Wealth managers of high net worth clients don’t necessarily need to understand the myriad permutations of planning for this situation, but they need to know the basics; they need to understand why the estate-planning legal community is in a state of confusion due to the issue of retroactivity; and they need to know how to discuss this situation in a way that lowers clients’ reasonable anxiety of the current state of affairs. In this article I will attempt to distill the most pertinent issues and offer suggestions for how we can and should be communicating with our clients through these difficult times.
Current regime: What’s the problem?
So, where are we now? The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the federal statute that has controlled the estate tax, generation skipping tax (GST) and gift tax since 2001, was promulgated with the idea that a future administration and Congress would “permanently” reform these tax regimens before the law “sunset” in 2010. The sunset provisions were designed to compel this reform by doing the unthinkable; eliminating the estate tax, GST and changing cost basis step up rules for one year, then returning these taxes and rules to 2001 levels.
For 2010 we have no estate tax and no GST. We still have a gift tax of 35% with a $1 million dollar personal lifetime exemption along with a cost-of-living adjusted annual gift exclusion (currently $13,000 per year). Cost basis step-up rules, or the rules that allow an inheritor of assets to value those assets at date of death values for capital gain purposes, have been changed to something called “carryover basis” which essentially means that inherited assets carry their cost basis over to their new owners. If no reform is forthcoming this year, on January 1, 2011, the rules revert back to those in place in 2001. We will have an estate tax, GST and gift tax with exemptions of $1million each. Carryover basis goes away and we return to the basis step-up rules as well.
So what is the problem? Isn’t it a good thing that some “lucky” wealthy people who die in 2010 will not have to pay estate and GST taxes? Isn’t it a good thing that in 2010 wealthy people can now make heretofore taxable generation-skipping transfers during life they couldn’t previously make without incurring tax? Doesn’t this all resolve itself in 2011 when these taxes come back with a vengeance and carryover basis goes away? Although affirmative answers to the above questions sound intuitive, unfortunately, like so many issues wealth managers face, it is more complicated than that.
For those who pass away, or those who wonder about the advisability of taking advantage of estate tax and GST tax elimination in 2010, there is a major, perhaps unintended hurdle known as retroactivity. When Congress failed to reform the estate tax regimen, and even failed to temporarily extend 2009 tax levels into 2010, some believed there would be many planning opportunities. In a previous article, “Federal Estate Taxes Loom,” I discussed this “Throw Momma from the Train” era, in which people make life and death decisions for themselves or others to avoid estate tax. Many attorneys and wealth managers saw both opportunities and problems with clients’ current estate plans (some described in more detail below) and wanted to move quickly to take advantage of this opportunity or rectify the problems.
What has slowed down many advisors is the specter of Congress being able to promulgate estate tax legislation retroactively to the beginning of the year. This would cause potentially huge tax issues, even for well-intentioned transactions that were undertaken in good faith within the statutory framework in place at the time of the transaction. What was supposed to be a non-taxable transaction, could, after the fact, become taxable.
How can this be? Well, retroactive legislation is fairly common. Courts have upheld retroactive legislation when the legislation is “rationally related” to a legitimate legislative interest. Courts have also overturned retroactive legislation as having violated the Due Process Clause of our Constitution. The case law here is deep and dense, well outside the scope of this article, but I’ve personally witnessed two very knowledgeable and influential members of my estate planning community arguing reasonably for both sides concerning the legal validity of retroactive estate tax legislation. This ambiguity has caused many practitioners to take a very conservative stance when it comes to transactions based on 2010 estate tax law.
Estate planning issues
As most wealth managers understand, clients with a level of wealth that until this year could have been taxable at the estate level often avoided estate tax with proper planning. Most of these estate plans use trust documents that are designed to minimize or eliminate estate tax by attempting to utilize fully the deceased’s estate tax exemption. Often this is done by funding a credit shelter trust (also known as a “B trust,” a bypass trust, or a family trust). An estate settler or trustee would fund these trusts based on a “funding formula” in the trust document. Most of these funding formulas use the federal estate tax exemption amount as part of the formula. As there is currently no estate tax (so no exemption), funding formulas for those who die in 2010 may not work as planned. For example, it is possible that some credit shelter trusts would not be properly funded and therefore, more assets may flow to the surviving spouse than planned. That spouse might, in the future, have to pay additional estate tax.
In another example, a plan uses the credit shelter trust funded by clauses that relate to estate tax as a means to transfer a specific amount to particular beneficiaries (like children from a first marriage). A funding flaw can over-fund or under-fund this trust, potentially resulting in serious and litigious ramifications surrounding which family member actually gets a deceased’s assets. In a situation where you have multiple blood lines based on second and even third marriages, this is a serious issue indeed.
Other “drafting issues” that have materialized, based on estate tax flux, are the emergence of state estate-taxes as a major planning problem and the new complexities and uncertainties that surround generation skipping transfers. These issues are complex and beyond the scope of this article, but for our purposes it is important for wealth managers to know that current plans not drafted to specifically deal with these issues may lead to unintended consequences.
What about acting now to take advantage of the lack of estate tax and GST?
It would seem intuitive then that there is a need to amend documents to avoid these types of pitfalls. There have been myriad examples of how these types of documents can be amended to solve for these (and many other) types of potential document failures. In reality however, it has been my experience that most estate planning attorneys my clients deal with are not strenuously recommending changes at this time to their client’s estate planning documents. Wealth managers need to understand why.
Retroactive legislation, as discussed above, has taken its toll on proactive planning changes to individual plans. Attorneys are not happy with the prospect of having to amend their documents based on a potentially very short-term issue. Once amended, clients and attorneys are faced with potentially having to amend again if reform comes to fruition. Should no tax reform be forthcoming, current documents that rely on estate tax exemptions for their funding formulas to work will return to functionality on January 1, 2011. Should federal estate tax reform happen this year, retroactively or not, or if reform doesn’t happen and the rates return to 2001 levels, individual states will be adjusting their state estate-tax rules based on these changes.
Attorneys and their clients don’t want to have to deal with the time and expense of producing multiple amendments to deal with these state estate tax changes. In my experience, many attorneys don’t feel it is prudent to act until we have more information about longer term estate, GST, and state estate tax legislation. When these issues are carefully explained, clients seem willing to take the short-term risk of their documents not being optimized for current conditions. When clients and their attorneys are motivated to adjust documents now, wealth managers must make sure they understand any amendments made and be vigilant in their communication if and when permanent estate tax reform motivates yet more amendments.
In these unprecedented times, wealth managers are dealing with unparalleled ambiguity concerning their client’s estate planning needs. Although each client is different, all clients appreciate their advisors communicating with them in good times and bad. Wealth advisors need to understand how their client’s documents are impacted by our current tax regimen, what actions are available to take to rectify problems, but perhaps most importantly, to be very wary of advocating aggressive changes to estate plans in an environment of great uncertainty and change.
John Bock, JD, CTFA is a senior vice president and trust officer at Key Private Bank. He serves as a fiduciary expert on the relationship management team, and can be reached at j[email protected].
More articles in this series on estate taxes:
Lawmakers Unable to Pass Estate Tax Reforms December 22, 2009 As of December 17th, the House and Senate have been unable to move forward on estate tax reform (or extension of the current law) to avoid the quagmire of the 2001 Tax Act’s (EGTRRA) sunset provision….
Federal Estate Tax Changes: Update December 11, 2009 There has been movement by both the House and the Senate to finalize some type of solution to pending elimination of estate and gift tax on Jan. 1, 2010. …
Federal Estate Tax Changes Loom November 17, 2009 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….