The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act
that President Obama signed on December 17, 2010 (2010 Act) makes fundamental
changes to the estate, gift, and generation skipping-transfer (GST) tax laws
applicable in 2010 (and beyond). The 2010 Act also provides fiduciaries an
essential measure of certainty when considering opportunities available until
the end of 2010. The new law confirms broad relief for certain 2010 transfers
that would otherwise be subject to the GST tax, imposes a federal estate tax on
2010 decedents but provides a $5 million exemption, and allows executors of 2010
estates a unique election out of estate tax and into a modified carryover basis
McGuireWoods’ Private Wealth Services Group is preparing a white paper on the
Act that will be distributed in early January. However, some aspects of the Act
present challenges and opportunities that justify fresh attention by, and in
some limited cases action by, fiduciaries during the few remaining days of 2010.
In general, the Act extends several provisions of the Economic Growth and Tax
Relief Reconciliation Act of 2001 (2001 Tax Act) for an additional two years.
Some of the most significant (albeit largely temporary) aspects of the Act
- Retroactive reinstatement of the federal estate tax for 2010 decedents
with an exemption of $5 million.
- Election out of estate tax, and into a modified carryover basis regime,
for 2010 decedents.
- A zero GST tax rate for 2010.
- An increase in the estate tax exemption from $3.5 million in 2009 to $5
- Reunification of the estate tax and gift tax in 2011 so that the gift
tax exemption in 2011 and 2012 is $5 million. This is expected to be the
catalyst for significant lifetime estate planning transactions (i.e., gifts,
sales, etc.) in 2011 and 2012.
- An increase in the GST tax exemption from $3.5 million in 2009 to $5
- Retention of the deduction for state death taxes.
- Starting in 2011, the ability to transfer a decedent’s unused estate tax
exemption to the decedent’s surviving spouse, which is referred to as
“portability.” This may have a significant impact on future estate planning
for many married couples.
- Extension of lower income tax rates, with a top rate of 35%.
- Extension of lower capital gains and dividend tax rates, with a top rate
- Ability to rollover directly from an IRA to a qualified public charity
- Alternative Minimum Tax relief.
- A 2% reduction in the Social Security payroll tax rate for 2011 only.
No GST Tax for (What Little Bit is Left of) 2010
Although the 2001 Tax Act eliminated the GST tax for transfers in 2010, many
fiduciaries had valid concerns about the possibility of retroactive legislation
which understandably deterred fiduciaries from taking significant action in
reliance on the 2001 Tax Act. The 2010 Tax Act provides much needed certainty by
confirming that 2010 will indeed be a tax “holiday” with respect to the federal
GST tax. Unfortunately, that certainty arrived only with President Obama’s
signing of the Act on December 17, 2010, which left fiduciaries with little time
to take advantage of the opportunities that will expire at the end of 2010.
The Act provides that the applicable rate for GST transfers made in 2010
is zero. This means that there is no GST tax payable in 2010 on: (1) direct
transfers to “skip persons” (either outright or in trust); (2) otherwise taxable
distributions from trusts that are not exempt from the GST tax; and (3)
terminations of GST non-exempt trusts. For direct skip gifts to trusts for the
benefit of grandchildren in 2010, there will also be no GST tax payable upon the
later distribution of the trust assets to the grandchildren (although the GST
tax may still apply to certain distributions to younger generations).
This temporary zero GST tax rate confirms a very short-lived opportunity to
make distributions to skip beneficiaries from GST non-exempt trusts, or to
terminate these trusts in favor of skip beneficiaries or possibly new trusts for
their benefit. Because of the significant burden of the GST tax, this
opportunity to avoid the GST tax raises immediate questions about the duties of
fiduciaries concerning distributions from or termination of GST non-exempt
Some trustees have previously contacted beneficiaries of GST non-exempt
trusts to discuss this opportunity. Before the Act, many trustees and
beneficiaries were reluctant to take advantage of this opportunity due to the
uncertainty in the tax law. Even with the passage of the Act, many trustees and
beneficiaries will not be able to take advantage of this opportunity, because of
the short period of time between the passage of the law and the end of the year.
