Back to blogging after time for some travel (business and pleasure) and catching up at work. As August reaches the half-way point (and it's finally hot), it's time to take stock of the state of the federal estate tax law. While healthcare reform is dominating the news, when Congress returns from the August recess, estate tax reform will almost certainly be on the agenda.
In 2009, the federal estate tax exemption is $3.5 million. That is, upon death every person can pass $3.5 million of assets to non-spouses free of federal estate tax. Assets in excess of $3.5 million are subject to tax at a rate of 45%. Many states, including New York, have separate state estate taxes; New York only permits $1,000,000 of assets to pass to heirs free of estate tax.
Under both state and federal law, an unlimited amount of assets can pass from a deceased spouse to his or her surviving spouse under a rule known as the unlimited marital deduction. However, upon the second spouse's death, all of that spouse's assets in excess of $3.5 million are taxable, including assets inherited from the first spouse to die. Essentially, a direct transfer of assets to a surviving spouse results in the "forfeiture" of the estate tax exemption of the first spouse to die.
Preserving the exemption for the first spouse to die is rather simple. An amount equal to the estate tax exemption (e.g., $3.5 million) can be funded into a credit shelter trust for the benefit of the surviving spouse and, if desired, other beneficiaries such as descendants. The surviving spouse can be the Trustee of the credit shelter trust; the spouse can be entitled to income from the trust, and principal distributions of any amount can be made to the surviving spouse or other beneficiaries for "health, education, maintenance and support." Maintenance and support are very broad terms and essentially mean that distributions of principal may be made for any need to support the beneficiaries' needs, including vacations, homes, cars, and the like. If that isn't enough, the credit shelter trust may be drafted to grant the surviving spouse a "5 x 5" power that permits the spouse to invade the principal of the trust for any purpose in an amount not to exceed the greater of $5,000 or 5% of the trust principal (typically valued as of December 31 of the prior year).
But all that may change dramatically come 2010 if Congress does not act. Under the existing estate tax legislation passed in June 2001, the federal estate tax is repealed for one year only; that is, assets of any amount may be passed upon death to both spouses and non-spouses free of federal estate tax. A downside of the existing law is that while the estate tax would be repealed in 2010, the current unlimited "step-up" in basis for inherited assets will also be repealed, with only $1.3 million of assets to be eligible for a full step-up in basis ($4.3 million if there is a surviving spouse), with any "excess" assets to be transferred at a "carryover" basis.
This rule has been tried once before in the mid-1970s and was quickly repealed as unworkable. Imagine trying to determine the basis of old AT &T stock purchased 50-years ago that has since split multiple times and been spun-off into numerous successor companies. The complexities of trying to determine cost basis of a decedent's assets will surely drive-up the costs of estate settlements and lead to howls of protest.
So with all the uncertainty, what's Congress likely to do? Given the timing, the current assumption is that while Congress wrestles with a long-term solution, it will extend for at least one year the current $3.5 million estate tax exemption, along with the unlimited step-up in basis.
Two of the most likely long-term proposals include:
1. "Freezing" the exemption at $3.5 million with a maximum tax rate of 45%, but also indexing the exemption for inflation; the proposal would also "reunify" the estate and gift tax credits (currently the lifetime gift exemption is $1 million), and permit "portability" of the estate tax exemption from one spouse to the other. However, the proposal would place limits on "valuation discounts" for planning vehicles such as "family limited partnerships" that are frequently used by high-net worth individuals to minimize estate and gift taxes.
2. Making permanent the exemption level at $2 million, indexing that level for inflation, and establishing progressive tax rates of 45 percent for estates valued between $2 million and $5 million; 50 percent for estates valued at $5-to-$10 million; and 55 percent for estates valued over $10 million. This proposal also includes reunification of the estate and gift tax exemptions and "portability" between spouses.
As Congress tackles this issue this fall, I'll keep my readers posted as to breaking developments.