Tracy Craig, The Daily Record Newswire
Only a few weeks are left before the end of 2012, and thus far there still is no resolution to the so-called “fiscal cliff” situation.
The term fiscal cliff, coined by Federal Reserve Board Chairman Ben Bernanke, refers to the combination of tax increases and mandatory spending cuts that are scheduled to take place on Jan. 1. That combination is due to the simultaneous expiration of multiple tax acts and extensions enacted over the past two years, coupled with mandatory spending cuts agreed to during the summer of 2011 by a bipartisan Congressional Debt Reduction Commission referred as the “super committee” in order to avoid a possible government default in the face of the debt-ceiling crisis.
While most of the discussions about the fiscal cliff seem to focus on how income taxes, capital gains taxes and qualified dividend tax rates may be affected by whatever deal Congress eventually makes (or fails to make), estate and gifts taxes also stand to be affected significantly.
Yet, these transfer taxes are typically given only a cursory treatment in most media stories on the subject.
By way of review, back in 2001, then-President Bush passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (or EGTRRA), which had the dual effect of gradually increasing the federal estate tax exemption amount until it reached $3.5 million per person in 2009, while simultaneously gradually decreasing the tax rate to a flat 45 percent tax.
EGTRRA culminated in 2010, with one year of federal estate tax repeal, while maintaining the federal gift tax at a flat rate of 35 percent (keyed to the highest graduated income tax rate) and a $1 million exemption amount.
However, EGRTRRA was scheduled to sunset on Dec. 31, 2010, resulting in an unwelcomed return to pre-EGTRRA exemption amounts and tax rates.
In December 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (or the 2010 Tax Relief Act), which (among other things not related to transfer taxes) had a profound effect on estate planning over the past two years.
The 2012 Tax Relief Act increased both the federal estate and gift tax exemption amounts to $5 million for 2011 (and then to $5.12 million in 2012), decreased the federal estate and gift tax rate to a historically low flat 35 percent rate, and created portability of federal estate tax exemptions (the ability to effectively leave your unused estate tax exemption amount to your spouse at death).
Similar to EGTRRA, the 2012 Tax Relief Act had a sunset provision, namely, Dec. 31, 2012, which brings us to the present fiscal cliff situation.
Unless Congress acts, the federal estate and gift tax exemptions amount will change to pre-EGTRRA law, or $1 million exemption amounts per person, and the federal estate and gift tax rates will again be graduated, starting at 41 percent and going up to 55 percent in most cases (with a 60 percent tax rate for estates in the range of $10 million to $18 million).
In addition, portability will cease to exist.
Prior to EGTRRA and the 2012 Tax Relief Act, the highest the federal estate tax exemption amount had ever been was $3.5 million (with the exception of the short-lived estate tax repeal in 2010), and the gift tax exemption amount reached a maximum of $1 million.
Many practitioners were caught by surprise with the increase of exemption amounts from $3.5 million to $5 million, and correctly saw the 2012 Tax Relief Act as a possibly (or likely?) limited time opportunity to make very large lifetime gifts for the first time ever without actually paying a gift tax.
Also prior to EGTRRA, the estate tax law of practically all states depended on federal law. States received a portion of federal estate taxes paid due to what was known as the state death tax credit.
EGRTRRA effectively phased out that credit. As a result, roughly half of the states, broke away (or “decoupled”) from the federal estate tax and created their own state estate tax. Most of these state estate taxes worked off of some prior version of the federal estate law. New Hampshire is the only state in New England that currently does not have a state estate tax.
All of this background should make it painfully apparent that these multiple tax laws have had the effect of drastically increasing the complexity involved in estate planning, especially when taking into account that many people own property in multiple states with different state estate tax laws.
Moreover, all of this planning is now done in an environment of uncertainty in which planners and clients alike are forced to engage in a sort of sophisticated guessing game regarding what exemption amounts and tax rates may be when we all wake up on Jan. 1.
But is it possible to predict?
Although it is practically impossible to predict the actual outcome, many commentators and practitioners do believe that Congress will take some sort of action.
There are those who believe a compromise will mean using the 2009 law, the $3.5 million estate tax exemption amounts and 45 percent tax rate.
However, as of the writing of this article, it was reported that Republicans in Congress had specifically rejected that proposal from the White House.
