FEDERAL ESTATE AND GIFT TAXES - WHAT IS NEW?

FEDERAL ESTATE AND GIFT TAXES - WHAT IS NEW?

FEDERAL ESTATE AND GIFT TAXES WHAT IS NEW? TABLE OF CONTENTS Chapter 1 - The Current Estate and Gift Tax Climate Chapter 2 - Proposed Legislation Chapter 3 - Modified Carryover Basis

Chapter 1 The Current Estate and Gift Tax Climate A. Introduction 1. The practitioner faces a significant dilemma when giving advice in the areas of estate and gift tax planning due to the significant changes brought about by EGTRRA (The 2001 Tax Act). 2. Most significant of these problems is the possibility that EGTRRA will not be made permanent. There is no way to predict whether or not a future congress will revote the law. The Sunset Provisions of EGTRRA force either the revote of the law making EGTRRA (or any specific portion of EGTRRA) permanent or the reversion to the laws made effective by the 1997 tax act. 3. Practitioners must understand what the current law is in the areas of estate and gift taxation, what the effect of the law is in the year 2010, what the consequences of total repeal of the law means, and what the prospects are for the reversion of the law to the prior tax act (1997) as well as what the prospects are for a change in the law. 4. Although this creates potential pitfalls for planners, it also creates opportunities for the practitioner in the area of business development. Opportunity now abounds for practitioners to review all aspects of estate plans on an annual basis with their clients and provides an opportunity to meet with and provide services for clients who have delayed preparing or implementing their estate plans. 5. It has become apparent that most practitioners have not developed a strategy for dealing with these issues with their clients. This is possibly due to the fear that a practitioner has regarding their lack of knowledge or experience in this area. 6. This chapter will serve to provide the following: (a) (b) (c) Summarize the Estate and Gift Tax provisions of EGTRRA; Discuss various issues raised by EGTRRA; and Discuss planning opportunities available to your client. B. EGTRRA Estate Taxation Provisions 1. The Federal estate tax rate and unified credit exclusions under EGTRRA are as follows: 1-1

New Law Rates & Exclusions Year Estate Tax Exclusion Top Tax Bracket Amount Rate above Highest Amount "Highest Amount" Tax on "Highest Amount" 2001 $ 675,000 55% (60%) (a) $3,000,000 $1,290,800 2002 $1,000,000 50% $2,500,000 $1,025,800 2003 $1,000,000 49% $2,000,000 $ 780,800 2004 $1,500,000 48% $2,000,000 $ 780,800 2005 $1,500,000 47% $2,000,000 $ 780,800 2006 $2,000,000 46% $2,000,000 $ 780,800 2007 2008 2009 2010 (b) 2011 (c) $2,000,000 $2,000,000 $3,500,000 Repeal of $1,000,000 45% 45% 45% Federal estate 55% (60%) (a) $1,500,000 $1,500,000 $1,500,000 Tax $3,000,000 (a) 5% extra (i.e. 60%) on $10,000,000 to the average of 55% rate (b) Repeal of federal estate tax & onset of carryover basis (c) Sunset Provision Title IX of the Act $ 555,800 $ 555,800 $ 555,800 $1,290,800 2. The Unified Credit Equivalent or "applicable exclusion amount increases to $1,000,000 (2002 & 2003), $1,500,000 (2004 & 2005), $2,000,000 (2006, 2007, & 2008), and $3,500,000 (2009). 1 3. The highest rate of tax is lowered to 50% (2002), and then declines 1% each year beginning 2003 until it levels at 45% (2007 to 2009). The amount upon which the highest rate is imposed starts at $2,500,000 (2002), then declines to $2,000,000 (2003 to 2006), resting at $1,500,000 (2007 to 2009). 2 4. Effective for decedents dying after 2009 (i.e. for 2010), the Federal Estate Tax is repealed. 3 5. EGTRRA does not apply to estates of decedents dying after 2010. The Code will thereafter be applied and administered as if the provisions and amendments had never been enacted. 4 1 IRC Section 2010(c) 2 IRC Section 2001(c) 3 IRC Section 2210 4 Section 901, Economic Growth and Tax Relief Reconciliation Act 1-2

