Did I Hear Someone Say the Estate Tax Was ... Repealed?

By: C. Daniel Vaughan, Esq.

In 2001, Congress enacted the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which increased the federal estate tax exemption to $1,000,000 in 2002, $1,500,000 in 2004, $2,000,000 in 2006, $3,500,000 in 2009, and called for total repeal of the estate tax effective January 1, 2010. The flip-side of that rosy news was that unless a future Congress voted to make the 2010 repeal permanent, the entire Act would expire on January 1, 2011, resulting in pre-EGTRRA law and a $1,000,000 federal estate tax exemption from that point forward. Given the country’s recent rate of spending, and the nature of the political negotiations immediately preceding the 2001 legislation, which saw the two sides angling for exemptions commonly thought to be between $3,500,000 and $5,000,000, most estate planning attorneys believed Congress would enact new, permanent estate tax reform well before the estate tax repeal unceremoniously reverted back to a $1,000,000 exemption at the start of 2011. Instead, conventional wisdom predicted a more organized effort to step-off of the estate tax exemption train at the appropriate stop, leaving us with a resulting exemption in the neighborhood of $3,500,000. Specifically, most practitioners predicted 2009 as the most likely year in which both sides would roll up their sleeves and hammer out a compromise.

Unfortunately, with health care reform dominating much of the 2009 legislative agenda, Congress could manage little more than light banter regarding the final stages of EGTRRA. As the ball dropped to close out 2009, the estate tax was repealed ... at least for the time being. Estate planning attorneys, clients, and their advisors are now left to examine three questions previously thought to be moot, given the anticipation of pre- 2010 estate tax reform: (1) Where are we now (what rules govern 2010)? (2) Where might we go from here (what directions may the estate tax system take as we draw near, and enter, 2011)? and (3) How does this picture affect existing estate tax planning arrangements?

1. Where Are We Now - Estate Tax Rules under EGTRRA in 2010: Like all tax provisions, the details of the 2010 rules are complicated. The highlights of the system in effect for 2010 are as follows:
(i) No federal estate tax in effect;
(ii) No federal generation-skipping transfer tax in effect;
(iii) Federal gift tax system in effect ($13,000 annual gift exclusion, $1,000,000 lifetime gift exemption and 35% tax rate);
(iv) Updated rules regarding basis at death (partial step-up in basis/partial carry-over basis). In an estate tax environment, most assets receive a step-up in basis upon death, in order to prevent such assets from exposure to both estate and income taxes. Without an estate tax system in effect, the estate’s assets receive a limited step-up in basis, and the remaining assets retain the decedent’s cost basis.

2.    Where Might We Go From Here – What Directions May the Estate Tax System Take Moving Forward: Given that most practitioners incorrectly predicted events leading into 2010, you should take all conjecture regarding the future of the estate tax system as little more than educated guesswork. That said, there are three general directions Congress may take moving forward:
(i) Congress may pass legislation in 2010 re-establishing the estate tax with a new exemption amount and rate system, and apply that system retroactively to January 1, 2010. Congress would almost certainly face constitutional challenges to such retroactive taxation (as with past retroactive tax changes), but one has to ask if this Congress would be deterred by such a threat.
(ii) Congress may pass legislation in 2010 re-establishing the estate tax as described above and apply that system prospectively only. Because this would mean a free pass to all decedents dying prior to legislation being finalized, one would guess Congress would act quickly, should they choose this alternative.
(iii) Congress may do nothing, allowing EGTRRA to expire and the estate tax to return with a $1,000,000 exemption as of January 1, 2011. Previously thought to be as realistic as a mirage in the desert, one has to admit that the chances of EGTRRA’s expiration, while still seemingly small compared to options (i) and (ii), are slowly growing by the day. Should Congress do nothing, either as the path of least resistance or as a result of the tug-of-war leverage game often played out in the halls of the House and Senate, we are staring down the barrel of significantly reduced estate tax protection for 2011 and beyond.

3. How Does This Picture Affect Existing Estate Planning Arrangements: Given that all expectations are that the estate tax system will return in some form or fashion no later than January 1, 2011, the challenge is to determine whether planning arrangements should be updated to address the environment prior to that date. For example, if existing documents structure distributions in reference to “the maximum estate tax exemption,” the fact that there is currently no estate tax exemption (because the estate tax does not currently exist) may cause the resulting disposition to reach a result inconsistent with the grantor’s planning goals. Like any substantial change, either personal or legal/tax related, the most prudent step to take is to consult with an estate planning attorney to determine the steps, if any, you should take to ensure that your planning arrangements will accomplish your goals, in 2010 and beyond.

For continued coverage on developments related to the estate tax system, stay tuned to future newsletters. Until then, enjoy the estate tax-free environment while it lasts!

<em>Dan Vaughan is an attorney at law with Vaughan Fincher & Sotelo, PC, practicing in Leesburg and Vienna, VA. He can be reached at 703.506.1810.</em>