Letter to Clients

Dear Clients and Friends:

As you have probably heard in the news, last year a new tax law was passed, the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"), creating considerable uncertainty for estate planning. We are now left wondering whether or not there will be estate taxes.

EGTRRA repeals the estate and generation-skipping transfer taxes - but not the gift tax -for one year, 2010. In 2011, we are back to today's rules meaning that each person can leave $1,000,000 (the so-called "exemption amount") without paying any estate taxes.

From now until the repeal, the exemption amount increases from $1,000,000 to $3,500,000. The problem in a nutshell is that the estate plan you have today will be not be adequate if you die in 2010. The not so funny joke amongst my colleagues is if you can tell us when you will die, we can prepare the appropriate plan. The problem created by EGTRRA is not at all funny and the consequences for all of us are serious.

The purpose of this letter is to briefly summarize EGTRRA and share our thoughts on the implications of the new transfer tax laws for estate planning.

THE NEW LAW

Background
Under the tax system effective this year, a person's estate is subject to estate tax on everything over the exemption amount of $1,000,000. A married couple gets a double exemption if after the first death assets equaling the exemption amount are put into a "bypass trust" (i.e. a married couple dying this year can leave $2,000,000 without estate tax). Even if the decedent's share is more than the "exemption amount", generally no estate tax is due at the first death if everything passes to a surviving spouse who is a U.S. citizen. When assets are inherited from a decedent, the income tax basis of appreciated assets are "stepped up" to the fair market value of the property.

Key Components of EGTRRA Affecting Estate Planning
The parts of EGTRRA most important for estate planning are as follows:

  • The top tax rates for estate tax, gift tax, generation-skipping transfer tax ('GST") are gradually reduced.

  • The amount exempt ("exemption amount") from the estate tax and generation-skipping transfer tax (but not the gift tax) is gradually increased. Estate taxes are repealed in 2010.

  • The "step-up" in the income tax basis of appreciated assets acquired from a decedent is repealed when the estate tax is repealed in 2010.

Increased Exemption Amounts and Decreased Tax Rates
The following table demonstrates the gradual increase in the "exemption amount" and modest decrease in tax rates under EGTRRA:

Calendar Year of Death Estate and Generation Skipping Tax Exemption Amount Highest Estate and Gift Tax Rates
2002$ 1 million50%
2003$ 1 million49%
2004$ 1.5 million48%
2005$ 1.5 million47%
2006$ 2 million46%
2007$ 2 million45%
2008$ 2 million45%
2009$ 3.5 million45%
2010N/A (taxes repealed)(gift tax only)
2011$ 1 million55%

Repeal of "step-up" Rules
If the estate tax and GST tax repeal is enacted in and after 2010, the present rules providing for a fair market value ( i.e., "stepped-up") income tax basis for property acquired from a decedent will be eliminated and replaced with a modified "carry-over" basis. This means that, for purposes of computing capital gain, inherited assets will not receive a full basis adjustment equal to the value of the assets at the date of death, as is now the case. Instead, appreciated inherited assets will retain the decedent's basis, which may result in substantial capital gains taxes when the inherited property is sold. EGTRRA does provide for a limited increased basis: an aggregate increased basis of $1.3 million may be allocated to a decedent's assets; and an additional aggregate increased basis of $3 million may be applied to assets passing to a surviving spouse.

CONSIDERATIONS FOR ESTATE PLANNING

Implications for Estate Planning Structure
Most estate plans provide for the estate to be divided into sub trusts after the demise of the first spouse. The sub trusts have either tax savings goals (avoiding estate tax at the second death) or non-tax goals (preserving a portion of the estate for children). The formula clause commonly dictates that the exemption amount will be put into a "bypass trust" (for the benefit of the surviving spouse or other beneficiaries).

Typical formula clauses allocate the largest amount of property to the bypass trust to reduce estate taxes at the survivor's death. However, what if, one spouse dies, and after that first death, estate taxes are repealed? An aggressive formula maximizing the bypass trust could create an income tax liability without any estate tax savings.

Further, if there is no federal estate tax, the typical formula clause could result in disinheriting your spouse or your children. For example, if the "exemption amount" is all of the first spouse's assets (all assets would be exempt if there is no estate tax), and the plan allocates the "exemption amount" to children or other beneficiaries, an intent to provide for the surviving spouse would be completely subverted and the spouse would receive nothing. If, on the other hand, the "exemption amount" is retained in a "bypass trust" of which the surviving spouse is the primary beneficiary, the surviving spouse is protected but other beneficiaries would receive nothing.

In sum, if transfer tax repeal is implemented, typical formula clauses will have no place and offer no guidance for allocations to sub trusts after the death of the first spouse. On the other hand, if the taxes are not repealed, such formulas are highly desirable to minimize and postpone transfer taxes. We anticipate additional legislation within the next few years to resolve the current uncertainty.

