Estate Tax Repeal and Surprising Matrimonial Implications

As with any new law, the ripple effects take a while to sort out. The 2010 Tax Act estate tax provisions were a game-changer, the effects of which will be felt by matrimonial practitioners for many years. This article discusses possible issues, traps, or opportunities that might arise as a result of the new law. As with any new development, practitioners need to be wary.

A Bit of History and Background

No advisers believed estate tax repeal would occur in 2010, but it did ' then it didn't. Repeal was real for almost all of 2010, but the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “TRA”) Public Law number, P.L. 111-312, signed into law by President Obama on Dec. 17, 2010, made the repeal effectively optional for 2010 decedents. Moreover, the generosity of the TRA is short-lived ' only two years. The mechanism of creating that generosity was generally to extend for two years the estate tax breaks contained in the 2001 Bush tax legislation. However, in 2013, the repeal of the 2001 repeal itself ends. This means that the $1 million exclusion and 55% rate will become law in 2013. Although Congress might resolve the confusion and uncertainty before 2013, many estate-tax practitioners are concerned that 2013 will bear witness to the same tax uncertainty as did 2010. There could be a gap period, similar to that of 2010, when the applicable law will be uncertain.

The Fall-out from 2010

The potential impact of 2010 estate-planning changes, the uncertainty as to future law, will affect matrimonial matters for years to come. The estate-planning implications of these circumstances had estate practitioners recommending steps in 2010 that could have unintended ' and potentially significantly adverse ' matrimonial consequences. Unfortunately, matrimonial practitioners will likely be scrambling around in 2013 and the months leading up to it, the way they were in 2010.

Large 2010 Gifts

For a significant portion of 2010, it was believed by many tax practitioners that consummating taxable gifts (above the $13,000 annual exclusion and $1 million lifetime exclusion), which were only taxed at the bargain rate of 35% in 2010, was a great planning idea. When contrasted with the 55% rate that was expected to apply to taxable gifts in 2011, that was potentially a 20% spread. Intentionally incurring a gift tax may have represented a 20% rate arbitrage, or so taxpayers and their advisers thought. Then the Baucus bill, introduced on Dec. 2, which proposed limiting the lower gift tax to gifts prior to that date, abruptly put a stop to most tax-oriented large gifts. However, on Dec. 17, the President signed historic estate-reduction legislation (a shock to many, if not most, estate planners). Instead of a 2001 rate increase to 55%, the rate was reduced to 35%. What did this all mean to estate planning and how might it affect matrimonial planning? One reason some wealthy clients made large gifts in 2010 before the new law became known was the anticipation of removing gift tax from their estates. If the gift tax is paid on transfers made within three years of death, the gift tax is included in the decedent's gross estate. IRC Sec. 2035. This would have provided significant estate tax planning leverage, depending on how the gift tax credit is calculated. If it is calculated as if the gift tax were paid at the 55% rate, the payment of gift tax at the 35% rate will provide in itself a tax benefit. One possible interpretation was that the estate will receive a credit for gift tax paid as if the gift had been made in 2011. IRC Sec. 2001(b). If the client survived for three years, the gift tax paid would be entirely excluded from the decedent donor's estate.

The relevance of this is that wealthy clients fearing the possibility of a reversion in 2011 to much harsher estate-tax rules may have pushed through gifts that they otherwise would not have made. In 2011, this will all be complicated as many of the wealthy taxpayers who made these gifts endeavored to revoke them in light of the new tax law changes.

Matrimonial Planning Consideration

When practitioners are engaging in forensic analysis that includes 2010-2011, being alert to these issues might have a significant impact. (Again in 2012, the same situation is likely to arise.) One of the issues that might come up is whether the non-donor spouse consented to the gifts. If gift tax returns are prepared early, or joint gift letters (informal letters acknowledging that the transfers are gifts that are employed by many estate planners) are used to confirm the intent to make a gift, it may be difficult to deny later that the impact of the gift was not understood. If your client is the donor, efforts should be made to obtain the written consent of the other spouse to minimize any problems that may arise at a later date. If you are evaluating a wealthy client's asset base concerning a matrimonial action, obtaining copies of gift tax returns, especially given the anomaly of the 2010 tax regime, might prove vital. Finally, be alert to the attempts to revoke, or recharacterize, gifts made in 2010. Clients that made taxable gifts in 2010 might have been better off waiting until 2011 and making the same transfers when the $5 million exemption would have sheltered the gift from tax. Unfortunately, no one could have known this until late December.

Gifts to or Trusts for Grandchildren

The generation-skipping transfer tax (“GST”) was repealed for most of 2010, then retroactively reinstated to Jan. 1, 2010, but with a 0% tax rate. Astute ex-spouses may well have used the 2010 tax uncertainty as an excuse to justify pre-divorce planning steps.