Trustees may receive requests before year-end from trust beneficiaries for
distributions from trusts that are subject to the GST tax. Those beneficiaries
seeking distributions to save GST taxes may not appreciate and may have little
patience for the process a prudent trustee must follow before making such
distributions, including properly evaluating the tax benefits and risks of such
distributions relative to the particular circumstances of the trust and the
For example, a prudent trustee may be concerned that distributions may
violate the trust terms and the settlor’s intent, extinguish the interests of
future beneficiaries, or expose otherwise protected assets to the claims of the
beneficiaries’ creditors. Beneficiaries will have a hard time understanding that
in many (if not most) cases it will be impossible to make the requested
distributions in the very little amount of time allowed by the Act, or, the
distributions will not be in the best interests of all trust beneficiaries to
whom the trustee owes duties.
While the tax benefits of distributions and terminations through 2010 are now
clearer, the duty of the trustee of those trusts is very much unclear. The
trustee will need to carefully review the governing instrument and state law to
determine whether the trustee has the authority to make the requested
distribution, and many trustees will find that authority lacking. The most basic
duty of the trustee is to administer a trust on its actual terms and in
furtherance of the intent of the settlor. Relatively few trusts will actually
provide for distributions or termination solely for the purpose of saving GST
taxes, and are more likely to condition distributions on the needs of
beneficiaries for support, health, education, and the like. In fact, in the
past, some trustees have been criticized for making distributions for tax
purposes where the document did not expressly allow the distribution.
If beneficiaries request a distribution to save GST taxes, the trustee should
consider employing financial and legal advisors in order to evaluate whether it
is prudent or even possible to make significant distributions from or terminate
GST non-exempt trusts before the end of the year.
Of course, just as in any discretionary action that involves significant
fiduciary risk, trustees should consider taking advantage of tools for managing
or eliminating that risk, such as beneficiary consents, releases,
indemnification, and court approval (although it is unlikely that there is
adequate time to obtain approval before the end of the year). If a trustee is
relying on a beneficiary agreement in connection with the termination of a
trust, the trustee must consider carefully whether it is possible to bind minor
and unborn contingent beneficiaries to the agreement. In states that have
enacted the Uniform Trust Code, this will be easier to accomplish through
Difficult Election for Executors of 2010 Estates – To Pay Estate Tax or
Modified Carryover Basis
The Act reinstates the estate tax retroactively effective as of January 1,
2010, with a $5 million exemption and a 35% tax rate. However, the executor of a
2010 decedent’s estate may elect instead to have the modified carryover basis
rules established for 2010 under the 2001 Tax Act apply. The executor must make
an affirmative election to apply the carryover basis rules. Once this election
is made, it is revocable only with the consent of the Secretary of the Treasury.
The Act provides that the estate tax return for a decedent dying in 2010
before December 17, 2010, the date of enactment, is not required to be filed
until September 2011, to provide executors with time to make such an election.
Modified Carryover Basis
Under the 2001 Tax Act, carryover basis rules govern the method by which
executors and beneficiaries of 2010 estates determine the income tax basis of
property acquired from a decedent, which is then used to calculate the gain or
loss upon the ultimate sale of the property. Under an estate tax regime,
beneficiaries took as their basis in inherited property the fair market value of
the property on the date of the decedent’s death (or, in certain circumstances,
a later “alternate valuation date”) as finally determined for estate tax
Therefore, the decedent’s basis in appreciated property was often
“stepped-up” in the hands of the beneficiaries. Under a pure carryover basis
regime, beneficiaries hold the property with the same basis that the decedent
had in the property (or the fair market value of the property at the date of
death, whichever is less). In other words, unrealized appreciation in the
property passing to beneficiaries will become taxable gain upon the sale of the
property. The basis of each item of property in the decedent’s estate must be
determined separately for this purpose.
As a substitute for an estate tax exemption, the 2001 Tax Act has a
“modified” carryover basis regime that allows each estate a $1.3 million basis
increase, known as the Special Basis Adjustment, which may be allocated by the
executor to certain appreciated property, but not in excess of the fair market
value of the property. Further, an additional $3 million basis increase is
allowed for property passing to the decedent’s spouse (including non-U.S.
citizen, non-resident spouses), known as the Spousal Basis Adjustment.
Particularly where the appreciation of assets in a decedent’s estate is
greater than the amount of the available basis adjustments, the allocation of
this basis among assets passing to various beneficiaries may be a contentious
issue. Certain beneficiaries may dispute the executor’s allocation of basis
adjustments and executors may need to seek guidance and approval by the court
with respect to these adjustments. However, the challenge for executors in
allocating the basis adjustments pursuant to the carryover basis rules is minor
compared to the potential fiduciary minefield regarding the executor’s election
of whether a 2010 decedent’s estate should be taxed under the carryover basis
rules or under the estate tax system.
