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Financial Planning > Tax Planning > Tax Reform

Federal Estate Tax Changes Loom

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With the Federal Estate Tax rules on the cusp of expiration (for one year) in a matter of weeks, wealth managers and their clients are having a difficult time predicting what the government will do (or not do) to deal with the pending sunset provisions of the current law. In the following article, we analyze the most current and leading proposed modifications and discuss what planners need to know now, in order to assist their clients and prepare in light of these proposed changes.

A laundry list of bills
Congress has numerous issues to deal with in estate tax reform that go far beyond exemption limits. Some of these issues include:

  • Estate tax rates and how they should be applied.
  • Reunification of gift and estate tax.
  • “Portability” of estate tax exemption unused by a deceased spouse or spouses.
  • GRAT term limits.
  • Valuation and discounting issues.
  • Regulation of Crummey withdrawal powers.
  • State death tax credit and deduction issues.

In fact, well over thirty bills have been introduced this year to attempt to deal with these issues, which are keeping legislators busy. While some of these carry minor implications, there are currently (as of November 2) four major bills likely to impact practioners and their clients which we review below:

House Bill 436. This bill was introduced in January of 2009. It permanently establishes the 2009 exemptions and tax rates ($3.5 million estate-tax exemption and top tax rate of 45%), retains basis step-up, reunifies the estate- and gift-tax exemption but adds limits to the valuation discount for family limited partnerships (FLPs). Finally, this bill provides strict valuation rules for the transfer of non-business assets.

Senate Bill 722. Introduced in late March 2009, this bill makes 2009 estate tax law permanent ($3.5 million estate-tax exemption and top tax rate of 45%), reunifies the gift- and estate-tax exemptions, indexes the exemption amount for inflation and allows for exemption portability (allows the transfer of a first-to-die spouse’s unused estate-tax exemption to his or her surviving spouse). Finally, Senate Bill 722 includes a special use valuation that benefits family farms and other real-estate heavy family businesses.

House Bill 2023. This bill has far more reach than the others because it drops the estate-tax-exemption level to $2 million and creates a tiered, top tax-rate metric starting at 45% for estates valued from $2-$5 million, 50% for estates valued at $5 to $10 million, and 55% for estates valued over $10 million, all indexed for inflation. Like Senate Bill 722, this bill reunifies the estate- and gift-tax exemption, allows for exemption portability and restores the state estate-tax credit.

House Bill 3905. This bill, also called the “Estate Tax Relief Act of 2009,” was introduced on October 22, 2009. HR 3905 calls for an increase in the estate-tax exclusion amount of $150,000 a year each year from 2010 through 2019. At the same time the bill calls for a reduction in the effective top tax rate by 1% a year. In 2019 this results in an exemption amount of $5 million (indexed for inflation thereafter) and a top tax rate of 35%. In addition, the deduction for state estate taxes would go down 10% per year through 2019, when it would cease to exist. HR 3905 also abandons carryover basis.

What can Congress do?
They have three options:

  • They can do nothing and cause the elimination of estate tax and generation-skipping tax in 2010. In 2011; there would be a return to $1million exclusions for generation skipping transfer tax (GST), estate tax and gift tax; as well as the 55% top tax marginal rate and the state death tax credit. You might think of 2010 as the “Throw Momma from the Train” period. For public policy and other obvious reasons, most commentators don’t believe this scenario is likely.
  • They can wrestle with, debate, amend, and pass one or more of the bills introduced this year. How that law would be configured is anybody’s guess, and with the end of the year swiftly approaching, most agree it would be a surprise if Congress pulled it all together and passed something with substantial reform this year.
  • Congress can punt, and enact a one-year extension of the 2009 rules through 2010. This would certainly keep “Momma” on the train, and allow Congress the time needed to do a thorough and responsible job of reform. Most commentators who are willing to make predictions believe Congress will choose this option.

Next steps for wealth managers
So what do wealth managers do now?If clients and their advisors believe they are facing the prospect of lowered exemption amounts in the future, there are several “just in case” strategies that might be used. For example, married clients can be protected from a potential reduction of the GST exemption by transferring assets into a GST exempt qualified terminable interest property trust (QTIP trust). A reverse QTIP election can be used to get assets into a GST-exempt trust before year end. Planners need to be careful as to the timing of the funding of the trust, and as to the filing of the tax returns, in order to assure the appropriate use of current law. Using a QTIP trust with a reverse QTIP election allows the grantor to support his/her spouse, and utilize his/her 2009 GST exemption while being able to dictate and control who the ultimate beneficiaries of the trust are (in a GST context, heirs). Although planners are usually loathe to advise any clients to pay gift tax, for unmarried clients, it might be appropriate to pay some gift tax now, in order to fund a GST exempt trust at 2009 levels.

Another potentially time-sensitive strategy is the use of grantor retained annuity trusts (GRATs). Available valuation discounts coupled with the historically low Internal Revenue Code (I.R.C.) Sec. 7520 rates make these trusts a timely option. Because each GRAT must run for a specified term (the shorter the better as the chance for success is greater), the use of short-term GRATs has been popular. The current administration wants to eliminate the short term GRAT by requiring a minimum ten-year term. It is unclear how those short-term GRATs already in place would be treated, although it is likely they would be “grandfathered,” making their use now a positive (if short-term) technique.

Where can wealth managers add value?
The above strategies and others like them are designed to take advantage of current laws while they still exist. However, the strategies ultimately require clients to make irrevocable decisions about their estate plans, decisions they might not otherwise make. It is essential that planners understand these types of strategies and which of their clients might benefit from them. Where warranted, it makes sense to pursue this type of planning. This might be the time, however, when the ambiguity in the future estate tax regimen should give planners pause to reflect on those parts of our clients’ estate plans that are not as sexy.

Regardless of the potential changes in the law, there are plenty of areas where we can offer value to our clients now. For instance, we should continue to be meeting with clients and reviewing their:

  • Financial plans
  • Current estate plans
  • Funding and beneficiary designations
  • Power of attorney and health care directives
  • Insurance needs

These steps, in addition to performing thorough reviews of clients’ 2010 options regarding Roth IRA conversions, should keep us all busy for a while.

As always, we have lots to do, and the uncertainty regarding the ultimate transfer tax reform is complicating things substantially. Word on the street is that an extension of current estate tax rules will be forthcoming sometime just before Christmas. The typical year-end regimen must include a review of pending legislation, an understanding of whom amongst our clients requires (and is willing to pay for) complex “just in case” planning, and also a temperance of anxiety about change that might make us overlook more basic planning and relationship needs.

John Bock, JD, CTFA is a senior vice president and fiduciary advisor at Key Private Bank. He serves as a fiduciary expert on the relationship management team, and can be reached at [email protected].


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