Estate planning under the Bush tax cuts.

SUMMARY OF TRANSFER TAX CHANGES MADE BY EGTRRA

EGTRRA phases out and temporarily repeals the estate and GST tax (but not the gift tax) by reducing rates, increasing the amount of unified credit that exempts an amount (the applicable credit amount (ACE)) from tax and increasing the GST tax exemption. (2) In 2011, the pre-EGTRRA rules will apply except that the applicable credit amount for both gift and estate tax purposes and the GST tax exemption will be indexed for inflation.

Pre-EGTRRA, the maximum estate tax rate was 55 percent on estates of over $3 million and the unified credit shielded estates of $1 million or less from federal estate tax. (3) The GST tax rate was a flat 55 percent, but the GST tax exemption shielded up to $1,120,000 from GST tax ($1,000,000 indexed for inflation).

In 2007, the maximum rate for both estate and GST taxes is 45 percent. The unified credit shields estates of $2 million or less from federal estate tax. Once the estate exceeds $2 million, the maximum rate applies. The GST tax exemption also is $2 million. In 2009, the rate will not be changed but the unified credit will shield estates of $3.5 million or less from federal estate tax and the GST tax exemption also will be $3.5 million. In 2010, there will be no federal estate tax and no GST tax. In 2011, pre-EGTRRA rules will be applicable except that the applicable credit amounts and the GST tax exemption will be indexed for inflation.

Pre-EGTRRA, the gift and estate taxes were "unified" because a single graduated rate schedule applied to cumulative taxable transfers during life and at death. The same amount of unified credit reduced the tax on gifts and at death; to the extent the credit is used to shelter gifts from gift tax, the amount of credit available to shelter the estate from estate tax is reduced. Post-EGTRRA, it is still the case that the use of unified credit to shelter gifts from gift tax reduces the credit available to shelter estates from estate tax. However, the maximum amount of gifts that can be shielded from gift tax is $1 million and this amount is not being increased. (4) Thus, an estate always will have some amount of unused available credit to reduce estate tax, regardless of the amount of taxable gifts the decedent made during his/her lifetime. The estate tax applicable credit amount can never be reduced by more than $1 million since this is the maximum applicable credit amount for gift tax purposes.

In 2010, when there is no estate or GST tax, there still will be gift tax. The rate will be 35 percent. (5) Unless death is imminent, there will be a substantial advantage in making gifts in 2010 to avoid the cost of the restoration of higher gift and estate tax rates the following year. This is particularly true for gifts to grandchildren, which, if made in 2010, will avoid GST tax. In 2011, the pre-EGTRRA rules will be restored. The maximum gift tax rate will be 55 percent. The GST tax rate also will be 55 percent. The combined cost of gifts to grandchildren will be 140 percent calculated as follows.

As shown on Table 1 above, the applicable credit amounts for estate and gift tax purposes are no longer the same and the GST tax exemption now substantially exceeds the amount a person can transfer by gift without gift tax consequences. This creates an incentive for donors to find creative ways to take advantage of a donor's GST tax exemption without incurring gift tax. Using the GST tax exemption as soon as possible allows increases in the value of the GST tax exempt property to avoid GST tax.

The gift tax will remain in effect in 2010. The circumstances surrounding the enactment of EGTRRA indicate that the reason for retaining the gift tax was to prevent donors from making gifts to lower bracket taxpayers to avoid income tax. (7) The tax rate will be 35 percent and the applicable credit amount will be $1,000,000. This puts a cost on large gifts in 2010 to avoid GST tax, but gifts in 2010 may still be worthwhile due to the 20 percentage point increase on transfer tax rates if pre-EGTRRA law is restored.

