What if the Estate Tax Is Repealed? Part I

What if the Estate Tax Is Repealed? Part I

Article posted in Transfer Taxes on 23 June 2003| comments
audience: National Publication | last updated: 16 September 2012
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Summary

In part one of this two part article, J. Michael Pusey, CPA shares his thoughts regarding the technical qualification problems that federal estate tax repeal might present for testamentary CRTs and transfers to them, the use of non- qualified CRTs, and planning for the gift tax, state inheritance tax, and new carry-over basis rules.

by J. Michael Pusey, CPA

Click here for Part 2 of this article.

There is much discussion of making the estate tax repeal of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) permanent. 1

Under current law, the estate tax exemption and maximum estate tax rates are as follows:

  
2003:        $1 million -    49%
2004-2005:   $1.5 million -  48% in 2004, 47% in 2005 
2006-2008:   $2 million -    46% in 2006, 45% in 2007-2008
2009:        $3.5 million -  45%
2010:        No estate tax  
2011:        $1 million -    55%

Unless Congress acts, the sunset provisions generally reinstate pre-2001 Act law - and the estate tax - in 2011. Under the sunset provisions, the estate tax exemption in 2011 will be $1 million (not the $675,000 exemption that was in place in 2001). Under pre-2001 Act law, a 5% surcharge was imposed on very large estates. 2

One of the major policy decisions of the 2001 Act was to "de-unify" the transfer tax system and discriminate against inter vivos non-charitable transfers in relation to testamentary transfers. The gift tax exemption is pegged at $1 million beginning in 2003; lifetime transfers don't enjoy the scheduled increases in the estate tax exemption. The gift tax rates are tied to the estate tax rates, except in 2010 when the gift tax rate is 35% (the maximum income tax rate).

Fine Tuning the Math When Split-Gifts Are Compared to Sales

The transfer to a charitable remainder trust (CRT) or in exchange for a charitable gift annuity (CGA) often entails appreciated property because these vehicles have the potential of avoiding or reducing capital gains tax. Absent debt, the transfer to a CRT does not normally entail any gain recognition, although some pre-contribution appreciation can eventually flow through as capital gain realized by the CRT.3 The bargain sale rules apply to the annuity portion of a charitable gift annuity.4 Providing certain conditions are met, annuitants can report realized gain ratably over their lifetimes.

The present-value of benefits under these split-interest transfers is compared to a Sale Alternative that assumes the donor simply sold the property.

EGTRRA didn't change the long-term capital gains rate, typically 20%, or in some cases 25% (gain arising from realty depreciation) or 28% for collectibles.

A large spike in income under the Sale Alternative makes it necessary for the planner to reduce that alternative for certain phase-outs of benefits for high-income taxpayers.

The Jobs and Growth Tax Reconciliation Act of 2003 reduced the general long-term capital gains rate from 20% to 15% for sales made on or after May 6, 2003.

The phase-out of personal exemptions remains with us in full force through 2005. In 2006-2007, 2/3 applies; in 2008-2009, 1/3 applies. Then the phase out is repealed in 2010.5 The limitation on itemized deductions may eliminate as much as 80% of certain deductions, including the charitable deduction. EGTRRA also phases out this rule. In 2006-2007, 2/3 applies; in 2008-2009, 1/3 applies. Then the phase out is repealed in 2010.6

In the long-run, if these provisions go away, the calculations will become simpler, but the charitable incentive may be less attractive because the Sale Alternative increases in value. The planner needs to keep in mind that these provisions remain with us through 2009.

Qualifying Testamentary CRTs and Testamentary Transfers to CRTs

EGTRRA seems to introduce a technical problem in so far as qualifying testamentary CRTs (and possibly testamentary additions to inter vivos CRUTs) under Sec. 664. If the estate tax charitable deduction goes away, how do you reconcile having a qualified CRT when the IRS has a history of saying the transfer has to be deductible if the trust is to be qualified?

The problem is the IRS' interpretation of regulations providing that a CRT is "a trust with respect to which a deduction is allowable under section 170, 2055, 2106, or 2522..." and which otherwise satisfies the definition of a CRAT or CRUT.7 A testamentary transfer to a CRT would not sustain a deduction under any of these Code provisions if the estate tax is repealed.

The reader may remember the much-discussed issue of whether an option could be used to fund a CRT. The goal was to side-step the problems arising when a CRT is funded with "difficult assets," such as debt-encumbered real estate. One of the arguments the IRS used in thwarting such planning was that a trust was not qualified because there was no deduction.8 To illustrate the dilemma during the current transition period, assume the will provides for a testamentary CRT. The individual dies while there is an estate tax. The estate tax charitable deduction would be available, and the marital deduction should be available if the spouse is the only beneficiary.9 The CRT itself is exempt under Sec. 664, and the estate plan works as planned.

If the charitably-minded individual dies the first day after the repeal of the estate tax, the CRT itself may be subject to unexpected income tax. If the trust's qualified status turns on sustaining a deduction and there is no deduction because the estate tax charitable deduction is repealed, the trust is no longer exempt under Sec. 664(c).

Part II of the article discusses this issue in greater depth.