Alternatively, many practitioners believe that $5 million exemption amounts are here to stay. These practitioners point out that exemption amounts have never gone down in the long history of the estate and gift tax.
Finally, there are those who fervently believe that $1 million exemption and 55 percent tax rates will re-emerge and, possibly, stick.
It is also useful to look at the estate tax in a broader context. With a federal estate exemption amount of $5 million, only .13 percent of all estates of decedents dying in a given year are even affected by the federal estate tax.
According to the Tax Policy Center, approximately 8,600 estates in 2011 needed to file a federal estate tax return, with only 3,270 estates actually paying an estate tax. In 2009, with a $3.5 million federal exemption amount, roughly 33,500 estates filed a federal estate tax return, with 14,700 paying a federal estate tax.
If the federal exemption amount is allowed to drop to $1 million in 2013, it is estimated that 114,600 estates will need to file federal estate tax returns, with approximately 52,400 paying a tax.
Finally, according to the Tax Policy Center, it is a fact that the estate and gift taxes fall on the Americans with the greatest amount of wealth. And, as has been widely reported, Congress is now considering whether those individuals should shoulder a greater portion of the tax burden.
In light of all this, the consensus seems to be that the federal estate tax is not likely to be repealed. Many commentators also believe that other types of sophisticated estate planning techniques, such as valuation discounts, transfers of property to intentionally defective grantor trusts, and grantor retained annuity trusts (GRATs) will be targeted in the near future to raise additional revenue.
Consequently, individuals with large estates will need to continue to plan to help minimize the estate tax to the greatest extent possible.
Last minute planning
While it is possible that Congress may reach an agreement prior to the end of the year, many believe that it is more likely that the a deal might not be reached until the very last minute or possibly not until sometime in 2013.
If no deal is made this year, pre-EGTRRA law will be in effect in 2013. However, even if this situation does occur, it is best not to panic and assume that those exemption amounts and tax rates are here to stay. It is possible for changes to be implemented in 2013 and be applied retroactively to the beginning year.
In light of all the uncertainty, a belief by most people that tax rates are going up, and the real possibility that certain popular estate planning techniques may cease to exist in the near future, the best course is likely to take advantage of existing techniques and to implement tax-saving planning during the final days of 2012.
For clients who are willing and able, making large gifts (in excess of $1 million) prior to year end can help lock in both federal and state tax savings. Although the structure of many gifting transactions can tend to be complex, there still may be time for such gifts to be implemented.
Due to the large $5 million exemption amounts, for many people a “straight” gift to an individual or a relatively simple irrevocable trust may be sufficient to transfer property.
Another option for locking a $5 million exemption for married couples is to create an irrevocable trust for a spouse, fund it with $5 million, and make the spouse the beneficiary. The assets can be out of the individual’s estate, but use of the assets is preserved for the spouse. Of course, issues can arise upon divorce or the premature death of a spouse.
Prior to making any large gifts, it is extremely important to perform a full analysis of all possible tax effects, taking into account potential estate tax savings versus potential capital gains tax exposure in the future.
That is because assets held until date of death receive a step up in basis to date of death value, effectively wiping away all appreciation (and capital gains taxes), while gifted assets use a carryover basis and the recipient becomes responsible for capital gains taxes upon the eventual sale of the assets.
In addition, it is important to consider the context of the gift and to structure it so that it is not vulnerable to the donee’s creditors; and for outright gifts, to make sure the donee is able to manage the gift.
Finally, those wealthy clients who believe strongly that tax rates are going up may wish to fully use all of their exemption amounts and transfer additional property and pay a gift tax at the rate of 35 percent on all assets gifted over $5.12 million (or $10.24 million for a married couple).
While it may seem counterintuitive to actually pay a gift tax, for those who can afford it, would like to transfer the property, believe their estates will always be subject to an estate tax, and believe that tax rates will be higher in the future, paying a gift tax at the “low” rate of 35 percent may be a good idea.
Regardless of where you personally believe the estate and gift tax will end up in the future, one thing is certain: There is still time to plan to take advantage of the 2012 law.
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Tracy A. Craig chairs the trusts and estates group at Mirick, O’Connell, DeMallie & Lougee, which has offices in Boston, Worcester and Westborough, Mass.
