Sorting it all out

The following is an edited transcript of the webcast “Estate planning: What should advisers do now?” held Feb. 2. InvestmentNews deputy editor Evan Cooper and InvestmentNews reporter Jessical Toonkel Marquez were the moderators.
InvestmentNews: Let’s start with an overview of where things stand. In 2001, Congress repealed the federal tax on the estates of people dying in 2010. That action will “sunset” Dec. 31, and the estate tax will be imposed next year at a maximum 55% with an exemption of $1 million.

That rate is what was charged in 2001, but it is an increase over what was charged last year — a maximum rate of 45% and an exemption of $3.5 million. Many people expected Congress to change the law to reinstate the estate tax this year, but it has failed to act. There is still a chance that lawmakers could do so retroactively to Jan. 1.

What are some of the implications of that situation?

Mr. Schlesinger: We have no estate tax in 2010 unless Congress acts retroactively to reinstate it, which will probably create a constitutional challenge to it, especially the longer [it takes]. I mean, if they did it today, maybe it would be OK retroactively reinstating it; if they do it on Dec. 31, I’m not so sure how far that is going to fly.

So you technically have no estate tax this year and no [generation-skipping transfer] tax this year. You have a gift tax, which is the same $1 million it was last year. But the rate has gone down from 45% to 35% because the gift tax is the maximum income tax rate in effect at the time of the gift. That is 35%. So that is the first aspect of it.

The second aspect, of course, is that you get modified carryover basis. If somebody dies in 2010, you do not get an automatic change in basis to date-of-death value or alternate valuation date. You get a basis equal to the decedent’s basis: For example, the decedent bought a stock at $1. If he had died in 2009 when it was worth $10, and his executive sold it at $11, there would be a capital gain of $1. Now we go to 2010, and if again it would be bought at $1, it is $10 on his date of death, and a few days later the executor sells it at $11, there is a capital gain of $10, even assuming it was long-term.

There is not necessarily a capital gains tax at death. It is triggered only if the asset is sold by the recipient. So if the recipient is not going to sell it, it is not the most serious thing in the entire world, even if somebody dies in 2010.

Also, every decedent’s estate has a $1.3 million basis allocation on appreciation. You get a $1.3 million step-up on the difference between the basis and the appreciation, and spouses get an additional $3 million. And a spouse can use the $1.3 million.

That’s where we are today. What can happen? Well, Congress can do a lot of things, or nothing. If they do nothing, we get to 2011; in 2011, you go back to 2001, and what you have is an estate tax with a maximum rate of 55% and a [surcharge] on large estates over $10 million of another 5%, so it could be a 60% effective tax.

No. 2, you get your exemption down to $1 million. Your GST exemption is indexed for inflation; it would be around $1.3 million because it is indexed back to 2001. In 2011, you would have your gift tax again, but you would have unification of the gift and estate taxes again, I believe, and you would have the state death tax credit reinstated. Between 2001 and 2005, the state death tax credit was repealed in 25% increments, and you got an estate death tax deduction in return. In 2011, you go back to where you were in 2001.

Remember, we do have the decoupling of states with the abolition of the state death tax credit. You have unified credits in states going anywhere from $675,000 in New Jersey to $3.5 million in states like Connecticut. You have states such as Florida that basically repealed their estate taxes, and any state that was tied to the federal, because there was no estate death tax credit anymore.

Because of the repeal in 2010, several states are introducing legislation in how to construe wills and what remedies you have if you do a will anticipating formula clauses under the laws that existed before 2010.

InvestmentNews: Carol, tell us a little bit about what is going on and what you are telling clients at Wilmington Trust.

Ms. Kroch: Well, what’s going on is a lot of confusion. What we are recommending to clients is — as painful as it is to think about changing your estate plan temporarily because you don’t know where things are headed — we do think it is a good idea for people to take a look, because with formula clauses that were based on a tax law that is no longer in effect, you can have some really startling results. And so I think that a first step is to see whether or not what you said you wanted is remotely like what you are going to get.

And a second step is also to think about whether the new basis rules would make you think about what assets should go to which beneficiary, because now for the first time, different beneficiaries may have more built-in capital gains that they would be taxed on if certain assets are sold.

