June 1, 2009

Planning Implications of Proposed Estate Tax Changes

US Capitol BuildingEarlier we reported the administration’s proposed changes to the estate tax laws. This article delves deeper to look at how proposals offered by the administration and in several Congressional bills, might affect common estate planning tools and techniques.

Of course, until Congress passes legislation and the President signs it, we won’t know just what changes we need to adjust for. It may be still be useful, however, to consider the various proposals.

Make the Estate Tax Permanent

We say the estate tax is not ‘permanent’ because the 2001 changes (that gradually increased the exemption amount to its current $3.5 million and reduced rates) will ‘sunset’ or go away in 2011. The law will then revert to its 2001 form – a $1 million exemption and maximum 55% rate. All the proposals would get rid of the sunset provision.

  • Some wills and trusts set up the last few years include protective language. This language essentially says something like, “If the estate tax reverts to the 2001 rules, such and such happens. Otherwise, something else happens.” If Congress makes the estate tax permanent, this language won’t be needed. Although some suggest changing those wills and trusts now, that seems unwise. After all, maybe Congress will be paralyzed and unable to do anything more than delay the changes a year or two.
  • Given Congress’ recent spending spree, it’s hard to understand why it wouldn’t just let the 2001 changes expire. The amount people could leave to their families would go down from $3.5 million to $1 million and the rates would go up on larger estates. The government would collect more money to pay for all its current spending. And they don’t have to do anything for that to happen. Their inaction would allow it to happen automatically. This would seem to be the financially prudent thing to do. Of course, no one has ever accused Congress of acting prudently.

How Much You Can Leave Estate-Tax Free

In 2009 you can leave $3.5 million estate-tax free. That amount may change (from a low of $2 million to a high of $5 million). Some proposals index the amount for inflation; others do not.

  • Before 2001 anyone with an estate over $600,000 at least considered basic marital deduction planning. If any of the current proposals are adopted, fewer people will need the same level of estate tax planning they would need if the exemption amount was $1 million. That does not mean they won’t need estate planning advice – just that they won’t need complex tax planning.
  • In the past, people turned to different tools and techniques to either reduce future growth or cut the current value of their estates. For example, many set up family limited partnerships. If the exemption amount stays at $3.5 million or is increased, some may decide they no longer need those sophisticated tools. They’ll discover, however, that unwinding them is a tad bit harder than creating them.
  • Life insurance trusts won’t be as necessary for smaller estates.
  • Those who have already set up an insurance trust may want to make changes. If they decide they still need the insurance but no longer care if the insurance is in their estate, they may want to unwind the trust. Because life insurance trusts are almost always irrevocable, unwinding them may be tricky and will require specialized advice.
  • If they decide they no longer need the insurance because they no longer have an estate tax ‘problem’, they will need help evaluating their options. Although the insurance is no longer needed for tax purposes, are there other reasons it may be important? Should they cancel policies? Split them into smaller policies and drop some coverage? Sell them in the secondary market? Reduce the face amount? (With older policies that could force a policy to become a modified endowment contract. If the policy is in a trust that may not create the same issues it would if the policy was individually owned.)
  • Outright bequests to the surviving spouse with the right to disclaim to a QTIP trust or bypass trust will probably become more common. After the first spouse dies, this lets the family evaluate what is best to do based on both the family’s financial situation and what the law is at that time. For example, if the first estate is close to $3.5 million when Dad dies and there is a good chance it will grow significantly before Mom dies, it may still be wise to use a bypass trust (also called a credit shelter or ‘B’ trust). Or they may decide to go ahead with Mom taking everything. However, consider the concerns of an outright bequest mentioned in the next section on portability.


People use bypass trusts because the unified credit is a ‘use it or lose it’ proposition. If the exemption is $3.5 million and Mom and Dad have a $7 million estate, the family can get the entire $7 million without paying a federal estate tax. But if Dad dies first and leaves everything to Mom, he doesn’t use his $3.5 million exemption. When Mom dies later, the family only gets Mom’s $3.5 million tax free; they pay tax on the rest of the estate. You ‘use’ the exemption by paying tax on the $3.5 million when Dad dies – either by him leaving the money to the kids (bypassing Mom) or by him leaving it to a bypass trust.

Four of the proposals would allow Mom to use the unused part of Dad’s exemption. If Dad leaves everything to Mom he doesn’t use his exemption. When Mom dies, she would be able to use Dad’s $3.5 million exemption as well as her own. The family could receive $7 million tax-free.

