Federal Estate Taxation: An Uncertain State of Affairs

From the Tax, Trust, and Estates Department of Karr Tuttle Campbell

By Kathryn M. Porter

Background

In 2001, Congress enacted the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”), which set forth rules regarding estate, gift, and generation-skipping transfer taxes for the then forthcoming decade.  The basic arrangement of EGTRRA included periodic decreases of maximum tax rates, periodic increases of applicable exemptions, a complete repeal of the federal estate and generation-skipping taxes in 2010, and a sunset provision in 2011 restoring tax rates and exemptions to the levels applicable under the 2001 law.

Throughout 2009, the general consensus among the estate planning community was that Congress would act to preserve the federal estate and generation skipping taxes and perpetuate exemptions and tax rates similar to those available in 2009 – a $1 million gift tax exemption and $3.5 million estate and generation-skipping transfer tax exemptions, all with a maximum tax rate of 45%.  Despite some effort in the House of Representatives last December, no action was taken.  We thus find ourselves facing the 2010 laws as originally enacted.

There are multiple possibilities as to how Congress might address this issue:  (1) Congress might enact new rules regarding estate, gift,  and generation-skipping transfer taxes during 2010 that would be effective as of the date of enactment or introduction such that there would be a period of 2010 in which there would be no federal estate and generation-skipping transfer tax and a later period of 2010 in which there would be such taxes; (2) Congress might enact new rules regarding federal estate, gift, and generation-skipping transfer taxes during 2010 that would be effective retroactively to the beginning of 2010, such that all of 2010 would be guided by rates and exemptions unknown as of today; or (3) Congress might be unable to resolve the issue, in which case the federal estate, gift, and generation-skipping transfer taxes would remain as contemplated in the original 2001 legislation.  Retroactivity would likely be subject to judicial review, the outcome of which is impossible to predict.

Federal Gift Tax

Under EGTRRA, the federal gift tax remains in effect in 2010.  The gift tax exemption stays at $1 million and the maximum gift tax rate decreases to 35%.  In 2011, the maximum gift tax rate will increase to 55%, with a 5% surcharge on gifts between $10 million and approximately $17.2 million, while the gift tax exemption will remain the same.

Federal Estate and Generation-Skipping Transfer Taxes

Under EGTRRA, the federal estate and generation-skipping transfer taxes are repealed in 2010.  In 2011, the estate and generation-skipping transfer taxes will be reinstated, each with a $1 million exemption (the generation-skipping transfer tax being indexed for inflation), and the maximum estate and generation-skipping transfer taxes increase to 55%, with an additional 5% estate tax surcharge on estates between $10 million and approximately $17.2 million.

Carryover Basis

Until now, estates have been administered under a fair market value basis adjustment regime, meaning that for the purposes of computing capital gains tax, when beneficiaries of a decedent inherited property, their basis in that property was equal to the fair market value of that property on the date of the decedent’s death (an exception existing for certain assets such as those held in qualified retirement plans and individual retirement accounts).  For practical purposes, if property had appreciated in value during the decedent’s lifetime, the beneficiaries benefited from a step-up in basis and conversely, if property had depreciated during the decedent’s lifetime, the beneficiaries would have a step-down in basis to the date of death value.

In contrast, the regime existing in 2010 under EGTRRA is one of a carryover basis, whereby beneficiaries inheriting property will receive a basis equal to the lesser of the decedent’s basis in the property or the fair market value of the property on the date of the decedent’s death.  Two adjustments exist, however, to soften the blow of the carryover basis regime.  A decedent’s estate is entitled to an aggregate increase in basis of up to $1.3 million.  Additionally, property passing to a surviving spouse, either outright or by way of a qualified marital trust, is entitled to an adjustment such that the surviving spouse’s basis in property can be increased by up to $3 million.  In neither case can the basis exceed the fair market value of the property as of the date of the decedent’s death.  With respect to community property, both the decedent’s and the surviving spouse’s interest in the property will be eligible for the basis adjustment.  In 2011 the previous basis adjustment regime will be available again.

Washington State Estate Tax

Washington’s own estate tax remains unaffected by the changes in the federal regime.  The state estate tax rate ranges from 10%, for estates worth over $1.5 million, to 19%, for estates worth over $9 million, with an applicable exemption of $2 million.  Washington does not have a state gift tax.

What This Means for You

The looming possibility of a retroactive estate tax makes this a very challenging time in which to plan one’s estate.  It is always our recommendation that you have your estate plans reviewed every three to five years or whenever any significant event occurs in your life in order to ensure that your documents adequately reflect current law and your testamentary intentions.  Because of current uncertainty, if it has been more than five years since you reviewed your estate plan, we would strongly urge you to do so.  We would also encourage a review of estate plans involving dispositive arrangements that are tied to estate or generation-skipping transfer tax exemption amounts.  A death occurring in 2010 could result in an unintended disposition of assets, potential consequences including the under-funding of bequests in combined family situations, diminished testamentary charitable gifts, or the under-utilization of generation-skipping transfer tax exemptions.  Finally, high net worth families might want to consider estate plan modifications due to temporarily reduced gift tax rates in 2010 and the temporary suspension of the generation-skipping transfer tax.

For more information on this topic and what effect the current law might have on your personal estate plan, please contact any of the Tax, Trusts, and Estates attorneys or your personal Karr Tuttle Campbell attorney, all of whom can be reached at (206) 223-1313 or by visiting the firm’s website at www.karrtuttle.com.

IRS Circular 230 Disclaimer:  To ensure compliance with requirements imposed by the IRS, we inform you that to the extent this communication contains advice relating to a federal tax issue, it is not intended or written to be used, and it may not be used, for (i) the purpose of avoiding any penalties that may be imposed on you or any other person or entity  under the Internal Revenue Code or (ii) promoting or marketing to another party any transaction or matter addressed herein.