Updated: Apr 5, 2019
What is the estate tax?
The federal estate and gift tax is a unified tax on the value of all gifts made by individuals during their lives and upon their deaths. Small annual gifts (typically those under $13,000) are not counted. Qualified gifts to charities and qualified gifts to spouses are also tax-free. The estate/gift tax is imposed on all remaining gifts to the extent exceeding an allowable exemption.
Didn’t the estate tax die in 2010?
On 1/1/2010, the estate tax died. But in late 2010, when Congress extended the Bush tax cuts, it also resurrected the estate tax. It did so retroactively, reviving it for persons dying in 2010! The new law raised the estate and gift tax exemption to $5,000,000, made the exemption “portable” between a husband and wife, and lowered the tax rate to 35%! Unfortunately, these favorable changes “sunset” (expire) in 2013, causing the estate tax to revert back to what it was in 2002, with a lower $1,000,000 exemption, higher maximum 55% rate, and no portability.
Retroactivity – a win/win for decedents dying in 2010
The estates of decedents dying in 2010 will benefit from the increased $5,000,000 exemption, even though those estates have the option of electing out of the estate tax altogether. This is a win/win. When the estate tax is in effect (whether or not any tax is due), the assets in a decedent’s estate usually take an income tax basis at date-of-death values (usually resulting in a step-up). For example, if Harry bought his ranch for $250,000 in 1952 and it increased in value to $4,000,000 on his death in 2010, his children could inherit the ranch, claim an income tax basis of $4,000,000, sell it for $4,000,000, and pay no income tax. At the same time, Harry’s estate would not suffer from any estate tax, because of the $5,000,000 exemption (assuming Harry’s total taxable estate remained under $5,000,000)! For the above reason, most decedent’s estates under $5,000,000 should not elect out of the estate tax. Fiduciaries for estates over $5,000,000 should seek professional tax advice before electing out.
Estate tax returns are now generally due for estates over $5,000,000. They should be filed within 9 months after death. Due to the retroactivity of the new law, estates of decedents dying before 12/19/2010 have until 9/18/2011 to file.
Uncertainty with portability
The new law made exemptions portable between a husband and a wife. These portability rules provide relief from bunching (aggregating the estates of a husband and wife). Assume Harry and Mary each have $5,000,000 in assets with a bunched $10,000,000 estate. If Harry dies first, he can give his $5,000,000 to Mary as a tax-free marital gift without using his exemption. If Mary dies before 2013, she can then give her bunched $10,000,000 estate to only son, John, without adverse tax consequences. The new portability rules allow Mary to aggregate Harry’s unused exemption with her own exemption. Her estate will have a $10,000,000 exemption, when she dies. However, an estate plan must be flexible in order to deal with the potential sun setting of the portability rules in 2013!
Uncertainty with bunching and lower rates
Assume Congress does not change the estate tax in 2013 and Harry dies in 2013, leaving Mary his $1,000,000 estate to combine with her own $1,000,000 estate. Mary will inherit Harry’s $1,000,000 as a tax-free marital gift. But on Mary’s death, her now combined $2,000,000 estate will exceed her $1,000,000 exemption by $1,000,000, resulting in an unnecessary $435,000 estate tax from her bunched $2,000,000 estate, when she passes her estate to John! A proper estate plan could avoid the tax. To do so, Harry should have his $1,000,000 bypass Mary’s estate by his gifting it to a trust or by Mary’s use of a disclaimer. Then Harry’s estate can take advantage of his own $1,000,000 exemption. When Mary dies, her own $1,000,000 estate will pass tax-free, because of her own exemption. Until the 2010 changes in the estate tax are made permanent, the possibility of bunching remains a significant estate planning problem.
Uncertainty with formula gifts
Many estates have “bypass” trusts, which typically use formulations that withhold a portion of Harry’s estate from passing to Mary, and vice versa. These formulations generally withhold the maximum amount or the maximum percentage possible without causing Harry’s estate to pay an estate tax. The withheld property is commonly called a bypass gift, or a non-marital gift or a credit shelter gift. However, these formulations, if not properly written, could also cause unwanted consequences. For example, assume Congress permanently eliminates the estate tax. A typical formula clause in Harry’s estate plan would prevent property from passing directly to Mary, even if that is what Harry might have otherwise wanted in the absence of any threat of estate taxes. This problem also results if Congress should raise the estate tax exemption or should permanently allow portability so that Harry’s estate would no longer be threatened with estate taxes, even if he should pass his property to Mary.
What will happen in the future?
Already in January, the Republicans have introduced several bills in the House to permanently repeal the estate and gift tax! These actions appear more politically motivated than realistic. With a Democrat in the White House, these efforts will likely fail for lack of being able to override a presidential veto, which would require a 2/3s vote in both the House and Senate. In 2013, if the Democrats fail to stay in the White House, the future of the estate tax is less clear, depending on the strength of the Republicans in the House and the Senate. If the estate tax is not then permanently abolished, Congress will most likely reach a compromise and make some of these changes permanent.
In the meantime, dealing with the uncertainties in the estate tax law is challenging. However, these challenges are no different than dealing with the continuing uncertainties within a family (divorces, deaths, etc.). Skilled estate planners can deal with these uncertainties and minimize unwanted risks. Smart clients will want to have their estate plans periodically reviewed to insure they have not become victims of changed laws and changed family circumstances.