  • This would eliminate the need for marital trusts and bypass trusts for most people with estates under $7 million – which is just about every American.
  • It would be especially useful when the first spouse doesn’t own enough in his or her own name to completely use the estate tax exemption. Mom dies with only $1 million in her name. Dad owns a business, pension and other investments that are worth $5 million. Under current law, Mom could only put $1 million into an A-B trust. Dad’s estate, when he dies later, would pay tax on everything over $3.5 million. With portability, Dad’s entire estate could pass tax-free to the family.
  • Use of the first spouse’s exemption would also keep that spouse’s estate open for IRS audit. It would stay open as long as the IRS could audit the survivor’s estate. Mom dies and Dad lives another 20 years. The IRS could go back and decide that Mom’s estate, instead of being worth $1 million, was really worth $2 million. That means Dad can leave only $5 million estate-tax free instead of $7 million. Of course, the family wouldn’t be able to plan for that because they wouldn’t know until the IRS audited Dad’s estate.
  • The portable amount is not increased because of inflation or earnings. If Dad lives 20 years after Mom dies, Dad still only gets $3.5 million (or whatever the exemption amount was when John died) even if the exemption amount has increased because of indexing. If there’s an expectation that the survivor may live many years and the decedent’s estate is close to the exemption amount, it may still be wise to use a credit shelter trust.
  • Under most of the proposals, portability would not apply to generation-skipping transfer taxes or to gift taxes. This is a tax trap for the unwary.
  • Many people will think trusts for surviving spouse are not needed. It’s true that bypass trusts may not be needed, but trusts have other benefits besides estate tax savings. These include asset protection, protection from a future spouse that could reduce what children receive, and the loss to children when a future spouse leaves property to his or her own beneficiaries.
  • All the proposals require the surviving spouse to make an election on a timely filed estate tax return. This is a tax trap for the unwary. Under current law, most estates don’t file a return unless the decedent has an estate worth more than the exemption amount. Mom dies with a $1 million estate – small enough no estate tax return is needed. But if it does not file that return, Dad won’t be able to use her exemption amount when he dies. He’ll have to decide if a potential future benefit is worth the cost and hassle of filing a return now. If his guess is wrong, it could be costly in the future.

Eliminate Carryover Basis

Under current law, when you die those who get appreciated property from you get to ‘step up’ their basis to the property’s value when you die. Beginning in 2010, step-up basis is set to disappear and they would carry over your basis. Dad owns some land with a $50,000 basis. He dies and leaves the land, now worth $90,000, to Daughter. Currently Daughter can sell the land for $90,000 and pay no tax. Beginning next year, however, she would have to ‘carry over’ Dad’s basis (instead of getting the step-up). If she sells the land for $90,000, she would have $40,000 of capital gain income. All the proposals do away with carryover basis.

  • Carryover basis language in wills and trusts could be eliminated – of course, only after Congress has made the change and the President has signed it into law.
  • Even if Congress leaves carryover basis in the law, documents anticipating carryover basis will still probably need to be changed. The rules will probably be much different than the assumptions most attorneys have used in drafting documents.
  • Those in community property states benefit from continuing stepped-up basis. They can step up basis on the entire property when the first spouse dies. That would change under the carryover basis rules. In separate property states, only the part owned by the spouse who died is stepped up.
  • Step-up basis does not apply to lifetime gifts. If Mom and Dad give Junior land with a $50,000 basis, when Junior sells it for $90,000 he has $40,000 taxable capital gain income.

Reunification of Gift and Estate Tax

The law now allows you to give only $1 million (and the annual $13,000 gifts) without paying gift tax. You can ‘give’ $3.5 million at death without paying tax. Two of the major proposals would let you make tax-free gifts up to the same amount you can leave tax-free at death. The primary advantage of a lifetime gift is that growth in the value of the gifted property is not included in your estate when you die.

  • This benefits those who make lifetime gifts to family of more than $1 million. It won’t mean anything to most Americans.
  • Family split dollar will not be needed as much to support life insurance policies with VERY large premiums.
  • This may encourage gifts to those in lower income tax brackets as part of income-shifting strategies. That will be especially true if Congress increases the brackets on higher incomes. If Dad is in a 45% income tax bracket and Son is in a 20% bracket, the family can keep more income in the family if Dad gives some of his bonds, let’s say, to Son.
  • Gifts among the very wealthy will probably increase.

Change in Estate Tax Rates

The proposals offer various options in setting the top estate tax rate. One sets the rate to the capital gain rate. Most keep it at the current 45% (generally for estates over $1.5 million). Some create surcharges of 5% or 10% for larger estates.

