JMBM Tax Newsletter Spring 2009: Estate Tax Legislation: The Good, The Bad and What To Do Now

A criminal defense lawyer meets with his client to advise him of the results of his DNA blood test. The lawyer says, “I have good news and bad news.” The client asks, “What’s the bad news?” The lawyers says, “Your blood matches the DNA found at the murder scene.” The client asks, “What’s the good news?” “Well,” the lawyer says, “Your cholesterol is down to 140.”

This old chestnut of a joke sums up Bill H.R. 436, introduced by Congressman Earl Pomeroy (D-ND) on January 9, 2009 (H.R. 436).

The Good News—Resolving Uncertainty
The good news is that H.R. 436 would resolve the uncertainty of the estate tax law, which currently provides for a $3.5 million exemption from estate tax and a maximum estate tax rate of 45% for deaths occurring in 2009, the repeal of the estate tax for deaths occurring in 2010, and the reinstatement of the pre-2001 rules for deaths occurring after 2010. Under the pre-2001 rules, the estate tax exemption was $1 million, and the maximum estate tax rate was 55%.

Under H.R. 436, the estate tax repeal in 2010 would be eliminated, and the current $3.5 million estate tax exemption would become permanent. The maximum estate tax rate would be 45%, but for estates in excess of $10 million there would be a 5% surtax to eliminate the graduated tax rates of less than 45% so that effectively there would be a flat 45% estate tax rate for large estates.

H.R. 436 also would maintain the current federal lifetime gift tax exemption of $1 million. H.R. 436 would also keep in effect the current step-up in basis law that generally adjusts the income tax basis of an asset to its fair market value at the date of the taxpayer’s death. The step-up in basis laws are scheduled to be changed dramatically in 2010 if no changes are made to current law.

The effective date of H.R. 436 is currently drafted to be the date of its enactment, so that it should not apply to transfers before that date.

The Bad News—Elimination of Discounts
As the criminal lawyer had to advise his client that his blood established his presence at the crime scene, H.R. 436 comes with bad news for those taxpayers with large estates. H.R. 436 eliminates valuation discounts for non-business assets, such as cash, securities, bonds, commodities, collectibles and real estate (unless the taxpayer meets certain material participation requirements) held by an entity such as a partnership or limited liability company. This includes minority interest discounts on the transfer of an interest in an entity where the transferee and members of the transferee’s family have control of the entity. Under current law, taxpayers have the ability to take advantage of significant discounts for lack of marketability and lack of control in connection with the transfer of non-business assets and interests in non-actively traded entities among family members. In general, these discounts range from between 25% and 45%.

There is a consensus among tax practitioners that Congress will enact a bill that will maintain some version of the 2009 estate tax law so that the law will not revert to the pre-2001 rules. However, no one is certain whether such a bill would eliminate the availability of discounts. For example, Representative Harry Mitchell (D-AZ) recently introduced Bill H.R. 498 entitled, “The Capital Gain and Estate Tax Relief Act of 2009,” that would also eliminate the repeal of the estate tax in 2010 and the reinstatement of the pre-2001 rules in 2011, gradually increase the estate tax exemption from $3.5 million to $5 million (between 2010 and 2015) and provide certain other taxpayer-friendly provisions. H.R. 498 does not contain provisions to eliminate or restrict the use of discounts currently allowed under law. Since a reversion to the pre-2001 rules is unlikely to occur, the remainder of this article only will analyze the effects of H.R. 436’s elimination of discounts.

Taxpayers have utilized various techniques to take advantage of the discounts described above, including the transfer of assets to a grantor-retained annuity or unitrust or to certain charitable trusts, such as a charitable lead trust, as well as the sale of assets to a defective grantor trust (DGT).

While H.R. 436 appears to permanently reduce estate taxes, provisions that eliminate discounts may in fact significantly increase estate taxes for many larger estates.

A Hypothetical Estate
As an example, assume John Doe, who is 72 years old, has a $50 million estate. He is a widower with four children. The assets in his estate include $20 million in bonds, cash and other liquid assets, $10 million in a personal residence and vacation home and $20 million in investment real estate (with regards to which John does not materially participate). John has no debt and is in excellent health. He is comfortable that he has sufficient liquid assets and income from his assets to support him in his accustomed lifestyle for the rest of his life. John plans to meet with an estate planner to discuss ways to reduce his estate tax. If John were to die suddenly in 2009 (before meeting with his estate planner) and if we assume that his estate will have $1 million in liabilities and expenses and other amounts that are deductible against the estate, John’s taxable estate would be $45.5 million ($50 million minus $1 million in liabilities and expenses and $3.5 million of estate tax exemption). He would incur an estate tax of approximately $20.475 million. The same result would occur under H.R. 436.

On the other hand, if John Doe had met with his estate planner in 2009—before he died—his estate tax could have been significantly reduced by taking advantage of one or more estate planning techniques.

Limited Liability Company
Let’s assume that in March 2009 John formed a limited liability company (LLC) for the purpose of providing orderly management of his assets as he ages. John transfers to the LLC $4 million in liquid assets, a 20% interest in an investment partnership valued at $3 million and all of his real estate interests (valued at $20 million). Under current law, John can take a discount for lack of marketability and lack of control on the value of the partnership interest. Assuming a conservative 33-1/3% discount, the $3 million partnership interest can be valued at $2 million. We are assuming no similar discount on the value of John’s investment real estate because we are assuming John is the sole owner of all of his real estate assets. Therefore, the total value of the assets transferred to the LLC is re-valued at $26 million.

Defective Grantor Trust
John then establishes an irrevocable trust for the benefit of each of his four children, sets them up as DGTs and sells to each trust a 25% interest in the LLC in exchange for a promissory note. Assuming each 25% LLC interest is discounted 35%, each promissory note would have a face amount of $4.225 million [($26 million – (35% of $26 million0)) ÷ 4 = $4.225 million]. Thus, John will have effectively transferred the assets, initially valued at $27 million, out of his estate in return for four promissory notes totaling $16.9 million.

If John suddenly died in April 2009, his taxable estate would be only $35.4 million (the assets transferred to the LLC and sold for $16.9 million plus the remaining $23 million, less the $1 million in deductible expenses and $3.5 million estate tax exemption). And, under current law, the estate tax liability on this amount would be $15.93 million. On the other hand, if this estate planning were to occur after H.R. 436 is enacted, no discounts would be allowed on the transfer of assets to the LLC. Each DGT would have to issue a promissory note in the amount of one-fourth of $27 million, or $6.75 million, and John’s estate would own promissory notes totaling $27 million, rather than $16.9 million. John’s taxable estate would be $45.5 million and the estate tax liability would be $20.475 million. Therefore, in 2009, the passage of H.R. 436 would cost John’s estate an additional $4.545 million in estate taxes.

Do You Need to Act Now?
At this point, no one is certain when a bill modifying the estate tax rules will pass and what would be the effective date of that bill. The effective date could be the date of the bill’s enactment, as is currently the case with H.R. 436, or an earlier date (such as the date when the House Ways and Means Committee and/or the Senate Finance Committee approve the bill). However, because one of the proposed bills significantly limits the use of discounts, most tax advisors are recommending that certain clients act quickly so that they can still take advantage of discounts. By implementing an appropriate plan before any bill eliminating the ability to take discounts is enacted, you might be able to enjoy the “good news” of any such bill without suffering from the “bad news” of the bill.