On the Brink Once More

Capital Letter No. 27

December 13, 2010

By Ronald D. Aucutt

The estate tax plays a featured role in unprecedented political theater.

Dear Readers Who Follow Washington Developments:

As everyone realizes, the last two weeks have offered non-stop drama, as Congress seeks to meet yet another year-end deadline.

THE “BAUCUS BILL”

Permanent Reinstatement of 2009 Law

On December 2, 2010, Senator Max Baucus (D-MT), the chairman of the Senate Finance Committee, introduced an amendment to pending tax legislation entitled the “Middle Class Tax Cut Act of 2010” and widely known as the “Baucus Bill.” As with Senator Baucus’s previous proposals, such as S. 722 he introduced on March 26, 2009, the amendment would permanently reinstate 2009 estate tax law, with a 45 percent rate and $3.5 million exemption, effective January 1, 2010. Executors of decedents who died in 2010 would be able to elect out of the estate tax into the carryover basis regime that has been 2010 law. In a result viewed by many as “too good to be true” and thus possibly an oversight, the Baucus Bill apparently would have left a testamentary trust completely free of GST tax forever if that election were made.

The application of the GST tax to trusts created upon death in 2010 is an elusive issue. To some, it is associated with the concerns about a constitutional challenge to the retroactive application of the estate tax to the estates of decedents who have already died, a challenge which itself might well fail but would create enough doubt that Congress will apparently avoid such retroactivity by allowing an election that would put executors and heirs exactly where they would have been under current law without an estate tax. To others, however, the prospective application of the GST tax to taxable distributions and taxable terminations experienced by a trust in the future is much different from retroactive application of the estate tax, even if that generation-skipping trust has already been created by the death of a transferor in 2010. The taxable events simply have not occurred yet. Still others point, for example, to the precedent of the Tax Reform Act of 1986, which, although signed into law by President Reagan on October 22, 1986, applied to inter vivos generation-skipping trusts created after committee mark-up action in September 1985, even though that committee action offered no guarantee of ultimate enactment. This analogy could support either the argument that the GST tax may appropriately apply to trusts already in existence or the argument that at least some notice must precede the creation of the trust. In this case, it would be hard to argue that the reinstatement of the GST tax would be a surprise, when it is basically the same tax we have had since 1986 and was scheduled to be reinstated on January 1, 2011, in any event. And if there were to be a challenge to the “retroactive” application of the GST tax to trusts that predate the legislation, it would probably have to be when a taxable distribution or taxable termination occurs, which may not be for a generation or longer. Some would view such suspense alone as a reason to choose the simplicity of amnesty for existing trusts as the Baucus Bill seemed to do.

Portability of the Unified Credit Between Spouses

The Baucus Bill also revived the idea of the “portability” of the unified credit, or “exclusion amount” or “exemption,” by making the portion of the exemption not used by a predeceased spouse available to the surviving spouse. This is an idea that has been around a long time. It was identified as an option in section 17 on pages 99-101 of the 2004 Report of the Task Force on Federal Wealth Transfer Taxes comprised of representatives from ACTEC and the American Bankers Association, the American Bar Association Section of Real Property, Trust and Estate Law and Section of Taxation, the American College of Tax Counsel, and the American Institute of Certified Public Accountants. It first received serious congressional attention when it appeared in the “Permanent Estate Tax Relief Act of 2006 (“PETRA”) (H.R. 5638), which the House of Representatives passed by a vote of 269-156 on June 22, 2006, and the “Estate Tax and Extension of Tax Relief Act of 2006” (“ETETRA”) (H.R. 5970), which the House passed by a vote of 230-180 on July 29, 2006, although those bills did not garner enough Senate votes in the last efforts of the Republican-controlled Congress to address the estate tax before the 2006 elections. Portability was supported on behalf of ACTEC by Transfer Tax Study Committee Chair Shirley Kovar in a Senate Finance Committee hearing on April 3, 2008, and it appeared again in last year’s Baucus Bill, S. 722.

