The US estate tax rules changed dramatically with the repeal of the estate and generation skipping taxes earlier this year and will undergo another radical change as of January 1, 2011, unless Congress intervenes.
During the Bush administration, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (‘EGTRRA') which set in motion a gradual phase in of lower estate tax rates and larger exemption amounts. The resulting tax reductions were scheduled to phase in over nine years. At the end of this phase in period, in 2009, the estate tax exemption amount was increased to $3.5 million per deceased and the rate of tax was 45 per cent. The 2009 gift tax exemption was $1 million and gift tax rates ranged from 41 per cent to 45 per cent.
EGTRRA provided for repeal of the estate and generation skipping tax (but not the gift tax) for the single year 2010. The gift tax exemption remains at $1 million but the rate is reduced to 35 per cent. Therefore, under current law an individual would have to die this year, or make a gift this year, to take advantage of the EGTRRA provisions. For 2010, EGTRRA also replaced the basis step up rule (which allows benefi ciaries of an estate an uplift in tax basis to fair market value) with a modifi ed ‘carry over' basis rule. Beneficiaries who inherit property from individuals dying in 2010 will take the deceased's basis in the property with a statutory increase of $1.3 million, and an additional statutory increase of $3 million for certain transfers to spouses. To the extent that the basis of estate assets is not adjusted to fair market value with the available statutory increases, capital gains tax will be imposed upon the sale of such assets.
EGTRRA itself is automatically repealed as of January 1, 2011. Unless Congress acts, this will result in a reversion to pre-EGTRRA law: a $1 million estate tax exemption and tax rates as high as 60 per cent!
During 2009, numerous bills were introduced to amend or extend the estate tax to avoid the 2010 repeal, and make the rules pertaining to the year 2009 permanent. On December 3, 2009, the House passed an estate tax bill that would keep the unifi ed credit exclusion at $3,5 million and repeal the new carryover basis rules (H.R. 4154). However, the Senate adjourned at the end of 2009 without passing H.R. 4154 or any other estate tax bill. Because of the failure of Congress to enact any estate tax legislation, we now have a one-year repeal of the estate and GST tax. However, Senate Finance Committee Chairman, Max Baucus, and several other members of Congress have publicly stated that Congress will seek to restore the tax retroactively in 2010.
The retroactive application of estate tax legislation has been upheld by the US Supreme Court in United States v. Carlton. In Carlton, the Supreme Court considered whether retroactive estate tax changes violated due process. The Court stated that the legislation would be upheld so long as it was rationally related to a legitimate legislative interest. In upholding the retroactive tax amendment, the Court emphasized that the legislative purpose was neither illegitimate nor arbitrary, Congress had acted promptly and established only a ‘modest' period of retroactivity, and taxpayers had no vested right in the Internal Revenue Code and must take their chances with respect to the tax results of a particular transaction.
Since the Carlton decision, there have been several other cases that support the legality of the retroactive application of tax changes. Given the current state of the law and the likely passage of legislation that is retroactive, there is no clear answer for estate planners and clients about what should be done now. Clouding the estate tax issue further is the fact that there is a still an independent state level estate tax in many states, including New York, California, Connecticut, New Jersey and Massachusetts.
The effect of estate and gift tax treaties with the US is also called into question by the absence of a US estate tax. In such a case, tax relief customarily provided by treaty may not be available as this relief depends on potential taxation under the laws of both countries.
In light of the potential pitfalls created by estate tax repeal it is important that US persons and non-US persons with US situated assets review their estate planning documents to ensure that their plans are still effective. For example, many documents use a formula to divide an estate between a spousal/marital share and the credit shelter/family share and during this repeal year assets may not pass as expected while there is no estate tax. Additionally, for estate plans that involve charitable bequests or second families, it is particularly important to review your plans carefully to ensure assets do not pass to the detriment of a surviving spouse or other family members.
Other pending legislation
Tax Extenders Act of 2009
In December 2009, the House of Representatives passed the Tax Extenders Act of 2009 (‘TEA') and it is currently under consideration by the Senate. If enacted, TEA would provide individuals and businesses income tax relief in 2009 by extending for one year (through 2010) more than 40 provisions that are scheduled to expire at the end of 2009.
The TEA contains tax provisions that encourage charitable contributions, provide community development incentives, provide tax relief in the event of a Presidentially declared disaster and support the deployment of alternative vehicles and alternative fuels. Also included in the TEA is a slightly revised version of the Foreign Account Tax Compliance Act of 2009 discussed below.
Foreign Account Tax Compliance Act of 2009 (‘FAT CAT')
FAT CAT could have a signifi cant impact on foreign fi nancial intermediaries, closely and widely held foreign collective investment vehicles and other closely held foreign entities, and foreign trusts.
If it is passed, FAT CAT would impose a 30 per cent withholding tax on all US-source income and the gross proceeds from the sale of assets that would produce US interest or dividends for foreign fi nancial intermediaries, closely and widely held foreign collective investment vehicles and other closely held foreign entities, unless they sign an agreement with Treasury to report the identities, account balances and account transaction activity of account holders that are US persons or have US persons as substantial owners.
Another important change in FAT CAT relates to the use of trust property by benefi ciaries. Under a new provision, the use of property held by a non-US trust by a US grantor or US beneficiaries of such trust will be treated as a distribution, in the amount of the fair market value of the use of the property, unless the grantor or such benefi ciary, as the case may be, pays the trust for the use of the property within a ‘reasonable period of time'. This provision could have a significant impact on trust structures that own assets such as real estate and art if the trusts allow the US beneficiaries to use this property without receiving adequate compensation.
FAT CAT also provides a new requirement for US persons that hold shares, directly or indirectly, in Passive Foreign Investment Companies (‘PFICs'). Under FAT CAT, US shareholders of PFICs must annually report their ownership interest in a PFIC, regardless of whether they receive a distribution or recognize gain. This requirement would supplement the currently existing information reporting requirements. So, for example, a US person owning shares of a non-US corporation which invests in art may face an annual reporting requirement if that company is classified as a PFIC.