InvestmentNews: Ray, what about your view at U.S. Trust?

Mr. Radigan: Well, I agree with everyone that this is a complete state of confusion. In drafting wills a couple of years ago, estate attorneys included various formula clauses based on the laws in existence, but of course now that the estate tax has been repealed, it is going to have dramatic effects.

It would be really easy if I was an attorney and I was drafting somebody’s will to say, “Put $3.5 million into a credit shelter trust.” And obviously, in a married couple’s estate, you are doing that to make sure that the first spouse takes advantage of the estate tax exemption and doesn’t waste it. The reason the will simply can’t say, “I put $3.5 million into my credit shelter trust,” is, No. 1, you don’t know what the size of the exemption will be when your client dies, No. 2, the client could use part of that exemption during his or her lifetime, and No. 3, you might be allocating the exemption to other types of testamentary transfers or non-testamentary transfers. So that is why you have to end up with a formula clause.

A sample clause might say, “Put the maximum amount into my credit shelter trust so that my estate doesn’t pay any federal estate taxes. And whatever is left, I give to my surviving spouse.” Well, if a decedent died with that will in 2009, what went into their credit shelter trust (assuming no gift tax exemption was used and keeping this very simple)? With a $5 million estate, $3.5 million would have gone into the credit shelter trust, and the rest, $1.5 million, would have gone to the spouse outright. In 2010, if I put the maximum $5 million into my credit shelter trust so that my estate does not pay any estate tax, now the spouse gets nothing. And then in 2011, assuming the law reverts back to where it was in 2001, $1 million goes into the credit shelter trust; $4 million goes to the spouse. So in three successive years, you have radically different results.

So what it says is sort of a reverse of formula No. 1: “Give my spouse the least amount possible so that my estate doesn’t pay any federal estate tax. And I give the rest to my credit shelter trust.” If I have a $5 million estate and I die in 2010, what is the least amount I can give to my spouse and not pay an estate tax? Zero. And everything goes into the credit shelter trust.

Mr. Schlesinger: Ray, one other thing on that is, most states have rights of election where if you disinherit a spouse, she or he has a right to either a third or some other portion in trust, so inadvertently, you may have caused a right of election.

Mr. Radigan: Here’s a sample clause with a slightly different formula: “Put the maximum amount into my credit shelter trust that is equal to my unused federal estate tax exemption. I give the rest outright to my spouse.” Well, let’s just focus on 2010. In 2010, there is no estate tax exemption, there is no estate tax, nothing would go there; everything would go to the spouse. Same thing if you use a fractional share, which is the formula underneath. So here is the problem: By using these various formula clauses, although the results are predictable in years where you have estate taxes — like 2009 and 2011 — you could have very different results in 2010.

Virginia is proposing that if you have a formula clause and you die in 2010, and the estate tax is still repealed, let’s treat it as if the decedent died Dec. 31, 2009. So, in all the formula clause examples that I gave before, what would happen is, in 2010, you would know that $3.5 million would go into the credit shelter trust, $1.5 million would go outright to the spouse. It does add clarity but is not necessarily the right result. And there could be varying consequences, depending on the formula that you use and the state that you die in.

InvestmentNews: One of the thoughts was that making a gift might be one way out of this mess. What’s the thinking on that?

Ms. Kroch: For people of significant wealth, there can be some real opportunities to take advantage of the fact that for the moment, the gift tax rate has dropped down to 35%, and there is no generation-skipping transfer tax. If people are going to take advantage of that situation, they have to be aware that the rate could revert back to 45%, and it could turn out that the generation-skipping transfer tax is applicable, so anybody doing this should be certain that they have enough GST exemption available to allocate to those gifts.

Mr. Schlesinger: Carol, wouldn’t it be smart to wait till later in the year and see what is going on in Congress, so you don’t make a gift that you think you are paying 35% on and you’re really paying 45%?

Ms. Kroch: Well, I think the risk is, if Congress ends up changing the law, prospectively, you could lose the window. And that is the one risk of waiting. One approach is to consider some kind of a formula gift. And I would be interested, Ray and Sandy, in how well you think those might work — and also to think about making gifts that could be disclaimed at the end of the year if there, in fact, is no generation-skipping transfer tax.

