With its attention focused> intensely on health care and financial reform, Congress failed last year to renew the estate tax, which taxed multimillion-dollar estates and expired at the end of 2009.
This was an important piece of legislation for both consumers and federal coffers. How important? If someone died last year, the portion of their estate that's over $3.5 million would be subject to a 45% tax. If someone dies in 2010, no matter how large their estate, it all passes on estate-tax-free. For the government, that could add up to some $26 billion in lost revenue, according to the Internal Revenue Service. Legislators have proposed a number of bills to rectify the situation ranging from reinstating the tax for the rest of 2010 to making the estate tax retroactive to Jan. 1, 2010.
A year with no estate tax might sound like a potential windfall, but the situation can present pitfalls.
Anyone who s retiring should be looking at this anyway even if Congress was on the ball, says David Sloan, an estate planning attorney with Holland & Knight in Boston.
Here s how you might be affected.
Most estate plans have trusts that contain a formula clause that outlines which assets go to a spouse exclusively and which go to children. Most estate planners base the formulas on whatever estate-tax exemption exists at the time of death. Once there is no estate tax, it reverts to zero. As a result, what appeared to be a well-considered plan may have an unanticipated result because the calculation was based on an exemption which doesn t exist.
For example, a typical estate plan includes a will that distributes everything to a trust. The trust often further divides the estate into two shares, says Sloan. One share is whatever amount that can pass estate-tax-free ($3.5 million last year) that would fund the family trust. The other share would be the balance of the assets, which would go into a marital trust, for the surviving spouse. (The tax on that money is deferred until the surviving spouse dies.)
Now, if that person dies in 2010, the formula says that his estate has to be divided into family and marital trusts. With no estate tax, the maximum amount that can pass into the family trust is all of it, which means the marital trust gets nothing, says Sloan. If the surviving spouse isn t a beneficiary of that family trust, they get nothing under the plan, much to everyone s surprise, he says.
The surviving spouse can make a claim (every state has a statute in one form or another that says you can t disinherit a surviving spouse). But hiring a lawyer and bringing an action against the estate can become an expensive hassle.
States are moving to counteract this uncertainty with their own laws
A handful of states including Idaho, Indiana, Maryland, Tennessee, Washington and others have enacted their own legislative fixes for this specific issue.
In these states, if the person who died had an estate plan drafted before 2010, the state legislation would override the formula used in the plan and interpret it as if it was drafted in 2009 with an exclusion amount of $3.5 million, says Stephen Hartnett, associate director of education for the American Academy of Estate Planning Attorneys. Other states have similar legislation pending.
If you re in a state that doesn t have this fix, go to your estate planning attorney and check if you need to revise your plan, says Hartnett.
Generation-skipping transfer tax
As part of the repeal of the estate tax, the generation-skipping transfer (GST) tax is also gone this year. The GST tax is a tax on assets or property that s passed from a grandparent to a grandchild (or great grandchild) in a will or trust. The GST tax has tracked the estate tax rate and exemption, which are 45% and $3.5 million, respectively. And unless Congress acts, the 2011 GST tax exemption amount will also go down to $1 million with a tax rate of 55%.
Some estate planners are advising their clients to make a gift to their grandchildren this year because they won t have to pay a tax. I would ask a client if they re comfortable with giving up the assets. If the answer is, Yes, I don t need this money and I would like to take care of my grandchildren, then this is the year to do it, says Howard Zaritsky, an independent estate planning consultant in Rapidan, Va.
Prospect of a $1 million exemption next year
It s anyone s guess as to how Congress will deal with the estate tax deadlock. If it does nothing, the estate tax will revert back to what it was before the law was enacted in 2001: a $1 million exemption and a progressive tax rate that tops out at 55% (higher than the previous 45% rate).
That would expose a broader swath of the population to estate taxes, says Sloan. Add up the equity in your house, your retirement portfolio, life insurance policy, and it s not that hard to reach $1 million.
To prepare for this or other scenarios, Sloan advises to talk with your lawyer and figure out what you d want to have happen to your estate. What we re doing for our clients is saying: Here s your pile of assets. Ignoring the estate taxes; how do you want to divide it up upon your death? Sloan says.