The American Taxpayer Relief Act of 2012 (ATRA) was passed only a few months ago. Because it doesn’t automatically sunset like the prior two acts, estate planners finally felt like they were in a stable planning environment.
But since the Treasury recently released President Obama’s 2014 budget proposals, there’s been a lot of grumbling about the President’s proposed estate, gift, and generation-skipping transfer tax provisions. If enacted, these proposals would change the estate tax laws yet again.
So is the Current Estate Tax Law Really Permanent?
President Obama’s proposals have caused a stir in the estate planning community. As one attorney complained, “estate planning should not be a process where the rules change every year and the government keeps moving the goal posts.”
So is ATRA permanent? In a word, yes. It is as permanent as it can be. But in this context, “permanent” must be understood relative to prior law. It simply means “does not automatically sunset.” It does not mean that it is an inviolable law that can never be changed.
I take President Obama’s budget proposals as position statements. His prior proposals regarding the transfer taxes had a zero effect when it came down to actually passing legislation. Both the budget and the Republican response are nothing more than political posturing.
I don’t think this is an uncertain tax environment. I hope that planners won’t latch onto this and encourage overly-complex planning “just in case” the President’s budget becomes law. While I think there’s still good reasons for credit shelter trusts and valuation techniques for taxpayers that are on the cusp of the current exemption, the vast majority of taxpayers don’t need full blown estate tax planning.
With that said, let’s take a look at the estate, gift, and generation-skipping transfer tax provisions of President Obama’s 2014 budget.
Reset Federal Estate, Gift, and Generation-Skipping Transfer Tax to 2009 Levels
ATRA set the exemption from estate, gift, and generation-skipping transfer (GST) taxes at $5 million, indexed for inflation after 2011 (currently $5.25 million). Surviving spouses may be eligible to double that amount using portability or credit shelter planning. The tax rate on gifts in excess of that amount is 40 percent.
According to the President:
ATRA retained a substantial portion of the tax cut provided to the most affluent taxpayers under [Tax Relief Act of 2010] that we cannot afford to continue. We need an estate tax law that is fair and raises an appropriate amount of revenue.
The President would reset the estate, gift, and GST tax to 2009 levels. As a result, the exemption amount would be reduced to $3.5 million for estate and GST taxes and $1 million for gift taxes, without indexing for inflation. The top tax rate would rise from 40 to 45 percent. Taxpayers would not owe taxes on prior gifts made while the exclusion was set at the current amount, and portability would still apply.
Require Consistency in Basis and Fair Market Value Reporting
Under current law, a taxpayer’s basis in property inherited from a decedent is stepped up to the fair market value of the property at the date of death. This is an income tax concept. Property included in a decedent’s gross estate is also valued at fair market value on the date of death. This is a transfer tax concept. Even though both the income tax laws and the transfer tax laws require the property to be valued at fair market value, current law does not require that the value for income tax purposes be the same as the value for transfer tax purposes.
The President believes that taxpayers should be required to take consistent positions when reporting basis and fair market value to the IRS. This would require both a consistency and a reporting requirement. The value used to step up basis for income tax purposes would be required to match value used for estate tax purposes. The executor of the decedent’s estate would be required to report the basis and valuation information to the recipient and the IRS. Similar rules would apply to lifetime gifts.
Require a Minimum Term for Grantor Retained Annuity Trusts
Grantor-retained annuity trusts (GRATs) have been a perennial concern of the President’s budget proposals. According to the President:
GRATs have proven to be a popular and efficient technique for transferring wealth while minimizing the gift tax cost of transfers, providing that the grantor survives the GRAT term and the trust assets do not appreciate in value. The greater the appreciation, the greater the transfer tax benefit achieved. Taxpayers have become adept at maximizing the benefit of this technique, often by minimizing the term of the GRAT (thus reducing the risk of the grantor’s death during the term), in many cases to two years, and by retaining annuity interests significant enough to reduce the gift tax value of the remainder interest to zero or to a number small enough to generate only a minimal gift tax liability.
In other words, the President is targeting short-term, zeroed out GRATs. Under current law, zeroed-out GRATs are a low-risk, high yield estate planning technique that exploit the Internal Revenue Code’s fixed valuation assumptions. If the assets in the GRAT decrease in value, the grantor is in no worse position than if the GRAT had not been established. But to the extent that the GRAT assets outperform the Internal Revenue Code’s valuation assumptions, the benefit is passed to the remainder beneficiaries tax-free.
The President’s proposal would make GRATs more risky by imposing a minimum and maximum term for the GRAT. The minimum would be 10 years; the maximum would be the grantor’s life expectancy plus 10 years. The GRAT would also be required to have a remainder interest with a value that is greater than zero at the time the interest is created and prohibit a decrease in the annuity during the term of the GRAT. These rules would apply prospectively to trusts established after the date of enactment. If enacted, these proposals would curb, if not eliminate, the use of GRATs as an estate tax planning technique.
Limitation of Duration of GST Exemption
Under current law, the allocation of GST exclusion to a trust excludes all future appreciation and income of the trust from GST tax for as long as the trust is in existence. At the time that the GST was enacted, the law of almost all states had some version of the rule against perpetuities, which limited the term of the trust.
Many states have now repealed or extended their rule against perpetuities statutes. By choosing a favorable jurisdiction, taxpayers can create GST exempt trusts that will grow in perpetuity, without the assets ever being subject to future transfer taxes.
The President would put a 90-year expiration date on the GST exclusion. On the 90th anniversary of the creation of a GST-exempt trust, the GST exclusion would terminate and the trust would become subject to GST tax.
Eliminate Intentionally Defective Grantor Trusts
Under current law, grantors can make gifts to trusts that are considered complete for federal tax purposes but incomplete for federal income tax purposes. These “intentionally defective grantor trusts” allow the grantor to decrease the value of his taxable estate by the amount of the gift and continue to pay income tax on the gift as though he had not made the transfer. The payment of income taxes on the completed gift further decreases the grantor’s taxable estate.
The President would eliminate this planning technique by coordinating the transfer tax and income tax rules. Gifts to trusts that are treated as grantor trusts for income tax purposes would be treated as incomplete gifts for federal transfer tax purposes.
As stated above, I take these proposals with a grain of salt. We can expect more of the same as Congress grapples with the budget deficit and discuss tax reform. But that doesn’t mean that change is imminent or that it’s time to plan for a speculative worst case scenario. We have a law that doesn’t automatically sunset. And, all things considered, a $5 million exemption indexed for inflation and built-in portability is a good deal.