Estate Tax Repeal: What Now?

In June 7, 2001, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Clients undoubtedly have heard about the estate tax provisions of the EGTRRA and wondered what estate tax repeal means to them.

Provisions of the EGTRRA

In general, the EGTRRA phases down the maximum estate tax rate from 60% in 2001 to 45% in 2009. In addition, it increases the estate tax exclusion in increments from $675,000 in 2001 to $3.5 million in 2009. In 2010, the estate tax will be repealed. In that same year, a modified carryover-basis system will generally allow a basis step-up for $1.3 million of assets passing from a decedent to any person, and an additional $3 million of assets passing to the decedent's spouse. To further complicate matters, the EGTRRA contains a sunset provision: it does not apply to estates of decedents dying after 2010.

What Will Congress Do?

Absent further legislation, the estate tax will return on Jan. 1, 2011 to a maximum 60% rate and a $1 million exclusion. Because this would result in a repeal for only one year (with carryover basis) and the reinstatement of the tax, estate tax practitioners widely agree that Congress is unlikely to allow the current legislation to continue unaltered.

One possibility is that Congress might permanently repeal the estate tax. However, if a Republican President and Congress could not enact complete repeal in a year with current and projected Federal budget surpluses, complete repeal is unlikely in the future under potentially less favorable conditions.

Another possibility is that Congress might lock in the tax rates and exemptions during one of the phaseout years. One view is that Congress might wait until the last minute and enact legislation in 2009 that locks in the 2009 rates and exemptions. However, if Congress was influenced by a desire to avoid revenue losses for the Federal government, legislation in 2009 would probably be unpalatable to Congress, because this could result in a relatively large net revenue decrease. Specifically, Congress might view the fact that the maximum estate tax rate after 2010 would remain at 45% (instead of increasing to 60% as planned under the EGTRRA) as a revenue decrease. In addition, Congress might view the fact that the estate tax exemption after 2010 would remain at $3.5 million (instead of decreasing to $1 million as planned under the EGTRRA) as a revenue decrease. These large revenue decreases would be offset only by a relatively minor revenue increase for 2010, when the estate tax would otherwise have been repealed.

Enacting legislation prior to 2009 might be more palatable to Congress. For example, legislation could be enacted in 2005, which would lock in the rates and exemptions in effect at that time (because it would result in a smaller net revenue decrease). Specifically, Congress might view the following as a revenue decrease: (1) the maximum estate tax rate after 2010 would remain at 47%, instead of increasing to 60%, and (2) the estate tax exemption after 2010 would remain at $1.5 million, instead of decreasing to $1 million. These revenue decreases would be smaller than if Congress were to make the changes in 2009. In addition, they would be offset by the following revenue increases: (1) the maximum tax rate would be locked in at 47%, instead of declining to 45% from 20062009, (2) the exemption would be locked in at $1.5 million, instead of increasing to $3.5 million over the same period, and (3) the estate tax would continue in 2010, instead of being repealed for that year.

How Should Taxpayers Plan?

Despite this analysis, no one knows for sure what Congress will do. Generally speaking, advisers can separate planning ideas resulting from the new law into lifetime gift planning and estate planning. For lifetime gift planning, advisers should inform clients who have allocated their entire applicable exclusion amount ($675,000) to prior gifts, that they can make additional gifts totaling $325,000 starting in 2002. In addition, the usual planning techniques (e.g., grantor retained anunity trusts, qualified personal residence trusts, intentionally defective irrevocable trusts and family limited partnerships) still work in most situations. As for estate planning, every client must review his existing will and trusts. However, it does not automatically follow that every client must change them.

When reviewing the will and trusts, particular attention should be paid to the "formula" clause, which allocates a client's estate between a marital share and a nonmarital share on death. Under the new tax law, a formula clause could have drastically different results for the surviving spouse and the client's heirs, depending on when the client dies. For example, one common formula clause generally reads as follows: "The nonmarital share will receive an amount which can pass free of Federal estate tax, with the residue of the estate passing to the marital share." If a client with a $5 million estate dies in 2001, the formula will result in $675,000 passing to the nonmarital share and $4,325,000 passing to the surviving spouse. However, if a client with a $5 million estate dies in 2010 when the estate tax is repealed, the formula would result in $5 million passing to the nonmarital share and nothing passing to the surviving spouse.

As the marital and nonmarital shares may be different, depending on when the client dies, advisers should show their clients the allocation of their assets based on their existing wills and trusts between the shares for different dates of death. This can be done by estimating the value of the current estate, assuming a growth rate, calculating the value of the estate in future years and illustrating the allocation of the estate between the marital and nonmarital portions.

After reviewing the analysis, the client may be comfortable with the projected allocations. For example, the nonmarital share may pass to a family trust that provides liberally for the needs of the surviving spouse. As such, in the above example, even though $5 million will pass to the nonmarital share and nothing to the surviving spouse if the client dies in 2010, the client may feel that the surviving spouse is adequately provided for. In such a case, it would not be necessary to amend the formula clause in the documents.

If the client is not comfortable with the projected allocations, however, he would have to amend the documents to achieve the desired allocations. If, for example, he wants no more than $2 million of assets allocated to the nonmarital share, the formula could state the following: "The nonmarital share will receive an amount that can pass free of Federal estate tax, with the residue of the estate passing to the marital share. In no event shall the amount passing to the nonmarital share exceed $2 million."

Another method of providing for the desired allocation is for the documents to state that all assets will pass to the surviving spouse, with any disclaimed assets passing to someone else (e.g., a family trust). On the client's death, the surviving spouse could implement a qualified disclaimer of a portion of the assets desired to pass to the family trust. The surviving spouse must abide by the following general rules for a disclaimer to be effective:

1. The disclaimer must be received in writing by the executor of the client's estate no later than nine months after the client's death.

2. The surviving spouse may not accept the assets or any benefits from them.

3. The surviving spouse cannot direct who will be the recipient of the assets.

While the disclaimer technique has the benefit of flexibility, clients should be careful when using this technique. For example, the surviving spouse may inadvertently accept benefits from the assets prior to the disclaimer, thereby disqualifying the disclaimer. In addition, the surviving spouse may intentionally not implement a disclaimer, even though doing so would be beneficial for the entire family from a tax or nontax standpoint.

From Todd A. Gardner, CPA, CFP, ChFC, Oak Brook, IL