Estate Tax Proposals from the Chairman of the Senate Finance Committee

March 30, 2009

On March 26, 2009, Senator Max Baucus (D-MT), the Chairman of the Senate Finance Committee, introduced the Taxpayer Certainty and Relief Act of 2009 (S. 722). Senators Jay Rockefeller (D-WV) and Charles Schumer (D-NY), both Finance Committee members, were cosponsors. Title III of S. 722 is captioned “Permanent Estate Tax Relief,” and it is significant. If enacted, it would make the 2009 estate tax law permanent, reconform the gift tax to the estate tax, provide a simplified way for a surviving spouse to use the unused estate tax exemption of the first spouse to die, and expand the “special use valuation” benefits for owners of farms and businesses.

Current Estate and Gift Tax Exemptions and Rates

Beginning this year, by operation of a “unified credit” based on an “applicable exclusion amount,” the federal estate tax provides what is equivalent to an exemption of $3.5 million per person, or $7 million for a married couple if each spouse has sufficient property and an estate plan that makes full use of the exemption. The estate tax rate is a flat 45%. For gift tax purposes, the exemption for lifetime gifts is only $1 million. Over $1 million, the gift tax rate begins at 41% and reaches the top rate of 45% at a level of $1.5 million.

Under legislation enacted in 2001, the estate tax (as well as the generation-skipping transfer tax), but not the gift tax, is scheduled to be repealed in 2010, and it returns in 2011 with an exemption of only $1 million and rates of up to 55% and higher.

Permanent Rates and Exemptions

Earlier this year, the Obama Administration’s budget proposals included a proposal to make the $3.5 million estate tax exemption permanent, and also to retain the current estate tax rate of 45%.

S. 722, like the Administration proposal, would make the $3.5 million estate tax exemption and 45% estate tax rate permanent. In addition, it would fully unify the gift tax with the estate tax by also making the lifetime gift tax exemption $3.5 million. Beginning in 2011, it would index both exemptions for inflation.

Portability of the Exemption Between Spouses

S. 722 would also provide for the long-awaited “portability” of the unused gift and estate tax exemptions of a deceased spouse to the surviving spouse and the surviving spouse’s estate. For example, if Husband 1 dies after 2009 without using his full exemption, perhaps because he leaves everything to Wife and it qualifies for the marital deduction, Wife may use the unused portion of Husband 1’s exemption for her own lifetime gifts, and her estate may use it at her death to augment her own estate tax exemption.

If Wife marries Husband 2, who then also dies, she may use the unused exemptions of both Husband 1 and Husband 2, subject to an overall limitation that the survivor’s exemption can be no more than doubled. But if Husband 2 dies before Wife, he can use Wife’s own unused exemption but he cannot use any of Husband 1’s unused exemption transmitted through Wife’s estate.

To take advantage of this new portability, a federal estate tax return would have to be filed when the first spouse dies, and portability would have to be elected on that return.

Even if S. 722 or some other form of portability legislation is enacted, many married individuals will forgo portability and continue to use credit shelter trusts (sometimes called bypass trusts), in order to exclude the intervening appreciation in value from estate tax at the surviving spouse’s death, or, if appropriate, to allocate GST exemption, which is not covered by S. 722 and might not be covered by any final portability legislation.

Special Use Valuation of Farmland and Other Business Real Estate

The estate tax is generally imposed on the fair market value of property, which is its “highest and best use” value. In the case of real estate like farmland, its highest and best use value might be its value for development, and that might be considerably more than its value as a farm.

Special valuation rules in the estate tax law permit real estate used as a family farm or used in another family business to be valued at its farm or business use, not its highest and best use, if it comprises a large enough share of the estate and meets other requirements for qualification. The overall amount by which the estate tax value may be less than the highest and best use value is limited. This year that limitation is $1 million. It is increased from year to year with reference to inflation indices.

S. 722 would make that limitation equal to the estate tax exemption. Thus, for 2010, the limitation would increase from $1 million to $3.5 million, and then would be indexed for inflation after 2010. At a 45% rate, that increase would save $1,125,000 in tax for an estate containing the right mix of farm or other business property. In some states with their own estate tax, the savings could be higher. In effect, that estate would have a double exemption.

If a proposal like this is enacted, it would be a good occasion for anyone with significant farm or business real estate assets to consider whether the special valuation benefit might be available, how large a benefit it might be, and what might be done to secure or strengthen one’s eligibility for that benefit.

Broad Appeal and Support

Permanence in the estate tax law is very much needed. Portability is both popular and “populist” (in the political sense) because it is thought to mostly benefit folks at the lower end of estate tax payers. Similarly, the changes to special use valuation are targeted to family farms and, to a lesser extent, other family businesses. In that respect, S. 722 presents a “middle class” flavor, which is a good credential to have these days.

Also in the vein of “middle class” tax relief, S. 722 would address the individual alternative minimum tax, the regular and capital gains tax rates for lower- and middle-income taxpayers, the child tax credit, marriage penalty relief, the dependent care credit, the adoption credit and adoption assistance programs, and the earned income tax credit. That grouping of hot topics, plus the support from the Chairman and two other members of the Finance Committee, make S. 722 a serious legislative proposal.

To be enacted into law, tax legislation must originate in the House of Representatives. But if S. 722 attracts support of other Finance Committee members and the Senate leadership, that traction will be noticed by those who draft tax legislation in the House, especially since S. 722 includes alternative minimum tax relief, which is a priority for Chairman Rangel (D-NY) of the House Ways and Means Committee. Alternatively, all or part of S. 722 could be added as a Senate amendment to a House-passed tax bill. Either way, S. 722 could be an important step toward stability in the estate tax law, and the estate planning lawyers at McGuireWoods will be watching its progress.

McGuireWoods’ Services

On March 23, 2009, McGuireWoods LLP announced a formal agreement to combine with the London-based international law firm of Grundberg Mocatta Rakison LLP (GMR), allowing the firm to better serve its clients and those of GMR with wealth management matters through an enhanced Private Wealth Services team.

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