduce the IRA bequest to the available exemption (whatever it may be at death),
–pass other assets (e.g., a life insurance policy, preferably in an ILIT) to the children to pay the estate tax liability, or
–pass non-IRA assets to the children while passing the IRA to the surviving spouse, perhaps in trust.
This area has an interesting conflict. For several years Congress has been encouraging the growth and creditor protection of retirement plans, particularly for baby boomers. However, the combination of estate taxes and income taxes on retirement plans in poorly planned estates after 2011 may create a significant tax windfall for the federal budget.
It should be noted that while retirement assets are the most likely assets to be subject to both income taxes and estate taxes, there are other assets (e.g., an installment note) that could create a similar double taxation issue when the exemptions are lower.
Demographics and Family Businesses. Not only will the increased estate taxes create liquidity problems for family businesses, but the increasing number of retiring family business owners and the passage of family businesses are going to create an increased need for life insurance. In a 2002 Mass Mutual study, 40% of the family businesses surveyed expected a leadership change in the following 5 years.
Many business owners intend to pass their businesses to one or more designated family members who will run the business after the entrepreneur’s death or retirement. However, because the business is often the largest single asset of the estate, the owner often passes part of the business ownership to other family members who are not involved in the business. This is an incredibly bad idea that creates family conflict.
The conflict is virtually inevitable, as each family member attempts to direct his or her own financial destiny and feels increasingly unable to do so because of the common business ownership with other family members. This is not a matter of “good” and “bad” family members; it is a matter of different life goals–a normal part of life. Many family businesses have paid huge legal fees because of these conflicts and/or have been forced to sell the business to alleviate the problem.
The solution lies in setting up a structure in the estate plan that assures those in the business own and control as much of the business as possible while giving outsiders other assets so that they can effectively control their own financial destiny. Life insurance is often a necessary element of this “equalization planning.” Often the entrepreneur will recognize the contribution to the business of those who have had long term involvement by passing a greater part of the business to them.
Treatment of Insurance. Many advisors have a wait-and-see attitude about what Congress is going to do. However, 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 December 31, 2007, clients who do not currently have a taxable estate (but who may have a taxable estate in 2011) will be forced to consider the use of life insurance trusts or the transfer of insurance policies directly to heirs.
Without question, new life insurance for clients with estates over $1 million should be kept out of the taxable estate, using life insurance trusts or direct ownership of heirs.
Anyone who says he or she knows what transfer tax legislation will be enacted in the next 4 years is either clairvoyant or deranged. Unfortunately, no one inside or outside of Washington has any real idea what is going to happen to the transfer tax rules in the next 4 years.
What is certain is that any expectation of an elimination of the estate tax is DEAD! Clients and their advisors should run projections that take into account the possibility that the 2001 laws could return in about 42 months and project the resulting tax cost and available liquidity in the estate. Forty-two months is a very short time for planning.