When Congress passed the 2001 tax act, few expected the provisions repealing the federal estate tax and generation-skipping transfer (GST) tax in 2010 to take effect. Yet it has indeed happened.

With Congress unable to reach a consensus for even a one-year continuation of existing law, the provisions of the 2001 Economic Growth and Tax Relief Reconciliation Act have suspended the application of the federal estate and GST taxes for this year.

Without legislation, the federal estate, gift and GST taxes revert to 2001 law next year, with substantially higher rates and lower exemptions. The uncertain state of the transfer tax laws creates some tax planning opportunities, but many more pitfalls and uncertainties. Retroactive reinstatement is a possibility, although likely to engender constitutional challenges that will take years to resolve. How do these uncertainties affect most estate plans?
Many estate planners are seeking to take maximum advantage of the available tax exemptions, such as the estate tax exclusion and the GST exemption (each of which were $3.5 million in 2009), by using formula language in estate planning documents tied to technical tax terminology. The use of formula language allows the estate plan of married clients to automatically adjust the share of the estate that passes to family members, other than the spouse, without incurring estate tax. It accomplishes this by expressing the amount in terms of "the maximum amount that can pass without estate tax" or "the amount equal to the estate tax exemption in effect at my death."

But these formulas have uncertain consequences when the tax or exemption referred to in the document is not in effect. What is the maximum amount that can pass without incurring tax under today's conditions? Perhaps it is the entire estate. On the other hand, the maximum amount sheltered by the exemption might be zero when the estate tax exemption is no longer in effect. Depending on the formula used and its possible construction, an estate plan could have the opposite results of what was intended when current law is considered.

Minimizing The Potential For Future Estate Tax
It is entirely possible we could go through the year without an estate tax. Property passing outright to any beneficiary, however, could be subject to future estate tax. Accordingly, the best estate plan for 2010 may be to require all bequests, especially those passing to a surviving spouse, to be held in trust. Valuable tangible personal property and residences frequently pass outright to a surviving spouse, but those devices may be subject to estate tax when the spouse later dies. On the other hand, property passing in trust when the estate tax is not in effect may avoid estate tax upon the deaths of both spouses, passing the entire estate to children estate tax free.

Although the GST tax is also repealed for generation-skipping transfers occurring in 2010, the consequences of any such transfers in subsequent years are far from clear. Transfers in trust are particularly uncertain because many of the rules mitigating the imposition of double GST tax also may have been suspended in 2010 under the 2001 act. The result could be that property transferred in trust for grandchildren without GST tax in 2010 becomes subject to GST tax when property is distributed to grandchildren in 2011 and thereafter.

If Congress does act this year, the resulting legislation may be prospective or retroactive. One should be circumspect in assuming retroactive legislation would follow 2009 law. While certain members of Congress have suggested that approach, it's not certain they will go in that direction.

Modified Carryover Basis
Prior to repeal of the federal estate tax, the income tax basis of assets included in a decedent's gross estate would be "stepped up" (or "stepped down") to his fair market value at the time of his death. In conjunction with the one-year repeal of the estate tax, a modified carryover basis regime was adopted. Thus, in 2010, the income tax basis of property acquired from a decedent is the lesser of the decedent's basis for income tax purposes or the fair market value of the property at the date of death.

Under the modified carryover basis system, each decedent has two available basis adjustments that may be allocated by the decedent's executor to increase basis, but not above fair market value at death. The first is a $1.3 million adjustment that may be applied to any "property acquired from the decedent" (which is specifically defined and may not include all the property that would have been part of the decedent's gross estate under prior law).

A married decedent has an additional $3 million of available basis adjustment that may be applied only to property passing outright to a surviving spouse or to a trust for the exclusive benefit of the spouse that requires the spouse to receive all the income during the spouse's lifetime. It will be important to ensure that your estate plan permits effective use of these basis adjustments.

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