The Great Disappearing Act: What Will Become of the Federal Estate Tax in 2010 and Beyond?

Corporate & Finance Alert
(Cathleen T. Butler)
September 8, 2009
Almost like magic, the federal estate tax will disappear on January 1, 2010 and reappear on January 1, 2011 with a much lower federal estate tax exemption of $1 million per individual and an elevated federal estate tax rate as high as 55% unless those magicians in Congress can conjure up a spell, or pass a bill, to reform the federal estate tax prior to the magical expiration date. Although no legislation has currently been passed, or even seriously debated, there are four main bills brewing in Congress’ cauldron to prevent the disappearance of the federal estate tax in 2010. Due to the current economic climate, none of the current key bills propose a repeal of the federal estate tax, as was previously contemplated by some members of Congress. Historically, federal estate taxes have been used by the U.S. government as a source of revenue during tough economic times and war, so it is anticipated, based on current economic conditions, that the federal estate tax will remain in existence.

By way of background, in 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was enacted to provide for a 10 year federal estate tax phase-out plan. From 2002 through 2009, the portion of an estate exempt from federal estate tax was gradually increased from $1 million to $3.5 million and the federal estate tax rate decreased from 50% to 45% until the magical year of 2010 when the federal estate tax would disappear for one year. Under current law, the federal estate tax is scheduled to reappear in 2011 with a much lower federal estate tax exemption of $1 million and a maximum federal estate tax rate as high as 55%, unless legislation is passed to change the law. Notably, the federal gift tax remains in existence in 2010, despite the non-existence of the federal estate tax, with gift tax rates equal to the highest individual income tax rate (expected to be 35% in 2010).

Although the House and Senate have introduced numerous bills addressing federal estate tax reform, the four main bills to watch are the Pomeroy Bill (H.R. 436), the Baucus Bill (S. 722), the Mitchell Bill (H.R. 498) and the McDermott Bill (H.R. 2023). Further, another source of possible changes to the federal estate tax can be found in the Treasury’s recently released General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (the “Greenbook”), which reflects the Obama Administration’s revenue proposals and contemplates federal estate tax reform.

The Pomeroy Bill (H.R. 436), the first bill of the current Congress to address federal estate tax reform, was introduced on January 9, 2009. The Pomeroy Bill proposes keeping the federal estate tax exemption at $3.5 million and the maximum federal estate tax rate at 45% with a 5% surtax on estates over $10 million. In addition, the proposed legislation seeks to eliminate the use of valuation discounts in a closely-held company which holds non-business assets (assets not used in an active trade or business). For example, any transfer of non-business assets (stocks, bonds, real estate, etc.) would be valued without any valuation discounts. The proposed legislation also seeks to eliminate minority discounts for active businesses if a family controls the entity. Of the four main bills, the Pomeroy Bill is the only bill to propose restricting valuation discounts.

The Mitchell Bill (H.R. 498), also known as the “Capital Gains and Estate Tax Relief Act of 2009,” was introduced on January 14, 2009. The legislation seeks to maintain the 15% capital gains rate for estates up to $25 million and then double the capital gains rate (30%) for estates over $25 million. The legislation further proposes gradually increasing the federal estate tax exemption from $3.75 million to $5 million from 2010 to 2015, indexed for inflation beginning in 2016. The bill also introduces the concept of portability of the federal estate tax exemption between spouses. Portability would allow a surviving spouse to use a deceased spouse’s unused exemption amount. For example, assume the first spouse died with an estate of $2 million and left an unused exemption amount of $1.5 million. On the surviving spouse’s death, the unused $1.5 million could be combined with the surviving spouse’s exemption of $3.5 million to provide the surviving spouse’s estate with an exemption of $5 million. Finally, the legislation seeks to unify the estate and gift tax exemption amounts, so that each individual could use the same single exemption amount towards gifts made during life or upon death. Under current law, the gift tax exemption is limited to $1 million while the federal estate tax exemption is $3.5 million.

The Baucus Bill (S. 722) was introduced on March 26, 2009 by senate Finance Committee Chairman Max Baucus (D-MT). The bill is known as the “Taxpayer Certainty and Relief Act of 2009.” This legislation covers income tax as well as estate tax relief. In addressing income tax relief, the bill proposes providing permanent alternative minimum tax relief indexed for inflation, making the 15% capital gains tax rate permanent, shifting individual income tax rates with the maximum rate being 35% and making the marriage penalty relief permanent. With respect to estate tax relief, the bill is similar to the Pomeroy Bill with the addition of portability and the absence of restrictions on valuation discounts. The legislation seeks to maintain the federal estate tax exemption at $3.5 million, indexed for inflation after 2010 and preserve the 45% maximum federal estate tax rate. The bill also proposes unifying the gift and estate tax exemptions so that individuals could pass $3.5 million during life or death without incurring an estate or gift tax. In addition, the bill would allow for the portability of the federal estate exemption between spouses, but would implement limitations for multiple marriages. Finally, the bill also offers some relief with respect to the special valuation rules for farms and small businesses. Under current law, if a farm or other real estate used in a business is in the gross estate, the property may be included in the estate at its special use value rather than its fair market value at its highest and best use if certain requirements are met. Currently, the reduction in the value of the property is limited and cannot reduce the decedent’s gross federal estate by more than $1 million. The Baucus bill proposes increasing the amount from $1 million to $3.5 million, thereby allowing qualified property to be reduced up to $3.5 million.

On April 22, 2009, the McDermott Bill (H.R. 2023), or the “Sensible Estate Tax Act of 2009” was introduced. The McDermott Bill implements a smaller federal exemption amount of $2 million, indexed for inflation, and provides for a graduated estate tax rate based on the value of the estate. The tax rate schedule imposes a 45% tax rate on estates between $1.5 million and $5 million, a 50% tax rate for estates between $5 million and $10 million and a 55% rate for estates over $10 million. The bill also proposes portability between spouses and seeks to unify the estate and gift tax exemptions. Moreover, the bill would restore the credit for state death taxes and eliminate the current state death tax deduction.

The Greenbook, released on May 11, 2009, reflecting the Obama Administration’s budget proposals, assumes that the estate and gift tax rates will remain at the current 2009 levels. In addition, the Greenbook proposes limiting the term of Grantor Retained Annuity Trusts (“GRATs”), a popular estate planning technique designed to freeze the value of assets to reduce estate taxes, to ten years. This proposal would eliminate the use of short term GRATs and require that the grantor of the GRAT survive at least ten years from the date the GRAT was created. If a Grantor dies prior to the expiration of the ten year period, the GRAT essentially fails and no estate tax savings is achieved. The Greenbook also proposes restricting valuation discounts for family-controlled entities in certain situations.

Although nothing is certain, except, of course, death and taxes, it is anticipated that Congress will at the very least pass legislation before the end of the year to continue the current federal estate tax exemption of $3.5 million per individual and a maximum federal estate tax rate of 45% for one more year until a more permanent bill is passed in 2010. In fact, the House and Senate versions of the 2010 budget resolution (H. Con. Res. 85 and S. Con. Res. 13) both as proposed by the respective Budget Committees and as passed by the House and Senate respectively, allow for 2009 estate tax law to be made permanent. Overall, we can expect that the federal estate tax will not disappear in 2010, but will continue in its present form with some modifications.

Should you have any questions regarding your own situation, please contact Cathleen T. Butler of our Corporate Department.