Each iteration of the portability proposal has been more restrictive in its treatment of the vexing issue of the surviving spouse who may have succeeded to unused exemptions from more than one predeceased spouse. PETRA and ETETRA avoided complex tracing and anti-abuse rules by simply limiting any decedent’s use of exemptions from previous spouses to the amount of that decedent’s own exemption. In other words, no one could more than double the available exemption by accumulating multiple unused exemptions from previous spouses. S. 722 restricted portability still further by limiting the source of unused exemption to a spouse or spouses to whom the decedent had personally been married. In other words, if Husband 1 died without using his full exemption, and his widow, Wife, married Husband 2 and then died, Wife’s estate could use her own exemption plus whatever amount of Husband 1’s exemption had not been not used. Ultimately, Husband 2’s estate could use his own exemption plus whatever amount of Wife’s own exemption had not been used. But Husband 2’s estate could not use any of Husband 1’s unused exemption transmitted through Wife’s estate. Some commentators describe this as requiring privity between the spouses. This month’s Baucus Bill went still further by limiting portability to just one spouse, the “last” deceased spouse.

Targeted Relief for Real Estate

The Baucus Bill would have provided substantial estate tax relief for real estate. The value of family farmland that met certain qualifications and passed to a “qualified heir” would not be subject to estate tax until it was disposed of by a qualified heir. The cap on the special use valuation reduction under section 2032A – currently $1 million, the statutory cap of $750,000 indexed for inflation since 1999 – would be tied to the applicable exclusion amount, $3.5 million in the Baucus Bill, and would be indexed for inflation beginning in 2011. The treatment of a disposition or severance of standing timber on qualified woodland as a recapture event under section 2032A(c)(2)(E) would be made inapplicable to a disposition or severance pursuant to a forest stewardship plan developed under the Cooperative Forestry Assistance Act of 1978, 16 U.S.C. § 2103e. Certain contributions and sales of qualified conservation easements would likewise not result in recapture under section 2032A. And the limitation on the exclusion from the gross estate by reason of a qualified conservation easement under section 2031(c) would be increased from $500,000 to $5 million.

Other Revenue Raisers

The Baucus Bill also included the requirement for consistency in basis reporting and a minimum ten-year term for GRATs that were proposed in the 2009 and 2010 Administration budget proposals. It provided a welcome answer to the question raised in Capital Letter Number 26 about whether a heir’s basis would be increased if the value of the asset were increased in an estate tax audit. Under the Baucus Bill, the basis would be adjusted to the value “as finally determined for purposes of chapter 11.” In the case of a sale before the estate tax value is finally determined, the basis reported on the estate tax return must be used, thereby adding one more issue to be considered before selling an asset for more than the value on the estate tax return before the estate tax audit is concluded. The Baucus Bill included similar rules for gift tax values.

The rules in the Baucus Bill requiring a minimum ten-year term for GRATs were the same as those that had been proposed by the 2010 Administration budget proposals and approved by the House of Representatives three times, on March 25, June 15, and July 1, 2010.

THE DEAL BETWEEN THE PRESIDENT AND SOME CONGRESSIONAL LEADERS

On Monday, December 6, President Obama announced on national television that he and certain congressional leaders had agreed on “the framework of a deal” to permit the 2001 and 2003 income tax cuts – the so-called “Bush tax cuts” – to be extended for two years. The President reported that the agreement included a one-year 2 percent payroll tax reduction, a 13-month extension of employment benefits desired by many Democrats, and an extension of the estate tax for two years – presumably 2011 and 2012 – with a $5 million exemption and a 35 percent rate.

It appears that the congressional leaders the President reached this agreement with were mostly Republicans, and the initial reactions of Republicans were supportive, even if not enthusiastic, while surprised Democrats originally reacted with skepticism or even hostility. As the days passed, Republican criticisms emerged while more Democratic support began to be heard. In the House of Representatives in particular, the Democratic resistance has been directed largely at the estate tax proposal, believed by many to be both overly generous and extraneous to the core elements of the compromise.

THE REID-McCONNELL AMENDMENT

On Thursday, December 9, the Senate released the text of an amendment (S. Amdt. 4753) to implement the agreement announced by President Obama. The amendment, to be offered by the Senate leaders, Senators Harry Reid (D-NV) and Mitch McConnell (R-KY), to an Airport and Airway Trust Fund funding measure (H.R. 4853), is entitled the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.” This is big. For the first time since December 16, 2009, when the Senate refused to consider the House-passed bill (H.R. 4154) that would have made the 2009 estate tax law permanent, there is reason to believe that we are looking at the details of the law that will guide our practices, at least for two years.