Mr. Radigan: One possible solution I heard, assuming again you are dealing with a married couple, is, you create a lifetime [qualified-terminal-interest-property trust] with the remainder to the kids. And then if you have retroactive legislation, you simply make the QTIP election and maybe have the trust drafted in such a way where it can collapse and go back to the spouse.

If there is no retroactive legislation, then there is no QTIP election; the spouse can disclaim and then it can go down to the spouse. The problem there is, you have to make sure that all income has to be paid to the spouse, and once he or she accepts the income, it is going to be virtually impossible to make the disclaimer.

Mr. Schlesinger: If you have an elderly client who is on death’s door, it may pay to take the gamble, because the worst that is going to happen is, you are going to pay what you are going to pay anyway. But you may end up better off in the long run. There were only going to be 6,000 taxable estates this year anyway, and 70,000 taxpayers subject to carry-over basis.

Ms. Kroch: I think the gift approach is for very high-net-worth families, and I think that it would work best if a family were prepared to make a gift anyway.

InvestmentNews: Sandy, what is going on in the state level that we should be aware of, and what does that mean for advisers and their clients?

Mr. Schlesinger: Well, you have two things going on in the state level. This is not new this year. Some 33 states are decoupled. And you have other states that have estate taxes that are independent. You have other states that have an inheritance tax. And you have states that have an inheritance tax and an estate tax. And as I said earlier, your exemptions run the gamut from $675,000 to $3.5 million. You ought to check your state. The disaster is if you have property in multiple states — and I don’t think anybody has figured out a formula to do it accurately if you are in three or four states.

The other element is what the states are doing to handle repeal. As Ray mentioned, Virginia is enacting legislation freezing will construction at 2009 Internal Revenue Code definitions.

And I heard that other states are trying to enact legislation. You have states like Texas where the legislature only meets every other year. So, again, it is a mess.

Ms. Kroch: Well, it is a discouraging mess, but I think that although it can be expensive for a client to revise their will, a lot of these formula issues and confusion about what you intended can be addressed in a will that has a new set of formulas that talks about what the individual testator’s desires are if there isn’t an estate tax, and what the desire is if it is reinstated. So there is some possibility of fording through some of the confusion — recognizing that you may have to do it all over again, once Congress finally comes up with a final solution for the estate tax, which may not be this year.

Mr. Radigan: And Carol, when you look at Virginia and the other states that are thinking of similar legislation, you can draft around this. So if you have a client who says, “I don’t want this result,” you can simply draft a new will, like you said, and provide exactly what the testator has intended.

Mr. Schlesinger: Yes, you can draft a new will every Monday, Wednesday and Friday. Your clients are not going to be very happy, though, if you came in today, they drafted a will, they signed it, you bill them, and six weeks from now, what you did has to be changed. So the political issue, the substantive client relation issue, is a very serious one.

Mr. Radigan: Right now, the best you can do is try to be as flexible as you can. For example, you draft a will — and, Sandy, I am curious about your opinion on this — stating: “If there is a federal estate tax that is not in effect at the time of my death, I distribute my property as follows.” Conversely, “If the estate tax is in effect at the time of my death, I distribute my estate as follows.” Should wills be that elaborate, that specific?

Mr. Schlesinger: We may have to go there. That is one of the approaches we are taking under appropriate circumstances. But, again, we don’t know what Congress is going to do. You are taking the bright-line approach, in Option 1 at least. My estate goes one way if there is an estate tax; it goes another way if there is not an estate tax. My question is, are you going to put your estate in a different formula if the exemption or the unified-credit-exemption equivalent is $1 million or $3.5 million?

And by the way, in your Option 1, you are just talking about the federal estate tax. Are you drafting for carry-over basis in Option 1?

Mr. Radigan: No. Good point.

Ms. Kroch: Nobody is saying this is easy, Sandy. What I was trying to say is, if you are elderly, if you are unwell and seriously worried that you might not survive 2010, it is possible to at least think about how much money you want to go into a family trust or a trust for your spouse, regardless of the tax consequences? At least draft a formula that gets the dollars in that you want.

Mr. Radigan: That leads to Option No. 2, where you leave everything to your surviving spouse, and to the extent they disclaim the property, it can go elsewhere.