The Challenge of the Election
For many estates, especially very large estates, the tax benefits will be
obvious and the decision to make this election will be easy. For other estates,
the tax benefits will be less clear and the analysis will be more challenging.
While projecting the federal estate taxes that would be due on an estate tax
return for a particular estate may be relatively straightforward, forecasting
the total tax liability under a carryover basis regime, which is dependent on a
number of independent factors, could be a significant challenge for executors.
Partial List of Factors Impacting Carryover Basis Election
- Calculation and apportionment of estate tax burden.
- Impact of election on formula clauses.
- Projected date of sale of each asset.
- Ability to allocate basis.
- Basis of each estate asset.
- Date of death value of each estate asset.
- Projected future value of each asset.
- Projected earnings from each asset.
- Tax character of any future gains or earnings on assets.
- Identity of the beneficiaries.
- Cash needs of the beneficiaries.
- Future income and estate tax rates.
- Domicile of beneficiaries and personal income tax information.
- Availability of asset-specific tax deductions and credits.
- Potential for disagreement among beneficiaries concerning the allocation of
- Conflicts of interest in making the election and allocating basis.
- The availability of binding consents or court approval.
- Whether a compensating equitable adjustment is appropriate, and whether it
should be approved by a court.
Some historical guidance may be found in a prior carryover basis election,
enacted with the federal Crude Oil Windfall Profit Tax Act of 1980, permitted
executors of certain estates to elect by July 31, 1980 to have the basis of
property received from the estate determined for federal income tax purposes
according to the decedent’s basis, rather than according to the value for estate
tax purposes (market value at date of death or alternate valuation date).
Otherwise, there is little historical guidance for executors faced with the
2010 estate tax election in terms of implementing a process that will fulfill
their fiduciary obligations and avoid liability. Current tax elections (such as
the QTIP election, the alternate valuation date election, and the election to
deduct estate expenses against income) offer little procedural direction to
serve as a bright line limit on a fiduciary’s liability when making a tax
election. These elections simply do not implicate the executor’s duties to the
same degree as the 2010 carryover basis election, or present nearly comparable
risks. State law offers little comfort, and merely charges the executor with
making elections in the best interests of the estate.
Managing Risks in Making the Election
The 2010 election is unique in the degree of discretion afforded executors,
and accordingly, there is no prescribed one-size-fits-all process that will
shield a fiduciary from liability when determining whether to pay estate tax or
to opt-out in favor of the 2010 carryover basis rules. General state law
principles of fiduciary duty in estate administration should guide executors;
however, these flexible guides offer little certainty or solace to the fiduciary
making the election.
Generally, the executor has a duty to preserve assets, defend against claims,
and to use reasonable care and skill in administration. Fiduciary actions are
governed by many fiduciary duties including the duties of loyalty and
impartiality, and are evaluated within the confines of the discretion granted
the executor under the provisions of the testator’s will and based on the
testator’s intent. With these principles in mind, fiduciaries must develop a
systematic approach to evaluate the 2010 election that includes extensive
information gathering, detailed calculations, and the involvement of
beneficiaries and the courts to limit liability.
Potential problems may arise in basis allocation among beneficiaries if the
appreciation in assets at the decedent’s death is greater than the amount of
basis adjustments available. In this situation, executors may have to choose
between (1) a 35% tax on the entire estate (in excess of the $5 million
exemption amount), a burden that may be more easily divisible among
beneficiaries, and (2) no estate tax, but a basis allocation that may fall more
or less favorably on certain beneficiaries. Difficulty will arise when the
testator has made specific bequests of appreciated assets and has not provided
for pro rata distribution among residual beneficiaries. These tough decisions
may lead to unhappy beneficiaries and potential claims against the executor.
Executor discretion in allocating basis will also depend on whether the
testator’s estate planning instruments grant the executor specific authority to
allocate basis and exonerate the executor from liability for any basis
allocation decisions. Even if broad discretionary authority is given to the
executor and the optimal allocations are made to minimize tax paid, perceived
unfairness may result in certain beneficiaries claiming violations of the duty
Adding to this challenge for executors is the fact that many decedents’ wills
contain provisions which provide for different dispositions of certain assets
depending upon the applicability of the estate tax. Thus this election could
affect the dispositive scheme of the estate assets, and should be made with
utmost caution. In such a case, the executor must be mindful of the allocation
issues discussed above and aware of both the testator’s goals when formulating
the estate plan and the impartiality due each of the beneficiaries.
