President Obama Tax Compromise Proposal December 6 2010

President Obama Tax Compromise Proposal December 6 2010

By: Martin M. Shenkman, CPA, MBA, JD

Obama’s Tax Proposal: What it Means to the Estate Tax

Too many details aren't clear and nothing has really been finalized, are some ramblings, and perhaps no more than that, based on two lines from this mornings electronic New York Times ...while I anxiously await the delivery of the real paper - electrons are just not the same. They just can't be folded into those neat packets like real paper to read on a bus.

The New York Times reported this morning that the Obama administration had cobbled together a deal with Republicans that would "ultimately" set an estate tax exemption at $5 million and a 35% rate.

While none of the details are clear, what this might mean is in 2011 a $3.5 million estate tax exclusion, similar to 2009, and an increase over some number of years to $5 million. A rate of 35% might be effective starting in 2011 or some later number of years. A phase down of the rate and a phase up of the credit over time will both allow Congress to do its budget magic of making the numbers more palatable by dampening the effect of what amounts to a tremendous loss of dollars to the federal fisc.

What the entire proposal, and the years of confusion and lack of action do demonstrate, is that Congress has still not understood an important perspective on the impact of taxes on economic decision and investment. Uncertainty is certainly as difficult for the wealthy to deal with as are higher taxes. What has been (and today remains) uncertainty about the impact of the estate tax has undoubtedly had a damaging effect on high net worth taxpayers making decisions. It's tough to make decisions without knowing the ground rules. Uncertainty negatively impacts the assumptions that have to be made on any projection.

So what might this all mean? Again still no clarity, but let's speculate on some of the possibilities and unknown. Bear in mind that after the repeal that know tax practitioner thought would ever happen (and once it did everyone was positive it would be changed retroactively!) our crystal ball is a bit cloudy when predicting estate tax laws.

Estate Tax Exclusion

An exclusion of $5 million will effectively make the estate tax inapplicable to well more than 99% of taxpayers. Some years ago a family net worth of around $3-3.5 million was reported as categorizing a family in the wealthiest 1% of the population. A $5 million threshold would thus mean far less than 1% of the families would be effected. If in 2009, with a $3.5 million exclusion, only about 16,000 decedents filed a federal estate tax return, a $5 million exclusion should reduce the number to a miniscule figure and severely impact producers of the software that prepares estate tax returns. Well, maybe. If the $3.5 million exclusion is the starting point presumably an equally small number of decedent's estates will be affected in 2011. But that is not yet the full story. When will the increases from $3.5 million (assuming that is even the starting point) begin?

Just in case you were curios the increased exclusion removes the risk of an estate tax for most on Capital Hill where the median net worth of the incoming members of Congress was reported to be about $1.8 million. Certainly this won't be a factor our leadership considers in its debating the new proposals.

Will the Exclusion be Inflation Indexed?

Will the figures be inflation indexed? The Bacus bill proposed that the applicable exclusion amount ($3.5 million) would be indexed for inflation after 2011. H.R. 4853, §303(a). While that was defeated, what might the horse trading over the current legislation lead to?

If the $3.5 million exclusion is increased in phases over say five years to $5 million that might track to some degree inflation. If, however, the exclusion is not inflation indexed, which would likely help the federal fisc in future years, what might a $5 million exclusion really mean in say 10 years? Certainly the vast majority of Americans would remain outside the reach of the estate tax, but if inflation indexing is not afforded, the initially high threshold for estate tax pain will begin to creep down the wealth ladder.

Portability and Bypass Trusts

Will portability be included in the proposal? Uncertain. It was included in the recently proposed and defeated Bacus bill and has appeared in other incarnations before, but its fate remains unknown. If enacted portability will permit a surviving spouse to use the estate tax exclusion that remained unused from his or her deceased spouse. This would enable taxpayers who did not engage in more sophisticated planning than an "I love you" will (I leave my entire estate to my beloved spouse outright and free of trust) to secure the benefit of what under 2009 and prior law required a bypass trust (applicable exclusion trust or unified credit shelter trust) to be formed on the first spouse's death. As many estate planners have pointed out, this could prove to be a trap for the unwary (or perhaps a trap for the penny wise and pound foolish). Failing to establish the bypass trust that had been the corner stone of most tax oriented estate plans of the past might lead the surviving spouse to a taxable estate problem, especially if the survivor's exclusion is not indexed for inflation.

What portability will undoubtedly do if enacted is dissuade even greater numbers of taxpayers from pursuing the type of planning they should. Many more rely upon outright bequests and forgo the use of trusts that, apart from estate planning, provided significant asset protection planning, management control, certainty as to distributions to intended remainder beneficiaries, and more.

Estate Tax Exclusion Impact on Consumers

If taxpayers are given a comfort level that a $3.5 million to $5 million estate tax exclusion is permanent, most taxpayers will likely resort to on line self-help will preparation software, or frequent living trust mills or other cheap "estate planning" options with even greater frequency than before. After all, the complexity of the estate tax won't affect them. General practice attorneys who commonly referred clients to estate planning specialists prior to 2009 because of their discomfort dealing with the complexity of the estate tax, may no longer see the need to make such referrals. The reality will be that a huge number of taxpayers will face difficult if not very damaging results because the myriad of other aspects of a proper comprehensive estate plan won't be addressed. Too few general practice attorneys or consumers begin to understand that estate tax is but one of many complex but vital matters estate planners address. Or is this just another estate planner whining about business perhaps declining?

