Estate tax expiration gives rise to opportunities — and heart-wrenching decisions

With the estate tax laws set to expire by year-end — and no clear indication when Congress will address the issue — some financial advisers and attorneys see an opportunity for their high-net-worth clients in this extremely muddled situation. Currently, there is a federal tax of up to 45% on estates valued at $3.5 million or more. Under a sunset provision in the law, the so-called death tax is scheduled to disappear in 2010. But the tax will be reinstated in 2011 — and at a rate of 55%. For years, legislators in Washington have said they would make sure the estate tax law didn't disappear by the end of this year. But with health care legislation taking center stage on Capitol Hill, the full Congress has yet to address the estate tax. The House did pass a bill tackling the tax earlier this month, but the Senate hasn't had time to consider the issue. “I have given up guessing what Congress is going to try to do,” said Catherine G. Schmidt, a partner with Patterson Belknap Webb & Tyler LLP. “I'm astounded that they let us get to a full repeal of the law when they said for so long this wouldn't happen.” It is likely that when Congress does get around to addressing the estate tax law issue next year, they will make it retroactive to Jan. 1. “Clearly, the correct public policy is to achieve continuity with respect to the estate tax,” said Senate Finance Committee Chairman Max Baucus, D-Mont., speaking on the Senate floor on Dec. 16. “We'll clearly work to do this retroactively.” But even if legislation is retroactive, experts believe that this loophole provides an opportunity for high net-worth-individuals to leave money to heirs at a lower tax rate than they'll undoubtedly pay once legislation is in place. Specifically, with the expiration of the estate tax law, the generation skip tax also disappears. This means that starting Jan. 1, individuals can gift up to $3.5 million to grandchildren and pay only gift tax on the money. “This is a big planning opportunity for advisers,” said Tom Karsten, managing partner of Karsten Financial LP. One way advisers can take advantage of this is by adding legal language that allows a client to make a gift to grandchildren, but stipulates that they can take it back if the law changes. Similarly, Ms. Schmidt is telling clients to stipulate that the gift to their grandchildren is contingent on the tax laws remaining favorable. Another way to get around this issue is by setting up a qualified terminable interest property trust, said Gail Cohen, head of global wealth management at Fiduciary Trust International. With the trust, a surviving spouse receives income for life, the principal is left to an heir, and no gift tax is paid, although the surviving spouse does have to pay taxes when the spouse dies. The account owners can elect to set up a “reverse QTIP” that allows them to take advantage of the generation-skipping tax exemption amount in effect the year the gift was made. So for 2009, the exemption could be locked in at $3.5 million. “I am telling clients to take advantage of this now, because the reverse-QTIP provision might go away in 2010,” Ms. Cohen said. It gets a bit more complicated as regards what to do if clients die before Congress addresses the estate tax law. At least for the short term, it's possible that heirs could receive up to $3.5 million without paying taxes on an estate. No one knows if those heirs will be taxed retroactively. “What if you know someone is terminal, and you can settle the estate quickly?” Mr. Karsten said. “It's unclear what would happen if you get a closing letter from the Internal Revenue Service before Congress passes legislation that makes the estate tax retroactive.” “I have had conversations about this with clients who have parents on life support,” said Jeffrey B. Kolodny, a partner with Phillips Nizer LLP. “They might want to keep them on life support until January. For someone who has $5 million to $10 million in the estate, this is a huge opportunity.”