6. Effective for decedents dying after 2001, the state death tax credit is phased out 5 over 4 years: 7. State Death Tax Credit (large estates) 2002-75% 2003-50% 2004-25% 2005-0% (Eliminated) Year Adjusted Taxable Estate Over Maximum Tax Credit Amount % of Excess Over Adj. Taxable Estate % Credit 2001 $10,040,000 $1,082,000 16.0% 100% 2002 $10,040,000 $812,000 12.0% 75% 2003 $10,040,000 $541,400 8.0% 50% 2004 $10,040,000 $270,000 4.0% 25% 2005 N/A N/A N/A 0% 8. The state death tax credit pops up again effective for estates of decedents dying after 2010. 6 deduction. 7 9. Effective for decedents dying after 2004, the state death tax becomes a C. Issues Estate Taxation 1. The Sunset provision effective for deaths after 2010 restores prior law "as if the provisions had never been enacted." Thus the unified credit equivalent amount would then be $1,000,000 (scheduled amount under current law) and not $675,000 (actual current amount in effect on date of enactment). 2. The state death tax credit phase out is really a disguised Federal revenue producer. Since the states receive the benefit of 16% (top state credit bracket) out of 55% (top current Federal bracket), the impact, before 2010, of reducing the Federal top estate tax rate to 45% coupled with reduction and elimination of the state death tax credit, is a revenue gainer. The Federal government's net take actually increases from 39% to 45%, before taking into 5 IRC Section 2011 6 Section 901, Economic Growth and Tax Relief Reconciliation Act 7 IRC Section 2058 1-3

account the impact of the state death tax deduction (which is currently not predictable because of the variety of state death tax not yet enacted). 3. Commencing 2006, when the Federal estate tax maximum rate drops to 46%, the Federal estate tax becomes a flat tax (no progression). This is because the unified credit equivalent, or estate tax exclusion, wipes out the hypothetical tax on the lower bracket. The 46% tax applies to amounts above $2,000,000, and the first $2,000,000 is excluded in 2006. 4. There is no limit on the amount of the deduction (contrast the credit) for payment of state death taxes. 5. The Federal estate tax credit for gift tax paid continues to apply, modified for deaths after 2004 to eliminate the reference to the state death tax credit. 8 exclusion. 6. No adjustment for inflation is provided for the Federal estate tax D. Planning Opportunities Estate Taxation 1. The Overfunded Credit Shelter Trust - Consider techniques for flexibility to avoid an over-funded credit shelter trust. The following alternatives should be considered: (a) (b) Cap the credit shelter trust amount; Provide a minimum marital bequest; (c) Utilize three trusts: the usual QTIP (or outright bequest), and the usual credit shelter amount subdivided into two trusts: Part one for the surviving spouse (but NO QTIP election) and Part two for the family or children; (d) A bequest to the surviving spouse and a disclaimer trust so the surviving spouse can adjust down the marital bequest; (e) Alternative trusts with authority in the executor to select amounts. 2. State Death Deductions - After 2004, do not allocate state death taxes to the credit shelter (under-funds the credit shelter trust), and review formula clause reference to state death tax credit. 3. Intentional Payment of Tax in Estate of First to Die - Previously it could have been beneficial to pay tax on a taxable estate of up to $3,000,000 in the estate of the first-to-die. The present value of the "prepayment" in general was neutral after the death of the survivor, and it utilized the lower rates a second time. Since the new rate generates a flat tax 8 IRC Section 2012 1-4

after 2006, this will no longer be viable planning. However, this technique should be reconsidered after 2010 in the event that Sunset of the law occurs. 4. Funding the "Poor" Spouse to Utilize Multiple Exclusions - In 2002 and 2003, combined estates of $2,000,000 escape estate tax if the first spouse dies leaving $1,000,000 to a credit shelter trust. This grows to $3,000,000 (2004 & 2005), $4,000,000 (2006, 2007, and 2008), $7,000,000 (2009), and reverts back to $2,000,000 (2011) if at least the first spouse to die owns one-half. The usual issue of turning over assets to the "poor" spouse (to protect against a premature death) balloons. For spouses hesitant to enrich the other, consider utilization of an intervivos QTIP trust. 5. Domicile - Many persons have changed their domicile principally for avoiding inheritance tax. For example, the State of Florida currently only has a "pick-up" tax, and may estate planners encourage their clients to change their domicile to Florida (or a state with Florida s characteristics). Is the change of domicile appropriate in light of the elimination (and reduction) of the state death? The answer may still be "Yes", depending on the size of the estate and what, if any, new state inheritance tax laws are enacted. 6. Life Insurance - Does life insurance funding of an irrevocable life insurance trust continue to have value? Consider the use of such a technique: business; Sunset; nontaxable estates; and (a) (b) (c) (d) (e) (f) (g) In business succession planning; In planning for liquidity for children not inheriting the family To fund taxes due in sizable estates of the second-to-die; With the unpredictability of the new estate tax provisions after To fund specific state estate and inheritance taxes in otherwise To fund income tax in 2010 now that carryover basis rules apply; With declining term to fund declining taxes. 7. Tax Saving Techniques - Consider whether there is still value to each of the following tax saving techniques: (a) (b) Qualified Personal Residence Trusts (QPRTs); Grantor Retained Trusts (GRTs); 1-5