Estate Tax Rates

The estate tax rate is proposed to decline to 35%. That is far lower than the 55% rate on the table for 2011 and lower than the 45% rate in the recent Bacus proposal. At 35% the estate tax won't look much more daunting than the income tax rates, and if income tax rates are raised in future years (after the two year Busch extension ends) the estate tax might be lower than the income tax rate for the first time. While the cost to the wealthy who remain affected will still be significant, a rate that is lower than income tax rates might result in a huge difference in the perception of the estate tax, lessening the worries wealthy taxpayers feel about the impact. While planning will continue for the wealthy, the urgency of the planning may take on a different and less ominous nature.


Grantor Retained Annuity Trusts ("GRATs") have been on the chopping block for years. These are trusts to which a taxpayer can make a gift and receive back in exchange an annuity payment for a fixed number of years. The term of years and percentage annuity were generally pegged to get the value of the gift to the GRAT close to zero or zero. GRATs often morphed into a two year cascading or rolling GRAT game that Congress finally got wind of as a no loose bet for wealthy taxpayer's portfolios. The early noise about the tax deal in Washington has not mentioned GRATs. Might be that the final legislation zaps' GRATs so that they can make the deficit projections look less ominous. Might be that the Republicans hold their ground and nothing changes. Hey, perhaps we'll have some really complex changes to GRATs that will be somewhere in the middle but keep tax lawyers salivating over new rules to explain to clients.

The question for today is, do we continue doing GRATs that clients have started? Do we stop cold? What if a taxpayer signs a GRAT today? What effective date for GRAT modifications might that be used? Will whatever is actually enacted have a date of enactment as the effective date for restrictions that are implemented?

Dynasty Trusts and GST Planning

"To sell or not to sell, that is the question." Many wealthy taxpayers have near completed estate planning transactions such as sales to grantor trusts waiting to determine if they should complete them in 2010. Since interest rates and asset values are at significant if not historic lows, selling assets to a grantor trust has grown in popularity. But what should a taxpayer do now with transactions like this on the cusp? This is kinda like Monty Hall on Let's Make a Deal.

Door No. 1 - For taxpayers in that estate tax tough "sweet spot" of greater than $1 million net worth, but less than $5 million. For this mid range wealth taxpayer, planning would be very valuable if the exclusion was the $1 million which is what it looked like it would be up until yesterday. But what if a $5 million exclusion mentioned in the Obama proposal is enacted? Planning for the $1-5 million net worth taxpayer might be a waste of effort and money. A $5 million estate exclusion might eliminate the specter of the estate tax for this range of taxpayers, so why plan? For some taxpayers that had been concerned about a $1 million estate tax exclusion, pursuing costly and complex planning may no longer be warranted. But then again nothing has passed Congress and it may be. Some of these clients may have planning nearly complete and were waiting until nearer year end to close the deal since if they don't make it to the end of the year their heirs will get the estate free of estate tax in 2010. But if the client is in that mid-wealth range of say $3-5 million, perhaps a tad higher, do they still engage in this planning? Should the planning be shelved? If an exclusion of $3.5 million is enacted and increased over time, perhaps elderly clients should proceed.

Door No. 2 - For wealthy taxpayers over $5 million net worth. For wealthy taxpayers above a $5 million net worth range it would seem that planning should proceed full steam ahead. GRAT may work today (assuming a date of enactment effective date is used for any GRAT changes). Discounts still work and the proposals in the Obama Green book and those in the Pomeroy bill proposed some time ago, have not yet been enacted (and may never be, get out your tax Ouija Board). So these taxpayers should perhaps proceed full steam ahead with consummating any planning they can do before year end. One never knows what horse trading might happen behind closed Congressional doors before final tax legislation passes. See the devilish discussion below.

Door No. 3 - For wealthy taxpayers over $5 million net worth. Hey, isn't that the same door as above? No, just being confusing. Congress should not have a Monopoly on confusion. Taxpayers with considerable wealth might re-evaluate note sale transactions and opt not to consummate them before year end. After all you cannot fund a dynasty trust in 2010 and have it GST exempt (or can you?). So many taxpayers that have deals on the cusp might just opt to wait until early January when presumably the GST exemption will be available to allocate to a new 2011 trust in lieu of a 2010 trust. These taxpayers could set up a 2011 trust that might be almost identical to a trust formed in 2010 but to which GST can be allocated. Then they could consummate a note sale transaction in 2011 to what should be a more assured GST exempt dynasty trust. The risks these taxpayers take is that interest rates might rise in the next few months, discounts might be eliminated, etc.

How do you make a call between the options? Unfortunately for taxpayers and advisers alike uncertainty abounds.

Devil in the Details

What might happen between Obama's proposal and a final tax act is quite uncertain. Will a host of planning techniques be sacrificed to make the budget deficit less ominous as a result of the estate tax modifications? Perhaps GRATs, discounts, crummey powers and other common planning tools will be restricted or eliminated. It might be that just the broad strokes proposed along with a grant of regulatory authority to the IRS to address the puzzles that remain is all that can occur under the pressure Congress might feel to act before year end. The wide array of planning implications between these two extremes creates yet more uncertainty.


Not possible to write a conclusion yet, but be optimistic, perhaps one day estate planners will be able to put away their Ouija Board and crystal ball and actual be able to again provide advice to clients based on known law.

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