Written By Ashlea Ebeling on Forbes.com
Lawyers see litigation and administrative nightmares resulting from political impasse.
Barring a last-minute political deal, the federal estate tax is set to disappear as of Jan. 1, 2010–for just one year. Democratic leaders of Congress are vowing to resurrect the tax retroactively sometime next year, but the impending lapse has estate planners in a tizzy. They worry the lapse could turn into a nightmare for some families.
“We may have to change every other client document,” laments Carol Harrington, the head of the Private Client Group at McDermott Will & Emery.
The one-year repeal of the estate tax has been a part of the law since the Bush tax cuts were passed in 2001. In 2011, when those tax cuts expire, the estate tax will come roaring back to life with a $1 million per estate exemption from tax and a 55% top rate. By contrast, for those dying in 2009, $3.5 million of each estate is exempt from federal tax and the top estate rate is 45%.
But the reality is that the families of those who die during the lapse–including those who aren’t so wealthy–may not save any tax and could face a real mess. “Beneficiaries will deal with uncertainty for years,” warns Kaye Thomas, a tax lawyer who opines on tax issues at his Web site, fairmark.com. “Having a brief period when the estate tax doesn’t apply will almost surely lead to questions as to whether wills and trusts drafted under the assumption that the tax would remain in force truly reflect the intent of the decedent,” he adds.
An unlimited amount can be left to a spouse tax-free. So estate planning documents drafted for couples often include formula clauses designed to preserve the estate tax exemption of the first spouse to die. But those clauses could spell trouble during the lapse.
Here’s how one such clause might backfire: A man has $6 million in net worth and his will gives his children from his first marriage the “exemption” amount with the rest going to his second wife. If he dies in 2009, when the exemption is $3.5 million, wife No. 2 is left with $2.5 million and the $3.5 million going to the kids is exempt from estate tax. Sounds fair and tax-savvy.
But if the man dies on Jan. 1, his will could be interpreted to leave the entire $6 million to his children with his widow left out in the cold. Imagine the family feuds–and litigation.
Even if the family gets along, and with no second-marriage issue, a will that unintentionally transfers all assets to the kids could create huge problems, including incurring extra state estate taxes (23 states and the District of Columbia have their own estate taxes).
In addition, if Congress reinstates the estate tax retroactively, some heirs of those who die during the no-estate tax time period are likely to put up a fight instead of paying big bucks in estate tax. “If there’s a significant estate, you’re going to have litigation,” predicts Donald Hamburg, an estates lawyer in New York City.
The question for the courts would be: “Is the retroactive estate tax an unconstitutional ex post facto law?” To be sure, a constitutional challenge is a long shot. Taxpayers sued and lost on whether it’s constitutional to retroactively increase the top estate tax rate in Nationsbank of Texas v. U.S. In that case, a woman died in March 1993, when the estate tax was 50%, with a $28 million estate. But as part of the 1993 budget deal, Congress later raised the rate for 1993 deaths retroactively to 55%. Her heirs sued over the extra tax, took it up to a Court of Appeals and lost. They were denied a hearing by the U.S. Supreme Court.
Still, the retroactive imposition of a tax–as opposed to a retroactive tax rate increase–is arguably different, says Blanche Lark Christerson, managing director at Deutsche Bank Private Wealth Management.
Heirs would have to wait until the constitutional issue is resolved in the courts before they get their inheritances. “It certainly will mean that inheritances will be delayed in whole or in part,” says Linda Hirschson, an estate lawyer with Greenberg Traurig in New York.
As a practical matter, people can take the position that the tax is retroactive and they’re not going to fight it, or they can take the position it’s not retroactive and gear up for a fight with the IRS and later in the courts. If they take the latter position, they’d better keep funds in the estate until things have cleared up, Hirschson says.
While only perhaps 5,500 estates over $3.5 million would have a tax problem with the retroactive imposition of the estate tax, tens of thousands of smaller estates still face a logistical and tax mess during the period the law has lapsed. As part of the current law, during the one year that the estate tax disappears, so too does a provision which gives all inherited assets a “step-up” in basis to their value at the time of the owner’s death. (Step-up means heirs can sell right away without owing any capital gains taxes.)
Instead, for the one year of the estate tax lapse, only the first $1.3 million in assets gets a step up in basis. That means heirs of some estates larger than that will have to pay lawyers and accountants extra to figure out which assets to include in the $1.3 million. Moreover, they may not even know what the original cost of various assets was.
Harrington notes that if there’s a surviving spouse, he or she can get an additional $3 million of assets that have been stepped up. So in theory, some estates might be able to shield up to $4.3 million from capital gains, depending on how an estate plan is drafted.
Still, the loss of step-up is a key reason planners assumed the politicians–if they wanted to keep their jobs–would change the law before 2010. Congress actually repealed step-up once before, but never allowed the provision to take effect because of the outcry from families, lawyers and accountants.
With all these problems there is a potentially huge planning opportunity, says Hamburg.
Along with the repeal of the estate tax is the repeal of the so-called “generation-skipping tax” (GST), a stiff extra tax that applies to transfers to grandchildren and others, which is designed to limit multigenerational gifts that skip a generation of tax. Wealthy grandma can make significant gifts to grandchildren using multigenerational trusts, paying a gift tax (which isn’t repealed) but no GST. “Lawyers are talking about setting up these trusts in January,” Hamburg says. It’s not clear if this will work if Congress reinstates the GST retroactively and it is held to be constitutional.
Where will this all settle? An estate tax with a $3.5 million per-person exemption ratcheting up to $5 million over 10 years, and a 35% top rate (or perhaps a top rate tied to the top personal income tax rate), predicts Dean Zerbe, national managing director with the AlliantGroup and former tax counsel to Sen. Charles Grassley, R-Iowa.
“This is a classic football exercise–you get politicians on both sides posturing,” Zerbe says. “The biggest winners out of this are the estate tax attorneys. It’s a sad day for everybody else.”
While planners have bemoaned the uncertainty since 2001, few believed the politicians would be reckless (or deadlocked) enough to let the tax expire and then come back. They always assumed there would have to be some sort of a political deal before time was up.
“I’ve never seen Congress do anything so stupid,” says Harrington. “The uncertainty is paralyzing. We were not cynical enough.”
You might think heirs of those who die between Jan. 1 and the signing of a new estate tax law will be in luck. That’s why there have been jokes about 2010 being the year to “throw mama from the train” or to send Dad hunting with Dick Cheney.