(CLTs) ; (c) (d) (e) (f) (g) Charitable Remainder Trusts (CRTs) and Charitable Lead Trusts Family Limited Partnerships (FLPs); Intentionally Defective Grantor Trusts (IDGTs); Dynasty Trusts (generation skipping); and Long term loans (to be "forgiven" after repeal). E. EGTRRA Gift Taxation Provisions 1. EGTRRA reduces the top marginal gift tax bracket to 50% for gifts made after December 31, 2001. Thereafter, the top marginal rate is reduced as follows: 2003 49% 2004 48% 2005 47% 2006 46% 2007, 2008, 2009 45% 2. After 2009, when the estate tax is repealed, the top marginal gift tax rate becomes equal to the top marginal income tax rate (in the new law, 35%). 3. For gifts made after December 31, 2001, the unified credit equivalent becomes $1,000,000. Although, in the years before the estate tax is repealed, the estate tax unified credit equivalent increases in steps from $1,000,000 for estates of decedents dying in 2002 and 2003 to $3,500,000 for estates of decedents dying in 2009, the unified credit equivalent for the gift tax remains $1,000,000. 4. The law also treats all transfers to trusts, except trusts that are treated as wholly owned by the grantor or the grantor's spouse for income tax purposes (i.e., a "grantor trust" as to the grantor or the grantor's spouse) as taxable gifts. 9 F. Issues Gift Taxation 1. EGTRRA ends the unified estate and gift tax system. Whereas the gift tax used to be a "backstop" for the estate tax, it appears that the gift tax will become a backstop to the income tax and used to prevent income-shifting transfers. 2. Under EGTRRA, the gift tax will operate in the same way that it does today. However, after 2009, once a donor has used the entire $1,000,000 gift tax credit equivalent, all taxable gifts in excess of the credit equivalent will be taxed at a flat 35%. 9 IRC Section 2053 1-6

3. More difficult to interpret is EGTRRA's provision that treats all transfers to trusts (other than trusts which are treated as being wholly owned by the grantor or the grantor's spouse for income tax purposes) as taxable gifts under IRC 2503. At first glance, this provision would seem to do away with Crummey Powers 10 and its progeny, that withdrawal rights are present interests in property and qualify for the annual exclusion. Nevertheless, some of Treasury's principal drafters of the new law have publicly stated that his provision was not intended to eliminate the so-called "Crummey Power. According to one Treasury Department official, even though the transfer to a trust is deemed to be a taxable gift, the donor can nevertheless apply all of donor's available exclusions and credits to the transfer. This argument seems to fly in the face of long standing definitions found in other sections of the Code. For example, to have a taxable gift there must first be a gift. 11 Crummey withdrawal rights that qualify for the annual exclusion under IRC 2503(b) are not included in the donor's gifts for the year. Nevertheless, until there is a technical correction or some form of qualification from Treasury, taxpayers are forced to rely on the informal (non-binding) public statements of Treasury staffers. G. Planning Opportunities Gift Taxation 1. Planning for an era with a gift tax but no estate tax, as well as the long transition period over which the estate tax is (or may not be) eliminated presents the planner with difficult decisions. For example, the planner must seriously consider whether the client should pay gift tax today to save an estate tax that might not exist when the client dies. It is for this reason that planning during the transition period to estate tax repeal, not knowing if repeal will ultimately happen is particularly difficult. 2. During the transition period, planners should consider the use of "zeroed out" freezing techniques such as Grantor Retained Annuity Trusts ("GRTs") or Intentionally Defective Grantor Trusts ("IDGTs"). Further, coupling the GRT with valuation discounts provided by limited partnerships can leverage the donor's ability to make gifts without consuming gift tax credit equivalent or making taxable gifts. 3. During the transition period clients may wish to consider purchasing life insurance to provide for estate liquidity before the estate tax is repealed or to hedge against the possibility that the estate tax will not be completely repealed. However, assuming the law does not disturb Crummey and its progeny, holding life insurance in an irrevocable trust will require the use of annual exclusions and possibly the grantor's gift tax credit equivalent. 4. Once these shelters from the gift tax have been consumed, premiums paid on insurance in the trust will be taxable gifts, requiring payment of a gift tax. Accordingly, careful consideration must be given to the insurance product purchased. 10 Crummey v. Commissioner, 397 F.2d 82 (9 th Cir. 1968) 4 In the case of gifts of present interests in property to a person by the donor, "the first [$13,000] of such gifts to such person shall not, for purposes of subsection [2503](a), be included in the amount of gifts made during such year. IRC 2503(b) 1-7

