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The Estate Tax: An Unexpected and Costly Scenario?

The Estate Tax: An Unexpected and Costly Scenario?

For nearly ten years, the estate and gift tax provisions of the Internal Revenue Code have received a decreasing level of attention from financial, tax and legal professionals.

The Tax Act passed in 2001 (“EGTRRA”) not only decreased the Estate Tax rates, but also increased the exemption amount to a maximum of $3.5 million for 2009. This meant that with minimal planning, a couple with a $7.0 million estate would incur no estate tax if both died in 2009.

However, the provisions of EGTRRA expired at the end of 2009, and for 2010, there is no Estate Tax in effect. It is important to realize that without the Tax there would be no step-up in basis for property of the decedent in the hands of the heirs. There is, however, a procedure for obtaining a limited stepped-basis for property of decedents dying in 2010. Therefore, it is critical that certain filings be made in order to receive stepped basis benefits.

Provisions of EGTRRA Not Extended

As the years passed leading up to 2009, nearly all financial and tax professionals believed that Congress would pass a bill extending the provisions of the 2001 EGTRRA. It was generally believed that the $3.5 million exemption would be extended, or possibly reduced, to $2.5 Million.

In December of 2009, the House of Representatives passed an extending bill. The bill was sent to the Senate, which has not yet taken action. Because of this inaction, it is now believed that any Bill passed would not be effective retroactively to the beginning of 2010.

The Estate Tax does return for 2011 with the exemption reduced to $1.0 million and the tax rates increased to a maximum of 60%. Therein lies the problem. In these past ten years many transactions have been planned and put into effect relying on a relatively high exemption amount.

Examples might include purchases of life insurance in which the ownership of the contract remains with the insured life; design and funding of buy/sell agreements in which the funding may be included in the estate of one of the owners; inadequate gifting programs; distribution decisions with respect to various retirement accounts and tax-deferred plans. The expansion of the Tax to include millions more estates means that no financial decision of substance should be made without at least a minimal consideration of the cost.

Significant Consequences for Failure to Plan

The cost of failing to plan will have significant consequences. For example, a couple with assets net of liabilities of $1.5 million each will have $1.0 million exposed to the Estate Tax. The Federal Estate Tax on $1.0 million will be approximately $345,000 and in Minnesota, the Minnesota Estate Tax will add approximately $100,000 for a total tax liability of $445,000.

This amount will impose a significant financial burden on the estate and also a burden on the administrator of the estate who will be responsible for raising the cash to meet that obligation. Frequently assets will have to be sold at a substantial discount in order to have sufficient cash available when needed.

Gifting is one strategy among many which may be used to reduce or eliminate the Tax. A gift will remove a portion of the estate to be taxed at the maximum rates. A gift removes all subsequent appreciation of that asset in the estate. In fact, after 7 – 10 years the appreciation of the asset will be sufficient to equal the projected tax cost. This means that the gift has been given at no net cost. We offer the following suggestions:

  • All business owners should act as though their estate will be subject to Estate Tax until demonstrated otherwise.
  • All life insurance contracts should be reviewed – especially with regard to ownership and beneficiaries.
  • All business organization Buy/Sell Agreements should be reviewed.
  • Gifting plans should be examined for greater opportunities.
  • Substantially appreciated property should be examined in light of charity contribution alternatives.
  • Retirement Plans of all types should be reviewed, and the timing and amount of distributions reconsidered.

Although President Obama’s Budget was based upon a $3.5 million exemption, it seems that inertia and political expediency have combined to return the Estate Tax to its former exemptions and rates resulting in an unexpected and costly scenario for millions of American families.

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