(To view this article as published in the August 2010 edition of the Massachusetts Lawyers Journal, please click here)
More than halfway through 2010, most unresolved estate and gift issues present in January remain. Congress has not altered the estate and gift tax. No formal procedure exists for allocating basis to assets inherited in 2010. Legislation regarding short-term GRATS and valuation discounts in family-held entities is pending. And § 2511(c) of the Internal Revenue Code has wreaked havoc on certain gifting strategies. With this uncertainty, it is vital for practitioners to understand the status of these issues, what lies ahead, and current opportunities.
1) Estate and Gift Tax. The federal estate tax is repealed for 2010. In 2011, the federal estate tax exemption returns to its pre-EGTRRA amount of $1 million, with a maximum estate tax rate of 55%. The House of Representatives passed a bill in December indefinitely extending the 2009 estate tax exemption of $3.5 million and a 45% estate tax rate. The Senate has been unable to pass a bill. With the November elections looming, it will be unlikely that Congress addresses the estate tax prior to that time. If 2011 arrives with a $1 million estate tax exemption and 55% tax rate, there will be a greater need for credit shelter trusts, irrevocable life insurance trusts, and other estate tax-saving trusts.
One of the major impacts of the absence of estate tax is on drafting and funding of trusts for married couples. Many trusts include funding formulas based on the current estate tax law and require the use of a Marital Trust only when needed to eliminate estate taxes. Thus, in 2010, all trust assets would be allocated to the credit shelter trust. This may leave the surviving spouse with less access and control than originally expected, and create conflicts of interest between the surviving spouse and the deceased’s children. The use of disclaimer trusts is one solution, allowing the surviving spouse to accept trust assets or disclaim all or a portion of them to fund the credit shelter trust.
The gift tax is not repealed in 2010. Taxpayers have a $1 million lifetime gift tax exemption. The maximum gift tax rate in 2010 is 35%. In light of the 2009 gift tax rate of 45% and 2011 rate of 55%, donors intending to make significant gifts could take advantage of the 35% rate.
2) Pending Legislation Regarding GRATs and Valuation Discounts. A donor transferring assets to a GRAT must retain an annuity interest for a term of years. For gift tax purposes, the amount of the transfer is the present value of the annuity plus a statutory imputed rate of return. If the actual rate of return exceeds the statutory rate, then the assets remaining at the end of the term pass to the remaindermen gift tax-free.
If the donor dies during the GRAT term, the assets are included in the donor's estate. To minimize this risk, a short annuity term, such as two years, is used. Further, short term GRATs capture rapid upswings in valuation. The Small Business and Infrastructure Jobs Tax Act of 2010, however, would impose a minimum ten-year term. The House passed the bill on March 24, 2010, but the Senate has not voted on the bill. Because the bill would not be retroactive, practitioners should take advantage of short-term GRATs now for appropriate clients.
The use of minority and/or lack or marketability discounts in family-held entities such as Family Limited Partnerships can yield significant gift and estate tax savings. H.R. 436, introduced in January 2009, provides that minority interests in a family-held entity that owns non-business assets are not entitled to such discounts. In its March 2010 budget report, the Joint Committee On Taxation again referenced eliminated of these discounts. Again, practitioners contemplating the use of valuation discounts should consider implementation now.
3) Carryover Basis and Allocation of Basis. Prior to 2010, the basis of an inherited asset equaled the asset's fair market value as of the decedent's date of death (stepped-up basis). In 2010, the basis of an inherited asset equals the decedent's original basis in the asset (carryover basis). The impact of this rule is mitigated for smaller estates. Property passing to those other than the surviving spouse receives a basis increase of $1.3 million and property passing to the surviving spouse, including QTIP property, receives a basis increase of an additional $3 million (not to exceed fair market value in both cases).
The carryover basis rules pose administrative problems. For estates exceeding the basis increase amounts, the executor must allocate basis asset by asset on Form 8389 and attach the form to the decedent’s final income tax return. There is a $10,000 penalty for failure to file this form. The Internal Revenue Service, however, has not issued the form yet. There is the additional challenge of determining the carryover basis, as original basis information is often unascertainable. Counsel to fiduciaries must consider tax filing positions carefully.
Fiduciaries and family members should be advised to locate and maintain any records that substantiate basis. Conflicts of interest could arise and fiduciaries should consider obtaining releases from beneficiaries before allocating basis to particular assets.
4) Section 2511(c). Effective only in 2010, § 2511(c) provides that if a transfer is made to a trust that is not a wholly-owned grantor trust, the transfer will be treated as a gift for gift tax purposes. Certain planning techniques are impacted by this rule. Transfers to non-grantor Medicaid trusts will be completed gifts, even if structured to result in an incomplete gift. The inclusion of grantor trust provisions over both income and principal should comply with § 2511(c) and still render the principal non-countable for Medicaid purposes.
§ 2511(c) also eliminates for 2010 a planning technique for business owners selling businesses. To avoid state income tax, a business owner may transfer ownership of the business to a properly structured asset protection trust created in New Hampshire (or a few other states), and the out-of-state trust sells the ownership interest. The trust can be drafted such that transfers to the trust are complete for income tax purposes but incomplete for gift tax purposes. Because the trust must be a non-grantor trust to avoid state income tax, the business owner will need to utilize gift tax exemption and might pay gift tax. Drafting the trust as a grantor trust to comply with § 2511(c), however, will result in state income taxation. Business owners contemplating the sale of a business and the use of the strategy are well-advised to postpone the sale, if possible, until 2011.
Whether these issues will be resolved by the end of 2010 remains to be seen. One thing is certain – their resolution will have a significant impact on the estate and gift planning environment.