percent rate would be in effect. For the wealthy, this would be incredibly costly.
While many tax advisers would probably wager with good odds that the $1 million exemption and 55 percent rate will never return, these are likely the same advisers that assured clients that the estate tax would never be repealed. No one really has a clue whether Congress will allow the exemptions to fall back to $1 million for estate, gift, and GST tax exemption purposes, extend the $5 million plus 2010 Act exemptions temporarily or permanently, or settle for something in between. (As you are probably aware, the Obama Administration has proposed $3.5 million exemptions for estate and GST tax purposes with a 45 percent rate.)
So how should you proceed? Basically, you need to weigh the cost, time, and effort of planning aggressively (even though it may prove to be for naught), against the potentially devastating tax costs of taking inadequate tax-minimizing steps during the remaining window of opportunity in 2012. This decision requires more than just a tax calculus. Even if the political winds in Washington result in another year or two extension of the current law (and don’t count on that!), if to-day’s low interest rates ratchet up as the economy recovers or other external events push them up, many of the interest-sensitive estate tax planning arrangements will lose their luster. The old adage “all things come to he who waits” never applied to tax planning, and it is certainly the wrong perspective on the estate tax in 2012.
Here are some possible 2013 outcomes, although most tax advisers have long ago tossed out their crystal balls and Ouija boards:
•In 2013, the 2010 Tax Act changes will expire (sunset). In very simple terms, the exemption for gift and estate tax purposes will decline to $1 million, the gift/ estate tax rate will increase to 55 percent, and the GST exemption will decline to $1 million (but inflation adjusted to a slightly higher level). The difference between the gift and estate tax exemptions and the inflation-adjusted GST exemption will add considerable complexity to planning for those taxpayers wisely looking to squeeze every drop of GST tax benefit out of their plans. Although few advisers believe these increases in the transfer tax system are likely to occur, the increases are on the books today and will automatically come into effect unless Congress takes affirmative action. Ignoring this possibility, whatever probability you may choose to assign to it, does not seem prudent.
•Continuation of the current 2012 paradigm with a $5 million (inflation adjusted or not) gift, estate, and GST tax exemption and a 35 percent rate.
•Continuation of the current 2012 paradigm with a $5 million exemption and a 35 percent rate, but elimination of many favorite transfer tax techniques: valuation discounts for certain intra-family transfers, grantor retained annuity trusts (known as GRATs), grantor trusts, and others. This approach could increase tax revenues while giving politicians the ability to boast that the exemptions stayed high.
•Go back to the $3.5 million exemption (but only $1 million for gift tax purposes) and the 45 percent rate that were law in 2009 and which President Obama has proposed for 2013. This could be with, or without, GRATs, discounts, and other wealth-transfer techniques affected.
•Repeal the estate tax in its entirety. This is looking like less and less of a possibility in light of the massive federal deficit. If Congress did the inconceivable and repealed the estate tax in 2013, then what revenue raising steps might they enact to replace it?
The possibilities are broad and unpredictable given the inaccuracy of everyone’s guesses about taxes for the past few years. One possibility is to repeal the estate tax and instead assess a capital gains tax on all appreciation in a taxpayer’s assets held at death. This is the system Canada adopted many decades ago to replace its estate tax system. This ultimate capital gains tax could be assessed on every decedent’s final income tax return. This approach isn’t subject to attack under the theory that you shouldn’t tax what was already taxed (which has been quite a powerful argument in the arsenal of those endeavoring to eliminate the evil death tax). This is because untaxed appreciation simply wasn’t previously taxed. This solves the step-up in basis issue at death as well. Taxpayers would have to value all assets owned at date of death (with certain exceptions) and their estates would pay a capital gains tax on all appreciation.
The ultra-wealthy who complained about the estate tax rates being confiscatory should not be able to fight this approach because the rate would be the lower capital gains rate (and any tax assessed would also be reduced by the tax basis in assets owned). If a “capital gains on death tax” is enacted, the gift tax will likely remain because it would be needed to backstop the capital gains tax to prevent taxpayers from making deathbed gifts of appreciated property (or the tax system may adopt a “gains tax upon gift” as well). That could mean a $1 million lifetime gift exemption. This provides yet another reason certain groups of taxpayers need to plan now and plan fast.
A number of these scenarios portend a possible return to a $1 million gift tax exemption whether the gift tax retains its historical role as a backstop to protect the estate tax, or whether the gift tax is enlisted again as it was in 2010 as a backstop to the income tax. In any event, a decline in the gift tax exemption to $1 million would severely limit the ability to shift substantial wealth for millions of taxpayers, not only the ultra-wealthy. This is why taking advantage of the large gift and GST tax exemptions now is very important.
TIMING ISSUES
Is 2013 really the deadline? Tax practitioners and taxpayers alike should be mindful that while the buzz consists almost entirely about planning in 2012 before the 2013 changes, it is possible, albeit remote, that a lame duck session of Congress, which follows the November election, may enact changes as well. So if you are really concerned, an early November target date (not December 31, 2012) should be pursued.
PLANNING NOTE: Let the White Rabbit from Alice in Wonderland be your mantra to 2012 planning: I’m late / I’m late / For a very important date. / No time to say “Hello, goodbye,” / I’m late, I’m late, I’m late.
INCOME TAX CONSIDERATIONS CANNOT BE IGNORED
With the potential for significant income tax increases in 2013 and considering the interconnectedness of estate and income tax planning, income tax issues cannot be ignored. Assets included in a taxpayer’s estate at death will generally receive a step up in income tax basis to their fair market value as determined for estate tax purposes and without income tax recognition. Assets given away before death will not step up (i.e., in general, the recipient of a lifetime gift assumes the donor’s tax basis in the gifted asset). Depending on the capital gain and ordinary income tax rates applicable to the taxpayer and his or her heirs on future sales, as compared to the federal (and state, if applicable), estate tax rates that may apply to assets held at death, gifting versus holding assets until death can have widely different results. Hence planning is essential.
With the possibility of income tax rate increases, should you convert your IRA to a Roth IRA before the year’s end? If the IRA is converted in 2012, the resulting income tax might prove to be much lower than in a future year. Also, the income tax paid upon conversion will remove those assets from the taxpayer’s estate and could generate a 55 percent marginal estate tax savings if 2013 brings a $1 million exemption and a 55 percent rate. On the other hand, if the estate tax exemption remains at the $5 million inflation-adjusted level and rates remain at 35 percent, a very different result may follow. Just to complicate matters, it is also appropriate to consider that annual distributions from an IRA (or pension plan) may be taxed at a lower rate than the entire amount of the IRA would be subject to upon conversion to a Roth IRA. Remember that income and estate