5. When drafting trusts, particularly testamentary trusts, the draftsperson should consider using discretionary trusts that benefit both the spouse and descendants. Such a trust would allow the trustee to distribute trust income (and even principal) among the spouse and descendants. This would allow the trustee to make distributions directly to the creator's descendants without having to distribute trust property first to the spouse who would then have to make a gift to the descendant to be benefited. This mechanism would save the spouse's annual exclusions and gift tax credit for the spouse's own property. Furthermore, after 2009, creation of this type of discretionary trust under a Will would not incur an estate tax. To plan for the new modified carry over basis rules, careful record keeping with respect to the basis of gifted property will be required. 6. Until planners are certain that the estate tax will be permanently repealed, essentially, most gift planning will continue as usual. Clients should be encouraged to make annual exclusion gifts. Because the estate tax may not ultimately be repealed, clients should consider making gifts up to the $1,000,000 gift tax exclusion to remove those assets and the appreciation thereon from their estates. 7. Although life insurance planning is more complicated, life insurance policies held in irrevocable trusts should continue to be considered to hedge against the estate tax not being repealed permanently. 8. Estate-freezing techniques (possibly coupled with vehicles that allow for valuation discounting) should be considered as a way to remove appreciation from the client's estate at virtually no gift tax cost. 1-8

Chapter 2 Proposed Legislation A. S. 3284 (July 17, 2008). Senators Carper (D-Delaware), Leahy (D-Vermont), and Voinovich (R-Ohio), together introduced S. 3284, which would have permanently reformed the Estate Tax. The bi-partisan S. 3284 included the following proposed changes, to have been effective January 1, 2009: 1. Made the Estate and GST taxes permanent; 2. Made the applicable exclusion amount permanent at $3,500,000, indexed for inflation after 2010; 3. Set the top Estate and Gift tax rate as 45% for estates and gifts over $1,500,000; and 4. Retained the present basis step-up rules. B. H.R. 436 (January 9, 2009) 1. Representative Pomeroy (D-North Dakota), introduced H.R. 436, which would have permanently reformed the Estate Tax. This bill included the following proposed changes, to have been effective for years after December 31, 2009: (a) Made the Estate and GST taxes permanent; (b) Made the applicable exclusion amount permanent at $3,500,000, without any indexing for inflation; over $1,500,000; (c) Set the top Estate and Gift tax rates at 45% for Estates and Gifts (d) Reinstated the 5% surtax on Estates over $10,000,000 and under $41,000,000, that absorbs the benefits of the applicable exclusion amount and lower rate brackets; (e) Retained the present basis step-up rules; and (f) Eliminated the use of valuation discounts for non-business family owned entities. Unlike the rest of the bill, this change would have been effective for transfers after the date of enactment. 2. This bill would have eliminated the use of marketability discounts even for interests in entities held by unrelated persons and minority discounts on family held entities, to the extent that they reflected passive assets. If enacted, this would have precluded the use of discounts for FLPs or FLLCs that hold marketable securities, cash, or life insurance policies, for 2-1