Because of the complicated problem such an election presents and the many
factors that must be taken into account to make an informed decision, the
fiduciary should employ the financial and legal advisors necessary to evaluate
each of these factors and arrive at a proposed course of action.
- Beneficiary Consents. After the executor has conducted a thorough analysis,
calculations and comparison of the tax consequences to the estate under each
approach, if possible, the executor should involve the beneficiaries in the
ultimate decision over whether or not to make the election. Further, the
executor should work with beneficiaries developing a proposed division of the
estate assets and proposed basis adjustment allocations in a manner agreed to by
all of the beneficiaries. If the carryover basis election is made, because of
the potential for huge shifts in economic value from the basis allocation
decisions, an executor should obtain beneficiary consents to any allocation of
the basis increase if possible.
- Court Approval. Regardless of whether the election is made, the fiduciary
may desire the protection of court approval of the ultimate decision. If the
fiduciary chooses to seek court approval, the fiduciary should determine the tax
and other consequences to the estate and the beneficiaries of each scenario, and
present recommendations to the court. Interested parties should be provided
notice and opportunity to contest the recommendations.
- Address Conflicts of Interest. Because of the delicate nature of the
election, an executor who is also a beneficiary of the estate should consider
resigning as executor to avoid any issues related to self-dealing (or its
appearance) and be replaced by an independent or corporate fiduciary. However,
professional fiduciaries may balk at being appointed under such circumstances.
It is recommended that fiduciaries seek not only advice of counsel regarding
this election, but also court approval for any election made.
- Conflicts between Executors and Trustees. Fiduciaries who are acting as
trustees but not executors should request information regarding the decedent’s
basis and the executor’s proposed basis allocations. If proposed allocations do
not meet the standards of fairness and loyalty owed to the trust beneficiaries,
the trustee must consider how to proceed and protect the interests of the trust
Uncertainty for Formula Clauses
The estate plans of many 2010 decedents contain formula clauses that are
dependent on federal tax concepts such as the amount of the estate tax exemption
or the GST tax exemption, the most ubiquitous being a division of the decedent’s
assets between a family share or trust (in the amount that can pass free of
federal estate tax by virtue of the estate tax exemption), and the marital share
or trust (the balance of the decedent’s assets).
When the federal estate tax was “repealed” for 2010, the interpretation of
these formulas became uncertain, and the literal language of the formulas could
at times produce results that were detrimental to the estate beneficiaries or
contrary to the testator’s intent.
In response to this problem, 20 states passed legislation that provided
default rules of construction to clarify the meaning of the formula clauses or
other relief from uncertainty. The following states passed corrective statutes:
|District of Columbia
Under the Act, the federal estate tax has been imposed on 2010 estates with a
higher $5 million exemption, but with an election to choose instead a modified
carryover basis regime. All formula clauses must be carefully reviewed in light
of the $5 million estate and GST tax exemptions for 2010. Also, for states with
corrective statutes imposing a default rule of construction, the statute must be
carefully reviewed to determine whether it will have any affect on the
interpretation of formula clauses. Particular attention must be paid to whether
the election into carryover basis will impact the operation of the corrective
statutes. The possibility of such an election was not generally considered in
the drafting or enactment of the state corrective statutes.
An additional concern is that the corrective statutes include a statute of
limitations for filing a suit to seek relief from the statute (most states
require the suit within one year from date of death). For decedents that died in
early 2010 and where there is the possibility of disagreement among the
beneficiaries, it may be necessary to initiate a suit very early in the 2011.
Many executors, understandably, will not have completed the analysis of the
carryover basis election by the date the suit must be filed under these
statutes. However, the courts generally welcome fiduciaries facing uncertainty
and it should be adequate to plead the basis for needing guidance without
needing to have fully developed any recommendations to present to the court.
This subject will be included in McGuireWoods’ Private Wealth Services Group
white paper on the Act that will be distributed in early January.
Help Moving Forward
The Act has created a virtual minefield of fiduciary liability for executors
and trustees that can be navigated by prudent process, thorough analysis, and
affirmative management of beneficiary expectations and concerns. The
McGuireWoods’ Fiduciary Advisory Services Team stands ready to provide service
and advice in the days and months ahead to aid fiduciaries in this process.
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