Expiration of estate tax creates opportunities, tough choices

As the clock wound down on the Federal estate tax late last year, some financial advisers and attorneys saw an opportunity for their high-net-worth clients in this extremely muddled situation.

The so-called death tax was slated to be repealed for one year as of Jan. 1, allowing those who die this year to escape a federal tax of up to 45% on estates valued at $3.5 million or more.

The tax will be reinstated in 2011 — at a rate of 55%.

For years, legislators in Washington have said they would make sure the estate tax law didn’t disappear by the end of last year. But with health care legislation taking center stage on Capitol Hill, the full Congress has yet to address the estate tax.

The House did pass a bill tackling the tax last month, but the Senate had no time to take up the issue.

“I have given up guessing what Congress is going to try to do,” said Catherine G. Schmidt, a partner with Patterson Belknap Webb & Tyler LLP. “I’m astounded that they let us get to a full repeal of the law when they said for so long this wouldn’t happen.”

It is likely that when Congress does get around to addressing the estate tax law issue this year, it will make it retroactive to Jan. 1.

“Clearly, the correct public policy is to achieve continuity with respect to the estate tax,” said Senate Finance Committee Chairman Max Baucus, D-Mont., speaking on the Senate floor Dec. 16. “We’ll clearly work to do this retroactively.”

But even if legislation is retroactive, experts think that this loophole provides an opportunity for high-net-worth individuals to leave money to heirs at a lower tax rate than they will undoubtedly pay once legislation is in place.

Specifically, with the expiration of the estate tax law, the generation skip tax also disappears. This means that as of Jan. 1, individuals can gift up to $3.5 million to grandchildren and pay only gift tax on the money.

“This is a big planning opportunity for advisers,” said Tom Karsten, managing partner of Karsten Financial LP.

One way advisers can take advantage of this is by adding legal language that allows a client to make a gift to grandchildren but stipulates that they can take it back if the law changes.

Similarly, Ms. Schmidt is telling clients to stipulate that the gift to their grandchildren is contingent on the tax laws’ remaining favorable.

Another way to get around this issue is by setting up a qualified terminable interest property trust, said Gail Cohen, head of global wealth management at Fiduciary Trust International. With the trust, a surviving spouse receives income for life, the principal is left to an heir, and no gift tax is paid.

The account owners can elect to set up a “reverse QTIP” that allows them to take advantage of the generation-skipping tax exemption amount in effect the year the gift is made. So for 2009, the exemption could be locked in at $3.5 million.

“I am telling clients to take advantage of this now, because the reverse-QTIP provision might go away in 2011,” Ms. Cohen said.

It gets a bit more complicated regarding what to do if clients die before Congress addresses the estate tax law. At least for the short term, it is possible that heirs could receive up to $3.5 million without paying taxes on an estate.

No one knows if those heirs will be taxed retroactively.

“What if you know someone is terminal and you can settle the estate quickly? It’s unclear what would happen if you get a closing letter from the Internal Revenue Service before Congress passes legislation that makes the estate tax retroactive,” Mr. Karsten said.

“I have had conversations about this with clients who have parents on life support,” said Jeffrey B. Kolodny, a partner with Phillips Nizer LLP.

“They might want to keep them on life support until January. For someone who has $5 million to $10 million in the estate, this is a huge opportunity,” he said.

E-mail Jessica Toonkel Marquez at [email protected].