Some of the revenue loss from reducing estate and GST tax rates and increasing the amounts shielded from those taxes was recouped by other EGTRRA changes such as replacing the state death tax credit with a deduction for state death taxes. (8) "State death tax" refers to estate tax imposed by a state in an amount equal to the federal estate tax credit allowed by IRC [section] 2011 prior to its repeal. The maximum state death tax rate under IRC [section] 2011 is 16 percent. The repeal of IRC [section] 2011 had the effect of repealing state death taxes because the credit became zero, but about half of the states have "decoupled" the state estate tax in order to maintain their tax revenue despite the repeal of IRC [section] 2011. The maximum effective federal estate tax rate was not reduced materially by EGTRRA until actual repeal in 2010. Before EGTRRA the maximum effective federal estate tax rate was 39 percent (the maximum federal rate of 55 percent minus the maximum state death tax rate of 16 percent) and the 2007 maximum effective federal estate tax rate is 37.8 percent (the maximum federal rate of 45 percent minus the revenue cost of the state death tax deduction). For coupled states (states that impose no state estate tax), the federal share of revenue increased because the effective rate of estate tax increased from 39 percent to 45 percent. The maximum combined effective tax rate for persons dying in decoupled states--those that still impose state death tax--is about 54 percent (37.8 percent effective federal rate plus 16 percent state death tax rate). This is only one percentage point less than the 55 percent rate in effect pre-EGTRRA.

The repeal of the state death tax credit and decoupling by some states means that there are enormous potential savings from establishing domicile in a state that does not impose state death tax. For persons in the top bracket, the marginal saving is almost nine percent.

State death tax is avoided by not directly owning real estate in decoupled states. (Real estate is taxed in the state where the real estate is located even if the owner is domiciled in another state.) For example, owning real estate through a corporation or partnership may avoid state estate tax because the owner of stock or partnership interests owns intangible personal property that is taxable only in the state of domicile. Conversely, if a person is domiciled in a decoupled state and owns real estate in a state that imposes no state estate tax, it would be better to own the real estate directly.

Prior to EGTRRA, the state death tax was neutral because every state and the District of Columbia imposed a state death tax, it was fully creditable against federal estate tax and, if more than one state imposed the state death tax, the state death tax was apportioned proportionately. Where some states impose estate tax and others do not, there is a risk that the apportionment of state death tax will not operate fairly. There is a greater risk that more than one state may claim to be the domicile of a decedent, particularly where a change of domicile appears to be both tax motivated and incomplete (i.e., because the individual did not sufficiently sever ties with the state in which he or she was domiciled previously).

Under current law, the basis of most types of assets acquired from a decedent is adjusted to equal fair market value on date of death. (9) This rule applies whether or not estate tax is due. For example, it applies both to smaller estates where no tax is due and to estates that pass to a surviving spouse and qualify for the unlimited marital deduction. In 2010, when the estate tax is repealed, only limited basis adjustments will apply. In general, the basis adjustment is capped at $1.3 million plus an additional $3 million for assets passing to a spouse or to a marital trust for the spouse. (10)

The carryover basis rule creates a very difficult record keeping problem and a very significant burden for executors who are required to file returns with the IRS to report basis and basis adjustment allocations. It also creates administrative burdens for the IRS. The IRS will have little motivation to audit the information returns filed by executors because the returns generate zero revenue.

Note that for people who have "negative basis" assets, the carryover basis regime could be far more costly than the estate tax.

No gain is realized at death under EGTRRA even though liabilities exceed basis (as in Example 2) unless the client leaves the real estate to charity, a foreign person, a governmental agency, or, to the extent provided in regulations, any person to whom property is transferred for a tax avoidance purpose. (11) Suppose the property in Example 2 is worth $90,000,000 or less (less than the mortgage) and the property is left to a charity. Gain would be realized. But if the property is left to George W. Bush, absent regulations, he would be stuck with a liability and not an asset. What if the property is left to a person who has no net worth? How is the tax to be collected? Is this constitutional? EXAMPLE 2 If the client has real estate worth $100,000,000 subject to a mortgage of $90,000,000 with a basis of $10,000,000 (due to depreciation deductions), the gain on a sale for fair market value would be $90,000,000 and the income tax on that @ 25% would be $22,500,000. The cash generated would be $10,000,000, leaving a cash deficit of $12,500,000. Had the person died, assuming a 50% estate tax rate, the estate tax would have been $5,000,000.