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Federal estate tax quagmire more complex as 2011 nears

It’s an old adage that the wheels of government spin slowly, but few attorneys would have predicted the glacial pace of estate tax reform in Congress, which has led to the repeal of the tax for 2010 and the potential reset of the tax next year to its highest level in a decade.

With no clear proposal from Congress to reform the law before the reset, estate planning attorneys have been playing a calculated guessing game for more than a year, and they see no end to the confusing situation in sight.

“I just don’t think most members of Congress care to do anything right now,” said Eric Matlin, managing partner at Matlin & Associates in Northbrook, Ill. “Maybe [estate tax reform] will be part of a comprehensive bill. That is what I tell my clients every day. But nobody knows.”

Congress lags, retroactive fix unlikely

The roots of the estate tax law problem extend back nearly a decade, to the passage of the Economic Growth and Tax Relief Reconciliation Act. The law provided for a gradual decrease in the overall highest estate tax rate from 55 to 45 percent between 2001 and 2009, while raising the exemption amount from $675,000 to $3.5 million during the same period.

The law provided that the estate tax be repealed in 2010 for a year before being reset to the pre-2001 levels of 55 percent and $1 million in 2011. The law was intended to be a temporary measure, built on the assumption that Congress would pass a new law to enact appropriate new estate tax levels before the 2010 expiration. But it didn’t. Instead, the estate tax fell to zero percent as of Jan. 1, 2010.

There was a late-hour effort to fix the problem. Last year the House passed H.R. 4154, a measure that would have kept the estate tax at 2009 levels, when there was a $3.5 million exemption for each individual ($7 million for each married couple) and a maximum tax rate of 45 percent. But the Senate has not acted on that or any other similar measure.

Over the past year, lawmakers have proposed individual bills as well as amendments to other pieces of legislation that would have created a number of fixes for the estate tax situation. Other proposals would have scuttled the estate tax altogether. But no plan has reached any point of serious consideration in the Senate.

Senate Finance Committee Chairman Max Baucus, D-Montana, has indicated that estate tax reform would likely be part of a broader tax reform package lawmakers will consider when they return from summer break in September, but it remains unclear what estate tax proposal, if any, would be included.

The delay has made it increasingly unlikely that the estate tax will be retroactively reinstated for 2010. Even the most recent estate tax reform legislative proposal — a measure from Sens. Blanche Lincoln, D-Ark., and Jon Kyl, R-Ariz. — would allow the estates of taxpayers who died in 2010 to either retain this year’s zero percent estate tax rate with “carry over basis,” or file under the provisions of a new bill which would create a permanent $5 million exemption and 35 percent tax rate.

Kyl expressed the same frustration trusts and estates lawyers and their clients feel.

“[On Jan. 1,] American taxpayers will face the largest tax hike in history unless Congress acts,” Kyl said when he introduced the bill in July, adding that “the lack of congressional action creates a tremendous amount of uncertainty for these families, small-business owners and farmers.”

But the fact that a retroactive tax law change is unlikely doesn’t make estate planning or law practice any easier.

“It’s getting too late to do anything retroactively,” said Beth Shapiro Kaufman, a partner in Caplin & Drysdale’s Washington office and former attorney advisor in the Treasury Department’s Office of Tax Policy. “I was shocked that we got to this point in the beginning of 2010. Now I would be shocked if [Congress] actually did anything about it for 2010.”

Uncertainty keeps lawyers on their toes

The uncertain state of tax law has turned attorneys into creative drafters and administrators, using the existing law to try to protect their clients to the best extent they can.

Matlin said that for one client in failing health with assets worth several million dollars, he utilized a Generation Skipping Tax — or GST — trust, which allows a certain exempted amount of assets to be set aside in trust for grandchildren without tax liability. In such setups, the children, or “skipped” generation, can receive income from the trust for their lifetime.

But the biggest tool for helping clients through the uncertainty, Matlin said, has been the use of disclaimers — which allow family members to decline to take an inheritance outright in favor of letting it pass into a trust for which they are named the beneficiary.

Such an arrangement buys time to allow the state of estate tax law to settle before deciding how the inheritance will be treated.

But even that isn’t easy, Matlin said.

“My staff and I very carefully look at the trust to determine” where and how to use disclaimers, he said.

Lawyers have also used the Qualified Terminable Interest Property — or QTIP — trust, which allows assets to be transferred to the estate of a spouse while still allowing the transferrer to designate who the beneficiaries of those assets will be.

“I think QTIP is the technique of the year for 2010,” said Kaufman.

But if an estate holder is unmarried or already widowed, QTIP trusts can’t be used.

“For the unmarried, it’s kind of a calculated risk,” Kaufman said. “There is a temptation to say, ‘Let’s wait until the end of December to see [what happens].’ But then Congress might do something in November, and you might lose an opportunity to” plan in another way if the client dies.

There are also other problems, such as conflicting state estate tax laws and decisions about whether to make charitable gifts.

“If you make a taxable gift, you incur a 35 percent gift tax,” Matlin explained.

While it may seem like a good idea to wait until 2011 when the gift tax rate will be lower than the 45 percent estate tax that could go into effect, an act of Congress could thwart that plan.

“Clients are in hunter-gatherer and conservation mode,” Matlin said. “They are not super interested in giving up their assets in this uncertainty.”

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