Emergency Will Repairs at Ground Zero-Estate Planning for 2010

Reprinted from The Estate Analyst, February, 2010

By Robert L. Moshman, Esq.

Every estate is at potential risk.
Here is a checklist to review
wills for 2010.

states now face a bona fide catastrophe. We've arrived at ground zero for the estate tax, and many estate plans were not designed for a world without any Federal estate tax.

Many wills need to be addressed immediately. Even a classic "credit shelter" or "A-B" plan could blow up under the current situation. Language from virtually every type of arrangement needs to be examined for each of the possible scenarios that could unfold.

Let's sort it all out and build a checklist of ideas, protections, and remedies that people can incorporate into their estate plans right now.

A Fine Mess Indeed

The estate tax repeal of 2010 isn't merely causing an uncertain time with a cloudy forecast for the tax code, the economy, and/or life in general. Congress is going for the gold, silver, and bronze medals of uncertainty.

Ironically, there is currently no Federal estate tax, and, in theory, this would be about as simple a set of rules as could possibly exist. No tax. The end.

Yet instead of bringing taxpayers freedom or nirvana, this repeal is a prelude to an inevitable tax of some kind.

Imagine the sad scene of a taxpayer who has come to the end of the road and is about to shuffle off this mortal coil and who could otherwise take some small solace in beating the estate tax...but cannot even be certain that this final tax victory will stand up.

"Do NOT resuscitate me," a departing taxpayer might instruct his agents, "and file my estate tax return as soon as possible!"

Alas, even if the estate tax return is filed immediately (rather than within nine months), the IRS still has three years to review it, and there would certainly be a red flag for any estate tax return filed during the estate tax repeal if there were a retroactive imposition of the estate tax.

There will undoubtedly be courtroom consternation as soon as an attempt to re-impose the estate tax is put to the test. A total free-for-all will ensue, with beneficiaries challenging wills, courts second-guessing what testators intended, and state legislatures weighing in to provide guidance in the void created by Congressional inattention.

In fact, Congress may end up trying to figure out how to relieve the symptoms of the mess without acknowledging that it was Congress that disrespected taxpayers by failing to stop this from happening. There was plenty of warning. It was discussed openly and endlessly. But in the end, the estate tax repeal has arrived by default, through Congressional inaction and dysfunction rather than consensus.

Dangerous Interpretations

An estate designed to maximize estate tax savings through use of the exemption amounts leaves the maximum exemption amount to the children and the remainder to a surviving spouse.

This may even be an estate plan that was amended to include flexible language in anticipation of the exemption levels increasing from $1 million to $3.5 million and then beyond. Does the will's language specify that the children get $1 million or $3.5 million? Or was the language modified to reflect "whatever the current estate tax exemption is at the time of my death," which would currently be zero?

Or the language in the will may direct that the maximum amount be transferred to the children, so long as it does not trigger any additional estate tax. In that case, the entire estate would go to the children.

The result when there is no Federal tax or exemption amount may be that the entire estate goes to the surviving spouse. This is a problem because a) it gives the children nothing at the time of the testator's death, and b) it may increase the estate of the surviving spouse to a level that turns out to be taxable in the future when the surviving spouse dies.

Example: John Doe leaves an estate of $5 million and dies when there is no Federal estate tax. His surviving spouse, Mary Doe, has a separate estate of $2 million. His will sets up a credit shelter trust for his children and a potential QTIP trust for his wife but relies upon the marital deduction.

Reliance on the marital deduction could backfire, in that the entire estate would then pass on to the surviving spouse. Some wills have not anticipated the various tax laws that will apply at the time of testators' deaths. Other wills have flexible language that will now be open to multiple interpretations.

State Interpretations: Maryland, Nebraska, South Dakota, Tennessee, Virginia, and Washington are all in various stages of adopting legislation that would treat the wills of decedents dying in 2010 as though the 2009 tax laws were still in effect for purposes of determining testamentary intent. Other states may be following suit. This is unfair to anyone who has taken the estate tax repeal at face value, planned for it in his or her will, and then happens to die during 2010 before Congress takes any action on the tax.