Nonqualified CRTs

In the long run, if the estate tax is repealed, we may eventually see more interest in the nonqualified CRT, a trust that doesn't meet the rigors of Section 664 but provides for distributions to charity after the termination of the noncharitable interests.10

A nonqualified trust could provide that the trust pay the traditional "income" to the noncharitable beneficiary, rather than an annuity or unitrust amount as is required for a qualified CRT. A nonqualified CRT may be exempt from the self-dealing rules.11 A nonqualified CRT could provide for invasion for emergencies, etc., which is strictly impermissible if the trust is qualified under Section 664.12

Of course, a nonqualified CRT would not have the tax-exempt shelter of Section 664(c), but that may not be a significant problem in many cases, particularly in relation to the privilege of having the flexibility of invasion.

Some charities even serve as trustees of nonqualified charitable remainder trusts. The scenario seems to be one where there is a long-established relationship, and the individual (not mega-wealthy) trusts the charity to see to the needs of the donor (or other non-charitable party) and administer the trust fairly, particularly if the individual becomes incapacitated. Obviously, conflicts of interest could be an issue.

There would seem to be many more instances where, given the absence of an estate tax, the nonqualified CRT would make sense. Planners may want to incorporate the prospect of a qualified CRT if the individual dies when there is an estate tax, and a nonqualified CRT if the individual dies when there is no estate tax - or when the estate is sufficiently sheltered by the higher exemption so that an estate tax charitable deduction is wasted. This could entail added cost, since the attorney may be drafting two radically different documents.

Gift Tax Caveats: Keep in mind that a donor can actually incur a gift tax on a transfer to charity, if the charitable gift tax deduction is blown. It can be done.13 Also keep in mind in any inter vivos transfer to a nonqualified CRT (or other vehicle), the donor not only forgoes the charitable income tax deduction but also the charitable gift tax deduction. In some circumstances, this can put a premium on planning to avoid a completed gift to charity upon funding the trust.14

Also, believe it or not, it would appear that the grantor can inadvertently, in effect, incur a gift tax on a retained interest as a result of having a nonqualified CRT. The grantor is normally sheltered from this problem with a qualified CRT except for certain CRUTs with an income limitation.15 For example, the problem would arise with a nonqualified CRT if the grantor retains the initial unitrust or annuity interest with a successor interest to the child and the latter is a completed gift. An incomplete gift to the child under the circumstances of Rev. Rul. 79-243, 1979-2 C.B. 343 would appear to avoid the Sec. 2702 problem.16 If the trust is nonqualified and outside the protection of the Section 2702 regulations that except certain transfers to qualified CRTs, the grantor may effectively incur a gift tax on his or her retained interest.

Gift Tax

The discrimination against inter vivos non-charitable gifts will put a premium on avoiding completed gifts for such interests.

For example, in a CRT context, the gift to the family member is incomplete when the donor retains the lifetime interest, the successor non-charitable interest arises upon the death of the donor, and the grantor reserves the testamentary right to revoke the successor interest.17 Note that satisfying the 10% minimum charitable remainder rule is more of an issue when there are multiple beneficiaries unless the trust is for a term of years.

Of course, gift tax concerns are eliminated when the transfer is to a spouse, assuming one sustains the marital deduction which is unlimited for both gift and estate tax purposes. However, note that the gift tax marital deduction is not available for a transfer to a CRT unless the spouse is the only beneficiary, or the only beneficiary other than the donor.18 Similarly, naming a surviving spouse and child as beneficiaries of a testamentary CRT forfeits the estate tax marital deduction.19

After 2009, EGTRRA enacts a rule for transfers in trust which provides:

"Notwithstanding any other provision of this section and except as provided in regulations, a transfer in trust shall be treated as a taxable gift under section 2503, unless the trust is treated as wholly owned by the grantor or the donor's spouse under subpart I..." 20

The legislative history is brief, and not very comforting:

"Also beginning in 2010, the top gift tax rate will be the top individual income tax rate as provided under the bill, and, except as provided in regulations, a transfer to a trust will be treated as a taxable gift, unless the trust is treated as wholly owned by the donor or the donor's spouse under the grantor trust provisions of the Code."21

This seems to vest extraordinary authority in the Treasury. Section 664(a) prefaces the CRT provisions with statutory language to the effect that the provisions of that section shall apply "in accordance with regulations prescribed by the Secretary..." A court has described the CRT regulations as "legislative regulations" because issued under the authority of Sec. 664(a).22 However, Sec. 664 is quite detailed and Congress obviously gave the topic much thought.

This new rule, if it becomes effective, gives the IRS broad authority. Usually, one compares the regulations to the statute to see if the IRS has reasonably done its job, but here there is no substantial statute from which to begin the trail. However, there are cases and rulings under the grantor trust provisions to examine.

This EGTRRA provision has the potential to materially impact transfers to CRTs (annuity or unitrust interests as well as charitable remainders) as well as charitable lead and other trusts.

After 2009, persons named in gift tax returns must be provided certain information.23 An expansion of the definition of what constitutes a gift when there are transfers in trust could also bring into play these reporting provisions.

