Back in late March, Dan L. Duncan, a Texas billionaire, his net worth estimated by Forbes magazine at $9 billion and ranked as the 74^th wealthiest individual in the world, died in his home in Houston at the age of 77.  He leaves behind what is considered the first extremely large estate to pass free of Federal estate tax in the 2010 year, a result of Congress allowing the estate tax to lapse for the 2010 year.

As I have blogged in the past and continue to monitor Capitol Hill on this issue, Dan Duncan’s death was a big loss in collection of revenues that our country can ill afford at this time.   The one year estate tax lapse was signed into law back in 2001 when President Bush signed the 2001 EGTRA.  Every authority on estate taxes thought the gap would be closed with the 2009 new Democratic Congress.  The current Senate Finance Committee is continuing to work hard towards compromise and reinstating the tax, however it remains unclear whether compromise will be reached and/or a retroactive tax will be instituted.  (Should the issue not make it through the halls of Congress, the estate tax will revert to pre-2001 laws and estates of individuals dying in 2011 and after will be taxed at the $1million level).  The argument exists that President Obama would like to reinstate at that level for wealthy Americans, negating the progress and compromises of the past. 

Mr. Duncan’s surviving wife and descendants will most likely inherit billions that in any other year would have gone to the coffers of the US Treasury.  If he had died in 2009, 45% of the value of his assets in excess of $3.5 million (and not otherwise going to his surviving spouse or charity) would have paid in Federal estate taxes.  While Federal estate tax law has long allowed that assets can be passed untaxed to a surviving spouse (who is a US citizen), Mr. Duncan apparently left a very large part of his estate to his children and grandchildren including his two business entities EPCO and Dan Duncan LLP, the natural gas and pipeline companies he built.  Should his inheritors decide to sell the shares in these entities, they would have to pay capital gain taxes calculated on the difference between the shares original cost and their market value at time of sale.  However, capital gains are capped at 15 percent.  Should Congress decide to pass a retroactive estate tax, many attorneys believe this estate and inheritors have the means and motivation to take their court battle all the way to the Supreme Court to determine constitutionality.

Whether you agree or disagree that the wealthy should pay tax upon death is not the purpose of this blog, but rather I want to point out how the congressional leadership of this country has practiced what I consider to be ‘‘malpractice” and or lack of stewardship at a time when our country’s deficits and spending are soaring.  Furthermore, it is morally unacceptable that our leadership has allowed this issue to persist 6 months into the 2010 year leaving in limbo the planning needs of many wealthy citizens. Also, it would be a safe assumption that Mr. Duncan, whom was known in Texas as one of the greatest philanthropists giving millions away to charity, would want his lasting legacy to be associated with this congressional debacle.

Three U.S. Senators are calling for a 10% “Billionaire’s Surtax.”  In a letter addressed to their colleagues, the three senators who are advocating for the tax write, “According to Forbes Magazine, there are only 403 billionaires in the U.S. with a collective net worth of $1.3 trillion. Clearly, the heirs to these multibillion fortunes should be paying a higher estate tax rate than others.”

The letter also points out the case of the late Dan L. Duncan, the billionaire Texan who died in March, whose $9.8 billion fortune, because of the now lapsed Federal Estate Tax, will pass to his heirs estate tax free.  The senators write, “At a time when we have a record-breaking $13 trillion national debt and an unsustainable federal deficit, people who inherit multimillion- and billion-dollar estates must pay their fair share in estate taxes.” 

The senators’ proposal would be retroactive to the start of 2010, which would likely face a court challenge from Duncan’s heirs as well as others.

The Wall Street Journal recently reported that Congress is contemplating a “prepaid” estate tax.  It is unclear exactly how such a model would work, but one scenario would allow people to create “prepayment trusts” in which they’d put assets into the trust for five years and pay a 35% capital-gains tax on the gains of the assets.  Then, when they die, the assets would presumably pass to heirs without any estate tax.

The benefit for the government is the creation of much-needed revenue now, but a big drop-off in collections later.

Could this work?  Possibly, but not for everyone.  People with liquid assets who can easily pay the taxes on their trusts would certainly benefit.  But for the average small-business owner with little to no liquid assets, it would obviously be more difficult.

Of course, we’ll be keeping an eye out for more developments on this.