Florida and New York are taking a different approach and are requiring executors to go to court to determine testamentary intent. It therefore becomes a serious financial burden on testators if their wills are ambiguous in any way because their estates can become engaged in judicial proceedings even without beneficiaries contesting the document.

What Happens Next

Here are the probable and improbable ways that things could play out.

PROBABLE: Congress reinstates the Federal estate tax as it existed in 2009 with a $3.5-million exemption and makes this tax retroactive.

This scenario then has two variations: one in which the court upholds the retroactive imposition of tax on estates of decedents dying during the period of repeal, and the other variation where the courts conclude that the reinstatement must be prospective only.

The retroactive approach is actually assumed by the President's budget for 2011, which includes revenues from taxes based on a $3.5-million exemption and taxes being collected retroactively from January 1, 2010, through the entire year.

This approach was also adopted by the House of Representatives, when it voted in favor of the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Bill of 2009 (H.R. 4154). The Senate did not take action on that Bill.

VARIATIONS: As long as Congress is tinkering with a reinstated tax, it can easily make a number of adjustments. For example:

With a higher exemption of $5 million. This is an amount that has surfaced in a number of discussions and proposals.

An estate tax prepayment option that involves testators making payments to a special trust earmarked for estate tax payments. This is a concept from Senator Maria Cantwell of Washington that provides a 35% estate tax rate incentive (in lieu of the 45% top rate that would be re-imposed). The drawbacks--amounts paid to the trust would continue to generate taxable income and would not qualify for the $3.5-million exemption. (Another serious drawback is the defeatist approach to estate tax planning.)

With a lower exemption. Remember, the $3.5-million level was only in place for one year, i.e., 2009, and that amount was determined eight years in advance before anyone was aware that the economy, the stock market, and property values would all have a major adjustment during 2008 and 2009. Many people have lost 30% of their estate values, even after a partial recovery. Congress could gravitate toward the $2-million exemption level that was in place during 2006 through 2008 because, in the new context of estate values, it would probably suffice to exempt more than 99% of all estates from taxation for many years to come.

With a return to the stepped-up basis for capital gains if not already part of other plans to reinstate the estate tax.

With a reunified gift tax system.

With a prepayment option that allows estate taxes to be paid prior to death. This is a fairly recent proposal.

Any of the above...but not retroactive. Why? Because too much time has already passed, and it is an egregious violation of fairness, not to mention constitutional rights. Once someone has died and can't make new plans, it is just plain wrong to rewrite the tax rules. Members of Congress will find it increasingly difficult to impose changes retroactively as more time passes.

POSSIBLE BUT LESS LIKELY: Congress fails to take any action, and we go from no Federal estate tax in 2010 back to the 2001 levels of a top estate tax rate of 55%, an exemption of $1 million, and presumably all the other rules that went with that for capital gains, generation skipping transfers, etc. This scenario seems fairly remote until you realize that Congress has been unable to address the arrival of the estate tax repeal despite apparent bipartisan support to do so.

Moreover, there is a political element to contend with. Neither party wants to be associated with imposing death taxes. The course of least resistance is to do nothing and allow the 2001 law to take effect. Because this result will arrive if Congress fails to act, it remains a distinct possibility. And, at that point, both parties may act to increase the estate tax exemption from the $1 million that will arrive automatically back to $3.5 million or some other level. In that convoluted way, members of Congress will then be able to look like they are decreasing death taxes rather than imposing them.

"IMPOSSIBLE": Congress makes the repeal permanent and addresses transfer taxes from a completely different angle. A flat tax on all estates with a state death tax credit to unify state deaths and generate state revenues. A national transfer fee on capital assets of decedents. A national inheritance tax. None of this has been proposed or is likely, but then again, who thought that the estate tax would ever be repealed? There was a 100% failure rate for expert prognostications on that issue.