Matrimonial Planning Considerations

Matrimonial practitioners should be alert to ex-spouses having made or planned transfers to grandchildren to deplete the marital estate. In blended families, these may well have taken the guise of gifts to grandchildren from the ex-spouse's prior marriage that depleted current marital assets. The issue to evaluate with hindsight will be whether these gifts were just good estate tax planning or were they instead a subterfuge of pre-divorce planning from the current spouse at the time the gifts were made?

Whatever is done concerning GST allocation, in January, all 2010 potential GST transfers should have been evaluated to determine what special GST treatment should be chosen (a late allocation of GST exemption, affirmative election out of GST allocation, etc.).

There are a number of implications to consider. The incentive for large outright transfers to grandchildren, gifts to trusts that only had grandchildren (more technically, “skip-persons”) as beneficiaries in 2010 was substantial. As discussed above with respect to the gift tax, matrimonial counsel should endeavor to confirm that the economic consequences of these types of transfers were really understood by the non-donor spouse, and not a subterfuge for pre-divorce planning.

Trustees Distribute to Grandchildren from Trusts in 2010

If your client had an irrevocable trust that was not exempt from GST tax in 2010, there was a potential tax benefit because the trust might have been able to make a distribution to a grandchild (or other skip-person) without any GST tax if distributions were made to grandchildren in 2010 when no GST applied.

Matrimonial Implication

The question remains: If the funds in a trust that was intended to help children are fully distributed to grandchildren, what impact might this have on family financial obligations in future years if a divorce occurs? Did a grandparent encourage this to prevent a divorcing child's soon to be ex-spouse from asserting an interest in, or even consideration of, a trust interest? As with many of the issues noted above the question for matrimonial counsel in hindsight will be whether the busting of a valuable trust was really done for legitimate estate and GST tax purposes in 2010. Or was it only the excuse used to justify steps that were really pre-divorce planning. For example, if your client was the co-trustee that authorized such distribution, was it really for tax planning or as a result of her now'ex-husband pressuring her to distribute funds out of the trust she controlled to minimize her involvement? Will your client, the trustee, now be exposed to liability because those funds have been distributed and can no longer be controlled?

Conclusion

This article has presented a number of disparate ideas of how matrimonial practice might be affected by recent estate tax legislation. Unfortunately, there are currently no firm answers for the future.

Martin M. Shenkman, CPA, MBA, PFS, JD, a member of this newsletter's Board of Editors, is an estate and tax practitioner and expert witness in Paramus, NJ. He provides a free planning newsletter that is available on www.laweasy.com; he co-authored Estate Planning After the Tax Relief and Job Creation Act of 2010: Tools, Tips, and Tactics, available from the AICPA on www.cpa2biz.com.

As with any new law, the ripple effects take a while to sort out. The 2010 Tax Act estate tax provisions were a game-changer, the effects of which will be felt by matrimonial practitioners for many years. This article discusses possible issues, traps, or opportunities that might arise as a result of the new law. As with any new development, practitioners need to be wary.

A Bit of History and Background

No advisers believed estate tax repeal would occur in 2010, but it did ' then it didn't. Repeal was real for almost all of 2010, but the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “TRA”) Public Law number, P.L. 111-312, signed into law by President Obama on Dec. 17, 2010, made the repeal effectively optional for 2010 decedents. Moreover, the generosity of the TRA is short-lived ' only two years. The mechanism of creating that generosity was generally to extend for two years the estate tax breaks contained in the 2001 Bush tax legislation. However, in 2013, the repeal of the 2001 repeal itself ends. This means that the $1 million exclusion and 55% rate will become law in 2013. Although Congress might resolve the confusion and uncertainty before 2013, many estate-tax practitioners are concerned that 2013 will bear witness to the same tax uncertainty as did 2010. There could be a gap period, similar to that of 2010, when the applicable law will be uncertain.

The Fall-out from 2010

The potential impact of 2010 estate-planning changes, the uncertainty as to future law, will affect matrimonial matters for years to come. The estate-planning implications of these circumstances had estate practitioners recommending steps in 2010 that could have unintended ' and potentially significantly adverse ' matrimonial consequences. Unfortunately, matrimonial practitioners will likely be scrambling around in 2013 and the months leading up to it, the way they were in 2010.

Large 2010 Gifts

For a significant portion of 2010, it was believed by many tax practitioners that consummating taxable gifts (above the $13,000 annual exclusion and $1 million lifetime exclusion), which were only taxed at the bargain rate of 35% in 2010, was a great planning idea. When contrasted with the 55% rate that was expected to apply to taxable gifts in 2011, that was potentially a 20% spread. Intentionally incurring a gift tax may have represented a 20% rate arbitrage, or so taxpayers and their advisers thought. Then the Baucus bill, introduced on Dec. 2, which proposed limiting the lower gift tax to gifts prior to that date, abruptly put a stop to most tax-oriented large gifts. However, on Dec. 17, the President signed historic estate-reduction legislation (a shock to many, if not most, estate planners). Instead of a 2001 rate increase to 55%, the rate was reduced to 35%. What did this all mean to estate planning and how might it affect matrimonial planning? One reason some wealthy clients made large gifts in 2010 before the new law became known was the anticipation of removing gift tax from their estates. If the gift tax is paid on transfers made within three years of death, the gift tax is included in the decedent's gross estate. IRC Sec. 2035. This would have provided significant estate tax planning leverage, depending on how the gift tax credit is calculated. If it is calculated as if the gift tax were paid at the 55% rate, the payment of gift tax at the 35% rate will provide in itself a tax benefit. One possible interpretation was that the estate will receive a credit for gift tax paid as if the gift had been made in 2011. IRC Sec. 2001(b). If the client survived for three years, the gift tax paid would be entirely excluded from the decedent donor's estate.