Carryover basis

The repeal of the estate tax will apparently carry some significant cost in the form of the repeal of the traditional step-up (or step-down) at death. EGTRRA enacted a carryover basis general rule for inherited property, subject to some significant exceptions - notably an exception for $1.3 million (plus adjustments for loss carryovers and built-in losses), and an additional $3 million for transfers to surviving spouses.24 These rules take effect in 2010 (and go away in 2011 under the sunset provisions).

Donors with appreciated property often struggle with comparing: (a) the Sell Alternative with significant capital gains tax; (b) the Donate and Deduct Fair Market Value Alternative, or the CRT Alternative, which can avoid capital gains tax; and (c) the Hold-On-Till-Death Alternative. Under the latter, the heirs would generally not incur capital gains tax except on post-death appreciation. There is the familiar exception for IRA proceeds, pensions, and other forms of income in respect of a decedent; these are not subject to step-up under Section 1014.

Unless one qualifies under an exception to the carryover basis rule, the Hold-On-Till-Death alternative is now "iffy" - contingent on passing away by 2009 (or after 2010 if the sunset statute prevails).

Whether the contingency of higher capital gains tax for heirs causes donors to weigh more heavily the Sale or Charitable Alternatives remains to be seen, but prospective donors should be given the perspective of the carryover basis changes enacted with EGTRRA.

As a practical matter, carryover basis may most often be ascertained (for a fee) by a CPA or lawyer rummaging through old tax files and broker statements. On the other hand, it would seem that taxpayers may have some legitimate after-death privacy concerns here because the information needed by the heirs is to be found in the decedent's old tax returns, tax files and financial papers.

If carryover basis will be very low, indeterminable or problematic, direct charitable gifts and CRTs will be major alternatives to be considered by philanthropically-minded individuals planning for appreciated assets.

State death taxes

The estate death tax credit has allowed states to share in the death tax revenue stream without increasing the tax. Historically, states have been permitted a significant income stream, essentially a diversion (or "sop") of funds that otherwise would flow to the U.S. Treasury. The federal credit against the estate tax for state death taxes is being phased out. The maximum credit (16% as recently as 2001) is 8% in 2003 and 4% in 2004.25 In 2005, the credit is replaced with a state death tax deduction.26 Even if the federal estate tax is repealed, there is much concern about on-going or higher state death taxes. This is to be resolved on a state-by-state basis.

It is anticipated that the state death tax will be a significant problem in many states. Disparity in basis for federal and state tax purposes may also be a problem. This complicates tax compliance and could also complicate the comparisons between sale versus charitable alternatives.

Conclusion

It may be that estate tax "repeal" will provide significant simplification for many taxpayers, but this interim period in which the estate tax is being (possibly) "uprooted" is also one of extraordinary complexity. Many taxpayers will need more frequent reviews of their estate plans. Many will want to include in these reviews a component of charitable planning.

Click here for Part 2 of this article.


  1. The repeal of the estate tax is found in IRC §2210. There are certain special rules governing qualified domestic trusts. In this article, we do not consider special issues involving non-citizen spouses.back

  2. IRC §2001(c)(2)back

  3. IRC §664(b)(2)back

  4. Regs. §1.1011-2back

  5. IRC §151(d)(3)(E), (F) as amended by the 2001 Actback

  6. IRC §68(f), (g) as amended by the 2001 Actback

  7. Regs. 1.664-1(a)(1)(iii)(a)back

  8. Ltr. Rul. 9501004, 9/29/94. See also Ltr. Rul. 9532006, 5/4/95, and Ltr. Rul. 9440010, 7/5/94.back

  9. Sec. 2056(b)(8)back

  10. For a general discussion, see "Nonqualified Charitable Lead and Remainder Trusts: Planning Considerations," Stephen M. Chiles, Taxes - The Tax Magazine, October, 1988, p. 777. Note that Mr. Chiles' article discusses a two-year rule concerning capital gains formerly found in Sec. 644; this rule was repealed in 1997.back

  11. See Section 4947(a)(2) which generally subjects CRTs to self-dealing and other provisions if the trust "has amounts in trust for which a deduction was allowed" under sundry provisions. Note: These provisions include Sec. 642(c).back

  12. See, e.g., Rev. Rul. 82-128, 1982-2 C.B. 71back

  13. IRC §2522back

  14. See "Nonqualified Charitable Lead and Remainder Trusts: Planning Considerations," Stephen M. Chiles, Taxes - The Tax Magazine, October, 1988, p. 777.back

  15. IRC §2702, Regs. 25.2702-1(c)(3)back

  16. Regs. §25.2702-1(c)(1)back

  17. Rev. Rul. 79-243, 1979-2 C.B. 343back

  18. IRC §2523(g)back

  19. IRC §2056(b)(8)back

  20. IRC §2511(c)back

  21. Conference Report, RIA's Complete Analysis of the Economic Growth and Tax Relief Reconciliation Act of 2001, page 1,041.)back

  22. Estate of Sara C. Cassidy, T.C. Memo. 1985-37.back

  23. IRC §6019back

  24. IRC §1022(b), (c)back

  25. IRC §2011back

  26. IRC §2058(a)back

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