Will Review Checklist for 2010

1. HAVE A PLAN, HAVE A WILL: Just because there is currently no Federal estate tax, people should not assume that they don't need a will! Estate planning helps determine which heirs receive assets, provides assets in trust to protect heirs from creditors, names executors to implement estate plans, and provides tax savings for whatever state and Federal tax rules apply in the future.

2. INVENTORY ASSETS: Valuations of stock portfolios and real estate holdings have changed dramatically over the past 24 months. For planning purposes, find out the current value of each asset.

3. CAPITAL GAINS PROFILES: What amount of appreciation applies to each asset? With the reduction of values, some assets that previously had some appreciation may now be sold or transferred with little or no appreciation. What is the potential for future capital gains for each asset? Which assets of the estate will be kept in the family for several generations? Evaluate which assets can be placed in permanent family trusts or transferred to family members now when their value is low.

4. DISTINGUISH PROBATE ASSETS: Many assets will not be directed by a will but will instead be distributed by contractual terms. Retirement plans, transfer on death bank accounts, insurance policies, annuities, and certain brokerage accounts name beneficiaries that can't be altered by a will. Review the total value of assets that will be distributed to each beneficiary if the testator were to die now without modifying any of these nonprobate arrangements.

5. TRANSFER STRATEGIC ASSETS: The family business and the real estate associated with it may be at very low values right now. Interest rates are also extremely low. These conditions lend themselves to structuring a transfer as a sale of assets from business owner to business owner's successor in the family. Example: Father sells Business to Son for $1,000,000 and takes back a valid promissory note for that amount. Son pays Father the IRS assumed rate of return under section 7520. This was 3.0% for January 2010. With 3.0% annual interest, $30,000 of interest is paid. Father continues to operate the business for several years and leases the property from Son for market rates, utilizing the $30,000 for that purpose. The business property is transferred to Son while its value is low, and the asset, and any future appreciation on it, is removed from Father's estate. NOTE: Similar reasoning makes this a very favorable time to employ a grantor retained annuity trust (GRAT), in which a grantor transfers assets to an irrevocable trust in return for an annuity based on the current 7520 levels for assumed returns.

6. CHRONOLOGICAL CONTEXT: When was the will and estate plan executed? When was it last reviewed? What has changed since then? Was the will modified with language that anticipated a) higher estate tax exemptions, b) total repeal, or c) the potential return to a $1 million exemption in 2011?

7. WHAT HAS CHANGED?: What has changed since the will was executed? Has the testator's employment, income, or living expenses changed? Have there been births or deaths in the family? Have assets been inherited? Have children or their spouses divorced or been exposed to creditors?

8. A GOOD YEAR FOR GIFTS?: The gift tax exclusion remains at $1 million, and the gift tax rate is 35% for 2010, down from 45% previously. Values of property are at low levels. A lifetime gift can accomplish multiple estate planning objectives, i.e., removing assets and their future appreciation from the testator's estate. A caveat is that the beneficiary should not be too young or exposed to creditors.

9. STATE DEATH TAXES MATTER: There are approximately 19 states with estate and/or inheritance taxes that will impact more estates than any version of the Federal estate tax. In "Where Not To Die in 2010," Ashlea Ebeling notes several recent changes, including a lapse of death taxes in Kansas, Illinois, North Carolina, and Oklahoma; a reduction of exemptions from $3.5 million to $2 million in Vermont in 2009; an increase in exemption from $2 million to $3.5 million in Connecticut; and a temporary estate tax that applies in Delaware between July 1, 2009, and July 1, 2013.

10. DISCLAIMER CLAUSES, TRUSTS: Let the surviving spouse or the primary beneficiary of the estate have some valuable leeway in redirecting assets. This is a key means of providing postmortem flexibility that can look beyond the existing tax laws at the time of death and allow a surviving beneficiary to obtain professional advice.