The Sunset in General

Section 101(a) of the Reid-McConnell Amendment simply extends the sunset in the oft-discussed section 901 of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) for two years by replacing “December 31, 2010” with “December 31, 2012.” As a result, everything that was expected to expire at the end of 2010 is now scheduled to expire at the end of 2012 instead.

The Estate Tax

Title III of the Reid-McConnell Amendment, under the heading of “Temporary Estate Tax Relief,” gives special attention to the estate, gift, and GST taxes, because of the unique disruption in those taxes in 2010. Section 301 reinstates the estate tax and repeals carryover basis for 2010. Section 302(a) establishes an estate tax applicable exclusion amount, or “exemption,” of $5 million and a top estate tax rate of 35 percent, effective January 1, 2010. It also indexes that $5 million exemption for inflation, beginning in 2012, and, being found in the context of a two-year extension, also ending in 2012.

The $5 million exemption and 35 percent rate, effective even for 2010, are a bit of a surprise. It is understandable that they would attract special attention. While the rest of the measures extending the 2001 tax cuts simply maintain the 2010 status quo through 2011 and 2012, the estate tax component of the compromise is different in two respects. First, unlike the income tax compromises, which prevent, in effect, a tax increase on January 1, 2011, the estate tax deal represents a tax cut when compared to 2009. Second, this tax cut is effective not just in 2011 and 2012, but also, in large part, retroactively in 2010. These two unique features of the estate tax compromise are likely to be vigorously criticized or invoked, respectively, in the political debate of the next few days.

Election. As many have expected, as discussed in ACTEC’s paper entitled “Addressing Technical Issues Relating to the Estate and GST Taxes” that was delivered to congressional staff members on June 18, 2010, and as foreshadowed in the Baucus Bill, the Reid-McConnell Amendment deals with the “retroactivity” of the 2010 estate tax provisions by permitting an executor to elect out of the estate tax back into carryover basis. Under section 301(c) of the Amendment, “[s]uch election shall be made at such time and in such manner as the [IRS and Treasury] shall provide” and shall be irrevocable except with IRS consent. Obviously, executors of estates that would not be subject to an estate tax, such as estates under $5 million, estates that pass largely to charity, and some estates that pass largely to a surviving spouse, will forgo the election and obtain the stepped-up basis for appreciated assets. Executors facing only a modest estate tax might also forgo the election, to get the benefit of the stepped-up basis. Even executors for whom the estate tax burden may be substantial may still consider the estate tax superior to carryover basis if basis presents unusual challenges, such as in the estate of a real estate developer.

But in most estates significantly larger than $5 million, the election out of the estate tax and into carryover basis will be a clear choice, because it will avoid an estate tax that is paid sooner and at a presumably higher rate than the additional income tax that would thereby be incurred on the sale of appreciated assets. This will likely be a small percentage of 2010 estates, and therefore it is appropriate that the default outcome in the absence of an election is that the reinstated estate tax apply. For those estates that do make that election, however, additional attention will be needed, particularly in the case of married decedents for whom careful steps may be needed to ensure the benefits of the increase in basis allowed under section 1022(c) for property passing to a surviving spouse or QTIP-style trust while minimizing the amount that will be subject to estate tax at the surviving spouse’s death.

Indexing for Inflation. The indexing of the applicable exclusion amount in 2012 will follow the normal indexing rules that have been applicable to income tax brackets since 1993 and in various transfer tax contexts – such as the $10,000 gift tax annual exclusion, the maximum decrease in value attributable to special-use valuation under section 2032A, the amount of value on which estate tax deferred under section 6166 is payable at a special interest rate, and the former $1 million GST exemption – since 1999. The inflation adjustment is computed by comparing the average consumer price index (CPI) for the 12-month period ending on August 31 of the preceding year with the corresponding CPI for 2010. Thus, the inflation adjustment to the applicable exclusion amount in 2012 will be computed by dividing the CPI for the 12 months ending August 31, 2011, by the CPI for the 12 months ending August 31, 2010.

