Recent Changes to Federal Transfer Tax Laws

March 2010

2010 brings with it unprecedented changes to gift, estate, and transfer taxes ("federal transfer taxes").

This memo explains the changes that took effect on January 1, 2010, and the additional changes that are anticipated, and describes some planning opportunities that may be of interest to you.

Changes in 2010

Congress took no action before the end of 2009 to prevent the changes (described below) to the federal transfer tax laws that were enacted in 2001 from going into effect as scheduled on January 1, 2010. Instead, Congress will probably pass legislation sometime this year, reinstating the law that was operative in 2009, and make the legislation effective retroactively. This means that for some period during 2010, the laws enacted in 2001 remain in effect. The legislation that changes rates or reinstates taxes on a retroactive basis might give rise to protracted legal challenges, which could create additional uncertainty.

The changes that took effect on January 1, 2010 are:

  • No federal estate tax on the estates of individuals dying during 2010.

  • No generation-skipping transfer tax on transfers in 2010 to grandchildren or more remote descendants.

  • A federal gift tax at a flat rate of 35% on an individual's lifetime gifts made during 2010, after that individual uses up his or her lifetime gift tax exemption amount of $1,000,000.

  • Introduction of a "carry-over" income tax basis for assets owned at death. "Basis" is the original cost of an item.  When the item is sold, its basis is subtracted from the proceeds of the sale to determine taxable gain. Under previous law, property owned at death automatically received a “stepped-up” basis equal to its date-of-death value. This  eliminated a tax being imposed on any pre-death appreciation in the value of the asset when it was eventually sold. The basis adjustment has now been eliminated, and property owned by a decedent is not "stepped up" to the fair market value of the asset at death. Instead, it "carries over" – that is, the basis is the lower of the decedent's original cost basis or the fair market value of the asset at death.  The law also now provides an additional allowance that permits the basis to be raised on a certain amount of assets to their fair market value at death.

Possible Legislation in 2010

We cannot predict what Congress will do with federal transfer taxes. Based on Congressional action to date, we believe it is likely that Congress will extend (perhaps "permanently") the federal transfer tax laws that were in effect in 2009 – that is, a federal estate tax exemption of $3,500,000 per person and a top estate- and generation-skipping transfer tax rate of 45%. It is possible that we might see even larger exemption amounts (perhaps up to $5,000,000 per person) and lower rates. It is also possible – but we believe less likely – that the estate and generation-skipping transfer exemption amounts will be reduced to $2,000,000 per person and rates increased above 45%.

The administration has also sought to close certain estate planning "loopholes" by reducing the availability to our clients of valuation discounts on transfers to family members, and by making it more difficult to transfer assets with no gift tax through the use of grantor-retained annuity trusts (GRATs). Even if Congress does not act, the Treasury Department may use its regulatory authority to restrict valuation discounts.

Scheduled Changes in 2011

If Congress continues to fail to act, the legislation enacted in 2001 is scheduled to "sunset" after December 31, 2010, which means that on January 1, 2011, the federal transfer tax laws will return to what they were in 2001.  The result would be:

  • Federal estate tax on estates of deceased individuals dying after December 31, 2010, at a top rate of 55 % (effective rate of 60% for certain estates); an exemption amount of $1,000,000 per person; and a credit allowed for state death taxes.

  • Federal gift tax rates graduated from 41% to 55% after exhausting the lifetime gift tax exemption amount of $1,000,000 per person.

  • Generation-skipping transfer tax rate of 55% on transfers to grandchildren or younger generations (or trusts for their benefit) after December 31, 2010, with a separate lifetime exemption of $1,000,000 per person (as adjusted for inflation after 1998).

  • Income tax basis of assets owned at death will again be "stepped up" to their fair market value at date of death.

If these changes are allowed to go into effect, they will dramatically increase the number of individuals affected by federal transfer taxes and the resulting amount of tax owed.

Planning Opportunities

This very confusing status of the federal transfer tax laws makes estate planning extremely difficult.

If Congress does not retroactively repeal the changes that took effect on January 1, 2010 (or if a court were to rule that retroactive changes are not permissible), there may be a brief window within which to take advantage of the lower gift tax rates, which decrease from 45% to 35%, by making gifts. In addition, there may be opportunities to take advantage of the repeal of the generation-skipping transfer tax by:

  • Making outright gifts to grandchildren and younger generations;

  • Making distributions from existing trusts that are not exempt from GST tax; and

  • Making a gift to a marital deduction trust with the remainder passing to grandchildren or more remote descendants (that might be grandfathered from future GST tax law changes).

Undertaking any such planning will carry risks and uncertainty about the application of future legislation which, if retroactive, could result in additional taxes. For example, if outright gifts to grandchildren in early 2010 do become subject to the retroactive imposition of gift and GST taxes at the rates that were in effect (a likely possibility), the combination of a 45% gift tax and a 45% GST tax on gifts greater than the available gift tax exemption and GST exemption could result in an effective tax rate of 110% on the amount of the gifts. Therefore, implementing any of these techniques will require careful consideration and will have to be structured as flexibly as possible in the face of possible future legislation.

This description is necessarily general and simplified. What we can say, however, is that if it begins to look as if the federal estate and generation-skipping transfer taxes will be eliminated for a significant period of time, your will or living trust should be examined to make sure that it accomplishes your objectives. And regardless of what action Congress does or does not take, this may be a good opportunity to review your current estate planning documents.

This memorandum presents a significant amount of information. After you have had a chance to read it, please feel free to contact us to discuss any questions you may have. We would be happy to review with you your current estate planning documents and the potential opportunities discussed above.