example. The bill would have enacted new 2031(d) and 2031(e) (redesigning presents subsection (d) as subsection (f)). 3. IRC 2031(d) provided that, for Estate and Gift tax purposes (but not GST tax purposes), the value of any interest in an entity that is not actively traded will be determined by valuing any non-business assets held by the entity as if the transferor had transferred such assets directly to the transferee, valuing the non-business assets separately and without any marketability or similar valuation discounts (apparently other than discounts for lack of control). For this purpose, a non-business asset would include any asset not used in the active conduct of one or more trades or businesses. A passive asset (such as cash or cash equivalents, stock of a corporation, equity, profits, or capital interests in any entity, evidence of indebtedness, options, forward or futurities contracts, notional principal contracts or derivatives, foreign currency, REIT interests annuities, real estate used in a real estate business, assets producing royalty income, commodities, collectibles and any other asset specified in regulations prescribed by the Secretary ) would be treated as used in the active conduct of a trade or business, only if it is business inventory or receivables (See 1221(a)(1) and 1221 (a)(4)), or a hedge with respect to inventory or receivables, or real property used in the active conduct of one or more real property trades or businesses in which the transferor materially participates (as defined for passive activity loss purposes under 469(c)(7)(B)(ii)). Any asset, whether passive or active, would be treated as used in the active conduct of a trade or business if it is held as a part of the reasonably required working capital needs of a trade or business. The disallowance of discounts applies to a nonbusiness asset that consists of a ten percent interest in any other entity, by disregarding the ten percent interest and by treating the entity as holding directly its ratable share of the assets of the other entity. 4. 2031(e) would preclude minority interest discounts for Estate and Gift tax purposes (but not GST tax purposes) with respect to a transfer of any interest in a non-public traded entity if the transferee and members of the transferee s family control the entity. C. H.R. 498 (January 19, 2009). Representative Mitchell (D-Arizona), introduced H.R. 498, which would have permanently reformed the Estate Tax and made the current capital gains rates permanent. This bill included the following proposed changes, which have been effective for years after December 31, 2009: 1. Made the Estate and GST taxes permanent; as follows; 2. Made the applicable exclusion amount permanent at $5 million, phased in (a) For calendar year 2010, $3,750,000; (b) For calendar year 2011, $4,000,000; (c) For calendar year 2012, $4,250,000; (d) For calendar year 2013, $4,500,000; 2-2

(e) For calendar year 2014, $4,750,000; and (f) For calendar year 2015 and thereafter $5,000,000. 3. Indexed the applicable exclusion amount for inflation after 2015; amount; 4. Raised the gift tax exemption to the estate tax applicable exclusion 5. Set the top Estate and Gift tax rate at the capital gains rate for Estates up to $25,000,000, and double that rate for estates over $25,000,000; 6. Indexed the $25,000,000 figure for inflation after 2014; 7. Repealed the Estate Tax deduction for state death taxes; 8. Retained the present basis step-up rules; 9. Made the unused applicable exclusion amount for the first spouse to die available to the surviving spouse. D. Administration s Budget Proposal (February 26, 2009). President Obama has supported reform of the Estate Tax, rather than repeal. The Administration s budget proposal presumed that the Estate Tax would continue at their 2009 rates and exemptions through 2019. Thus, the Administration proposal would have: 1. Made the Estate and GST taxes permanent; after 2010; $3,500,000; 2. Set the applicable exclusion amount at $3,500,000, indexed for inflation 3. Set top Estate and Gift Tax rate at 45%, for Estates and Gifts over 4. Retained the present basis step-up rules; 5. Set the gift tax exemption at $1,000,000. 2-3

E. S. 722 (March 26, 2009) 1. Senate Finance Committee Chairman Baucus (D-Montana) introduced a bill to make permanent many of the provisions of the current tax law and to index several key exemption levels (such as the alternative minimum tax). The bill would, for example, have made permanent the 10%, 25% and 28% individual income tax rates, the 15% percent top tax rate and the 5% rate for middle-income and low-income taxpayers on long-term capital gains and dividends. Title III of the bill, dealing with wealth transfer taxes, would have also: (a) Made the Estate, Gift and GST taxes permanent; Gift Tax exemption; (b) Reunified the Estate Tax and the Gift Tax, creating a $3,500,000 bracket; (c) (d) Made permanent the 45% top Estate, Gift and GST tax rate Made permanent the $3,500,000 applicable exclusion amount; (e) Indexed the applicable exclusion amount, Gift Tax exemption and GST exemption for inflation after 2010; (f) Increased to $3,500,000 the maximum valuation reduction for farm or business realty under IRC 2032A; (g) Indexed the maximum valuation reduction for farm or business realty under IRC 2032A for inflation after 2010. This would have saved at least up to $1,125,000 in estate taxes at a 45% rate; and (h) Made the unused applicable exclusion amount of the first spouse to die available to the surviving spouse (the Portability provision). 2. The portability provision would have allowed a deceased spouse s personal representative to elect irrevocably on a timely filed estate tax return to permit the surviving spouse to use the first spouse s unused applicable exclusion amount. The provision was similar to the provisions found in an earlier bill (H.R. 498 on January 19, 2009) introduced by Representative Mitchell. The filing requirement for a surviving spouse s Estate would have still been tied to the amount of basic applicable exclusion amount, without regard to the carried over portion of the first spouse s exclusion. The IRS would have had no limitations period on when it could examine a deceased first spouse s Estate Tax return to adjust the amount of applicable exclusion amount carried over by the surviving spouse. In addition: (a) The first spouse s applicable exclusion amount received by the surviving spouse would not be indexed for inflation. Thus, only the surviving spouse s applicable exclusion amount would thereafter be affected by indexing. 2-4