Mr. Schlesinger: Except she’s not the mother of my three children.

Mr. Radigan: Well, no, of course the next option would be the QTIP, where you have a lot more control of the ultimate disposition of that property. QTIPs are used as a way of taking advantage of the marital deduction, without making necessarily an outright bequest.

Mr. Schlesinger: The QTIP — or a QTIP coupled with a disclaimer — is a good solution, but you have to have a cooperative spouse.

Mr. Radigan: Yes.

Ms. Kroch: I would like to hear what both of you think about the problem of states that don’t provide for an independent QTIP election. Some states will allow a QTIP election. Others provide for a marital deduction when you have a QTIP that is elected under federal estate tax law; I don’t know how you make an election at the moment.

Mr. Schlesinger: Technically, there is no such thing as a QTIP right now.

Ms. Kroch: Well, that’s the problem.

Mr. Schlesinger: Now, again, the argument is that states which track the Internal Revenue Code as of a certain date, there was a QTIP, and therefore, even if you didn’t have an independent QTIP in that state, you may well now have it.

Mr. Radigan: The real problem, though, is that in states that permit QTIP elections only if there is a corresponding federal QTIP, if you have no federal estate tax, maybe you can’t make a state QTIP election.

InvestmentNews: Sandy, why doesn’t the QTIP exist anymore, legally?

Mr. Schlesinger: Because of the repeal of the Internal Revenue Code section which created the QTIP. Technically, all of the sections of the code dealing with the estate tax and the GST tax theoretically don’t exist this year.

Ms. Kroch: A QTIP is unlike a regular trust, which is not a concept of federal law but is a state law concept. A QTIP is a creature of a specific estate tax code section, and that section doesn’t exist right now.

Mr. Schlesinger: I really think the argument is not that the estate tax and GST tax are repealed for 2010. There is a moratorium in 2010 on those taxes. And my argument would be, all of those terms remain the same because in 2011, it will be as if 2010 never happened.

Mr. Radigan: I would agree with that.

Ms. Kroch: I think it is an interesting question because one of the other arguments is that it is as if the entire period of 2001 to 2010 never happened. I think if this continues for a full year, we will probably get some guidance from the Internal Revenue Service on some of these questions.

InvestmentNews: Sandy, you mentioned that it could be a headache for people who have properties in multiple states, but does it matter where the person’s domicile is, or where the will or trust is executed?

Mr. Schlesinger: No, it is not where the trust is executed. When you die, your estate tax is set by your place of domicile. But if you own tangible personal property or real property, that is taxed by the state where the property exists. So therefore, you could end up with an estate tax in more than one state, not necessarily a duplicate of tax — but a proportionality of the tax. And not all of the states compute that the same way.

Another question you have just raised that is causing a huge debate in New York right now is the mobility of trusts. In other words, I execute a trust in New York — a high-` income tax state — and want to move it to a tax-friendly state like Delaware or Florida. And here is another case where the laws are all over the place. Is a trust sited where the trustees are, where the beneficiaries are or where the money is? And states vary on that. I think those are more or less the basic three variables. Another could be where the trust was executed in the first place.

InvestmentNews: So given the fact that a lot of states are addressing this differently, how would you advise advisers to deal with their clients on this matter?

Mr. Schlesinger: Very carefully.

Mr. Radigan: The other implication here is that charities are starting to get scared, because if there is no estate tax, and I make a charitable bequest and I don’t get a charitable deduction, am I still going to make that charitable bequest? So this has more implications than just revenue to Washington or Albany or whatever state you are living in; it could have charitable implications as well.

InvestmentNews: Are you seeing that already?

Mr. Radigan: Not yet.

InvestmentNews: Here’s a question from the audience: The step-up in basis is gone in 2010 but supposedly reappearing in 2011; if a person dies in 2010 and has several highly appreciated assets, does the estate get to use the $1.3 million step-up credit against any combination of those appreciated assets? Or if the total appreciation in all of those assets was less than $1.3 million, would there essentially be no taxes when those assets are sold by the heirs?

Ms. Kroch: The example said that there was less than $1.3 million total gains inherited in the assets. If, in fact, those were sold in 2010 or 2011, the total amount of gain is less than $1.3 million, you have that to allocate to the assets. So if that is the question, there wouldn’t be any capital gains tax whether they were sold in 2010 or 2011.

