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Uncertainty of Estate Taxation and Importance of Estate Planning

In 2001, Congress enacted the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). The EGTRRA reflects congressional cooperation on several issues including tax rate reduction, estate tax repeal, marriage penalty relief, education incentives, child tax credit increase, pension reform, and alternative minimum tax relief. Congress designed the EGTRRA to meet budgetary constraints by phasing the provisions in and out over a ten-year period, with a projected sunset in 2011 that would reinstate the tax law as it was prior to the enactment of the EGTRRA.

Under the estate tax provisions of EGTRRA, the tax rates have steadily declined from 55% in 2001 to 45% in 2009. The exemption amount has steadily increased from $1 million in 2001 to $3.5 million in 2009. Meanwhile, the transfer of property owned by an individual at death will pass to heirs tax-free in 2010 due to the estate tax repeal, which provides for no federal estate tax imposed on the transfer as well as an unlimited exemption amount. However, as a result of the projected 2011 sunset provision, the tax rate will return to 55% while the exemption amount will return to $1 million. Although the sunset has been removed from some of the EGTRRA provisions, Congress has done nothing to make the estate tax repeal permanent nor to change the tax rates or exemption amounts after 2010.

There appear to be four possible alternatives to managing the upcoming estate tax repeal and sunset provisions of the EGTRRA. First, Congress could do nothing and let the repeal occur in 2010 and the EGTRRA provisions sunset in 2011. This would allow the estate tax to vanish entirely next year and thenreappear in 2011 with a tax rate of 55% and an exemption amount of only $1 million. Second, Congress could pass legislation to make permanent the 2009 tax rate and exemption amount of 45% and $3.5 million, respectively. President Barack Obama's budget recently passed by Congress includes a stated assumption that the estate tax will remain at the 2009 rate and exemption amount. Because of this stated assumption, it is apparent that President Obama and the Democratic congressional leaders strongly oppose repeal of the estate tax. Therefore, it would be reasonable to anticipate that Congresswill approve legislation that extends the estate tax into future years. Third, Congress could pass legislation that increases the tax rate and/or decreases the exemption amount. This alternative would allow the federal government to generate more revenue as a result of a higher tax rate and the possibility of more estates being subject to estate tax due to a decreased exemption amount. Fourth, Congress could enact a temporary patch for 2010. This temporary patch would extend into 2010 the 2009 tax rate of 45% and the 2009 exemption amount of $3.5 million. More than likely, the patch would be enacted in late 2009 to be effective for 2010. There is an expectation of major legislation in 2010 to make permanent the estate tax and exemption amount to be effective for 2011 and future years.

Although Congress is likely to pass legislation to eliminate the temporary repeal and make the estate tax permanent, there is still much uncertainty regarding estate tax and estate planning. Under current law, the lowest tax rate and largest exemption amount are in effect this year, no estate tax is in effect next year, and then a higher tax rate and lower exemption amount are in effect for 2011. Regardless of what happens in Congress with the estate tax, there are several methods that can be implemented in order to lower an individual's gross estate. These methods will reduce the amount of estate tax levied on the transfer of property that is included in the individual's gross estate at death.

One way to lower an individual's gross estate is to gift amounts during an individual's lifetime. For 2009, an individual is allowed an annual gift tax exclusion for gifts of up to $13,000 per donee to an unlimited number of donees. Spouses may combine their annual exclusion amounts and give split-gifts of up to $26,000 per donee. Even if the entire gift comes from only one spouse, an election can be made on a gift tax return to treat the gift as being made by both spouses, thereby allowing annual tax-free gifts by one spouse of up to $26,000 per donee. Also, gifts in excess of the annual exclusion amount may be offset by an individual's lifetime gift tax exemption, which is currently $1 million.

In addition, payments for health care expenses and qualified tuition are not subject to gift tax and are considered to be tax-free gifts if paid on behalf of someone else. However, the payments must be madedirectly to the provider of medical or educational services and should not be paid as reimbursement to the person who incurred the expenses. The exclusion is unlimited, meaning that any amount may be paid on behalf of someone else for health care expenses or qualified tuition and still be considered a tax-free gift.

Another way to lower an individual's gross estate is to transfer property tax-free from one spouse to the other spouse, who is a United States citizen. The property transfer may be made outright or in trust to the spouse. Generally, a trust must, at a minimum, distribute all income to the spouse for life in order to qualify as a tax-free transfer to the spouse. In order for the trust to qualify as tax-free, there can be no limitations on the requirement of distributing all income to the spouse for life. Therefore, a trust that provides limitations such as distributions of income to the spouse until that spouse sells the house or remarries will not qualify as a tax-free trust. However, tax-free transfers between spouses may still be accomplished even though the surviving spouse receives a life estate if the executor of the estate elects to have the property qualify as a qualified terminable interest property (QTIP) trust. With a QTIP trust, no estate tax applies on the transfer of assets to a spouse, but estate tax may apply upon the death of the surviving spouse because the assets in the QTIP trust will be includible in the spouse's gross estate. The QTIP trust guarantees that remaining assets after the death of the surviving spouse will pass to the beneficiaries, who were previously selected by the first deceased spouse. The QTIP trust also offers a measure of asset protection for the surviving spouse because the QTIP assets can only be used for the benefit of the surviving spouse and are not generally recoverable by creditors of the surviving spouse.

An interesting concept that has been discussed by Congress is portability of the lifetime exemption amount between spouses. This concept would allow the remaining lifetime exemption of the deceased spouse to transfer to the surviving spouse at death. The lifetime exemption amount is expected to remain at the 2009 amount of $3.5 million. Should portability be enacted by Congress, spouses will not have to be as concerned with who owns what assets during life and at death because any unused amount at the death of the first spouse would automatically transfer to the surviving spouse. For example, if wife died first and had $1 million in assets at her death and husband had $6 million in assets, then wife would use only $1 million of her $3.5 million lifetime exemption amount. Her remaining $2.5 million would then transfer to husband, which would allow husband's entire $6 million in assets to avoid estate taxation upon his death.

One thing is for certain. In order to fund various programs and stimulus packages, the Obama Administration will be seeking to derive revenue from many sources. Based on the recent actions of Congress, one could be led to believe that the estate tax will not be repealed and will more than likely remain at the 2009 tax rate of 45% and 2009 exemption amount of $3.5 million. However, Congress could generate more revenue by either increasing the 2009 tax rate and/or decreasing the 2009 exemption amount, or by doing nothing and allowing the estate tax to revert back to the tax rate of 55% and exemption amount of $1 million, which were in effect before the passage of EGTRRA. This would subject more estates to taxation, thus raising more revenue. Methods such as making lifetime gifts, making payments for health care and qualified tuition, and transferring property from one spouse to the other can assist individuals in avoiding estate taxation by lowering an individual's gross estate. Because estate tax rates are substantial, these methods will be increasingly important in the event that the exemption amounts decrease in the future. What should you do? You should begin estate planning under existing law because it is safe to assume that the estate tax will not be repealed in the near future. Also, keep in mind that not making a decision regarding estate planning is making a decision. If death occurs prior to any estate planning, it could result in unnecessary taxation of an individual's gross estate. The bottom line, begin estate planning now.

About the author: Chrissy M. Leggett, CPA

Chrissy Leggett is a tax services supervisor at HORNE LLP and provides family wealth and advisory services and specializes in trust and estate taxation.