(b) The surviving spouse would have been able to take advantage of a carryover of unused applicable exclusion amount from more than one predeceasing spouse, but like H.R. 498, this bill limited to $3,500,000 the amount of the unused applicable exclusion amount from multiple deceased spouses. This was intended to discourage serial marriages as a tax shelter device. GST exemption. (c) There would have been no portability for the first spouse s unused (d) Unlike a non-marital trust, the portable applicable exclusion amount would not have sheltered income and growth in asset values. Coupled with the lack of indexing for the first spouse s applicable exclusion amount, this would strongly favor the use of a non-marital trust for clients if the surviving spouse is likely to have a fairly long period of survivorship. (e) Unlike H.R. 498, this bill would have extended the portable applicable exclusion amount to the surviving spouse s Gift Tax exemption. (f) Unlike a non-marital trust, a portable applicable exclusion amount would not provide any of the other benefits associated with a trust, including asset protection, protection from the claims of a new spouse, diversion of the assets from the first spouse s family to a new family created upon remarriage of the surviving spouse, or professional asset management. (g) Unlike a non-marital trust, the portable annual exclusion would give the surviving spouse a full step up in basis at death, whereas the non-marital trust does not receive such a second step up in the basis. This would arguably make enacting a portable applicable exclusion amount an expensive tax change (in terms of revenue loss), and may inhibit the enactment of similar legislation in the future. If enacted, however, a non-marital trust is still superior to a portable exemption, because the Estate Tax rate on appreciation sheltered by the trust is always higher than the capital gains rate in the basis increase not obtained by the trust. F. Congressional Budget Resolution (April 2, 2009; passed both Houses of Congress on April 29, 2009). 1. The Congressional Budget Resolution presumed that the Administration proposal would have been adopted. The Senate, however, in its resolution debate, approved a 51-49 vote on Amendment No. 873, sponsored by several Senators, including Senate Finance Committee members Lincoln (D-Arkansas), Grassley (R-Iowa), Enzi (R-Wyoming). Roberts (R- Kansas) and Kly (R-Arizona), which would have created a revenue-neutral reserve to: indexed for inflation; (a) Raise the estate tax applicable exclusion amount to $5,000,000, (b) Set the top maximum Estate Tax rate at 35%; 2-5

spouses. (c) (d) Reunify the estate and gift tax unified credits; and Establish portability of the applicable exclusion amount between 2. Before the Senate approved this amendment, Majority Leader Harry Reid (D-Nevada) said, It is so stunning, so outrageous that some would choose this hour of national crisis to push for an amendment to slash the Estate Tax for the super wealthy. It passed anyway. 3. Contemporaneously, the Senate also passed Amendment No. 974 introduced by Assistant Majority Leader Durbin (D-Illinois), creating a point of order against any Estate Tax legislation beyond what is assumed in the underlying resolution (making permanent the 2009 rules), unless the bill provided an equal amount of tax relief to taxpayers earning less than $100,000. 4. The House, in its budget resolution debates, voted to allow the Estate Tax to be overhauled with other unspecified changes that would not, in the aggregate, cost more than $72,000,000,000 over the next five years, and $256,000,000,000 through 2019. The House also passed an amendment to force a vote on reinstating the statutory pay-as-you-go rules if the bill does more than extend the Bush-era tax cuts. 5. In conference, it was agreed simply to make the 2009 law permanent. G. H.R. 2023 (April 22, 2009) 1. Representative McDermott (D-Washington), introduced H.R. 2023, The Sensible Estate Tax Act of 2009, which would have made the following changes, to have been effective for years after December 31, 2009: (a) Made the Estate and GST taxes permanent; (b) Made the applicable exclusion amount permanent at $2,000,000; (c) Indexed the applicable exclusion amount after 2010; (d) Re-unified the Estate and Gift tax exemptions; (e) Raised the top Estate and Gift Tax rate brackets to 45% for Estates or Gifts that are over $1,500,000 but not over $5,000,000, 50% for Estates and Gifts that are over $5,000,000 but not over $10000,000, and 55% for Estates or Gifts that are over $10,000,000; (f) Indexed the rate brackets after 2010; (g) Restored the state death tax credit and repealed the state death tax deduction for Estates of Decedents dying after 2008; and 2-6

