Winter 2008 Newsletter
Repeal the Estate Tax? Yes or No, Much Remains to be Done
By: C. Jordan Ball III
Legislation enacted in 2001 fundamentally altered the longstanding framework for taxation of wealth transfers and, for a single year, eliminates the estate tax and the tax on generation skipping transfers altogether. The current structure, under which taxes are reduced, eliminated, and then reimposed at levels in effect prior to enactment of the legislation, gives rise to a host of problems. To a large extent, these problems appear to have been ignored on the assumption that the 2001 legislation is so thoroughly flawed that one can safely assume it will be revoked or amended long before the most extreme provisions go into effect in 2010.
Aside from the glaring defects in the 2001 law,a number of problems arise from the fact that tax determinations for one year frequently depend on actions taken or attributes obtained in prior years. After a brief review of the history of the 2001 legislation and an assessment of its current status, this paper examines two such instances, in which the statute does not adequately address the effect of tax repeal followed by reimposition, and for which further guidance is necessary.
Since 2001, when President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTTRA”), many have noted the merely temporary nature of the repeal of the estate tax. New York Times columnist Paul Krugman perhaps summed up this feature most succinctly in his designation of the legislation as the “Throw Momma from the Train Act of 2001.”1 As drafted and currently in effect, EGTTRA provides for the gradual shrinking of the reach of the estate tax through a series of increases in the “applicable exclusion amount,” i.e., the value of assets an estate may possess without incurring a federal estate tax. Originally set at $1 million, the applicable exclusion amount has increased to its current level of $2 million, with an increase to $3.5 million scheduled for estates of those dying in 2009.2 Full repeal of the estate tax actually occurs only for those meeting their end in 2010,3 with Mr. Krugman’s appellation reflecting the fact that, like Cinderella overstaying the royal ball, the estate of one who remains of this world past the stroke of midnight of January 1, 2011 will be subject to tax at the rates, and with the exclusion amount, provided for prior to EGTTRA’s enactment. Thus, the billionaire’s son will receive his inheritance free of estate tax if his parents meet their end en route to the 2011 New Year’s Eve party, but will lose 55% to federal estate tax if the unfortunate event occurs on the return home.
Predictions as to the ultimate future of the estate tax have changed in tandem with the prevailing political winds.4 Initially, many commentators saw permanent estate tax repeal as a certainty; however, the end of federal budget surpluses has brought about a brighter future for the estate tax, although the exact combination of exclusion amounts and rates that Congress will adopt remains unclear. Throughout the last seven years, however, the one common thread of thought has been that the law as currently in force will certainly be amended prior to the scheduled 2011 return of the estate tax, and likely will be dealt with prior to the scheduled termination of the estate and generation skipping transfer taxes in 2010. Therefore, criticism of EGTTRA’s deficiencies has always been muted by the common wisdom that, one way or another, the statute will be rewritten and its various short-comings will be addressed at such time.
Regardless of how universally derided the current statutory scheme, one must consider that time for remedial action is passing quickly. It is almost certain that Congress will take no significant action prior to the inauguration of a new President. By then, 2009 will have arrived with its $3.5 million exclusion, and the new administration could well be accompanied by a significant bloc in the next Congress that has no qualms about reviving a tax that has never been paid by more than a small percentage of the wealthiest families, alongside a significant number of representatives who continue to view as political suicide the taking away of tax benefits already granted. Thus, it is certainly conceivable that conditions may exist under which legislative gridlock could exist on this issue for several years.5 Given this possibility, the time is quickly approaching where the estate planning community must consider, in addition to “what if repeal is made permanent,” and “what if the estate tax remains with a $3.5 ($5, or $10) million exclusion amount,” the question “what if we actually get to 2011 with this crazy law still in effect?”
In addition to the obvious, pressing issues presented by the prospect of EGTTRA continuing in its present form, numerous, more technical issues are raised by the prospect of a continuation of EGTTRA. In particular, it is unclear what effect will be given to EGTTRA’s section 901 (i.e., the “sunset provision”) in cases where future tax results depend on events occurring prior to 2011. Below, we examine two such issues which have, to date, received insufficient attention, likely the result of few estate planning professionals having yet considered the possibility that EGTTRA would not be substantially amended prior to such situations arising. The first concerns the tax on generation skipping transfers, and how some transfers made during the tax repeal year of 2010 may be taken into account in later years, assuming the tax on generation skipping transfers goes back into effect. The second concerns application of the basis adjustment rules of I.R.C. §1014, in light of EGTTRA’s sunset provision. As currently written, the statute appears to offer heirs of those dying in 2010 a far more generous tax treatment than is generally assumed to be the case.
