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What Estate Tax Reform?

The landscape in which all wealth advisors manage trusts and create estate plans is about to be altered dramatically. But those changes may not be the ones everybody is expecting.

(This article originally appeared as a free e-newsletter from Trusts & Estates magazine. To sign up for these bi-monthly Wealth Watch e-letters from Trusts & Estates, go here.)

The landscape in which all wealth advisors manage trusts and create estate plans is about to be altered dramatically. But those changes may not be the ones everybody is expecting.

I talk to many colleagues about estate tax reform and everyone says that the federal lawmakers “have got to do something.”

But do they?

Everyone predicted that by 2009 we’d have seen an amendment to the estate tax law. So far, everyone was wrong.

In fact, it’s time that we realize there’s a real possibility that Congress could allow the estate tax to go back to 2001 levels. I hope I’m proven wrong. But we should advise our clients to take action this year—just in case that back-to-the-future scenario occurs. Indeed, we have to advise them in 2009 to take into account any number of possible scenarios.

So, let’s break it down. First, let’s look at what the current law provides, then at what the law might be, and finally at what we should consider doing, right now, to safeguard our clients.

Here’s the current law:

In 2009, we have. . .
$3.5 million generation skipping transfer (GST) tax exemption
$3.5 million exclusion from estate tax
$1 million exclusion from gift tax
45 percent top marginal rate
No state death tax credit

In 2010, there’s supposed to be . . .
No GST tax
No estate tax
$1 million exclusion from gift tax

And in 2011, we’re slated to get . . .
$1 million GST exemption
$1 million exclusion from estate tax
$1 million exclusion from gift tax
55 percent top marginal rate
State death tax credit reappears

Now, let’s be honest: No one has a crystal ball, so it’s impossible to say with certainty what will happen. It is possible that any one of the following could occur:

• Congress will do nothing.

• Congress will enact a one-year extension of the 2009 law through 2010 only.

• Congress will enact a one-year extension of the 2009 law and make significant estate tax law changes in 2010 to extend permanently, or make significant estate tax law changes in 2009 to extend permanently, including:

—making the 2009 law permanent;

—reducing or increasing the various exclusions;

—unifying the gift and estate exclusions;

—reinstating the state death tax credit.

How are we to plan for so many potential future scenarios?

If we do nothing, the biggest potential loss under current transfer tax law is the loss of $3.5 million of GST tax exemption. Advisors should consider discussing now with their clients the possibility of making inter vivos gifts to prevent the loss of the full $3.5 million for their clients. For married clients, this can be achieved without paying gift tax.

So, consider the following strategies:

Strategy #1: Option To Pay Gift Taxes Or Not If There Is a Spouse

Make a gift of the remaining GST exclusion into a qualified terminable interest property (QTIP) trust. Postpone funding the trust until late in the year to see if Congress extends the GST exclusion into 2010.

If not, then make the gift at the end of the year and make the QTIP election to avoid paying current gift tax, make a reverse QTIP election to treat the creator of the trust as the transferor for GST purposes, and allocate the creator’s remaining GST exemption against the trust to protect it from GST.

If, before filing the gift tax return, Congress passes a law that makes the GST exclusion permanent, consider making the QTIP election—but not the reverse QTIP election—to allow for future, more effective GST planning.

If Congress also gives us unification of estate and gift exclusions, consider making no QTIP election and allocating the GST exemption.

If necessary, consider extending the gift tax return filing date to Oct. 15, 2010, to allow even more time for Congress to act.

Assure that the spouse’s will directs that estate taxes on the GST-exempt QTIP be paid from assets other than the QTIP assets. Try to minimize distributions to the spouse from the trust to maximize the amounts left to descendants. At the spouse’s death, have the trust pour over into an exempt-style trust designed to last for multiple generations.

Even if Congress does not pass a law unifying the exclusions, it may make sense to pay gift taxes. This is especially true if the creator lives in a state that has an estate tax but does not have a gift tax. Consider drafting the trust “Clayton–style,” so that if no QTIP election is made, the assets fall into a family-style GST trust.

Strategy #2: Pay Gift Taxes If No Spouse

Determine if your client should be making a taxable gift in 2009 and paying the gift tax in 2010.

There is only one downside to paying those taxes: If Congress enacts an extension of the law beyond 2009 that includes unification of the estate and gift tax exemptions. If that happens, your client will pay gift taxes unnecessarily early (that is to say, in 2010) to shelter that GST exemption, when he could have sheltered it without paying any gift tax. Of course, the client’s other assets still will be subject to estate tax at death, but the loss of the use of the gift tax money could be significant.

Factors to consider in determining whether to take the risk of paying gift taxes:

(1) Can the client afford to pay the gift tax and does the client have such a large estate that estate taxes are inevitable?

(2) Is the client older, so that the loss of the use of the gift tax payment is less meaningful, because the time horizon for growth of those assets is shorter?

(3) Does the client live in a gift-tax-free state, so that the savings in state estate taxes will meaningfully offset the pre-payment of gift taxes?

If the benefits of paying gift tax outweigh the risk of pre-paying the gift tax, set up a GST exempt trust for the benefit of descendants and fund it as late in 2009 as possible.

If Congress enacts a one-year extension, make the taxable gift in 2010, perhaps later in the year to see whether Congress enacts a favorable estate tax law that includes unification in 2011.

If there is no such favorable law, then make the gift in 2010, file gift tax return in 2011, allocate GST exemption against trust, and pay the gift taxes.

And what if the estate tax disappears in 2010?

Well then, there are other planning techniques we’ll have to discuss at that time.

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