The Administration's Estate Tax Budget Proposals

February 28, 2011

The Obama Administration’s Budget Proposals include little new and nothing surprising, but do serve as a reminder that federal estate tax legislation is far from settled.

On February 14, 2011, the Treasury Department released its “General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals,” popularly known as the “Greenbook.” The Greenbook proposes returning the estate, gift, and generation-skipping transfer (GST) taxes to 2009 levels and adds the following five specific proposals to change the substantive rules for those taxes:

  • Making “portability” permanent.
  • Requiring estate tax value to be used as basis.
  • Limiting the use of valuation discounts.
  • Imposing a minimum ten-year term on GRATs.
  • Limiting GST exemption to 90 years.

These proposals should be taken into account in planning and timing the implementation of estate planning techniques during 2011 and 2012 since they represent the Administration’s current thinking with respect to those taxes.

Exemptions and Rates

In a footnote to the table of contents, the Greenbook states, among other things, that “[t]he Administration’s policy proposals reflect changes from a tax baseline that modifies the Budget Enforcement Act baseline by … freezing the estate tax at 2009 levels.” Translated, that means that after agreeing last December to an increase through 2012 in the estate, gift, and GST tax exemptions to $5 million (with an inflation adjustment for 2012) and a decrease in the rates of those taxes to 35%, the Obama Administration is now proposing that in 2013 the exemptions return to $3.5 million for the estate tax, $1 million for the gift tax, and something over $1 million (reflecting inflation adjustments since 1999) for the GST tax.

This comes as no surprise. It is what the Administration has proposed the last two years. And it is consistent with the notice served in the State of the Union Address, where the President, presumably with an eye mainly on income tax cuts but in words broad enough to evoke the estate tax, said:

[I]f we truly care about our deficit, we simply can’t afford a permanent extension of the tax cuts for the wealthiest two percent of Americans. Before we take money away from our schools or scholarships away from our students, we should ask millionaires to give up their tax break.

This proposal faces an uncertain future given the likely great difficulty of overcoming the political resistance to effectively raising the estate tax and extending it to more estates in 2013. But this confirms that the end of 2012 might bring suspense and drama comparable to what we saw last December, with the future exemptions, rates, and even existence of the estate tax in doubt again. See our white paper entitled The 2010 Tax Act’s Impact on Estate Planning and Administration: Making Sense out of the Confusion (January 2011).

Five Specific Proposed Changes

The 2011 Greenbook includes five proposals – some old, some new – under the heading “Modify Estate and Gift Tax Valuation Discounts and Make Other Reforms.”

  • “Make Permanent the Portability of Unused Exemption Between Spouses”

“Portability” of the exemption (or “unified credit”), described on pages 38-42 of our white paper, permits a surviving spouse (that is, a widow or widower) to use for gift and estate tax purposes any amount of the now $5 million exemption that is not used by the predeceased spouse, if the predeceased spouse died after December 31, 2010, and the executor of the predeceased spouse affirmatively elects this treatment on an estate tax return. Like the other provisions of the 2010 Tax Act, portability is scheduled to expire at the end of 2012 and thus would not be very useful unless it is extended

The Greenbook proposes to extend portability beyond 2012 permanently. Combined with the proposal to return to the 2009 estate and gift tax exemptions of $3.5 million and $1 million, respectively, the portability set forth in the 2010 Tax Act would have to be refined, particularly in the coordination of the different gift tax and estate tax exemptions.

The Greenbook estimates that making portability permanent would reduce federal revenues by $3.681 billion over fiscal years 2012-21. That assumes the Administration’s baseline of a $3.5 million estate tax exemption. The estimated revenue loss would presumably be higher with an exemption at or comparable to the 2011 level of $5 million. But this affirmation of portability increases the likelihood that in some form portability will stay in the law after 2012.

  • “Require Consistency in Value for Transfer and Income Tax Purposes”

Currently, the cost basis of property acquired from a decedent is, in general, “the fair market value of the property at the date of the decedent’s death.” That is the same as the standard for imposing the estate tax. Nevertheless, if the recipient of property from a decedent was not the executor, it is possible for that recipient to claim, for income tax purposes, that the executor just got the estate tax value too low, and that the recipient’s basis should be greater than the estate tax value. Usually, of course, such claims are made after the statute of limitations has run on the estate tax return. But such claims can be accompanied by elaborate appraisals and other evidence of the “real” date-of-death value that, long after death, is hard to refute, thus “whipsawing” the IRS between a low estate tax value and a higher cost basis for computing taxable capital gain.

Restating a proposal made by the Administration in 2009 and 2010, the Greenbook would simply require the income tax basis of property received from a decedent to be equal to the estate tax value. If Congress ever gets around to it, this proposal will also require some technical refinement, but is unlikely to meet much resistance. After all, it will merely enact what many people assume the law already is, and arguing against consistency is hard.