(h) Allowed the surviving spouse to use the first deceased spouse s unused applicable exclusion amount. 2. It is estimated that this proposal would have cost $202,000,000,000 less over the ensuing 10 years than the Administration s proposal. Also the McDermott bill s portability provisions would have limited the average total application exclusion amount that one could carryover from all predeceased spouses to $2,000,000, indexed for inflation. H. H.R. 2658 (June 2, 2009). Representative Capuano (D-Massachusetts.), introduced this bill, which would have made the following changes: 1. Made the Estate and GST taxes permanent; 2. Made the applicable exclusion amount permanent at $5,000,000 for Estate Tax purposes; and 3. Indexed the applicable exclusion amount after 2010. I. CBO Report (August, 2009) 1. The Congressional Budget Office ( CBO ) issued a report, Budget Options (vol. 2) presenting explanations of various budget options Congress was consideration to help pay for reform of the health care system. The CBO did not propose any specific combination revenue features; it merely reports approach being considered by the Congress, and estimates the revenue effects of these proposals. Among these reports was Option 48, which would have permanently reformed the Estate, Gift and GST rules. The CBO discussed four alternatives: (a) Alternative 1 would have reunified the Estate and Gift tax and set the exemption for the combined tax at $5,000,000 starting in 2010, index that amount for inflation, and set the tax rate equal to the top rate on capital gains (currently set for 15% in 2010 and 20% thereafter). Stepped up basis would have applied to assets transferred from a Decedent. No deduction or credit would have been given for state death taxes. It was estimated that this alternative would have reduced revenues by $128,000,000,000 over the period from 2010 to 2014. In 2014, approximately 5,300 estates would have been required to pay some Federal Estate Tax under this alternative, compared with about 58,000 under current law (after EGTRRA s expiration). (b) Alternative 2 would reunified the tax and make the same changes, except that instead of a single tax rate, two would apply. The first $25,000,000 of the taxable Estate would have been taxed at the top capital gains rate, and taxable transfers above $25,000,000 would have been taxed at 30%. (The $25,000,000 threshold would be indexed for inflation.) Through 2014, revenues would fall by $117,000,000,000. In that year, some 5,300 estates would have Federal Estate Tax liabilities. (c) Alternative 3 would have reunified the tax and set the exemption at $3,500,000 beginning in 2010, indexed that amount for inflation, and set the tax rate at 45%. The stepped-up basis would have continued to apply to assets transferred from a decedent, but 2-7

unlike the other three approaches, this alternative would have retained EGTRRA s deduction for state death taxes. It was estimated that those changes would have reduced revenues by $65,000,000,000 over five years. About 9,400 estates would have had to pay some Federal Estate Tax in 2014 under this alternative. (d) Alternative 4 would have made EGTRRA s provisions for Estate and Gift taxes in 2010 permanent rather than temporary. Thus, the Estate Tax would not have been reinstated, and the Gift Tax exemption would have remained at $1,000,000. In addition, this would have permanently retained the modified carryover basis that EGTRRA specifies in 2010 for some transferred assets. It was estimated that together, those changes would have reduced revenues by $163,000,000,000 between 2010 and 2014, and no one would have had to pay Federal Estate Taxes in 2014. 2. The CBO stated that an advantage of all of the alternatives is that they would provide more certainty about future Estate and Gift Tax law, which would have simplified Estate planning. Also smaller estates (or, in the case of Alternative 4, all Estates) would have been exempt from filing Estate Tax returns, which would have reduced the filing burden for some Taxpayers and their heirs. Because the first three alternatives would have retained the Estate and Gift Tax, returns would still have been filed for some Estates, and some would have been required to pay Estate Taxes. 2-8

A. IRC 1022 Chapter 3 - Modified Carryover Basis 1. The basis of property acquired from a decedent dying after December 31, 2009 is equal to lower of: death; (a) (b) Decedent s adjusted cost basis in the property, or; The fair market value of the property on the Decedent s date of 2. This Code section replaces IRC 1014 (unlimited step-up in basis at the date of death of a Decedent). B. Basis Adjustments Still Permitted 1. For total non-spousal transfers at death: assets; plus plus (a) (b) $1,300,000 of unrealized appreciation can be added to inherited The sum of unused capital loss carryovers under IRC 1212(b); (c) The sum of unused net operating loss carryovers under IRC 172; plus (d) The sum of losses that would have been allowable under IRC 165 if the property acquired from the Decedent had been sold at fair market value immediately before the Decedent s death. 2. In the event of a transfer to a surviving spouse, an additional $3,000,000 of unrealized appreciation can be added to such inherited assets. A transfer to a surviving spouse is defined as: (a) An outright transfer to a surviving spouse; or (b) A QTIP (all income payable each year to surviving spouse and no person other than surviving spouse can receive any principal during spouse s lifetime). 3-1

