Change Continues: Federal Estate, Gift and Generation-Skipping Transfer Tax Changes to Exemption Amounts, Exclusion Amounts and More to Come?

Estate Tax Exemption for 2009 Increases to $3.5 Million

The year 2009 will bring an expected increase in the amount that may pass free of federal estate tax, and the new year also brings a number of questions about the future of the estate tax. Since 2001, the estate, gift and generation-skipping transfer taxes have been in a state of change, as to rates and the amounts of property that can pass free of tax. Under current law, the federal estate tax exemption equivalent amount will increase in 2009 from $2 million to $3.5 million. The maximum federal estate tax rate for 2009 remains at 45 percent.

Estate Tax Repeal For 2010 — Reinstatement in 2011 — Congressional Action

The current law calls for full repeal of the federal estate tax in 2010, which means that no federal estate tax would be imposed on the estates of those who die in 2010. If Congress does not enact alternate estate tax legislation, the federal estate tax will return in 2011, with an exemption equivalent of only $1 million and a top estate tax rate of 55 percent.

There are indications that Congress may enact estate tax legislation during 2009, rather than have the 2010 repeal of the federal estate tax go into effect as scheduled under current law. The current tax plan of President-elect Obama calls for freezing the estate tax exemption at the 2009 level of $3.5 million, with a 45 percent estate tax rate. A popular contemplated change is so-called “portability” of estate tax exemptions between spouses, which could simplify estate tax planning for married couples significantly. Under the current estate tax system, each spouse must use his or her own estate tax exemption equivalent independently, or its benefit will be lost. This is a common occurrence when one spouse leaves everything to the surviving spouse. With portability of the estate tax exemption, couples could plan for the optimal use of the exemption equivalent available to the couple, but complications arise in the context of multiple marriages. If portability of the estate tax exemption is enacted, most married couples will wish to revisit their existing estate plan.

Annual Gift Tax Exclusion Increases For 2009

Each year, donors may make annual exclusion gifts directly to any individual, each referred to as a donee, or to certain trusts benefiting a donee, without gift tax consequences. In 2009, the amount of such excluded gifts increases from $12,000 to $13,000. Married couples may elect to split gifts, which allows a married couple to gift $26,000 per donee each year. Since there is no limit to the number of annual exclusion gifts that a donor may make to different donees, annual exclusion gifting is a surprisingly useful technique of transferring wealth without reducing a donor’s valuable gift and estate tax exemption. Additionally, special rules exempt the direct payment of qualified health and education expenses from gift tax, so direct payment of health insurance premiums, tuition and other similar expenses may be made on behalf of an individual in addition to gifts of the annual exclusion amount to that individual.

Gift Tax Exemption Equivalent Remains at $1 Million

Regardless of the increase to the estate tax exemption equivalent amount under current law, in 2009 the exemption amount for lifetime gifts remains at $1 million. Thus, lifetime gifts in excess of $1 million will trigger the payment of a federal gift tax, even though the estate tax exemption, if death were to occur during this period, would be $2 million in 2008 and $3.5 million in 2009.

The gift tax exemption also remains at $1 million in 2010, when the federal estate tax is repealed for one year under current law. The top marginal federal gift tax rate is to be 35 percent in 2010. In 2011, the gift tax exemption is to be $1 million, and the top marginal federal gift tax rate is to be 55 percent.

Generation-Skipping Transfer Tax Exemption Equal To Estate Tax Exemption

The generation-skipping transfer (GST) tax is imposed, in addition to the estate tax, generally on transfers of property — made directly or through a trust or similar arrangement —  to a “skip person” (i.e., a beneficiary in a generation more than one generation below that of the transferor, such as a grandchild or more remote issue of the transferor or a non-relative more than 37½ years younger than the donor). The GST exemption tracks the estate tax exemption amount until the GST tax is repealed in 2010. The GST exemption in 2009 will be $3.5 million, with a tax rate of 45 percent. In 2010, the GST tax is repealed, and there is no GST tax. For generation-skipping transfers after 2010, the GST exemption will be $1 million, indexed for inflation after 1997, with a tax rate of 55 percent.

Can You Ensure That the Changes in Estate, Gift and Generation Skipping Transfer Tax Exemption Amounts and Tax Rates Do Not Thwart Your Estate Plan?

With the varied federal estate tax exemption amounts currently scheduled for 2009-2011 planning is complex, but is still possible and arguably more necessary than never. Additionally, the known and expected changes in the estate tax law may make it necessary to rethink your current estate plan and possibly change your will (or revocable trust).

Among issues to consider is whether the tax planning called for on the first spouse's death is appropriate. For example, with the increased exemption amount in 2009, if your will provides for a so-called bypass or credit shelter trust in an amount generally equivalent to the federal estate tax exemption, the result could be that more assets than you might wish would be distributable to that trust. Consequently, this could also mean that your spouse would receive a smaller amount outright, or that a credit shelter trust for your children's benefit would receive more than you expected or desired when you made your will.

State estate taxes are also a growing concern. Depending upon your state of residence and in which states you own property, it may now be the case that state estate or inheritance tax will be at a level that could also result in an increased overall estate tax liability. The reasons for this are complex and vary on a state-by-state basis, so it is important to consult estate planning counsel regarding this issue. In short, many states now have state estate tax exemptions that are lower than the federal exemption. As such, an estate could be exempt from federal estate tax but have liability for state estate taxes. In fact, in some states an estate plan for a married couple, designed to save maximum federal estate taxes, could trigger a state estate tax. Some states have enacted laws that allow for state estate tax deferral when a state estate tax is triggered on the first spouse's death, but extreme care must be taken to ensure that an estate can take advantage of such state estate tax deferral.

Another development on the state law level is that a number of states have adopted versions of the Uniform Trust Code. Trusts (and wills that create trusts) that are governed by the laws of a state that has adopted the Uniform Trust Code should be reviewed to ensure that the Uniform Trust Code provisions are complied with or that various opt-outs are considered.

Will Carryover Basis Become Effective?

For estates that consist of substantially appreciated assets, the 2010 estate tax repeal is offset by the modified carryover basis rules that would apply, in 2010 only, to a decedent's assets, rather than the step-up in basis rules that apply under current law. The step-up in basis (to the greater of an asset's fair market value or the decedent's basis) will still apply to $1.3 million of a decedent's property and an additional $3 million of a decedent's property that meets the definition of qualified spousal property transferred to a spouse. The decedent's basis is further increased by certain capital loss carryovers, net operating loss carryovers and built-in losses. As such, even with the carryover basis regime, beneficiaries, especially of smaller estates, may actually receive a stepped-up basis in inherited assets.

Because the personal representative (executor) of the estate has the power to allocate the step-up in basis asset-by-asset, in some estates direction to the personal representative regarding the basis allocation may be warranted, and it may be prudent to review whether the selection of the personal representative is appropriate considering the personal representative's significant power to allocate basis.

Action: Estate Plan Review

It has always been true that periodic review of existing documents by trusted counsel is advisable to ensure that your estate plan continues to meet your needs and current family circumstances and reflects your wishes. With the significant changes summarized above, it is important to revisit your estate plan frequently to ensure that you remain comfortable with the federal and state tax consequences.