Generation Skipping Transfers Made During 2010
Although most attention has been directed at the increased exclusions and repeal, albeit temporary, of the estate tax, EGTTRA’s similar provisions with respect to the tax on generation skipping transfers (“GST”s) is truly the gift that keeps on giving. The tax on GSTs serves as a backstop to the estate tax, preventing the clever and financially advantaged from avoiding, or at least minimizing, the estate tax’s intended effect of taking a bite out of large accumulations of wealth upon each transfer to the next generation. This goal is achieved by taxing transfers made to a “skip person,”i.e., a beneficiary who is more than one generation removed from the transferor. The intended effect is compromised, however, by the equal taxation of all skips, regardless of the number of generations involved, and by the availability of exemptions that can remove property from the GST tax regime in perpetuity.
Traditionally, these anomalies have been ameliorated by the existence in most jurisdictions of the Rule Against Perpetuities, a rule inherited from the English common law which limits the duration for which one can maintain control of one’s property after death. In the last few decades, however, the scope of this rule has been substantially diminished by its repeal in many jurisdictions, together with the use of trusts organized in such jurisdictions by grantors residing in states where the limitation survives. Therefore, to the extent one can remove assets from the GST system, they maybe kept there, free of transfer taxes, not only for the grandchildren or great-grandchildren, but for many generations to come.
The manner by which one removes assets from the GST tax system is primarily through use of one’s GST exemption, as defined in I.R.C. §2631, which amount is allocated to donated property in order to determine its “inclusion ratio,” defined in I.R.C. §2642. Described as briefly as possible, the first task is to identify when there has been a generation skipping transfer, by determining whether the recipient of property is a skip person with respect to the transferor. If there is a GST, then tax is imposed on the value of the property transferred at a rate equal to the highest estate tax rate, multiplied by the inclusion ratio. By allocating GST exemption in the amount of the full value of property transferred, one can reduce the inclusion ratio of the gifted property to zero. Obviously, if the inclusion ratio of the property transferred is zero, the tax imposed will be zero as well. Thus, by holding assets in a separate trust with an inclusion ratio of zero, distributions may be made to innumerable future generations with no transfer tax imposed.
Under the current law, I.R.C. §2631(c) defines the GST exemption amount as “equal to the applicable exclusion amount under section 2010(c) for such calendar year.” As discussed previously, this amount is currently $2 million and will increase to $3.5 million in 2009. However, there is no applicable exclusion amount set forth under 2010(c) for 2010, not surprising as there is neither an estate tax, nor a GST tax for that year, pursuant to EGTTRA. However, as noted above, EGTTRA sunsets at the end of 2010, so that a GST occurring after that date presumably will be subject to tax.
One might assume that a wealthy client might be able to remove large amounts of property from the transfer tax system by placing such property into a trust for the benefit of subsequent generations. However, transfers in subsequent years from such trust to the grandchildren, great-grandchildren, etc., may be generation skipping transfers.6 In fact, because EGTTRA does not provide for any exemption during 2010, the technically correct answer appears to be that such a strategy would result in a trust with an inclusion ratio of one. Therefore, although trusts established in 2010 may be free of generation skipping tax when established, they may actually result in tax at the full maximum rate upon subsequent distributions from the trust.
One might justify this result as an attempt by Congress to make certain that the well situated are unable to use self-help to make the temporary repeal of the GST tax permanent with respect to their property .This would explain why repeal is not accompanied by an unlimited exemption amount. However, allowing no exemption for transfers made during the 2010 repeal makes no sense and could leave some taxpayers worse off than if there was no estate/GST tax repeal at all.
Determination of Gain on the Sale of Property Inherited in 2010
For many families, particularly if one assumes the continuation of $3.5 million (or even the $2 million), exclusion amounts, the estate tax is of little or no concern. For the children of such families, the 2010 repeal of the estate tax may actually be a curse rather than a blessing, because repeal is closely tied to the repeal of an income tax rule of long standing, I.R.C. §1014. In general, this rule provides that property acquired from a decedent, such as through a be quest or a distribution upon death from an inter vivos revocable trust, is to be held by the transferee with a basis equal to the fair market value of the property at the date of the decedent’s death. As part of EGTTRA, a paragraph (f) was added of I.R.C. §1014, repealing the section with respect to decedents dying after December 31, 2009.7 Thus, someone receiving an inheritance from a decedent in 2010 may expect to take the property with a tax basis equal to the basis of the property in the hands of the decedent, i.e., a “carryover” basis.8
Much of the discussion leading up to EGTTRA’s passage seemed to presuppose a link between this income tax rule and imposition of the estate tax, although the connection is one grounded more in political expediency than logic.9 However, when one closely examines the statutory language of EGTTRA, it appears that repeal of the step-up-in-basis rule10 will apply largely at the transferee’s election, as shown by the following simple example. Imagine that D began a business long ago that has since gone public, and D currently owns stock in the company worth $500 million, but for which his basis is negligible. D is a widower, and has one child, B, to whom he plans to leave all his assets.
If D passes away prior to 2010, he would immediately lose close to half his estate to federal estate tax, and perhaps more than half once state taxes are taken into account. However, B would receive the remainder with a fair market value at death basis, so that she would be able to sell or exchange her shares without recognition of the gain built into the share value during D’s life.
