FAQs — The Economic Growth and Tax Relief Reconciliation Act

What is "EGTERRA"?

As you may have heard discussed in the media or at cocktail parties, the federal estate tax and a related tax known as the generation-skipping transfer (GST) tax automatically expired at 12:01 a.m. on New Year's Day, 2010. The Economic Growth and Tax Relief Reconciliation Act ("EGTRRA") of 2001 provided for gradual increases in the estate tax "exemption amount" (i.e., the portion of your estate that will escape federal taxation at your death), as well as decreases in the maximum estate tax rates. Obviously, both of these aspects of the law were good news for all taxpayers.

The EGTRRA law also provided for the sunset (not a "repeal," as it has been coined in the press) the estate tax and GST taxes only for 2010. The federal gift tax remained unaffected by this "sunset" provision and remains in effect for 2010.

Many assumed for the nine years since EGTRRA's passage that Congress would never allow the EGTRRA provisions to expire and that the one-year sunset would never really come to pass, assuming that Congress would act in time to extend the law. As late as June 2010, there have been rumors reported of bipartisan deals to raise the exemption to $3.5 million at a 35% tax rate, and to make it retroactive to January 1, 2010. However, with the death of billionaire Dan L. Duncan who left a tax-free fortune of $9 billion, retroactive legislation is unlikely given the fact that Mr. Duncan's heirs have approximately $4 billion at stake that they will be willing to spend on legal fees to oppose any retroactive legislation.

In the meantime, Congress has failed to act. Thus, while there is no estate tax or generation-skipping transfer tax for 2010, both taxes are set to be reinstated as of January 1, 2011, with a $1 million exemption amount for each tax. By comparison, in 2009, the estate tax exemption amount was a generous $3.5 million for a single person and $7 million for a married decedent. (The GST tax exemption in 2009 was also $3.5 million per person.)

Even worse, the estate tax and GST tax will each carry a maximum tax rate of 55% beginning in 2011 absent the passage of new legislation. The top rate for estate tax and the GST tax in 2009 was only 45%.

The estates of individuals who die in 2010 will not be subject to either estate or generation-skipping transfer taxes at the federal level. Both taxes will automatically reappear on New Year's Day 2011, greatly impacting the estates of many Americans who will pass away in 2011 and beyond.

How does EGTRRA affect Lifetime Gifts?

Unlike the estate and GST taxes, the gift tax was not repealed for the year 2010. You can make tax-free gifts throughout 2010 (and beyond absent changes in the law) to an unlimited number of people as long as each gift does not exceed $13,000 per recipient. Because a husband and wife may agree to combine their gifts, together they will be able to gift $26,000 to each recipient in 2010 without incurring any gift tax or using up their lifetime gift tax exemption. The total amount of lifetime gifts that you can make free from gift tax remains at $1 million for 2010 and beyond.

How does EGTRRA affect the "Step Up in Basis Rule"?

Until December 31, 2009, the IRS provided a "gift" of a "step-up-in-basis" rule. The "Step Up" rule applied when a beneficiary received property from the estate of a decedent which "stepped up" the basis, thereby eliminating any potential capital gains. For example, a father purchases a house in 1980 for $100,000. At the time of the father's death in 2009, the house was valued at $800,000. The beneficiary who inherited the house sold it for that amount in 2009. Is the $700,000 of appreciation a taxable capital gain to the seller – the beneficiary of the property? Under the previous "Step Up" rule, the answer was no. The basis (or cost) of the seller-beneficiary was "stepped up" to fair market value at the time of the decedent's death. Because that value was $800,000, and he sold it for $800,000, there was no taxable gain. (in fact, the seller-beneficiary could have sold the property for as much as $1,050,000 without incurring a taxable capital gain if it was his primary residence because he or she would still have been entitled to the $250,000 capital gain exemption).

This all changed on January 1, 2010. EGTRRA significantly limits the step-up in basis of appreciated assets. For decedent's dying in 2010, although there is no tax due to the federal government, beneficiaries will only receive a "step-up" in basis for the first $1.3 million of appreciation. A surviving spouse has a slightly better benefit and can receive a step-up in the basis of acquired assets for an additional $3 million of appreciation.

What steps should I take in light of the changes under EGTRRA?

In light of the unknown future of the estate and GST taxes, certain estate planning techniques require caution:

• One major caution concerns wills that use a formula to divide an estate between marital and by- pass trusts. If the by-pass trust is not capped, i.e., if the formula does not set a maximum funding for the by-pass trust, the portion intended for the surviving spouse may be largely or entirely depleted.
• Similarly, a will that defines a charitable bequest in terms of the charitable deduction allowed under the now-repealed estate tax laws may produce unintended results.
• Other techniques are still viable, whether there is an estate tax or not. For example, a discounted and leveraged gift of a residence or second home may still be impacted through a qualified personal residence trust (QPRT). The donor may reside in the home until the end of the QPRT, and may even be able to lease back the property at fair market value from the new owners.
• The donor of a gift to a charitable remainder trust may retain a life payment of up to 90% of the value of the gifted property. The donor would receive an income tax deduction equal to the value of the gifted property not retained. There is no gain or loss recognized by the charitable remainder trust on sale of the property. Payments to the donor from the trust will be taxed partly as income, partly as capital gain; it is possible that a portion of the payments will be considered a distribution from principal and thus not taxable.
• If new legislation is not enacted, the GST tax exemption will drop to $1 million in 2011. Therefore, it might be expedient to make lifetime gifts now. Of course, if Congress acts before the end of 2010, this strategy may lose its effectiveness.

What is the Status of the Changes to the Federal Estate Tax?

See above. Congress has not yet acted and there is no bill pending or in the pipeline. In addition, the death of billionaire Dan Duncan in March 2010 left behind a tax-free fortune of $9 billion, leaving his heirs unlikely to welcome any efforts to retroactively impose a tax on estates for decedents passing away in 2010.