Estate Tax Uncertainty

An Overview of Estate Taxes in the U.S.

Matlin & Associates, P.C. — Northbrook, Illinois

Movie Announcer's Voice: "In a world of uncertainty..."

The estate tax is something to think about if your net worth exceeds the "applicable exclusion amount," the number that is taken off the top of a person's estate at death before federal estate taxes kick in. At this time, no one knows what the exclusion will be in 2010 or future years, but this is the current schedule for the recent past, present and future:

Saying it another way, the exclusion from federal estate taxes disappeared for people dying in 2010. For people dying in 2011, a sunset provision kicks in and reduces the exclusion amount for estate taxes to only one million dollars per person.

There is no limit to gifts between spouses who are citizens, during lifetime, or upon the death of the first to go. Gifts to charities can also be unlimited without an estate tax.

The current situation requires planning for multiple uncertainties in the estate tax laws, because:

• There is currently no estate tax in 2010.

• If Congress makes the 2009 estate tax level retroactive later on in 2010, the Federal applicable exclusion amount will be $3,500,000 per person and the Illinois applicable exclusion amount will be reinstated at $2,000,000 per person.

• If Congress does nothing in 2010 regarding the estate tax, the applicable exclusion amount for Federal estate taxes will be $1,000,000 per person in 2011. If no change is made to the Federal estate tax, the Illinois estate tax will be reinstated in 2011 with an applicable exclusion amount of $2,000,000 per person.

If the combined net worth of you and your spouse exceeds the 2009 applicable exclusion amount (which may be reinstated) or the 2011 applicable exclusion amount (which will become law if Congress does not act in the coming year), there are various estate tax planning techniques that can be utilized, the most basic being a shelter trust.

• If the Federal applicable exclusion amount is reinstated at $3,500,000 and the Illinois applicable exclusion amount reverts to $2,000,000, a fully funded shelter trust in the amount of $3,500,000 may result in an Illinois tax upon the death of the first spouse.

• If the current (and probable future) combined net worth of you and your spouse is less than $2,000,000 and your shelter trusts automatically fund, then consider amending your trusts if the shelter trust was established purely for estate tax reasons. An automatically funded shelter trust established either when the threshold for estate taxes was lower than the 2009 level or even the scheduled 2011 level or if the value of your estate has declined significantly, may not suit your current needs.

• If your primary residence is fully or partially owned by a revocable trust that automatically flows into a shelter trust upon the death of the first spouse to die, you may wish to fully examine the effects of that funding.

Some possible legislative scenarios regarding the estate tax:

1. The repeal of the Sunset Provision. This would amount to the elimination of the federal estate tax permanently rather than for just one year. There is little chance of that happening any time soon. The "death" of the death tax is, for now, a dead issue.
2. The federal estate tax exclusion reverts to $1 million, as it is scheduled to do in 2011. If no new law is passed, this is what will be the automatic default. The top tax rate, currently about 45% will rise to 55% (plus the 5% surtax). If this happens, the stepped-up basis will also return automatically. A mere $1 million exemption will truly hurt the middle class.
3. A new estate tax with a new exclusion and top rate greater than zero (even for people with tens of billions) but less than half (even on relatively modest Americans whose estate exceeds $1 million). Democratic leadership has argued for a continuation of the $3.5 million exemption (plus possible inflation adjusters in the future) with a 45% top bracket while mainstream Republican leaders argue for a $5 million exemption, with a top bracket as low as 15% (the top capital gains rate in 2009). If any of this is agreed upon and enacted retroactively to include this 2010 "throw momma from the train" year, expect a major court battle, ending up in the Supreme Court.
4. A revival of the stepped-up basis. The bookkeeping difficulties of using a "carryover" basis (basically, the original cost, plus improvements) to measure capital gains after the sale of assets that follow a person's death constitute an argument that the stepped-up basis at death continue and that the U.S. look elsewhere for additional tax revenue.
5. Bringing back and increasing the QFOBI (qualified family-owned business-interest) deduction that existed prior to 2004 to alleviate the impact of estate taxes on family-owned businesses and farms, whose vulnerability to the tax make the issue so politically sensitive. In addition to allowing for increased deductions, the QFOBI would again allow a payout period stretched over 15 years, giving qualifying businesses the time to pay their taxes (instead of the usual nine months from the date of death).
6. Automatically allocating the applicable exclusion amount of the first spouse to die, potentially eliminating the need for shelter trusts that as used by many married couples exist solely for estate tax reasons. This could allow a married couple to exclude $7 million from taxes (if the exclusion is $3.5 million), without the need for trusts. The exemption would be "portable," so that the unused exclusion amount of the first spouse to die would automatically be added to the surviving spouse's exclusion. The complicating aspect of this becoming law is the reality of the multiple divorce and marriage cycle.
7. Taxing inheritances, rather than the estate itself. Typical planning tactics would then shift to spreading the wealth around more broadly by naming more beneficiaries, as multiple smaller gifts would be taxed less than larger concentrated ones.
8. Reunification of estate and gift taxes, as was the law prior to 2001. At present time, the maximum gift beyond annual exclusion gifts to any person other than a U.S. citizen spouse is $1 million. Above that, gift taxes are paid.

