Estate Plans in Uncertain Times

With 2006 fast approaching I can’t help but pause to think about our estate and gift tax regime. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 changed the rules of the game. Following the enactment of EGTRRA estate planners and tax attorneys went to work defining and clarifying how estate plans should be structured for maximum flexibility in light EGTRRA. Congress has yet to clarify the uncertainties associated with EGTRRA and, as a result, many taxpayers and tax advisers have yet to restructure their estate plans. The importance of restructuring estate plans is increasing as the sunset time EGTRRA draws near, so this post will review some of the basic uncertainties and solutions.

Perhaps the most obvious EGTRRA uncertainties involve the increasing applicable exclusion amount (AEA). The AEA has increased from $120,667 in 1977 to $3,500,000 in 2009. Much of this AEA increase has occurred over the past few years. For example, the AEA increased from $675,000 in 2000 to $2,000,000 in 2006. This large increase over such a short time will be particularly problematic for estate plans consisting of credit-shelter (or A/B) trusts with pecuniary formulas. The pecuniary formula is the mechanism in credit-shelter trusts which allocates the amount that is to go to the marital trust (for the benefit of the surviving spouse) and the family trust (for the benefit of others).

The pecuniary formula accomplishes this by: (1) allocating the surviving spouse the amount necessary to take full advantage of the unlimited marital deduction or (2) allocating the surviving family members an amount equal to the AEA. If there is no estate tax or AEA then in the former case the surviving spouse might not receive anything and in the later case the surviving family members might not receive anything. This situation will be most unfortunate for those individuals who are dependent on the decedent and who are otherwise unable to support themselves - such as surviving spouses and minor children.

This situation can be easily avoided with advance planning. For example, the estate could employ a non-formulary qualified terminal interest (QTIP) property allocation instead of a pecuniary formula. This could involve one-lung QTIP or Clayton QTIP trusts. Alternatively, the estate could cap the amount that passes to the family trust, employ a fractional marital deduction formula, or provide that the only property to pass to a credit-shelter trust would be the property disclaimed by the surviving spouse.

A second set of EGTRRA uncertainties involves the step-up basis changes. For those individuals who pass away after 2010 the tax basis of property from a decedent will be the lesser of the decedent’s adjusted basis in the property or the fair market value of the property on the decedent’s date of death. With numerous caveats, executors will be able to increase the basis of property by $1,300,000 and an additional $3,000,000 for property passing to a surviving spouse (either outright or in a QTIP arrangement). As discussed above, many estate plans employ a pecuniary formula which could result in the surviving spouse getting little or nothing from the decedent’s estate. In those cases the surviving family or other beneficiaries would not be entitled to the additional basis step-up. Using a non-formulary allocation would help ensure that this extra basis step-up is not wasted.

In addition, one of the caveats for the extra basis step-up is that the step-up is not available for property over which the descendant holds a power of appointment. Thus, property held in power of appointment trusts might not qualify for this limited basis increase; whereas, property held in QTIP trusts might qualify for the limited basis increase.

A third set of EGTRRA uncertainties involves the repeal of the state death tax credit. Many states have not decoupled from the federal estate tax system, so those states impose no state estate taxes. On the other hand, a number of states have decoupled and, thus, impose state estate taxes. This raises a number of planning opportunities for locating assets in different states and it also presents a number of obstacles for trusts which employ pecuniary formulas that are tied to the federal estate tax.

These uncertainties have made it more important to consider other estate planning structures, such as: transferring high income or appreciation property to grantor retained annuity trusts, installment sales to defective grantor trusts, transferring property to charitable lead annuity trusts where the remainder interest has only a nominal value, and making inter-family loans and gifts.

It is probably safe to say that most estate plans have not been updated in light of these uncertainties. These are a few of the considerations that taxpayers and estate planners will have to grapple with in the coming years — regardless of whether the estate tax is repealed or if the AEA is increased. It ought to be an interesting couple of years.