  • The surcharges probably would have little impact on how people plan their estates. Once you get to a 45% rate, most people won’t do things differently just because the rate is five or ten percent higher.
  • However, a ‘decrease’ so the top estate tax rate is tied to the capital gains rate probably would have a significant impact. If the most you’ll save by estate tax planning is a 20% tax, many will be hesitant to use sophisticated discount tools and lifetime gifts. They will consider two factors. Most complex estate tax planning means family members take over Mom and Dad’s basis in the property they receive and will pay capital gains when they sell the property. Second, most of that planning means Mom and Dad must give up varying amounts of control. Mom and Dad may question whether they want to give up control just so the kids can pay a 20% capital gains tax. (Yes, I know the capital gains tax is only on the gain while the estate tax is on everything. But the margin of benefit goes down and that’s what people are going to see.)
  • Tying the rate to the capital gains rate makes planning a little more difficult because that rate is more likely to change (and change more often) than a set estate tax rate.
  • A ‘decrease’ may encourage more people to use life insurance to pay the tax rather than trying to avoid it through sophisticated (and often complex) planning techniques.

Loss Of Marketability And Minority Discounts

When you die and own a business, your estate can often take marketability and minority discounts in determining the value of your interest. After all, who will pay full value for a piece of a family business – unless you are part of the family? Or for a business interest that can’t be freely sold?

One of the proposals (HR 436) would eliminate marketability discounts – even for interests owned by unrelated persons.

It would also eliminate minority discounts for family-owned interests in passive assets. Passive assets include cash or cash equivalents, stock of a corporation, options, derivatives, foreign currency, REIT interests, annuities, real estate used in a real estate business, collectibles, etc.

The change applies only to estate and gift taxes. It does not apply to generation-skipping transfer taxes.

  • This would mean no discounts for family limited partnerships or family limited liability companies that hold marketable securities, cash, or life insurance policies, etc.
  • The change would not eliminate marketability discounts for active businesses. It also would not affect valuation discounts for tenancy in common interests in tangible assets, such as real estate.
  • Family attribution rules could expand the impact of the bill.

Concluding Thoughts

If there’s anything certain about taxes, it is that they will change. Perhaps that’s part of why many people consider some of the more complex estate tax tools but only a small percentage of them actually adopt those concepts. Do you really want to do something that will be hard (or impossible) to unwind if you think the rules of the game may change – and what you’ve done will be rendered meaningless?

As these proposals wend their way through Congress, we’ll keep you updated.


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3 comments to Planning Implications of Proposed Estate Tax Changes

  • Geraldine Brown

    Do you have any tips for reconstructing basis especially on stock that may once have been held in certificate form? I have a client who began buying stock when he got out of the navy after WW II and continued purchasing or used dividend reinvestment in the stocks for his entire life. Some like General Telephone are almost incomprehensible. They were then moved through several investment firms like Merrill Lynch and Fidelity, each time without a recorded basis. Since at his his age he could die next year and these assets are valued at at least $2,000,000, we do not want to have to claim zero basis for his heirs.

    Posted by Geraldine Brown, Attorney at Robert E. Bourne, P.C. on the Trusts and Estates Network group on LinkedIn.com

    • Walt Bristow

      There’s an article on Kiplinger.com you may want to look at. The author says “The best tool I have seen for reconstructing basis in this kind of situation is called BasisPro. It’s part of a service called Gainskeeper, which is available for $349 per quarter. Also, the same service is available as part of TurboTax Premier tax preparation software.” The Turbotax software is $74.95.

      Marketwatch and Yahoo Finance can also help track down historical information.

      If the stock is held at a brokerage firm, their reorg departments may be able to help. Sometimes those back offices can do miracles.

      CCH publishes the Capital Changes Reporter. It has data on over 58,000 corporations going back over 100 years. You may be able to get access through an investment firm. Also, CPAs may have it. Larger libraries may have copies as well. It’s available in print, on CD and on the internet.

  • Heinz Brisske

    If portability becomes a reality in any new federal estate tax legislation, many people will be lulled into a false sense of security and think that they no longer need to engage in credit shelter planning. For many, that could end up being a huge mistake.

    For instance, not setting up a credit shelter trust means that the leverage available in such a trust will be lost. Assume that the predeceased spouse sheltered only $2 million. If the surviving spouse lives for a considerable period of time beyond that first death, that $2 million could easily grow to $3 million or beyond (assuming healthy rates of growth), and the surviving spouse would still have $5 million of exclusion to use ($7 million minus $2 million).

    Also, for second marriage situations, or remarriage situations, being able to protect assets for the predeceased spouse’s children is much more easily accomplished using a credit shelter trust than a marital trust.

    Asset protection is another reason to continue to do credit shelter planning.

    On the whole, even if portability becomes the law, I think that estate planners will be well-advised to review each client’s situation very carefully. Most married clients with larger estates, in my opinion, will still benefit from credit shelter planning. It may look somewhat different depending upon state death tax laws in your jursdication and other changes to federal estate tax laws, but the core principles will continue to be valuable and applicable.

    Posted by Heinz Brisske, Principal, Huck & Brisske, LLC on the Estate Planner Legal Network group on LinkedIn.com