Implications for Appreciated Assets
Under EGTRRA, the current unlimited "step-up" in basis is replaced with a limited "step-up" in basis. The limited increased basis provisions will shelter $3 million for assets transferred to a spouse plus $1.3 million for assets transferred to anyone, plus another $1.3 million for assets transferred on the death of the surviving spouse. The step up rules apply to $5.6 million of appreciation in the assets, not merely to the fair market value of the assets.

In effect, the new tax laws replace an estate tax with a capital gains tax. Therefore, where current estate plans reduce estate taxes, future plans will take advantage of the new carryover and basis step-up rules to save capital gains tax.

Summary of Planning Considerations

  • Most current estate plans do not adequately address EGTRRA if the decedent dies in 2010. Once further legislation is passed clarifying the tax system, plans can be modified. If estate taxes are in fact repealed, most estate plans will need to be revised.

  • The prospect of carry-over basis in 2010 requires increased attention to keeping records of the income tax basis of each asset to minimize difficulties for beneficiaries. Records must be maintained for improvements made to all real estate and for items acquired as gifts or from the estates of parents or others from whom assets are inherited.

  • If repeal of the estate tax is implemented, life insurance will still be advisable because of anticipated exposure to capital gains tax on assets inherited after 2010 and the likelihood of state inheritance taxes. However, the amount and type of insurance should be reviewed.

  • Planning with trusts for non-tax reasons will remain as important as ever. The use of trusts for management purposes in the event of incapacity, to hold assets for minors, to protect assets from a beneficiary's potential creditors and to protect against a beneficiary's spendthrift habits are not affected by changes in the tax law.

  • In light of the uncertainty of changes, but the potentially dramatic effect such changes may have on estates and their beneficiaries, estate plans will need much more flexibility than in the past. As the law changes, you need mechanisms to amend your estate plan, especially if you become incapacitated.

  • Formula clauses must be reviewed in light of the possibility of estate tax repeal. Some clauses may generate an income tax liability on the funding of the sub trusts without resulting in any estate tax savings.

Checklist in Reviewing your Estate Plan
The question many of you are now asking is what do you need to do in light of the changes in the tax laws. To start ask yourself:

  1. Is my estate, including all my life insurance, retirement plans, home equity, real estate and other assets, subject to estate tax (see chart of "exemption amount" on page 2)? Do I have an A-B trust or an A-B-C trust, meaning that on the first death my assets will be divided into a bypass, survivor's and QTIP trust? If your answer to either question is "yes", then if estate taxes are repealed, you will need to revise your plan. Most everyone is waiting for further legislation before amending current plans.

  2. If my estate is greater than the "exemption amount", could my formula clause create an income tax liability? If post death appreciation is allocated to sub trusts such that the amount put into the bypass trust is "fairly representative" of the overall appreciation, then your formula clause will not generate an income tax liability on the funding of sub trusts. Since most people do not believe that estate taxes will be repealed, even if your formula may generate an income tax liability, you will be maximizing the bypass trust. The estate tax savings usually outweigh the income tax paid.

  3. Did I sign a Durable Power of Attorney that allows my agent to amend my trust if I am incompetent? If so, then your agent can amend your trust if estate taxes are in fact repealed and you are incapacitated. Nevertheless, if you are concerned about the possibility of incapacity, then you may want to consider appointing a special trustee who can modify your plan. It is easier for a special trustee than for an agent under the Durable Power of Attorney to amend the plan. If you are concerned about becoming incapacitated and then the tax law changing, you would amend your trust now to appoint a special trustee with power to further modify your trust to conform to the new tax laws.

  4. Lastly, review other general issues: Are all of my assets are in my trust? Have my financial or personal circumstances changed? Am I comfortable with my choice of guardian and trustee? Do I have enough life insurance? Should I discuss a Section 529 college savings plan with my financial advisor? Do I own property as joint tenants that can now be owned as "community property with rights of survivorship"? Do I have a Buy-Sell Agreement with my business partner? Have I reviewed my plan within the last 2 years?

CONCLUSION

This letter highlights the estate planning considerations that flow from the EGTRRA changes in the estate tax, gift tax and generation-skipping transfer tax laws. Since there will be three Congresses and at least one new president before 2010, a total repeal of the estate and the generation skipping tax is not clear. A Republican House, Senate and President passed repeal in 2010, at a time of large federal budget surpluses. Changes in the Congress and White House or a continuing economic downturn could make actual repeal impossible. Further, the sunset provision makes estate tax repeal temporary (one year) under the current law, and easy to change.

Although estate tax repeal may never happen, we advise you to review your plan in light of EGTRRA. If you have any questions about reviewing your plan, please do not hesitate to contact us.

Yours truly,
LERMAN & LERMAN

This summary is intended to provide an overview of developments in and implications of the tax laws that affect estate planning. It should not be construed or relied upon as tax or legal advice.