3. The $1,300,000 and the $3,000,000 basis adjustments can only be allocated to the inherited assets received from the decedent which have the unrealized appreciation. 4. The unused capital loss and operating loss carryovers and the IRC 165 losses can be applied against any inherited asset received from the decedent. 5. No basis adjustment is allowed on assets received as a gift within three years of death unless such gifts were received from a spouse (and the spouse did not receive the transferred assets as a gift within three years of the Decedent s death). 6. No basis adjustment is allowed for Income in Respect of a Decedent (IRD) property. 7. Basis modifications are limited to the fair market value of the assets at the date of the Decedent s death. 8. Non resident aliens can only adjust basis by $60,000 plus the spousal adjustments. They cannot take advantage of the adjustments for loss carry-forwards. C. Example. The Decedent has an asset with an adjusted basis at death of $2,000,000. The fair market value of the asset on the date of death of the Decedent is $6,000,000. Therefore, the $4,000,000 difference is unrealized appreciation. (a) If the asset is passed to the Decedent s spouse, the Executor of the Decedent s estate can allocate up to $4,300,000 of stepped-up basis to the asset. (b) If the asset is passed to the Decedent s child, the maximum allocation of basis is $1,300,000 unless other modifications are permitted (such as loss carryforwards). D. Reporting of Modified Carryover Basis 1. IRC 6018 requires the Executor of the Estate of the Decedent to file a Federal Tax Return if the value of the estate exceeds $1,300,000. (NOTE: This is the minimum value of the Decedent s Estate, not the actual unrealized gain itself.) 2. Non resident aliens must report such gains if the Estate within the United States is greater than $60,000. 3. There should be collaboration between the Executor of the Decedent s Estate, the heirs to the Decedent s Estate, and the beneficiaries of non-probate assets. 4. In addition to reporting this information to the Internal Revenue Service, the Executor of the Decedent s Estate must also provide this information to the various beneficiaries of the assets within thirty days of the filing with the Internal Revenue Service. 5. The penalty for failure to file this return is $10,000. 3-2

E. Miscellaneous Issues Relating To Modified Carryover Basis 1. Allocations Made by the Executor (a) Can the Executor, who is also a beneficiary of the Estate of the Decedent make the allocations? (b) Should an Executor, who is also a beneficiary of the Estate of the Decedent make the allocations? (c) Can the Executor be sued over the allocations made? How can the Executor be protected? (d) Who should have the power to make allocations? (e) What are the income and estate tax consequences to a beneficiary making the elections? (f) What if there is no probate and therefore no Executor? 2. What if the only assets which can receive the allocation were supposed to be left to someone other than surviving spouse? 3. What will happen to Buy-Sell Agreements for businesses which have substantially increased in value over the years? The Capital Gain Tax may now be a factor. 4. What if the property is jointly owned (with the right of survivorship) with a child or a spouse? 5. Is property held in a Revocable Inter-Vivos Trust eligible for basis stepup? 6. Should assets qualifying under the $3,000,000 additional spousal step-up be left outright to the surviving spouse or should these assets be transferred to a QTIP Trust? 7. How much property must be left to a spouse or other beneficiary to get the full basis adjustment? 3-3

8. With regard to substantial non-probate property, who should allocate basis, and what problems and pitfalls exist? 9. Should the Decedent make allocations in his/her Last Will and Testament? 10. Effect on Partnership IRC 754 and 743 only operate if adjusted basis of the Estate/successor at interest is more than the adjusted basis of the Partnership in the property. 11. New IRC 1040 treats adjusted basis of property used to satisfy pecuniary gifts in an Estate as equal to the date of death value (not carryover basis) in order to avoid income recognition (deemed sale rule). However, the transferee still uses carryover basis rule to determine basis, and the transferee still recognizes gain on post death appreciation. 12. Pecuniary vs. fractional marital share formulas going forward Same issues; fractional share formulas eliminate income tax on post death appreciation. appointment. 13. No basis adjustments for assets over which the decedent had a power of trust. 14. No basis adjustments at spouse s later death for assets held in a QTIP 15. The exclusion under IRC 121 for $250,000 of gain resulting from a lifetime for the sale of an individual s personal residence will now be available for estates, revocable trusts, and individuals who receive the home as inheritance from the decedent. 16. NOTE: For 2010, it is estimated there would have been approximately 6,000 estates with a value in excess of $3,500,000. It is further estimated that there will be more than 70,000 estates affected by new carryover basis provisions. 3-4