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Estate Tax Revisit

We believe that estate taxes would not be repealed in 2010.  With President Obama taking office, expect more adjustments ahead.

In this article we provide insight on the estate tax’s current status and how business owners can plan for the near future.

What changes can we expect in regard to estate tax rates?

The estate tax levied a 55 percent maximum tax rate on all inherited assets above a $1 million exemption. The exemption level has risen and the tax rate has been dropping since 2001, down to 45 percent with a $3.5 million exemption. Current law calls for the tax to be repealed in 2010 with a reversion back to 55 percent tax rate and $1 million exemption in 2011. The estate tax rates also apply to gifts during life; however the gift tax exemption has remained fixed at $1 million.

Obama proposes freezing the estate tax at 2009 levels — a 45 percent tax rate on estates valued at more than $3.5 million. Married couples can combine their exemptions for a total of $7 million. Obama’s plan would completely exempt 99.7 percent of estates from taxation.

If 99.7 percent of estates are exempt, shouldn’t the estate tax just be repealed?

According to the Treasury Department, a permanent repeal would cost $522 billion in lost tax revenues over the next decade. The cry from ‘death tax’ opponents that many small businesses and farms are devastated by estate taxes is a myth. The Urban Bookings Tax Policy Center reported that when the exemption was $1.5 million, only 440 small businesses and farms were hit with this tax. An analysis by the Congressional Budget Office added that at the $3.5 million exemption level, only 159 small businesses and farms would owe any estate tax.

What about taxpayers who are still subject to the 45 percent rate?

The unfortunate taxpayers that are still subject to estate tax undoubtedly are not completely satisfied with a reduction in the estate tax rate from 55 percent to 45 percent. Almost half of their estate will fall into the hands of the IRS. But there is hope for them. First of all, among the estates that do owe taxes, the ‘effective’ tax rate — which is the percentage of the estate that is paid in taxes — averaged about 20 percent in 2005 (the latest year for which IRS data is available). As for planning for estate tax reduction, now is an opportune time.

The current low valuations in the stock market and depressed real estate values provide estate-planning and gifting opportunities. In addition, low interest rates provide for certain gift-leveraging techniques, which rely on the IRS’s monthly published Applicable Federal Rates (AFRs). A combination of low valuations and low AFRs creates phenomenal gift-leveraging techniques for those that believe in the long-term strength of the U.S. economy.

Are there any other advantages to implementing gifting or estate tax reduction strategies now?

Yes. President Obama’s campaign position included attacks on valuation discounts. Minority interest, fractional interest and lack of marketability discounts have allowed taxpayers to significantly reduce the value of assets subject to gift and estate tax. These discounts may be limited or disallowed by future legislation, so implementing techniques before Congress eliminates or restricts such discounts is imperative.

What are some specific planning techniques?

Annual gifts to donees are partially exempt — the annual exclusion rose from $12,000 to $13,000 in 2009. A husband and wife with three children and seven grandchildren could transfer $260,000 per year out of their estate with no gift tax consequences.

Further gifting to utilize the gift tax exemption amount of $1 million (per donor) will pass appreciation and income from the gifted assets to recipients.

Utilizing a Grantor Retained Annuity Trust (GRAT) remains a beneficial estate-planning tool. Appreciation of assets in excess of the IRS AFR hurdle rate (3.6 percent at the time of publication) would pass gifts tax-free to the grantor’s designated beneficiaries. If the assets do not appreciate above the IRS hurdle rate during the term of the GRAT, the assets would come back to the donor with no economic downside.

Use of an installment sale to a grantor trust would allow you to lock in low AFRs for several years. This would allow for a shift in value (above the AFR hurdle rates) and also protect against possible changes in law that would restrict discounts and limitations on GRATs.

There are many other viable estate-planning tools and techniques that should be discussed with your tax adviser, but the key is to plan ahead.