Indexing will occur in $10,000 increments, so the amount applicable in any year will be a relatively round number. But, unlike the typical inflation adjustments on which the indexing is patterned, the result of the calculation will not be rounded down to the next lowest multiple of $10,000. It will be rounded to the nearest multiple of $10,000 and thus possibly rounded up. If enacted, this will not make a huge difference in practice – obviously not more than $10,000 in any year. But it will also need to be remembered that the calculation will be repeated every year with reference to the CPI for the 12 months ending August 31, 2010. Because of the rounding rule, it will be a mistake to assume that the applicable exclusion amount for any particular year will simply be inflation-adjusted for the following year. All annual calculations will be redone with reference to the 2010 baseline and then rounded to the nearest multiple of $10,000.

Of course, it seems silly to speak of “annual” calculations when the Reid-McConnell Amendment provides for indexing for just one year, 2012. Clearly, the legislative language has been written in contemplation of the 2011-2012 rule being extended, presumably before the end of the presidential election year of 2012. This reminds us somewhat of what Congress did in 2001, but without the gap or disruption of a repeal year like 2010, which will not be repeated under the Reid-McConnell Amendment.

The Gift Tax

The gift tax is not changed for 2010. The exemption remains $1 million, and the rate remains 35 percent.

Beginning January 1, 2011, the gift tax chapter will no longer have its own unified credit (“determined as if the applicable exclusion amount were $1,000,000,” as section 2505(a)(1) provided for gifts from 2002 through 2009) or its own rate schedule. It will once again be the same as the estate tax unified credit and rates. This is introduced in section 302(b)(1) of the Reid-McConnell Amendment under the heading “Restoration of unified credit against gift tax.” Many of us have winced a bit in referring to a “unified” credit since 2004, when the estate tax exemption increased to $1.5 million but the gift tax exemption remained at $1 million, although the credits were still “unified” in the sense that the credit used affected the credit available both for future gifts and for estate tax purposes. Under the Reid-McConnell Amendment, the estate and gift tax calculations will again be identical and, in that sense, once again “unified.” Beginning in 2012, the gift tax exemption will therefore be indexed for inflation, because it will be identical to the indexed estate tax exemption.

This is a hugely relevant development for purposes of most current planning for large gifts. If this proposal is enacted, it will mean that estate planners who have been pondering ways to make major gifts before 2011 when the gift tax rate goes up to 55 percent will instead be making sure that many of those gifts are deferred to 2011 when the gift tax exemption goes up to $5 million. The new year-end rush may be to find ways to rescind, disclaim, recharacterize, or otherwise reform major taxable gifts already made in 2010 – an endeavor with which the IRS should be sympathetic under these extraordinary circumstances that taxpayers did not create, but there are no guarantees.

In what is called a “conforming amendment,” section 302(e) of the Reid-McConnell Amendment will repeal section 2511(c), which Capital Letters has never tried to understand anyway.

The GST Tax

The GST tax exemption and rate will remain tied to the estate tax applicable exclusion amount and top rate, just as they have been since 2004. Perhaps the biggest relief is that the reinstatement of the estate tax means that once again there would be an applicable exclusion amount and therefore a GST exemption for inter vivos transfers in 2010. In fact, it would be $5 million. Instantly many estate planners will go from worrying about the acrobatics needed to allocate GST exemption to a trust created or added to in 2010 to considering late allocations of the bulked up $5 million GST exemption to trusts created or added to before 2010 when the law was clear but the GST exemption was smaller.

There will be no election out of GST tax for 2010 as such. But, for anyone who has made a taxable distribution from a trust or a “direct skip” gift to a grandchild in 2010, section 302(c) of the Reid-McConnell Amendment sets the 2010 GST tax rate at zero, regardless of inclusion ratios or any other calculations.

In 2011, the GST exemption and rate are again tied to the estate tax, so that the GST exemption will be $5 million and the rate 35 percent. In fact, this will be the first time ever that the gift, estate, and GST tax exemptions and rates are all “unified.” For 2012, the GST rate will remain 35 percent and the GST exemption will presumably increase somewhat by reason of the inflation adjustment.

Deaths in 2010. It is with regard to generation-skipping trusts created at death in 2010 – once the scenario that many thought would most clearly escape GST tax forever – that the analysis becomes most difficult. In the majority of estates for which no election back into carryover basis is made, the GST tax will work fine. The tax rate on direct skips will be zero and the GST exemption allocable to trusts created at death will be $5 million.

