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.
Retroactivity
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.
