The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") provided some of the most significant estate tax changes in the last 30 years. However, the act had one of the most disturbing timebombs ever enacted in a major piece of tax legislation: The entire law dies on Jan. 1, 2011!
When EGTRRA passed, most estate planners expected that Congress would enact some form of permanent transfer tax legislation before 2011. However, as I pointed out in my article in National Underwriter on Nov. 20, 2006, it is growing more plausible that we will return to the 2001 rules in 2011. Consider this possible scenario:
o It is unlikely that new transfer tax legislation (if any is adopted) will not be seen until mid to late summer in 2007, at the earliest. Democrats will probably enact tax legislation containing provisions that are unpalatable to the president. The president must either sign the legislation or veto it and hope Congress enacts a more responsive bill after the November 2008 congressional and presidential elections.
o In 2008, based upon past political history, it is highly unlikely that any significant compromise tax legislation will be enacted; compromise legislation does not tend to happen during a presidential election year.
o In 2009, the country will have a new president and a new Congress. Every new president wants to make their mark with new tax legislation. Three overriding issues will probably be driving any tax reform legislation.
First, the tax code has reached such a degree of complexity that many experts believe it is effectively broken. Americans are increasingly demanding a simpler and fairer tax code. Any reform will naturally include a search for additional revenue sources.
Second, by 2009 there will be a huge need to fix the Alternative Minimum Tax (AMT) disaster. According to the Congressional Budget Office, about 2 million taxpayers paid AMT in 2002. Over 30 million taxpayers are expected to pay AMT in 2010. Under current law, in 2010 (the year of the AMT's peak effect during CBO's current baseline projection period), 66% of the 26 million taxpayers with adjusted gross income (AGI) between $50,000 and $100,000 will owe more tax as a result of the AMT. Among the 9 million taxpayers with AGI between $100,000 and $500,000, more than 85% will owe more tax.
Third, by 2009, the extent of the coming budgetary shortfall caused by entitlement programs for the baby boomers and their parents will be even more apparent and may start impacting the 5-year budget window of current planning.
o Each of these issues will require Congress and the president to find new sources of revenue. Could Washington decide that the revenue from an increased estate tax solves some of its revenue problems? The huge wealth transfer expected in the next 50 years could be an alluring source of "found money."
The November 7 election effectively killed any serious possibility of a permanent elimination of the estate tax. Even the $3.5 million to $5 million exemptions that have been discussed are an increasingly unlikely event. Given the partisan wrangling that is tying up compromise legislation in Washington, there is an increasing possibility that Washington will fail to enact any permanent legislation, resulting in a return to the pre- EGTRRA rules on Jan. 1, 2011.
The unfortunate reality of this uncertain environment is that planners and their clients need to start planning now for the possibility of a return to 2001 in 2011. Planners need to consider the possibility that their clients will have become incapacitated by 2011 and will be unable to revise an estate plan that assumed the availability of a much larger estate exemption than that available after 2010. A return to the pre-EGTRRA rules would create a number of liquidity issues for estate planners and their clients.
Higher Taxes. Without the adoption of permanent legislation by the end of 2010, on Jan. 1, 2011, the payment of federal estate taxes will skyrocket for many estates. As pointed out in my previous article, at current inflation rates, the $675,000 exemption of 2001 will be roughly equivalent to the $1,000,000 estate exemption in 2011.
Wealthy decedents could be subject to both higher overall tax rates and lower exemptions. From 2007-2009, the federal estate tax rate will effectively be a flat 45%. The federal estate tax rate in 2001 capped out at 55% for estates above $3 million. Estates valued at over $10 million paid an additional 5% surtax (until the estate equals $17,184,000) designed to eliminate the benefit of the marginal tax rates below 55%.
The combination of a reduced estate exemption and a higher estate tax can have a significant impact on clients who have not planned on the higher cost. Let's look at 3 separate scenarios. First, assume a single taxpayer has a $1.5 million estate in 2007, growing at an annual rate of 5%. Scenario 1 shows the federal estate tax cost to the client from 2007-2013.
Instead, assume the client had an estate of $3 million (see Scenario 2), growing at an annual rate of 5%. Note the combined impact of a lower exemption and higher tax bracket. From 2008 to 2011, the estate taxes to this client will more than double. The combined effect of a lower exemption and higher tax rates can have a much greater impact than either planners or their clients expect.
Last, assume the above client had an estate of $10 million. Scenario 3 shows the impact of the 2007-2011 changes. Note that the combined lower exemption and higher tax rate in 2 years (from 2009 to 2011) increased the estate taxes by over $2.7 million.
Perhaps the most important aspect of these 3 scenarios is the reducing percentage of the estate that will ultimately pass to heirs. For example, in the last 2 scenarios, the combined impact of a higher tax and lower exemption causes a 19%-36% increase in the effective tax rate in the 2 years from 2009 to 2011.
