President-elect Obama proposed three items related to federal estate tax reform during the campaign: (i) freezing the federal estate tax exemption amount and top marginal estate tax rate; (ii) creating a “portable” federal estate tax exemption for married individuals; and (iii) continuing the use of fair market value on date of death as the income tax basis for property inherited from a decedent (i.e., so-called “stepped-up” basis).
- Freezing the federal estate tax exemption amount and top marginal estate tax rate.
President-elect Obama has proposed freezing the federal estate tax exemption at the 2009 rate of $3,500,000 per person and freezing the top marginal estate tax rate at the 2009 rate of 45%.
- Creating a “portable” federal estate tax exemption for married individuals.
A portable exemption works as follows: if the estate of the first spouse to die does not use all or a portion of his or her $3,500,000 exemption, the unused exemption would be available for use by the estate of the surviving spouse. Generally, under a portable exemption, the estate of the surviving spouse may then shelter assets with a fair market value of up to $7,000,000 from the federal estate tax. President-elect Obama’s advisors have stated that 99.7% of estates would not pay any federal estate tax through a combination of the portable exemption and a freeze of the 2009 estate tax exemption and rate. Without a portable exemption, a married couple with $7,000,000 of net assets with an estate plan leaving all assets to the surviving spouse would owe no federal estate tax on the death of the first spouse but would owe approximately $1,575,800 of federal estate tax on the death of the second spouse. With a portable exemption the federal estate tax could be zero in this example.
- Continuing fair market value tax basis for property.
President-elect Obama has proposed continuing the use of the fair market value on date of death as the income tax basis for most inherited property. The notion of fair market value on date of death as the income tax basis for inherited property is known as the “basis step-up” or “stepped-up basis” assuming the inherited property has increased in value from the date of acquisition to the date of death. Under current law, property inherited from a decedent receives an income tax basis equal to the fair market value of the property at the date of the decedent’s death (or, in some instances, the fair market value six months after the date of the decedent’s death). For example, if a decedent purchased stock in 1990 for $100,000 and the stock is worth $1,000,000 on the date of the decedent’s death, the person inheriting the stock receives a tax basis in the stock of $1,000,000. The subsequent sale of the stock by the beneficiary for $1,000,000 would not result in any taxable gain. Under current law, the basis of property received from decedent’s dying after December 31, 2009, may not receive a fair market value basis. As a result, in the above example, the beneficiary receiving the stock worth $1,000,000 purchased in 1990 for $100,000, would realize $900,000 in taxable gain.
The annual exclusion amount will increase, effective for gifts made on or after January 1, 2009, from $12,000 to $13,000 per donee. In 2009, donors may give $13,000 to any other individual without incurring federal gift tax, and to any close relative without incurring any Tennessee gift tax. For gifts made before January 1, 2009, the limit is $12,000 per donee. Beginning in 2009, married donors may give up to $26,000 per donee (previously $24,000) without incurring gift tax, even if only one spouse makes the gift, so long as the both spouses agree to split the gift for federal and Tennessee gift tax purposes. Amounts paid directly to health care providers and educational institutions for tuition for the benefit of any donee continue to be exempt from federal and Tennessee gift tax.
Creating and implementing an annual gifting program, either through outright gifts or gifts in trust to children, is a relatively simple way for individuals or married couples with taxable estates to transfer assets to their children without paying gift tax on the transfer and to remove those assets (and their potential appreciation in value) from their estates for federal estate tax and Tennessee inheritance tax purposes. Gifts are often made to one or more trusts for the benefit of the donors’ children. The use of a trust is often appropriate if the children are not of an age where they are financially responsible. Either spouse could be the trustee of such trust, which would permit the trustee spouse to retain control over the investment of the assets. A properly drafted trust will permit a married couple to give up to $26,000 per child to the trust annually. Gifts to an irrevocable trust for children will be protected from creditors of the children, including divorced spouses.
An example of the estate tax savings that can be achieved through the implementation of an annual gifting program follows. A married couple age 60 with $5,000,000 of net assets today will be worth approximately $19,384,422 in 20 years (assuming 7% annual growth and income). The estate tax (based on the 2009 rates and exemption) due on the death of the surviving spouse in 20 years will be approximately $6,500,000. By gifting $100,000 per year, or 2% of the growth and income from $5,000,000, this married couple will have net assets valued at $13,266,488 in 20 years. The federal estate and Tennessee inheritance tax (based on the 2009 rates and exemption) due on the death of the surviving spouse in 20 years will be approximately $3,500,000. Consequently, by implementing an annual gifting program, this couple has saved their children approximately $3,000,000 in estate and inheritance tax, without paying any gift tax on the annual gifts. If this married couple were to contribute to the trust an asset with a discounted value, like a family limited partnership interest, the estate and inheritance tax savings would be even more pronounced.
The federal estate tax exemption will increase from $2,000,000 to $3,500,000 for decedents dying on or after January 1, 2009. The unlimited marital deduction remains in effect. An individual, therefore, may pass an unlimited amount to his or her surviving spouse upon his or her death and up to $3,500,000 to non-spouse beneficiaries without paying any federal estate tax. Under current law, the federal estate tax exemption amount will remain $3,500,000 for the 2009 tax year and, in 2010, the federal estate tax will be repealed for one year. In 2011, the tax returns with an exemption of $1,000,000. As discussed above, however, President-elect Obama has proposed freezing the federal estate tax exemption at $3,500,000.
The federal exemption amount was as low as $600,000 in 1997 and $1,000,000 as recently as 2003. Many estate plans developed and implemented in 2003 and before for married couples provide that upon the death of the first spouse, an amount equal to the exemption amount to be set aside in a family trust for the benefit of the spouse and children with the amount in excess of the exemption to be distributed to the surviving spouse (either outright or in trust). The family trust is designed to avoid the federal estate tax on the amount in the family trust upon the death of the surviving spouse. If a married couple has this type of plan in place today and their combined assets (including the death benefit from any life insurance) are less than $3,500,000, they should consider simplifying their wills since the family trust is not necessary upon the death of the first spouse to avoid estate tax upon the second death. Married couples for whom this type of planning is still appropriate may want to consider capping the amount available to fund the family trust to insure the surviving spouse receives sufficient assets.
The exemption for the Tennessee state inheritance tax remains unchanged at $1,000,000, which is $2,500,000 less than the current federal estate tax exemption of $3,500,000. This substantial difference is sometimes referred to as the “Tennessee gap.” The Tennessee exemption and the federal exemption were the same amount until 2003 so that any amount passing into a family trust upon the death of the first spouse under the planning described in the preceding paragraph would have been exempt from both the Tennessee inheritance and the federal estate taxes at the death of the surviving spouse. These types of estate plans now result in Tennessee inheritance tax being due upon the first-to-die of a married couple since an amount in excess of the Tennessee exemption (i.e., the “Tennessee gap”) passes to the family trust and not to the surviving spouse. The amount of the Tennessee inheritance tax that would be due in 2009 upon the first-to-die in an estate with this type of planning is $225,900. These types of estate plans for married couples should be revised to defer this Tennessee inheritance tax to the time of the death of the surviving spouse.