Increased State Estate Taxes

The 2001 Act contained a hidden estate tax increase for many people that will continue into the near future. Prior to 2001 many states, including Illinois, had their own "pick-up" estate taxes that were coupled with the federal estate tax in an arrangement that provided money for the state coffers, but did not result in any additional estate tax burden. The state estate taxpayer received a dollar-for-dollar credit on the federal return. By "de-coupling" the federal estate tax from the state estate tax, the U.S. government grabbed a larger part of each estate tax dollar paid and the states' estate tax of as much as 20% has become an additional separate estate taxpayer burden.

If the laws do not change, a typical Credit Shelter/Applicable Exclusion Amount Shelter Trust for a married couple intended to reduce overall estate taxes upon the death of the surviving spouse, if fully funded in 2011 or later with $3.5 million upon the first death, may result in a state estate tax of more than $200,000 upon that first death, if your state, like Illinois, has retained a $2 million state estate tax exclusion. Note that Illinois and many other states whose tax code is tied to the federal government have eliminated their estate tax only in 2010.

Although you will not have to pay more than one state estate tax on a single asset, your estate may have a tax obligation in every state where you own property. That alone may present enough of a reason for you to sell a vacation home that you rarely use.

When the dust settles, not only is a re-coupling of state and federal estate taxes unlikely, but the possibility exists that you may not even get a deduction for state estate taxes on your federal return, let along the former dollar-for-dollar credit given in the past. Elimination of the federal deduction for state estate taxes has been proposed and remains a possibility.

Besides the potential migration of Americans for climate and other reasons, state estate taxes will be an additional reason for some very wealthy people to choose the proper state as principal domicile in anticipation of death.

Gifting During Life: The Unlimited Marital Deduction

The unlimited marital deduction allows you to make gifts of any size to a spouse who is a U.S. citizen, with no tax or reporting requirement. A lifetime gift to a non-spouse that exceeds the annual exclusion amount ($13,000) in any calendar year requires a gift tax return. Filing a gift tax return depletes your applicable exclusion amount and triggers a gift tax if your aggregate gifting beyond annual exclusion gifts exceeds $1 million.

If your spouse is not a U.S. citizen, you must report any annual transfer beyond $133,000, depleting both the $1 million lifetime gift exclusion and the applicable exclusion by the overage.

Gifting Upon Death: The Unlimited Marital Deduction

If your spouse is a U.S. citizen, you can bequest to him an unlimited gift with no estate tax consequence. For spousal bequests in excess of the applicable exclusion amount, if the gift is not outright, he must at least unconditionally receive all income generated for there to be no estate tax.

However, overuse of the unlimited marital deduction may needlessly result in an estate tax upon your surviving spouse's death, in those instances where a shelter trust, automatically created or created postmortem via disclaimer, should be used.

Distributions to a life-partner who is not a spouse, during lifetime or following death, do not qualify for the unlimited marital deduction. Likewise, since the federal government does not recognize same-sex marriages, spouses of the same gender who have married in those states also do not qualify for the unlimited marital deduction.

If you or your spouse is not a U.S. citizen, you may need a Qualified Domestic Trust.