Four leading industry experts weigh in on the estate-tax conundrum
We're now entering the eighth month of 2010 — a year in which we've had no estate tax. We're also facing possible legislation and uncertainty on other issues including the allowable terms and forms of grantor retained annuity trusts (GRATs) and the continuation of the valuation discounts in family limited partnerships (FLPs). What effect has this had on estate-planning practitioners and what are their clients doing to prepare for an uncertain future? We asked four leading estate-planning experts — David A. Handler (DAH), David R. Hodgman (DRH), Charles A. Redd (CAR) and Joshua S. Rubenstein (JSR) — to answer the following four questions on the effect of the lapsed estate tax:
Are you finding your clients receptive to doing estate planning now instead of waiting for the laws to be more certain?
What problems are you experiencing with estates of people who have died in 2010?
Do you believe retroactive changes in the law will occur before the end of 2010?
Do you believe it's more likely out of revenue concerns and politics that Congress will allow 2010 to pass and 2011 to occur without change?
Based on their answers, we can see that the uncertain state of the law has had different effects on their clients and the way in which they practice. Our experts also have insightful opinions on what may or may not happen in the future. Here's what they had to say:
Most of our experts acknowledge that life (and death) go on so clients must continue with their estate planning. One expert, however, has encountered many clients who were resistant to working on their estate plans until certain issues are clarified.
DAH: My clients have been very receptive to engaging in estate planning notwithstanding the uncertainties in the law. They realize that it's very unlikely that the estate tax will be repealed and that perhaps certain doors of opportunity are closing. In particular, some clients are speeding up the pace at which they make taxable gifts (at the 35 percent tax rate), establish GRATs with terms of less than 10 years and establish and transfer interest in FLPs (before legislation eliminates discounts).
DRH: Our wealthier clients continue to implement leveraged gifting techniques without delay. Virtually all expect the estate tax to be around for their lifetimes, and any tinkering around the margins of rates and exemptions is pretty much irrelevant to them. So, they're doing short-term rolling GRATs with marketable securities, longer term GRATs with family business assets, installment sales to intentionally defective grantor trusts and partnership freezes, all of which take advantage of the current low interest-rate environment.
Clients with more modest estates are more affected by the legislative uncertainty. Some are still holding out hope that the exemptions will be increased enough so that between two spouses, no tax will be due. As a result, they are less inclined to engage in leveraged lifetime gifting techniques.
Probably of greater impact than any tax law uncertainty is the impact of market conditions. The dramatic market downturn in 2008 and 2009 caused many clients to adopt a “hunker down and wait” mentality. Many short-term GRATs were complete failures, because nothing was left for the remainder takers; and even though the short-term GRAT strategy clearly contemplates that there will be years like this, some clients seem not to have been emotionally prepared. Accordingly, the expense and hassle (both modest compared to the potential benefits) of continuing to implement a rolling GRAT strategy and the disappointing recent results have dissuaded some from staying the course.
Many other clients, however, have recognized that the dip in the market (and generally increased volatility) present a significant opportunity for leveraged gifting. In particular, clients with high concentrations in a single stock have been taking advantage of the market declines to roll over GRATs and take advantage of the low stock price. Clients with closely-held businesses also have embraced the lower valuations that have resulted from the downturn and implemented GRATs and sale transactions. As a result, we have experienced an increase in the use of leveraged gift techniques for family business owners.
Of course, clients whose health suggests a higher mortality risk face unique issues this year. We have sent multiple newsletters to our clients and have also directly contacted clients whom we know are in poor health or who have estate plans that might not work as intended if they die this year. Some, but not all of those clients have executed stop-gap amendments that address these concerns.
Overall though, the tax law uncertainty has had little impact on our clients' interest in estate planning. Life driven events (marriage, divorce, births, deaths, evolution of family businesses and stock market volatility) loom much larger than the tax laws in this regard.
CAR: In my practice, there's a small universe of clients who are keenly aware of their mortality and understand that there are, during this period of transfer-tax uncertainty, opportunities to be considered (for example, outright, direct skip “formula” gifts) and pitfalls to be avoided (for example, implementation of word formulas in existing documents in an unintended and disadvantageous way if death occurs when the federal estate tax doesn't apply).