The proposal would be effective, unless it is changed, as of the date of enactment and is estimated to raise tax revenue over ten years by just over $2 billion.

  • “Modify Rules on Valuation Discounts”

The importance to Treasury of this proposal is seen in its influence over the heading for the section that contains all five of these proposals, “Modify Estate and Gift Tax Valuation Discounts and Make Other Reforms.” In brief, the proposal would tighten up rules enacted in 1990 that require certain restrictions inherent in family owned corporations, partnerships, limited liability companies, and similar entities to be ignored when valuing interests in those entities transferred between family members. The proposal would empower Treasury to promulgate regulations measuring those restrictions against standards prescribed in the regulations, and not measuring them, as the 1990 legislation did, against default state law, which can change.

This proposal is also repeated from 2009 and 2010. See our legal update: “Administration Proposals Would Limit Estate Planning Techniques” (5/12/2009). It is estimated to raise revenue by $18.166 billion over ten years.

These or similar valuation rules may be enacted sometime, although Congress seems to be in no hurry. Moreover, a Republican-controlled House of Representatives seems less receptive to legislation that might increase the burden of the estate, gift, and generation-skipping transfer taxes. Even though there may not be much interest in such rules in Congress these days, anything might happen on short notice, as was the case with the 2010 Tax Act. For that reason, a good idea for anyone contemplating transfers involving interests in family owned entities is to remember to complete them without unnecessary delay.

  • “Require a Minimum Term for Grantor Retained Annuity Trusts (GRATs)”

In the last of three proposals repeated from 2009 and 2010, the Greenbook would require grantor retained annuity trusts (GRATs) to have a term of no less than ten years, in contrast to terms commonly in use of two or three years. A GRAT is ineffective if the grantor does not survive the GRAT term, and this change would increase that mortality risk. In addition, a short-term GRAT often succeeds by capturing a dramatic upswing in value, which in a longer-term GRAT might be offset by declines in value or periods of less dramatic growth. A ten-year minimum term would reduce the attractiveness of GRATs in that way also.

The limitation on GRATs would apply, unless it is changed, to GRATs created after the date of enactment and is estimated to raise revenue by almost $3 billion over ten years. Although that is a modest gain these days, it may be tempting to some lawmakers in this Congress. Indeed, this proposal was actually included in three different measures that passed the then Democratic-controlled House of Representatives, but not the Senate, in 2010. See our legal update “House Votes to Limit GRATs” (3/29/2010). Thus, although action is not thought to be imminent, those who are contemplating GRATs should not delay, especially while rising interest rates are also chipping away at the effective of GRATs.

  • “Limit Duration of Generation-Skipping Transfer (GST) Tax Exemption”

This proposal is new this year as a Greenbook proposal, but it is reminiscent of ideas that have been floated from time to time over the years. The GST tax was enacted in 1986 to roughly subject a long-term trust to a tax similar to the estate tax once each generation. A trust may be made exempt from the GST tax by the allocation of GST exemption, originally $1 million but now increased to $5 million. But changes in the law of many states since 1986 have removed limitations on the duration of trusts, permitting the allocation of GST exemption to potentially last forever or for hundreds of years. This proposal would limit the effectiveness of the exemption to 90 years.

The proposal would apply to trusts created after the date of enactment and to additions to trusts made after the date of enactment. Because it will not raise revenue for 90 years, it may escape serious attention. But, combined with the $5 million GST exemption that some fear will disappear in 2013, this proposal to tax future generation-skipping trusts more severely may encourage the creation of such trusts without delay.

Conclusion

In the final countdown to the enactment of the estate tax provisions of the 2010 Tax Act in December, no revenue raisers were considered. The Administration’s release of these proposals, mostly revenue raisers, is a reminder that the failure to consider revenue raisers was probably an anomaly, and that revenue raisers to offset tax relief or reduce budget deficits are likely to receive serious attention from the current Congress.

More fundamentally, the renewal of the Administration’s position on the appropriate long-term level of estate tax is another reminder that the 2010 Tax Act is temporary and will be very much in play and very much in doubt over the next two years.

McGuireWoods Private Wealth Services

Private Wealth Services is ranked by Chambers and Partners, the international rating service for attorneys, as one of two top-band private wealth services practice groups in the country, with professionals in several U.S. cities and in London, dedicated to estate planning and the analysis of related tax and fiduciary issues.

McGuireWoods Fiduciary Advisory Services

Fiduciary Advisory Services advises financial institutions and other clients about planning, tax, and fiduciary matters. This includes advising executors and trustees in managing risks, avoiding litigation, and handling litigation when it does arise.

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