The Temporary Repeal of the U.S. Federal Estate Tax—What's Next?

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By Jennifer J. Wioncek, Esq. and Robert F. Hudson, Jr., Esq.
Baker & McKenzie, Miami, FL

Not only did 2009 end on December 31, 2009, but so did the U.S. federal estate and generation skipping transfer ("GST") taxes, at least temporarily. As of January 1, 2010:

1. The U.S. federal estate and GST taxes are currently repealed for decedents dying during 2010.

2. Property passing from a decedent's estate by inheritance during 2010 is not entitled to the coveted "stepped-up" basis to the fair market value at the time of death of the decedent, but has been replaced with a system that generally "carries over" the decedent's basis in the property at the time of death, with the possibility to increase the basis of assets included in the decedent's gross estate up to $1.3 million (plus an additional $3 million if property passes to the surviving spouse) for decedents who are U.S. citizens and persons domiciled in the United States ("U.S. domiciliary") and $60,000 for non-U.S. citizens who are not deemed to be domiciled in the United States ("non-domiciliary").

3. The U.S. federal gift tax remains in effect with a $1 million lifetime exemption for U.S. citizens and U.S. domiciliaries (whereas no equivalent exemption exists for non-U.S. citizens who are non-domiciliaries); however, the top U.S. federal gift tax rate has fallen from 45% to 35%.

4. New reporting requirements are in place for gifts and transfers at death during 2010.

Under current law, U.S. federal estate and GST taxes in effect immediately prior to 2010 are scheduled to sunset, with former tax rules springing back into effect for those decedents dying after December 31, 2010. That is, absent Congressional action this year, we will return in 2011 to the tax law largely as in effect before 2001, with the top U.S. federal gift and estate tax rate set at 55% and with only $1 million exempt from U.S. federal estate and GST tax for U.S. citizens and U.S. domiciliaries (and only a $60,000 exemption amount for non-U.S. citizens who are non-domiciliaries who hold U.S. situs property at the time of death, unless modified by an applicable U.S. estate and gift tax treaty).

In 2009, most interested observers expected that Congress would pass legislation preventing the repeal of the U.S. federal estate and GST taxes in 2010. In fact, different bills were proposed in both the House and the Senate to this effect, with the last bill introduced essentially continuing the 2009 tax rules, i.e., setting the top U.S. federal gift and estate tax rate at 45% and with $3.5 million exempt from U.S. federal estate and GST tax for U.S. citizens and U.S. domiciliaries. However, a number of influential Senators were holding out for lower maximum tax rates and larger exemption amounts, so that it became evident by the end of December 2009 that any new U.S. federal estate, GST and gift tax legislation would be put on hold until 2010.

As of February 2, 2010, the Treasury Secretary and Senate Finance Committee Chairman publicly announced their support for legislation made retroactive to January 1, 2010, to undo the current repeal of the U.S. federal estate and GST taxes. However, such discussion was quickly rebutted by other members of Congress, including the Senate Majority Leader, who sees the U.S. federal estate tax system as less of a priority than the passage of legislation designed to produce jobs or change the health care system. Unfortunately, the public and tax professionals can not accurately predict what will happen next and are left with having to speculate as to what the various political cross-currents are likely to produce. Although some may question the constitutionality of retroactive legislation that would impose estate and GST taxes on such early 2010 transfers after the fact, legal precedent does exist that would find a retroactive tax to be constitutional. Nonetheless, until such new, retroactive legislation in fact emerges, individuals with material wealth should be reviewing their current estate plans to make sure that such plans take into consideration the current repeal of the estate and GST taxes and stepped-up basis rules. For example, individuals should ensure that so-called "credit shelter" and "by-pass" trusts are not worded in a fashion that might result in certain beneficiaries being accidentally excluded from benefiting and should also be aware that beneficiaries inheriting assets with significant appreciation will be subject to U.S. federal income tax when sold by a beneficiary in the future.

Given the current state of political flux as to what will happen next with the U.S. federal estate and GST taxes, the planning opportunities and pitfalls will be more challenging.  Most interested observers believe that Congress most likely will pass retroactive legislation some time this year and reinstate the U.S. federal estate and GST taxes and stepped-up basis rules. However, in the meantime, it appears that taxpayers do have the opportunity to continue reducing their gross estate by taking advantage of the newly reduced U.S. federal gift tax rates (to a maximum of 35%).  In addition, persons can make gifts up to the annual exclusion amount per donee (i.e., $13,000 for 2010) that are exempt from U.S. federal gift tax, with any gifts in excess of a U.S. citizen's or U.S. domiciliary's remaining $1 million lifetime exemption now only subject to a maximum rate of 35%. Also for 2010, gifts of up to $134,000 can be made to non-U.S. citizen spouses free from U.S. federal gift tax.

Recently, Senator Carl Levin and several other influential congressman have floated the idea of any new estate tax legislation enacted this year including an election as to whether the 2010 decedent's estate wishes to apply the currently applicable rules (meaning no estate or GST tax, but also no "date of death step up in basis" of the estate's assets) or the 2009 tax rate and exemption rules (i.e., 45% maximum tax rate and $3.5 million exclusion equivalency amount). If such an election is enacted, it might serve (1) to defuse any constitutional challenges to the potentially retroactive reinstatement of the 2009 rules plus (2) it would provide an interesting tax application matrix, depending on the size of the estate, the amount of built-in gain and other variables.

 For more information, in the Tax Management Portfolios, see Streng, 800 T.M., Estate Planning, Peebles, 844 T.M., Estate Tax Credits and Computations, Harrington, 850 T.M., Generation-Slipping Transfer Tax; and in Tax Practice Series, see ¶1330, Federal Income Tax Consequences of Gifts and Inheritances, ¶6350, Estate Planning, ¶6340, Generation-Skipping Tax, and ¶6140, Gifts, Estates and Related Income Tax Basis Rules.