Generally, however, I'm finding clients are affirmatively resistant to working on their estate plans until I can give them reliable advice as to what the rules are. Many clients whom I serve anticipate an unpleasant estate-planning experience if they proceed now. They believe either I will give them an incredibly convoluted and complicated set of documents (“If federal estate tax does not apply to my estate, then Disposition ABC; if federal estate tax does apply to my estate, then Disposition XYZ”), or they will have to have two successive, independent estate plans (one for right now and another to be created for and at the time when the transfer-tax laws have become clearer). Lots of folks are unwilling to make the investment of time and money to go down either of these paths. Each of them, of course, has a crystal ball that assures them they will not die until the transfer tax laws have stabilized.
JSR: Ah, why is your first question different from all other questions? At all other times, we have at least known what the tax laws are; now, we don't even necessarily know what the options are for what they will become, let alone for what they may be at the moment. So one might well expect that clients would wait for greater tax certainty. But this presupposes that taxes drive our clients' estate-planning decisions. As estate planners, we often ascribe more importance to taxes than our clients do, because taxes are objective, and there are right (closer to zero dollars) and wrong (further away from zero dollars) answers. Most clients, however, resist having taxes be the tail that wags the estate-planning dog. If all of our clients listened to all of our tax advice, they all would have died this year. Clients, in the light of tax advice, make decisions predominantly for business and personal reasons — as they should. Just because we don't know what to tell them doesn't mean there aren't things they need (and want) to do. So there's still lots of need to do planning now for all of the traditional reasons that have little, if anything, to do with taxes — aging, providing for beneficiaries, successioning businesses, art collections and other illiquid assets, etc. And of course, there's still a gift tax, and everyone believes that the estate tax will return. In the current low interest environment, therefore, devices like GRATs, installment sales, charitable lead trusts and private annuities work particularly well. Indeed, there has been a particular premium on doing GRATs this year, before their use may be Congressionally curtailed (whether by imposition of a minimum term or the inability to zero them out).
A few of our experts singled out fiduciaries as having the difficult task of deciding what distributions to make in this environment. They also mention that not knowing how to apply a stepped-up carryover basis is confusing and creates other problems.
DAH: These estates truly face uncertainty as we don't know if the estate tax will be retroactive when enacted. As a result, we don't know how to fund their trusts and whether tax basis has been stepped up. The investment decisions are also more complex because of the basic question. Further, there's no GST exemption to allocate currently, but that, too, may change. Many of these clients are in a holding pattern and waiting for clarification of these issues.
DRH: The administration of estates of people who've died in 2010 is characterized by frustrating uncertainty that in many cases has forced us to place many estates on hold. We don't know if we have a step-up in basis, so in many cases we have deferred selling assets. We don't know whether all assets will pass to a family trust or whether some assets will pass to a qualified terminable interest property or other marital deduction trust, so we have deferred funding trusts. We don't know if we have any generation-skipping transfer (GST) tax exemption to allocate and we don't know if distributions from trusts not exempt from the GST tax will retroactively attract a GST tax, so we have taken a wait-and-see attitude for GST planning this year. We don't know if a disclaimer may be appropriate and, if so, how much should be disclaimed, so distributions have been deferred to avoid an “acceptance” that would preclude a qualified disclaimer. We don't even know if a death tax return is required or what information will be requested. It's basically a frustrating mess for everyone.
I sense that Congress may be feeling more pressure to address the issue, especially as news stories have begun to appear describing some very wealthy individuals who have passed away and left the U.S. Treasury high and dry — for example the Texas billionaire, Dan Duncan, who died worth $9 billion and whose estate likely will owe no estate tax.
CAR: Dealing with the carryover basis system imposed by Internal Revenue Code Section 1022 with respect to 2010 decedents has already proven to be a train wreck. A couple of examples of problems illustrate the point.
Many of those who were old enough to have died a natural death this year owned some significant assets at death that they had held for decades. We have found, unsurprisingly, that assembling cost basis data for such assets is often impossible — a frustrating situation for us and for estate beneficiaries.
When to sell assets to raise needed cash in the estates of 2010 decedents is perplexing. Ordinarily, of course, the prudent approach for a fiduciary is to raise cash as soon as possible after cash requirements have been determined. In the current environment, however, some fiduciaries are tempted to defer selling assets until after Dec. 31, 2010, anticipating that they may be able after that date to claim a basis in estate assets equal to fair market value as of date of death. Waiting, however, subjects the fiduciary to potentially enormous investment risk.