As we’ve been discussing, both the estate tax and the generation-skipping transfer tax were repealed at the end of 2009.  The twist being that, at any time, Congress may vote to retroactively re-instate the tax, or, if no action is taken this year, it may automatically renew in 2011.    That said, there is still a gift tax for people who give away more than $1 million during life – the only difference is that the top tax rate has been reduced from 45 percent to 35 percent.
 
One of the many provisions of estate tax law that is often overlooked is the gift tax exclusion for amounts paid directly for someone’s tuition or medical expenses.  Many people understand that they can give away 13K (or 26K for a married couple) each year without any gift or estate tax consequences.  What you might not know is that you can pay for things like medical expenses or tuition in any amount what-so-ever.  You could pay for a friend’s operation or college or business school tuition (or even someone’s private high school or other lower school education tuition) with no gift or estate tax consequence.  Similarly, a grandparent could help their children pay for current, day-to-day medical or tuition expenses - things like doctor co-pays, prescription drugs, and dental bills.  The only condition is that these “med-ed” payments, as they are called, must be made directly to the providers of those services.
 
To facilitate this in the simplest way possible, we have advised clients to open a “Family Savings Account”.   For example, a client opens a bank account in their own name starting at whatever amount they want (adding to it as needed).  They then give debit cards to their children or grandchildren and let them use the debit cards for payments made directly for tuition or medical expenses.  Alternatively, a client can give as many children as they want power of attorney over that account, so that they can write checks (again to medical providers or to educational institutions for tuition). 
 
Although you don’t technically need a lawyer to set up an account such as this, you obviously do need to trust the person who has check-writing authority or a debit card to not spend the money on other things.  And, in some cases, it might just be preferable to have a lawyer, accountant or financial adviser play this role and write checks on behalf your children, grandchildren’s or other desired persons’ medical and tuition expenses.

Last week, the Senate took steps towards placing estate tax legislation (the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Bill of 2009) onto the Senate calendar. This maneuver may result in the Senate bypassing the Senate Finance Committee in an effort to address the most recent estate tax legislation, which expired at the end of 2009.  On December 3, 2009, the House approved the bill, but the Senate, wrapped up in healthcare legislation, failed to act on the measure.

The proposed legislation would indefinitely extend the current exemption for estates up to $3.5 million per individual and $7 million for married couples.  It would also set a maximum rate of 45 percent on estates above this threshold.

The final year of The 2001 Tax Act (EGTRRA 2001) is now upon us, and estate tax repeal, at least temporarily and unless reinstated retroactively, is upon us.  Quite frankly, I never expected this to happen.  I, along with many of my colleagues, anticipated Congress to act before this.   Now, we have to consider that, at least for some part of the 2010, all transfers at death will be estate tax and generation-skipping transfer tax free. 

The Early Byrd Catches the Worm

That said, due to the Byrd Rule, which limits laws with a negative fiscal impact to 10 years, EGTRAA is set to expire on December 31, 2010.  This means that the estate tax law is scheduled to revert back to what it was as of January 1, 2001, as if the changes never occurred.  (The federal estate tax exemption will become $1,000,000, the GST exemption will be somewhat greater, and the maximum estate tax rate will return 55% - with a surcharge for certain estates of 5%.)

The looming question is:  Will Congress be able to address the massive confusion that is taking place when trying to understand and plan for a year of no estate and GST tax?  Complicating the matter, if Congress were to make new legislation retroactive to January 1, 2010, numerous lawsuits over the constitutionality of such a move may occur.  Such proceedings could end up tied up in the courts, possibly culminating in a Supreme Court decision.  

The Blame Game

It should not be a foregone conclusion that Congress can make the estate tax retroactive to January 1, 2010.  Many already feel the reinstituting the estate tax on a retroactive basis would be unconstitutional.  And, many say it would be in the best interest of the country to do nothing and let EGTRRA sunset (which means a $1,000,000 estate tax exemption, with a maximum rate of 55%).  The Democrats argue that a Republican Congress and President signed the law creating this insanity.  Republicans argue that they have steadfastly argued for total repeal of the “death tax” – which resonated with the people, at least back in 2001. Democrats had the opportunity to permanently end the “death tax” and chose not to.  Both sides had numerous opportunities to compromise on an exemption number (like 3.5 million or 5 million or even greater) and an estate tax rate (like 45% or 35% or even lower).  In addition, this issue will likely be a significant mid-term election discussion.  The most likely outcome of all of this will largely depend on the political priorities on Capitol Hill.