But if the executor elects out of the estate tax into carryover basis, which will probably occur in the largest estates that are likely to include generation-skipping trusts, the result is uncertain. A sentence added to the end of section 301(c) of the Reid-McConnell Amendment that did not appear in the Baucus Bill makes it clear that such an election will not affect the treatment of property placed in a generation-skipping trust as “subject to the tax imposed by chapter 11” for purposes of section 2652(a)(1)(A). Therefore, the decedent will be the “transferor,” “skip persons” will be defined with reference to that transferor under section 2613, and that will govern the taxation of the trust in the future. But there is no specific reference to the other important way that the GST tax rules are linked to the estate tax rules, which is the definition of the GST exemption in section 2631(c) by reference to the estate tax applicable exclusion amount in section 2010(c). If the executor makes an election that causes the estate tax chapter to “not apply” (section 2210(a)), it looks like there might be no applicable exclusion amount in section 2010(c) and therefore no GST exemption.

This result, clarifying that the GST tax applies to a trust but preventing the allocation of any GST exemption, would be manifestly unjust and clearly was not intended. The argument will occur to many, and in the absence of any congressional clarification should be confidently made, that because the election under section 302(c) is explicitly stated to apply “with respect to chapter 11 of such Code and with respect to property acquired or passing from such decedent (within the meaning of section 1014(b) of such Code),” the election does not apply for purposes of chapter 13, meaning that for purposes of section 2631(c) (part of chapter 13) the $5 million applicable exclusion amount in section 2010(c) should be available after all. An argument that depends on any provision of chapter 11 surviving an election out “with respect to chapter 11” is certainly not as solid as we should be entitled to expect, and a clarification of the statutory language would be much preferable. But it is obvious that any attempt to change statutory language that is under the intense scrutiny that today’s political climate demands would be tricky.

Portability

Section 303 of the Reid-McConnell Amendment includes provisions for the portability of the unified credit between spouses that are identical to those in the Baucus Bill, conformed to the exclusion amount ($5 million) and effective dates of the Amendment. Portability could no more than double a surviving spouse’s own exemption and would be limited to the unused exemption of the survivor’s last deceased spouse (limitations that seem redundant except in the case where the exemption might be reduced in the future). As with all previous versions of portability, the predeceased spouse’s executor must affirmatively elect portability on a timely filed estate tax return, and such an election will keep the statute of limitations on that estate tax return open forever, but only for the purpose of determining the amount of unused exemption, not to make adjustments to that return itself. And Treasury will be given broad authority to flesh out the portability rules in regulations.

As articulated in the Reid-McConnell Amendment, portability will apply only in 2011 and 2012 and only when the predeceased spouse has died in 2011 or 2012, another signal that a extension of this provision beyond two years is contemplated.

Although portability of a predeceased spouse’s exemption to the surviving spouse would simplify estate planning for some married couples, a credit shelter trust would still offer advantages, especially in the largest estates. The advantages include (i) protecting the expectancy of children, especially in cases of second marriages and blended families, (ii) sheltering intervening growth in value and accumulated income from estate tax, (iii) and permitting use of the predeceased spouse’s GST exemption, because the portability proposal will apply only to the gift and estate taxes.

No Other Changes

The Reid-McConnell Amendment includes nothing on GRATs, consistent basis, valuation discounts, or special treatment for farmland or conservation easements.

Nor does the Reid-McConnell Amendment remove the shadows of “sunset” from the other changes made by EGTRRA, affecting the GST exemption (expanded deemed allocations and elections, qualified severances, determinations of value, and relief from late allocations), conservation easements, and section 6166. Those provisions are only extended for two years.

Comment

Just under a year ago, on December 16, 2009, when Senator Baucus asked unanimous consent that the Senate pause from its consideration of health care reform and approve an extension of 2009 transfer tax law for just two or three months, Senator McConnell asked Senator Baucus to agree to consideration of an amendment reflecting, as Senator McConnell described it, “a permanent, portable, and unified $5 million exemption that is indexed for inflation, and a 35-percent top rate.” Senator Baucus objected to Senator McConnell’s request, whereupon Senator McConnell objected to Senator Baucus’s request, and all hopes of transfer tax legislation in 2009 died. Now, except for permanence, the Reid-McConnell Amendment is on the brink of fulfilling Senator McConnell’s request.

We will be watching this closely over the next few days. And we strongly suspect that we will be watching closely again in about two years.