Interpreting word formulas in some 2010 decedents' estate-planning documents has presented challenges. What is meant by a marital deduction formula that refers to “the smallest amount necessary to reduce federal estate tax to zero?” We have observed that in some situations it depends on who you ask!
The specter of possible retroactive reinstatement of the federal estate tax is causing great consternation, both for fiduciaries and beneficiaries, in the administration of the estates of 2010 decedents because, until the state of 2010 law has crystallized, distributions to beneficiaries are risky.
JSR: There are any number of problems being confronted by the estates of people who have died this year — particularly by the beneficiaries of those who died early in the year. Fiduciaries are in many cases unable to make distributions because they can't yet determine who gets what (particularly in the case of tax dependent dispositions) until they know whether estate taxes will be retroactively reinstated. This also means that beneficiaries who might take more under one set of circumstances than another, and would be inclined to disclaim under one set of circumstances, are running out of time within which to disclaim — and in fact may run out of time within which to do so before Congress acts with respect to possible retroactive reinstatement. This all means that fiduciaries are holding on to estate property longer, not knowing to whom to give what, which often gives estate creditors a longer time period within which to assert claims than they would normally have had.
Possibility of Retroactive Changes
Our experts seem to agree that retroactive changes in the law are unlikely. But, some raise the possibility of an elective option.
DAH: As 2010 progresses, the less likely the tax laws will be changed retroactively. On the other hand, as members of Congress read news stories about billionaires' estates passing free of tax to their heirs, they may be swayed in favor of retroactive enactment.
DRH: At this point I would believe almost anything. My best guess is that any retroactive reinstitution of the estate tax will include an “election option.” Any election to be covered by the estate tax, of course, would be made only for modest estates that would benefit from a basis step-up and still owe no estate tax. Some of the more interesting questions relate to whether Congress would reserve special, harsher treatment for transactions that are voluntary and intended to game the system. One example of such a gambit is to gift all of a healthy spouse's assets to his terminally ill spouse just before death. The deceased spouse has an estate plan that leaves all the assets in a family trust controlled by the surviving spouse. Will this be subject to a retroactive estate tax? Or what about a large distribution from a trust that isn't exempt from the GST tax to a skip person? Especially if the distribution bears no relationship to the beneficiary's needs, will Congress give that a pass? There are many other ways to game the system that apply in particular circumstances, and while it will make any new law much more complex, pressure may build on Congress to address such perceived abuses.
CAR: I boldly predict that retroactive reinstatement of the federal estate tax and GST tax will not occur. Here's why:
First, the developed law doesn't clearly establish that retroactive reinstatement would pass muster under the due process clause. Those who believe retroactive reinstatement would be constitutional often cite U.S. v. Carlton, 512 U.S. 26 (1994), to support their position. I believe the facts of Carlton are so far distinguishable from what would be a Congressional attempt to resurrect an entire tax system from the ashes that Carlton, although undeniably relevant, would by no means be controlling precedent.
Second, as a practical matter, Congress has waited too long to implement retroactive reinstatement. The longer Congress dithers, the less likely the courts would sanction retroactive reinstatement and the more pressure members of Congress will feel (particularly from the anti-“death” tax crowd) just to turn the page and make any transfer tax changes prospective only. In this connection, it is noteworthy that, as I compose this piece, there is no indication of Congressional will to reinstate federal estate tax and GST tax retroactively.
Third, upon calm reflection (if that's possible inside the Beltway), Congress will see that, on balance, there's less to gain than to lose with retroactive reinstatement. Already in 2010, several citizens of astounding wealth have died. The fiduciaries and beneficiaries of the estates of these decedents have both the economic incentive and ability to carry on a years-long fight against retroactive reinstatement. I believe Congress understands it would invite further scorn and ridicule were it to enact a law that would be certain to extend significantly the hiatus of 2010.
JSR: I would hope that Congress will have answered the question of retroactive reinstatement by the time this article is published. If not, then retroactivity becomes increasingly unlikely, as estate tax returns for someone dying on Jan. 1, 2010 would be due on Oct. 1, 2010 and retroactive reinstatement thereafter becomes more unfair and harder to implement. There's much talk about giving fiduciaries the option to elect whether estate taxes should be retroactively applied to estates of persons dying this year. That strikes me as “the most unkindest cut of all.” The fact that we currently don't know who should inherit a decedent's property is Congress' fault. By giving fiduciaries an option to decide, Congress would be asking them to favor one class of beneficiaries over another and make themselves litigation targets. The main advantage of retroactive reinstatement would be that the possibility that there would be estate taxes in 2010 was something clearly contemplated by every decedent, and if an aggrieved beneficiary wants to sue Congress over the constitutionality of retroactivity, at least it will be the responsible party being sued. I don't think it's fair to ask fiduciaries to take a bullet for Congress.