If D passes away in 2010, under the current law he would not pay any federal estate tax, and B would receive the entire $500 million estate (subject to state estate taxes and administrative expenses, of course). If B immediately sells or exchanges all the shares, she clearly would recognize capital gain income on the sale, and the estate essentially would be reduced by the capital gains tax (at whatever rate such tax may be imposed at that time, and subject to the relatively minor adjustments to basis allowed under I.R.C. §1022). This result certainly compares well with that in the prior paragraph; however, if B waits until 2011 to sell her shares, she might be better off still, by another's $45 million.
If B sells the shares in 2011, she (or her accountant) would turn to the Internal Revenue Code to determine her income tax due for that year. I.R.C. §61(a)(3) would include the gain on the sale of the stock in her income, although I.R.C. §1(h) would limit the rate of tax applicable to her capital gain. Determination of the amount of her gain would fall to I.R.C. §1001, which would define such gain as the excess of the amount realized (we will assume she received the fair market value of $500 million) over the adjusted basis, as established in I.R.C. §1011. I.R.C. §1011 refers to applicable sections of Subchapter O of the Code, which would include I.R.C. § 1014. Although this section currently contains a provision stating that it will not apply with respect to decedents dying after December 31, 2009, and although I.R.C. §1022 explicitly applies to property acquired from a decedent dying after December 31, 2009, Section 901 of P.L. 107-16 (“Sunset of Provisions of [EGTTRA]”) clearly states that EGTTRA’s provisions “shall not apply – (1) to taxable, plan, or limitation years beginning after December 31, 2010, or (2) . . . to estates of decedents dying, gifts made, or generation skipping transfers, after December 31, 2010.” Thus, for the tax year for which the tax is being computed, the applicable law will be I.R.C. §1014, without subsection (f), and without I.R.C. §1022, which will provide her a fair market value at death basis in the property, allowing her to receive and convert her inheritance into cash free of estate and income tax.
Obviously, this is not the intended result of the EGTTRA legislation. It does raise a question of the nature of tax basis, i.e., whether basis is an attribute of property that is computed and attaches upon its receipt,or whether it is an attribute to be determined under the law in effect at the time it is actually needed – in the above example, at the time of computation of gain on the sale of inherited property.
Presumably, Congress can define basis as it wishes. For example, it could decide to encourage fuel efficiency by allowing businesses to have a basis of twice the acquisition cost of any hybrid vehicle placed into service in the next three tax years. A quick glance through the rules of Subchapter O of the Internal Revenue Code confirms that the basis determination rules have been remarkably consistent over many decades, until the enactment of EGTTRA, so it may be that there simply has not been occasion to consider the question raised above. Given the increasing likelihood that a consensus sufficient to overhaul the entire EGTTRA framework may not arise prior to the critical years of 2010 and 2011, it may be time to focus on addressing the issues discussed above, as well as other obvious deficiencies in the EGTTRA statute, through narrowly focused, technical legislation, rather than continuing to wait for a comprehensive settlement of the estate tax debate.
C. Jordan Ball III represents clients in estate planning and administration related matters in Norfolk,Virginia.
1Paul Krugman, Editorial, Reckonings: Bad Heir Day, New York Times, May 30, 2001.
3I.R.C. §2210. The repeal of the tax on generation skipping transfers is contained in I.R.C. §2664.
4In fact, the fate of the estate tax most significantly shifted with actual winds. In the late summer of 2005, there appeared to be a consensus in Congress to make estate tax repeal permanent. However, action on the measure was immediately put on hold in response to Hurricane Katrina, after which support for permanent repeal appeared to have waned.
5The ill effects of the legislation could be felt before late 2010, particularly if there is an active movement to reinstate an estate tax at levels comparable to what existed pre-EGTTRA. With an exclusion amount covering $7 million for a married couple (which often can be augmented significantly by valuation reduction planning), there well might be individuals willing to make the ultimate commitment to secure an exclusion that appears in jeopardy.
6Whether the beneficiary is a skip person depends on the generation assignment of the transferor. For a helpful illustration of the principles involved, see Reg. §26.2653-1(b), Example 1.
7Whether this provision will survive is subject to much speculation. A previous attempt to discard the rule was retroactively cancelled amid much protest, presumably based on the burden of maintaining or locating the records necessary to establish the basis of property held by a decedent.
8Actually, this is an oversimplification, in that I.R.C. §1022, added by EGTTRA, provides for a limited increase in the tax basis of property acquired from a decedent.
9See, Michael Graetz & Ian Shapiro, Death by a Thousand Cuts (Princeton University Press 2005), at 23.
10The term “step-up-in-basis rule” is, of course, a misnomer, as I.R.C. §1014 sets the basis as date of death value, regardless of whether the basis in the hands of the decedent was higher or lower.