Riding the Estate Planning Roller Coaster for the Next Three Years

By William R. Stromsem, J.D., CPA

The graph line of estate tax effective rates for the next three years would make an exciting roller-coaster ride. In 2001, the effective estate tax was set for a steady 10-year downward run, scheduled to reach a 45% maximum rate with a $3.5 million exemption in 2009 and then to be completely eliminated in 2010. In 2011, though, the tax is to be restored to the pre-2001 55% maximum rate with just a $1 million exemption.

When Congress set about reducing estate taxes in 2001, it faced self-imposed revenue neutrality requirements that would have been violated by a permanent elimination of the estate tax. At the time, most believed that a later Congress would eventually have to address the budgetary issue in order to prevent the eliminated taxes from being restored and to avoid the problems of carryover basis. (The legislation that phased out estate taxes provided for carryover of basis from a decedent to an heir when estate taxes were eliminated.)

As 2010 approaches, tax legislators and policy makers are sharply divided on a more permanent approach to taxing the transfer of wealth from one generation to the next. Although the AICPA had encouraged an early resolution so that planners could plan more effectively and clients could die more peacefully, this has not happened (see AICPA comments of April 3, 2008, March 11, 2008, June 22, 2006, July 28, 2005, May 9, 2005, and February 2001).

For those dying during the remainder of 2008 and most of 2009, the law will continue as is, with few legislative days left in this year and with the new Congress probably still in startup mode until next June. Congress procrastinated on extending tax benefits that had expired at the end of 2007 but finally got around to passing the extenders bill as part of the Emergency Economic Stabilization Act of 2008, P.L. 110-343.

Estate taxes are much more difficult, and Congress probably will not address the issue until the end of 2009, when it senses the urgency of avoiding the impending elimination/restoration/carryover basis fiasco. Hopefully, Congress will not make the ride even more thrilling by delaying action until 2010 and then trying to retroactively reinstate the tax after its elimination.

Into the Tunnel

As tax advisers try to plan ahead, the estate tax roller coaster is heading into an election-year tunnel, with no one knowing where the rates are going and with divisive discussions of "death taxes" versus "tax breaks for the rich." After the election, lawmakers will be looking for revenue to pay for election-year promises, to stimulate the economy, and to deal with an ever-growing system of entitlements, so it is impossible to predict what they may come up with.

Both presidential candidates oppose the sudden elimination and restoration of estate taxes, and both would provide lower estate taxes than would otherwise go into effect if the old law were restored in 2011. However, there is a great difference in how the two candidates would structure rates and exemptions. Barack Obama proposes to permanently continue the 2009 rates and exemption at a maximum of 45% and $3.5 million. John McCain would be more generous, setting these at 15% and $5 million on a permanent basis beginning after 2009.

Democrats will likely control both houses of Congress after this election, with little of the sympathy for estate taxpayers held by the Republican Congress that phased out estate taxes back in 2001. If Obama wins the election, some form of his plan will likely be enacted. If McCain wins, forecasting estate taxes will be much more difficult, with the executive and legislative branches of the government probably sharply divided on the issues.

McCain would index the exemption amount to avoid erosion of the "permanent" exemption but at this point Obama would not. Both candidates support portability— transferring any unused exemption in the estate of the first spouse to die to the surviving spouse. While this would prevent having to plan to avoid the loss of the unused exemption, a higher estate tax rate might mean that many would still benefit from estate planning of marital bequests to equalize estate tax rates.

Twists and Turns

If clients knew when they were going to die, their estates would be well planned. However, because a client's family and advisers do not know when the client will die, estate tax planning will be different for each of the next few years. For example, if there is no estate tax in 2010, a marital deduction trust might not be desirable, and the best tax plan might be to give everything that earlier generations will not need to the client's children or grandchildren. If the estate tax is restored in 2011, tax planning for the surviving spouse will then be minimized.

Basis Carryover

As part of the phaseout of estate taxes, Congress provided that carryover basis would go into effect in 2010 when the estate tax is eliminated. Under the carryover basis rules, the decedent's heirs would take a carryover basis in property they inherited from the decedent, and the appreciation realized by a decedent before death on the inherited property would be recognized by the heirs when it was sold. This policy, which was tried in the late 1970s but repealed retroactively in the early 1980s, is favored by tax policy purists who see the step-up at death as a loophole.

The carryover basis provision was added to the estate tax phaseout legislation as a concession to the policy wonks, but most observers believed that it would never go into effect and that Congress would deal with it when it addressed the elimination/restoration of the estate tax. Congress is expected to save taxpayers and their advisers from having to dig up decedents' basis, but it must act by the end of 2009 to avoid another period of taxpayer uncertainty and administrative difficulty and another likely retroactive repeal of carryover.

Estate and Gift Tax Integration

As Congress deals with estate taxes, it has an opportunity to deal with a structural problem related to transfer taxes. Before 2001, an integrated estate and gift tax system taxed lifetime and at-death transfers cumulatively with one rate structure and exemption. The current system decouples the two transfer taxes, with a $1 million exemption for gifts (which is less than the estate tax exemption). Hopefully, Congress will restore the integration so that lifetime transfers are not disadvantaged in relation to transfers at death. This would be a refreshing tax policy improvement, freeing taxpayers to structure their transfers and eliminating a tax difference based on an otherwise irrelevant distinction.

State Taxes

When Congress reduced federal estate taxes, many states decided that they could use the money better than those who stood to inherit it and increased their estate and inheritance taxes. McCain would continue the deduction for state death taxes as under current law, but the states would prefer enactment of the more generous credit of prior law to retain their revenue. In either case, some states may be slow to change their laws or unwilling to lose this revenue, so taxpayers and advisers will have to watch state legislative developments.

Coming into the Station

Estate planning has always been one of those activities that clients want to do once and then forget and that most practitioners tend to think of as fill-in work when they are not busy with income tax deadlines. But for the next few years, clients may need an annual review and possibly new documents or one set of documents with different dispositions depending on the year of death. Tax advisers are going to have to become estate planning activists and get their clients to join them for the ride—one that will be a little less thrilling if everyone has a better idea of what is coming around the next curve.

William Stromsem is communications director in the Tax Division of the AICPA, an associate professor of accountancy at George Washington University, and a member of the board of DC Community Tax Aid. For more information about this column, contact Mr. Stromsem at wstromsem@aicpa.org.

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