Step by Step

Probably the most controversial and confusing aspect of EGTRAA is that it replaced, for 2010, the estate tax and GST with a modified carryover basis.  Under the law that was effect in 2009, subject to some exceptions, assets owned at death received a basis “step-up” to a fair market value at death.  For example, if a client were to die owning a stock that they purchased many years ago, the beneficiaries could sell that stock at its fair market value of today and pay little or no capital gains tax (though the value of the stock would have been subject to estate taxes at it fair market value on the date of death).  The only capital gains tax that would be paid is the difference between the sale price and fair market value at time of death.

Under the 2010 repeal of the estate tax, a beneficiary receives property with an adjusted basis equal to the lesser of the decedent’s basis or the asset’s fair market value at the date of death.  This means the automatic “step up” is eliminated at death but retains the “step down” for depreciating assets.  Many attorneys agree that this modified carryover basis will impact far more decedents than those that would have been impacted by the estate tax.    To offset this loss, EGTRRA provides the executor or any other person responsible for the decedent’s property can allocate a $1.3 million “aggregate” increase on an asset by asset basis.   Assets left outright to a spouse receive an additional $3 million “spousal property basis increase”.  Assets left to a spouse in a “marital trust” may be eligible for this additional $3 million property basis increase depending on the terms and provisions of the marital trust.  In any event, this ability to increase the basis on certain assets will certain complicate the administration of estates of persons dying in 2010 and could lead to lawsuits if an executor’s action in increasing the basis of certain assets benefits the estate’s beneficiaries unequally.

The Bottom Line

I have always advocated that all existing estate plans created more than 4 years or so ago should be reviewed to make certain the client’s objectives are still being met.  The elimination of the estate tax for 2010 makes it imperative that many estate plans be reviewed and possibly changed.  For instance, if someone created their estate plan when the federal exemption was significantly lower, and should the client die in 2010, a client’s estate planning documents may include a formula that could shift assets from a spouse to another beneficiary.  This may be of particular concern where a client wanted his or her children or other relatives to receive the amount that passed free of estate tax and for the surviving spouse to receive the balance.  If all of the assets pass free of estate tax, then the surviving spouse may end up with nothing.  This could be a totally unintended consequence and could be particularly ugly for second marriages and children from a prior marriage.  It is important to make certain that the will or trust language will ensure assets are available for the surviving spouse.

As all of the above demonstrates, it is important that every person’s estate plan be periodically reviewed and provide the necessary flexibility and provisions to take account of current and ever changing tax circumstances.

Serves me right, I go on a wonderful 10 day vacation from work and look what happens:  Congress finally passes an estate tax bill.  The full story is that the House has passed a bill that would permanently FREEZE the applicable exclusion amount (i.e., the amount that passes free of Federal estate tax) to 3.5 million and FREEZES the rate at 45%.  The Senate will now take up the passed House bill.  Then, if the Senate makes any changes, it goes to a conference committee.
 
The good news:  Something may happen before the end of this year to end the uncertainty.  AND the bill that passed the House does not change any other aspect of the estate tax laws (other than repealing carryover basis, which would have been a disaster anyway).  Therefore, GRATS, valuation discounts and other estate planning tax reduction techniques are still viable.
 
The bad news:  Anything can happen and NOTHING is permanent.  Hence, Congress can still act before the end of this year to eliminate or restrict GRATS and valuation discounts.  Clients should not be lulled into a false sense of security.  Action should be taken as soon as possible before Congress closes the door on these techniques.

I have written previous blogs on this topic in an effort to plan and keep my clients informed of the possibilities for the future.  As we rapidly move forward to the end of the year, I thought that by now, we would have seen some discussion in congress on the estate tax law and possibly an amendment to the current legislation.  Everyone had predicted that 2009 would be the year we saw change, but what if Congress just allows the estate tax to go back to 2001 levels?

Let’s review the current law as it exists today 2009:  $3.5 million exclusion from generation skipping transfer (GST) tax; $3.5 million exclusion from estate tax; $1 million exclusion from gift tax; 45% top marginal rate and no credit for state estate taxes (states like Maryland and DC imposed their own estate tax, which is currently a deduction on a Federal estate tax return). 

