Death of Estate Tax Planning?
Only a handful of estates are worth more than $5.0 million (approximately 1 in 1,000), so the new law will eliminate estate taxes on all but the very largest estates.
With the new exemption portability rules, there is little need to worry about estate or gift taxes. Consequently, for 99.9% of estates, complex exemption planning with multiple trusts should become extinct
But what about estates worth more than $10.0 million?
Estate vs. Income Tax
The new estate tax rate of 35% has reduced the spread between estate taxes and income taxes to such a degree that estate tax planning for even the largest estates may become obsolete.
NOTE: Estate tax planning involves the comparison between the estate tax rate and the federal and state income tax rate. When the estate tax rate was 50% or higher, the financial advantage of eliminating estate taxes was clear; with the tax rates now roughly the same, the rationale for estate tax planning has greatly diminished.
For example, assume a federal capital gain tax rate of 15% and a state tax rate of 5% (a combined 20%). When the estate tax rate was 55%, there was a 35% spread between the estate tax and income tax; under the new rules, the spread is only 15%. If the capital gain rate returns to its traditional 20% rate and the taxpayer lives in a state that has an income tax rate of 9% (California or New York), the spread drops to only 6%.
NOTE: For collectibles (artwork, jewelry, antiques), the federal income tax rate is 28%, so for these items, the combined federal and state income tax rate may actually be higher than the federal estate tax rate.
There are other drawbacks to using the traditional estate-tax minimization techniques:
1. California Proposition 13 – Each spouse has a $1.0 million exemption for real property transferred directly to children or grandchildren under Proposition 13 (property tax reappraisal rules).
If, however, the parents place their real estate in a family limited partnership or other entity, the exemption is lost. Because the exemption is based on the property’s “assessed” value and not the fair market value, an estate worth $10.0 million may have an assessed value of only $2.0 million and the exemption could cover all the properties against a property tax reassessment. Assuming a 2% property tax rate, the difference could be $160,000 in annual property tax increases.
2. Basis Step-Up. In general, property distributed through an estate obtains a basis adjustment to fair market value as of the date of death. Thus, if an estate comprised of real property worth $100 million ($80 million of which is allocated to the buildings and $20 million is allocated to the raw land) is taxed at 35%, the properties will have a new basis for depreciation purposes of $80 million. The benefit of this deduction to the beneficiaries may offset 2-4% of the estate tax
3. Uncertain Federal and State Tax Rates and Future Economic Conditions. As states cope with severe budget shortfalls, many could raise taxes in the future. Also, the federal capital gains rate of 15% could be raised to 20%. As state and federal income taxes rise, the gap between income taxes and estate taxes narrows.
Coupled with depreciation benefits and potential property tax savings, it is not clear that estates taxed at 35% will benefit from estate tax planning.
Remember, complex estate tax planning can be expensive, time-consuming, an administrative burden and subject to IRS challenge. Also, these complex strategies can backfire if certain assumptions about future tax laws or economic conditions prove to be faulty.
The current estate and gift tax regime is a huge bounty to the extremely wealthy. Predictions are that the new law will survive its expiration date of December 31, 2012.
Because of the elimination of estate taxes for married couples with estates under $10.0 million and a 35% estate tax rate on any amounts over the exemption, there may be little incentive to engage in customary estate tax minimization.