January 2010

Estate Tax Repeal and Retroactive Reinstatement

With the ringing in of the New Year, a very peculiar provision in the Tax Code took effect: the one-year repeal of federal estate taxes. This repeal dates back to an estimated $1.35 trillion dollar tax cut package George W. Bush signed on June 7, 2001 in fulfillment of his campaign promise to reduce taxes. The legislation is commonly known as the Economic Growth and Tax Relief Reconciliation Act of 2001, or simply EGTRRA. It contains a gradual increase in the estate tax exemption through 2009, capping at $3.5 million per person, followed by a one-year repeal of all federal estate taxes commencing January 1, 2010.

EGTRRA's provisions, containing many tax cuts, expire on December 31, 2010. This includes the estate tax repeal which, on expiration, would reinstate the estate tax provisions that existed in 2001 prior to EGTRRA. In short, without action by Congress, estate taxes will be repealed for one year (2010) followed by a restoration of the estate tax at 2001 rates (ceiling of 55%), and exemption levels in existence in 2001 ($1 million per taxpayer adjusted for inflation since 1997).

Generation Skipping Transfer (GST) taxes are essentially a duplicate layer of estate taxes imposed for transfers to individuals more than one generation removed from the transferor. They are tied into the exemption levels, rates, and the one-year repeal of estate taxes. Hence, GST taxes likewise have technically been repealed as of January 1st subject to reinstatement December 31st, in the event Congress does not act.

It should be noted that neither the increased estate tax exemption nor the estate tax repeal affect the annual lifetime exemption for gifts, which has remained at $1 million per individual. The top tax rate for gifts, previously set at 45%, is reduced to 35% for 2010 under EGTRRA.

Assets transferred by gift have always resulted in a "carryover" of the donor's basis to the recipient. In contrast, the tax basis of assets transferred on death have always been "stepped up" to fair market value on the date of death whether or not estate taxes have been paid, practically eliminating the income tax liability for estates and heirs on disposition of assets after death.

As of January 1, 2010, EGTRRA provided that the pre-existing "step up" in the tax basis of assets transferred by a decedent will apply only to $4.3 million of assets passing to a spouse and to $1.3 million of assets inherited by non-spouses. Any asset transfers outside of these parameters would result in a carryover of basis to the recipient, like a gift. The resulting paperwork quagmire necessary to keep track of assets that get a new basis and those that don't complicates reporting. This is in addition to the increased income tax liabilities that estates and heirs would face on disposition of inherited assets.

In the years since the enactment of EGTRRA, Congress has introduced legislation and deliberated on making the one-year repeal permanent. It was on the verge of passing such legislation when a natural disaster hit: Hurricane Katrina. As a result, and in view of the rapidly growing federal deficit, the permanent repeal legislation was tabled.

In his campaign, President Obama indicated that he would favor making the 2009 estate tax exemption of $3.5 million permanent. However, health care legislation took priority and Congress made no changes to EGTRRA before 2009 year-end.

Where does this leave taxpayers? Both the House and Senate entertained different versions of legislation containing provisions involving a $3.5 million estate and generation transfer tax exemption during December of 2009. However, they could not reach a sufficient consensus on all provisions prior to adjourning. It is a near certainty that Congress will act sometime this year to pass and retroactively reinstate to January 1st the estate and GST tax and probably set exemption levels of $3.5 million per taxpayer.


Nevertheless, the current status of inaction creates planning and personal dilemmas. It certainly leaves the status of taxable estates of individuals passing away prior to reinstatement of the tax in a state of disarray. It also raises the possibility that the retroactive reinstatement of the estate tax would be subject to constitutional challenge on the basis of a violation of due process rights. Heirs might want to hold off spending because such a challenge, while not carrying a high probability of being sustained, could encounter years of delay in the court system.

While the current financial environment, with low tax rates and relatively depressed prices, is ideal for tax planning, the uncertain status of the estate tax laws make it difficult to fully plan an estate for a person who passes away during this gap period. Individuals should view this time as an important period to revisit and review estate plans in light of current and anticipated changes.

Contact us to arrange your consultation with one of our experienced advisors about this or any of your tax-related concerns by calling us at 203-239-6888.

Your Tax and Financial Advisors at Konowitz, Kahn & Company, P.C.

 

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