Mr. Schlesinger: Well, your problem is you have a disconnect in 2011; you don’t have the $1.3 million step-up anymore. But you have an asset that was acquired when you didn’t have carry-over basis, when you didn’t have step-up in basis.

Ms. Kroch: That is the question: whether or not the rule stays with those assets that were inherited in 2010.

Mr. Schlesinger: If carry-over basis and modified carry-over basis are going to be in effect, you are going to have a huge amount of regulation, legislation or litigation.

Ms. Kroch: If you have got enough basis to allocate, if you have enough gains that are below the $1.3 million allocation, then you don’t really have a problem for a sale in 2010. You don’t have to face the difficult decision of what assets to allocate it to.

I think the question that Sandy was raising about 2011 is whether an asset inherited in 2010 gets a changed basis in 2011 because the estate tax law is reinstated, as if prior law had never existed.

Mr. Radigan: Not only do you have the $1.3 million basis adjustment but you have the extra $3 million adjustment that goes to the surviving spouse, either outright or by way of QTIP trusts. So there, too, there might be decisions as to what property you are going to adjust and what property you are not going to adjust.

Ms. Kroch: And going back to formulas, that is a very good example. You could end up with a $5 million estate that was given entirely to the children, rather than to the spouse, because of the oddities of the formula clause this year. And if the capital gain is substantial, you have lost the ability to allocate it because the spousal allocation is much greater.

InvestmentNews: Is it OK to do nothing and see what happens?

Mr. Schlesinger: As long as you don’t die.

Mr. Radigan: Well, as long as there is a will in place and the will still coincides with the intent of the testator, I would say yes. At some point, it might become apparent long-term what is going to happen, and you can make the adjustment there.

Mr. Schlesinger: I agree. We are all talking about how drastic and terrible this is. Remember, we have less than a year to go, and the number of deaths that are going to be subject to the tax are relatively few, and also the proportionate number of the people who are going to die are going to be comparatively few. Having said that, remember what happens in 2011. You are going to go back to a $1 million exemption if they do nothing, if they don’t make 2009 permanent. Remember, there were all sorts of bills floating around Congress; one Republican bill was to gradually increase the exemption up to $5 million over several years and decrease the rate over several years to 35%. Will the Democrats be brought to compromise in the House because of the Republicans’ new power in the Senate?

Anything could happen, including just going back in 2011 to 2001. And look what happens there. Your old formula clauses, a good portion of them were drafted thinking that the unified-credit-exemption equivalent would not be $3.5 million but $1 million, $1.5 million or $2 million.

So ironically, some of the older wills may well be even more appropriate in 2011.

InvestmentNews: Briefly, let’s get an overview from each of you as to what an adviser should do.

Mr. Radigan: We are basically explaining to clients that, “Look, because the estate tax laws are in a state of flux right now, here is what your will says, here are the possible consequences. The best option might be to do nothing. Relax. Let’s see what happens.”

Or if the client can’t sleep at night and right now it just dramatically impacts how they want to distribute their estate, maybe include a will with flexible portions and disclaimers so that you can adjust to these various issues, whether the client dies in 2010 or 2011 and beyond.

Ms. Kroch: It gives families some sense of control if they have thought through an issue, and they may decide that it is not worth the cost of revising the will. But at least you have the conversation and start thinking about whether that will works for the family as it is written. It is also important to have a conversation about the basis. I think in some cases, the basis won’t be that complicated.

In others, it really may require them to think about how they would allocate that basis and to put specific directions in the will.

Mr. Schlesinger: I am advising people not to panic. First of all, I am stressing that the federal estate tax is not really important to the entire world, in the sense that it affects a relatively small portion of the population. If you expect Congress to drop everything else and focus on this, you are deluding yourself. I am also saying we have to draft wills. Clients want their wills done; they are not understanding when a lawyer says, “You should wait till 2011 to do your will.” And I agree that you do the wills as flexibly as humanly possible, but in the cover transmittal letter, you advise the client that we may have to revisit this because we don’t know what Congress is going to do — because Congress doesn’t know what it is going to do.

To listen to the webcast, go to InvestmentNews.com/ taxtranscript.