Now, for 2010 we are slated for no Federal estate tax; no Federal GST tax and $1 million exclusion from gift tax.   If nothing happens in Congress, then we are slated to return in 2011 to the pre-2001 tax laws:  i.e., $1 million GST exemption (as indexed for inflation after 1998); $1 million exclusion from estate tax; $1 million exclusion from gift tax; a 55% top marginal estate tax rate, and state death tax credit reappears (so that any state death tax is a dollar for dollar reduction from the Federal estate tax).

This scenario of uncertainty makes it extremely difficult for advisors and their clients in the creation of estate planning documents.  Some possibilities are: Congress could do nothing; Congress could pass a one year extension of the 2009 law; Congress could extend the current law and exemption levels permanently; Congress could reduce or increase the various exclusions rate etc. 

And, while I hope not, the administration and lawmakers in Congress could just allow the 2001 estate tax reform legislation to expire and therefore the estate tax laws would revert to the pre-2001 limits in 2011. The question becomes how do you plan and discuss strategies and make recommendations to clients.  I have always advised clients to plan for the tax law that we currently have, but to keep your estate plan flexible enough to account for future changes to the tax laws or your assets and net worth.

However, given the current uncertainty and the possibility that Congress could allow the current law to lapse so that we have once again have an exclusion from GST tax to be $1 million (as indexed), some clients may want to plan to avoid GST tax on a full 3.5 million dollars worth of assets, even if the law in the future only allows for an exclusion at a lower rate. 

One strategy would be to make a taxable gift in 2009, pay gift tax in 2010, and exempt as much as 3.5 million from GST tax.  Only clients who have very large estates should even consider this pre-payment of gift (and estate) tax.  If you are interested in this type of strategy, you would be able to provide a future estate and gift and GST tax pool of funds that would be available for multiple generations of your descendants. 

A second strategy would be to create a trust for the benefit of your spouse.  While there would be no current estate or gift tax, you would be able to fully use your 3.5 million exclusion from GST tax by using a currently little used technique called a “reverse QTIP election”.  Basically, you would establish a QTIP Trust for your spouse, fund it with 3.5 million of assets, file a gift tax return next year, and fully allocate your GST exclusion to the 3.5 million gift to the QTIP Trust.  Again, you would be able to provide for your future descendants to have access to a pool of funds that would never be subject to estate, gift or GST taxes.

Using these and other strategies can provide for a tax free transfer of wealth to your future generations.  Creating a flexible estate plan that takes into account the current estate tax laws will produce the most optimal estate plan for you and your heirs.

A recent article on TheHill.com, Debate Over Estate Tax Likely to Wait Until 2010″, suggests that a split among Democrats and a busy fall agenda is likely to have lawmakers hold off this year on debating the future of the estate tax, even though it is set to expire at the end of the year.

Many experts forsee that the most likely scenario for estate tax reform is a one-year extension on current estate tax laws which would buy Congress time to make broader reform in 2010.

We will, of course, be following this closely!

I remind my clients often to contact us immediately any time there’s been a significant change in their lives, including, but not limited to:  the death of a beneficiary or anyone else named in your will, a change in marital status, new children, a change in state residence, and, as we’ll discuss in more detail, a significant change in the value of your assets or a change in tax laws. 

It’s no secret that the majority of Americans have been impacted by the current economic crisis.  Investment values have sharply declined, leaving many (particularly those nearing retirement) unsure of what to do with their assets. 

This financial uncertainty, coupled with the January 1, 2009 increase of the federal estate tax exemption from $2 million to $3.5 million, may be causing a shift in your estate plan. 

How?  Very often, estate plans can use formula clauses to fund a bypass (tax savings) trust with assets up to the maximum amount of the federal estate tax exemption ($3.5 million) with the “remainder” of the estate (often including IRAs and 401(k) accounts) passing to a surviving spouse. 

For example, a client may wish for a set percentage of assets to pass outright to a surviving spouse.  But, lower asset values and the higher estate tax exemption may result in an inadequate amount.

Another area for concern is with charitable gifts or distributions to children, grandchildren or other relatives on the death of the first spouse.  With fewer assets to go around, one might be concerned about making such allocations out of concern that there won’t be enough left to a surviving spouse.

The bottom line?  Not all estate plans are created equal and they certainly can require updating.  After all, an outdated or inadequate plan is often worse than no plan at all.