Change After 2010?
Our experts are all over the map on this one. Some are convinced that some type of action is forthcoming; others are equally as certain that Congress will drag its feet and may not do anything.
DAH: I don't believe that Congress will allow 2010 to pass without changing the current state of the gift and estate tax laws, despite politics and revenue concerns. The federal government needs money and taking it from the wealthiest Americans is always the easiest approach. Moreover, contrary to popular explanation, the estate tax isn't borne by a (deceased) person who worked hard to achieve financial success and paid his taxes along the way, but is instead borne by his heirs who were born or married into the right family and are about to receive a windfall. That makes the estate tax even more “palatable” to our representatives deciding who will bear the collective tax burdens. Further, as more stories are published about large estates passing tax-free in 2010, Congress may be motivated to act to correct a perceived inequity to the estates of those who died before Jan. 1 and after Dec. 31 of this year. For example, the estate of a widow who died last December with a $10 million estate paid millions in estate tax, but the estate of a person with billions dying this year pays nothing.
DRH: While I was wrongly convinced that Congress would act before the end of 2009, I'm even more convinced that Congress will not allow the estate and gift-tax system to revert to the 2001 level of exemptions ($1 million per person) and tax rates (55 percent). Nor do I think revenue concerns will change that result. There are too many people, including small business owners, who have come to rely on exemptions of $3.5 million per person. Whether the legislation accomplishing that will occur before 2011 is another question. Given the highly partisan atmosphere in Washington, it seems quite possible that no agreement will be reached until they are at the brink. Skeptics have noted that estate tax reform is a topic that seems to generate intense lobbying and very large campaign contributions. The question those skeptics ask is why would Congress finalize this any sooner than absolutely necessary? That could be as late as the due date for a tax payment for the first people to die in 2011 — which will be Sept. 30, 2011.
CAR: If we reach 2011 without any changes in federal estate tax law (meaning the pre-2001 tax act transfer-tax law automatically returns), federal revenue results may be mixed. On the one hand, estates having a value of between $1 million and $3.5 million would become subject to federal estate tax. On the other hand, a large majority of estates having a value greater than $3.5 million would actually generate smaller federal estate tax revenues than under 2009 tax law because the federal credit for state death taxes would be restored, and, as a direct result, the “pick-up” estate tax systems of many states, now dormant, would be revived.
A political reality, as has been eloquently articulated by others, is that the longer members of Congress can drag out estate tax reform, the more campaign contributions they can extract from those who seek to influence the outcome. If Congress extends the debate into 2011, those campaign contributions will continue to flow.
Another consideration is that, by today's economic standards, having an estate of between $1 million and $3.5 million doesn't necessarily place an individual in the category of “rich.” Indeed, after taking into consideration life insurance death benefits, retirement assets and home values (even in the current residential real estate market), a lot of “middle class” individuals have estates in that size category. Congress probably doesn't relish the prospect of being seen as doing nothing and thereby allowing the “death” tax to extend its tentacles to those who can't derisively be referred to as “wealthy” Americans.
The bottom line? I think 2010 will pass with no changes in federal transfer tax law. Political paralysis and the lure of additional campaign funds will prevail for the rest of this year and into the next.
JSR: Absolutely, the longer it takes to enact corrective legislation, the more likely that out of revenue and political considerations, Congress will just sit on its hands and permit 2001 law to be reinstated in 2011. This question presents a wonderful opportunity to sermonize.
