Estate Tax Battle Heats Up

May 18, 2006

Published in the AICPA Wealth Management Insider

As summer approaches, temperatures are rising.  And the battle in Congress over the future of the federal estate tax is heating up, too.

In 2005, the House passed a bill to completely repeal the “death tax.”  The Senate was ready to take up the issue after the Labor Day break last year, but Katrina came along and the vote never happened.  Senate GOP leaders promised that they would hold a vote on the federal estate tax in May, but now that vote will likely be delayed until early June. 

In the upcoming May or June vote, the Senate is unlikely to vote for a complete repeal of the estate tax.  For a bill to pass, 60 Senators must agree, and most in the Senate acknowledge that there are not 60 votes for repeal.   Instead, most anticipate a compromise bill from the Senate that would lessen the “death tax” burden. 

The latest estate tax proposal

The latest proposal for a compromise Senate bill, championed by Senator Jon Kyl (R-Ariz), would raise the exemption from estate tax to $5 million per person and lower the tax rate on amounts over $5 million to 15%.   This is a change from the current $2 million estate tax exemption and 46% tax rate.

The end of Crummey powers?

In addition to potential changes in the estate tax exemption and tax rate, rumors abound that the Senate may also take steps to do away with Crummey powers in gift trusts.  Many of you are familiar with this gift tax device, named after a famous tax case, where a donor to a trust allows a trust beneficiary a right to withdraw the contributed assets, in order to qualify the gift for tax-free treatment under the federal gift tax annual exclusion (currently $12,000). In anticipation of possible Congressional action on Crummey powers, some practitioners are advising clients to act now if they wish to create trusts that would take advantage of this gift-tax break, hoping that trusts in effect before the date of any new law will be grandfathered. 

No more dynasty trusts?

There is also talk that the Senate will do away with “dynasty” trusts.  Many of you have encountered a college professor who taught the dreaded “rule against perpetuities.”  Essentially, a rule against perpetuities codifies a government’s dislike for trusts that last for multiple generations, without the imposition of estate or inheritance tax as the assets move from one generation to the next.  Most states have their own particular versions of a rule against perpetuities, forcing assets in long-term trusts to finally become subject to transfer tax after a measured period of time, such as 90 years.  The classic rule, dreaded by all attorneys on law school exams, provides that a trust cannot last longer than the “lives in being” (including lives in gestation) on the date a trust becomes irrevocable, plus 21 years.  The “lives in being” is usually the group of the donor’s descendants who are living at the time.   

Certain enterprising states have done away with the rule against perpetuities, probably for two reasons: one, to reduce confusion (at least among the law students in their state); and two, to attract trust business to their state banks and trust companies.   Now, there seems to be a move afoot in the Senate to impose a federal rule against perpetuities, which would trump the more permissive laws passed by these enterprising states.  Once again, some practitioners are advising clients who may be interested in creating long-term dynasty trusts to take action now, before any possible Congressional action on this front.

Reform or Repeal

As the time for a Senate vote nears, what are the arguments being made for reform of the estate laws versus a complete repeal?

Those arguing for reform say that:

• A complete repeal would result in a loss billions of dollars of federal revenue, perhaps up to $1 trillion, over the next 10 years, unwise considering the increasing federal deficit and looming problems with Medicare and Social Security.
• With complete repeal comes also the loss of the change in income tax basis to fair market value at death.  When an inherited asset is later sold, the calculation of capital gain or loss will be cumbersome, if not impossible, in many cases.
• Family farms and small businesses fail to survive more than one generation due to a lack of good succession planning and unwillingness of the next generation to retain the business, but not due to the burden of the estate tax.  Robert Carlson, head of the North Dakota Farmers Union, recently reported that only 300 farm estates, or less than 1% of farms, are subject to estate tax each year. 
• Wealthy people give more to charity when the estate tax is in effect.  While it’s hard to measure a person’s motivation to give to charity, some worry that a zero estate tax world would reduce the incentive of large donors to make significant charitable gifts.
• Very wealthy families are pushing the repeal of estate tax in order to save millions, if not billions, of dollars in estate tax.  In late April, advocacy groups Public Citizen Group and United for a Fair Economy released a report, Spending Millions to Save Billions, claiming that certain high-profile families, including the families associated with Gallo wines, Campbell soups, Mars candy, and Wal-Mart, are promoting the repeal of estate tax because they stand to save more than $71 billion if the estate tax is repealed.
• Taxpayers would pay less to accountants and attorneys for estate tax compliance and for tax avoidance techniques if the estate tax exemption were increased and the tax applied to far fewer people.  [We may want to start planning our retirements earlier, or finding other ways to provide valuable services to our clients.]

Proponents of a complete repeal of the estate tax argue that:

• Small farms and family businesses are harmed by the estate tax, and many fail to pass to the next generation because of the estate tax burden. 
• Sure, wealthy families may save millions, if not billions, of dollars if the estate tax is repealed, but they will reinvest those savings into the economy, creating businesses and job opportunities, which in turn generates greater income tax revenue for the government. 
• The Congressional Joint Economic Committee (consisting of 12 Republicans and 8 Democrats), which may be a wealthy family’s new best friend, just released an extensive report, Costs and Consequences of the Federal Estate Tax, which finds that the arguments for repeal of the estate tax are strong, and the benefits of retaining the estate tax are few.
• The estate tax does not necessarily provide an incentive for people to give to charity at death.   In fact, of taxable estates in 2004, Costs and Consequences of the Federal Estate Tax reports that only 18.5% took advantage of the charitable deduction from estate tax.
• Taxpayers would pay nothing to accountants and attorneys for compliance costs and estate tax avoidance techniques. [But take heart, there may be more income tax work helping clients determine the income tax basis for those inherited assets.] 

The tax and finance industries, including CPAs, financial advisors, tax attorneys, and family business succession planners, will certainly be affected by any substantial change in the estate tax laws.  Whether it is for the better or for the worse, we’ll wait and see.  Life insurance companies that promote life insurance as a vehicle to pay estate tax may suffer a drop in sales if the tax burden is eased. 

Stay tuned.  Watch for news of Senate action in late May or early June.  Remember, the House will have to approve any compromise bill as well.