The year 2010 has been a good one for the beneficiaries of large estates, but their lawyers need to be prepared for significant changes on the horizon.
Congress repealed the federal estate and generation-skipping transfer taxes for 2010. In a $10 million estate, for example, the repeal represents an estate tax savings of $2,925,000 as compared to 2009. Unless Congress takes action, however, the federal transfer tax system will return with a vengeance at the stroke of midnight on Dec. 31. The same $10 million estate will incur $4,795,000 in estate taxes in 2011, a 64 percent increase from just one year ago.
These changes are coming as a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA, the source of the so-called Bush tax cuts currently being debated, also made substantial changes to the federal transfer-tax system. Those changes culminated in the 2010 repeal of the estate and generation-skipping transfer taxes and a reduction of the gift tax rate to a historically low level of 35 percent. But EGTRRA sunsets by its own terms at the end of this year, and the federal transfer-tax system as it existed in 2001 will come back to life.
Most of the headlines concerning the federal transfer taxes have focused on the return of the federal estate tax for estates valued at greater than $1 million. Indeed, this is big news; the exemption has not been this low since 2003. But much more is at stake for the high-net-worth clients who Texas lawyers represent.
• The Texas inheritance tax will reappear. The Texas inheritance tax is tied to the federal credit for state death taxes. The Texas law took advantage of the federal credit and designed the inheritance tax to be equal to the maximum credit available. As a result, the Texas inheritance tax captured tax money that otherwise would have gone to the federal government and provided revenue for the state. EGTRRA eliminated the credit in 2005, and, consequently, reduced the Texas tax to zero. Because the sunset provision brings back the credit, it also effectively resurrects the Texas inheritance tax.
• The transfer tax rates will increase. The estate tax rates are graduated and increase as the size of the estate increases. The gift tax rate is tied to the estate tax rate, while the generation-skipping transfer-tax rate equals the maximum estate tax rate. Beginning next year, the maximum estate tax rate will increase from 45 percent in 2009 to 55 percent in 2011 for estates of more than $3 million. An extra 5 percent surcharge also will apply beginning for estates valued at $10 million until the average tax rate equals 55 percent.
• The family owned business deduction will come back. The deduction allows certain estates to claim a deduction of up to $675,000 for qualifying family owned business interests. Generally speaking, an interest in a trade or business will qualify if the decedent’s ownership interests in the business exceeded 50 percent and the decedent had participated materially in the business. EGTRRA had phased the deduction out by the end of 2003.
• The qualification for an extension to pay taxes will be restricted. Estates holding certain closely held and active businesses, which comprise at least 35 percent of the estate, may elect to pay related estate taxes over a 10 year period. Under EGTRRA, a “closely held business” could have up to 45 shareholders. The sunset reduces the number of permissible shareholders to only 15. Lending or finance businesses and holding companies also will be less likely to qualify for the extension of time.
• Conservation easements will be restricted. Conservation easements restrict development potential and effectively lower the value of the land. But instead of adjusting the land’s value for estate tax purposes in recognition of the easement, federal law allows an exclusion of up to $500,000. Under EGTRRA, the underlying property could be located anywhere in the United States. Now, the underlying property must be located within 25 miles of a metropolitan area, national park or wilderness area. The sunset makes no provision for conservation easements granted while EGTRRA was in place.
• Certain deemed allocations of generation-skipping transfer-tax exemption will be lost. Most lifetime gifts to irrevocable trusts have at least some generation-skipping transfer-tax potential. Gifts to Crummey trusts — trusts that give the beneficiary the power to demand the value of the gift that was made — typically qualify for the annual gift tax exclusion, but they do not necessarily escape the generation-skipping transfer tax for distributions to skip persons (e.g., a grandchild or someone 37 and one-half years younger than the grantor). To avoid the generation-skipping transfer tax on the trust’s appreciation in the future, the donor must allocate exemption at the time of the gift.
Under EGTRRA, donors are generally deemed to have allocated exemption to trusts at the time of their gifts. Beginning with gifts made in 2010 (not 2011), however, donors must file gift tax returns to make the allocation. Also, donors will lose the ability to allocate generation-skipping transfer exemption retroactively to an irrevocable trust if the trust’s primary beneficiary predeceases the donor.
• Qualified severances for generation-skipping transfer-tax purposes vanish. For trusts potentially subject to the generation-skipping transfer tax and for which there is insufficient generation-skipping transfer-tax exemption to exempt a trust, it is more tax efficient to split the trust so that the first trust is exempt, while the second is not. EGTRRA allows a trustee to sever a trust into an exempt and a non-exempt trust at any time. The sunset eliminates qualified severances.
Congress may or may not act to address the sunset of EGTRRA. For now, at least, significantly more individuals potentially will be subject to the estate tax, and estate-planning lawyers should remain busy in the near future addressing these changes.
R. Glenn Davis is a shareholder in ScottHulse in El Paso. He prepares estate and business succession plans for individuals and families and advises individual and corporate fiduciaries in the administration of estates and trusts throughout far West Texas and southern New Mexico.