The relevance of this is that wealthy clients fearing the possibility of a reversion in 2011 to much harsher estate-tax rules may have pushed through gifts that they otherwise would not have made. In 2011, this will all be complicated as many of the wealthy taxpayers who made these gifts endeavored to revoke them in light of the new tax law changes.

Matrimonial Planning Consideration

When practitioners are engaging in forensic analysis that includes 2010-2011, being alert to these issues might have a significant impact. (Again in 2012, the same situation is likely to arise.) One of the issues that might come up is whether the non-donor spouse consented to the gifts. If gift tax returns are prepared early, or joint gift letters (informal letters acknowledging that the transfers are gifts that are employed by many estate planners) are used to confirm the intent to make a gift, it may be difficult to deny later that the impact of the gift was not understood. If your client is the donor, efforts should be made to obtain the written consent of the other spouse to minimize any problems that may arise at a later date. If you are evaluating a wealthy client's asset base concerning a matrimonial action, obtaining copies of gift tax returns, especially given the anomaly of the 2010 tax regime, might prove vital. Finally, be alert to the attempts to revoke, or recharacterize, gifts made in 2010. Clients that made taxable gifts in 2010 might have been better off waiting until 2011 and making the same transfers when the $5 million exemption would have sheltered the gift from tax. Unfortunately, no one could have known this until late December.

Gifts to or Trusts for Grandchildren

The generation-skipping transfer tax (“GST”) was repealed for most of 2010, then retroactively reinstated to Jan. 1, 2010, but with a 0% tax rate. Astute ex-spouses may well have used the 2010 tax uncertainty as an excuse to justify pre-divorce planning steps.

Matrimonial Planning Considerations

Matrimonial practitioners should be alert to ex-spouses having made or planned transfers to grandchildren to deplete the marital estate. In blended families, these may well have taken the guise of gifts to grandchildren from the ex-spouse's prior marriage that depleted current marital assets. The issue to evaluate with hindsight will be whether these gifts were just good estate tax planning or were they instead a subterfuge of pre-divorce planning from the current spouse at the time the gifts were made?

Whatever is done concerning GST allocation, in January, all 2010 potential GST transfers should have been evaluated to determine what special GST treatment should be chosen (a late allocation of GST exemption, affirmative election out of GST allocation, etc.).

There are a number of implications to consider. The incentive for large outright transfers to grandchildren, gifts to trusts that only had grandchildren (more technically, “skip-persons”) as beneficiaries in 2010 was substantial. As discussed above with respect to the gift tax, matrimonial counsel should endeavor to confirm that the economic consequences of these types of transfers were really understood by the non-donor spouse, and not a subterfuge for pre-divorce planning.

Trustees Distribute to Grandchildren from Trusts in 2010

If your client had an irrevocable trust that was not exempt from GST tax in 2010, there was a potential tax benefit because the trust might have been able to make a distribution to a grandchild (or other skip-person) without any GST tax if distributions were made to grandchildren in 2010 when no GST applied.

Matrimonial Implication

The question remains: If the funds in a trust that was intended to help children are fully distributed to grandchildren, what impact might this have on family financial obligations in future years if a divorce occurs? Did a grandparent encourage this to prevent a divorcing child's soon to be ex-spouse from asserting an interest in, or even consideration of, a trust interest? As with many of the issues noted above the question for matrimonial counsel in hindsight will be whether the busting of a valuable trust was really done for legitimate estate and GST tax purposes in 2010. Or was it only the excuse used to justify steps that were really pre-divorce planning. For example, if your client was the co-trustee that authorized such distribution, was it really for tax planning or as a result of her now'ex-husband pressuring her to distribute funds out of the trust she controlled to minimize her involvement? Will your client, the trustee, now be exposed to liability because those funds have been distributed and can no longer be controlled?

Conclusion

This article has presented a number of disparate ideas of how matrimonial practice might be affected by recent estate tax legislation. Unfortunately, there are currently no firm answers for the future.

Martin M. Shenkman, CPA, MBA, PFS, JD, a member of this newsletter's Board of Editors, is an estate and tax practitioner and expert witness in Paramus, NJ. He provides a free planning newsletter that is available on www.laweasy.com; he co-authored Estate Planning After the Tax Relief and Job Creation Act of 2010: Tools, Tips, and Tactics, available from the AICPA on www.cpa2biz.com.