We have lost our way with respect to tax policy. The major impetus behind the transfer-tax system has never been revenue production. No one ever built a bridge, dam or airport from estate tax revenues. Rather, it has always been a policy driven tax. It's human nature to hoard wealth. Transfer taxes encourage the redistribution of wealth. If one does no planning, roughly half of one's wealth goes to the government. Unlike income taxes, however, the avoidance of which is called “tax evasion,” transfer taxes, the avoidance of which is called “tax planning,” are designed to be avoided in one of three statutorily sanctioned manners: (1) leaving money without tax to surviving spouses (so that they don't become public burdens); (2) leaving money without tax to charity (again to reduce the public burden); and (3) gifting assets at reduced tax cost during one's life to children (so that they can receive assets not in their dotage but when they need it, and so that the wealth creator is still alive to help teach them how to manage the funds — again all reducing the public burden). The bones of the pre-2002 transfer-tax system existed in more or less unaltered form since creation. The 2001 Tax Reform Act eviscerated the nearly century old policy behind the transfer-tax system, during which time human nature has, predictably, not changed.
Assets have always been marked to market for income tax purposes if they are subject to an estate tax. Transfer taxes are graduated taxes that almost no American pays because of the comparatively high thresholds. Income taxes, by contrast, are essentially flat taxes that almost every American pays because of the comparatively nominal thresholds. Having transfer tax rates that are substantially higher than income tax rates encourages avoiding transfer taxes (by doing socially desirable things such as leaving money to a surviving spouse or to charity, or by making gifts to children during a taxpayer's life — all of which alleviates what might otherwise be a governmental burden), in order to pay higher income taxes instead. Maintenance of the integrity of the income tax system and maximizing income tax revenues is crucial (as income taxes do build bridges, dams and airports).
Having a unified credit against the estate and gift tax also serves to encourage wealth distribution, but in the manner selected by the taxpayer, not by the government. And having a credit for state death taxes, which was eliminated after 76 uninterrupted years by the 2001 Tax Reform Act in order to pay for the one-year-only ephemeral “repeal” of the estate tax in 2010, made sure that there was no morbid competition among states to attract people to their state in order to die.
In my view, it's essential that the pre-Economic Growth Tax Relief Reconciliation Act (EGTRRA) (that is, the 2001 Tax Reform Act) transfer-tax system be restored. The only serious problem with that system was that the $1 million unified credit had not grown sufficiently since the $600,000 unified credit created by the 1976 Tax Reform Act, and too many modest estates were being subject to estate tax. If the pre-EGTRRA transfer-tax system were restored, with a significant increase in the unified credit, everyone's interests would be served. Only the wealthiest of Americans, with estates in excess of the threshold, would be subject to estate tax. They could easily avoid that tax by leaving money to their spouses, by leaving money to charity or by gifting assets to children, which would preserve the government's ability to collect higher income taxes from those assets instead. Restoring the old 55 percent estate tax bracket, along with the 16 percent state death tax credit, will ensure that in the case of estates that do no planning, the federal government receives the same 39 percent net tax it always did, that every state participates ratably in revenue sharing (at a time when states desperately need money) and that income taxes on estates will continue to be paid at the highest rates. (Note that estate administration expenses can be deducted against either the estate's estate tax or the estate's income tax.) When the estate tax rates are higher, the deductions are taken against the estate tax, and income taxes remain high. When estate tax rates are comparable to, or lower than, income tax rates, then greater taxpayer savings would be achieved by deducting those expenses against fiduciary income tax, and fiduciary income tax collections would plummet.
Whether restoration of the pre-2002 estate-tax system with a higher unified credit would cause a temporary revenue loss is unclear, but unlikely. To whatever extent restoring the credit for state death taxes might cause a short-term diminution in estate tax revenues (since for taxpayers dying in states that currently have no state estate tax but that still have in their statutes a tax equal to the credit for state death taxes, the net federal rate would drop from the current 45 percent back to the historic 39 percent), that will quickly be made up as the economy recovers and the size of taxable estates grows again. For taxpayers, however, dying in states that still have an estate tax, which in most cases is at least 16 percent, that state estate tax is deductible against the 45 percent federal estate tax (which at the 45 percent rate creates a deduction against the 45 percent tax of 7.2 percent, making the current net federal rate only 37.8 percent). As a result, for taxpayers dying in those states, restoring the credit for state death taxes and the 39 percent net rate would actually result in an immediate estate tax increase.
David A. Handler is a partner in the Chicago office of Kirkland & Ellis, LLP. David R. Hodgman is a partner with the Chicago office of Schiff Hardin LLP. Charles A. Redd is a partner in the St. Louis office of Sonnenschein Nath & Rosenthal LLP. Joshua S. Rubenstein is a partner in the New York City office of Katten Muchin Rosenman LLP