Estate Tax Proposals from the Finance Committee Chairman

Capital Letter No. 15

March 27, 2009

By Ronald D. Aucutt

An important Senate bill would make 2009 estate tax law permanent, reconform the gift tax to the estate tax, and make the estate and gift tax unified credit portable between spouses.

Dear Readers Who Follow Washington Developments:

Those of us who expect a permanent estate tax legislative solution to most likely come from “Senators in the middle” (see Capital Letters 8 and 9) pay close attention to Chairman Max Baucus (D-MT) of the Senate Finance Committee. Thus, on March 26, 2009, when Senator Baucus introduced the Taxpayer Certainty and Relief Act of 2009 (S. 722), including Title III captioned “Permanent Estate Tax Relief,” it was significant.

Permanent Rates and Exemptions

Not surprisingly, S. 722 would make permanent the current $3.5 million estate tax applicable exclusion amount and 45% rate. This is consistent with the Obama Administration’s budget proposals. It would again fully unify the gift tax with the estate tax by providing a single exclusion amount of $3.5 million, and it would also make the cap on the reduction of value under the special use valuation provisions of section 2032A equal to the applicable exclusion amount. Beginning in 2011, it would index the applicable exclusion amount for inflation.

S. 722 would also make permanent the other transfer tax changes made by the Economic Growth and Tax Relief Act of 2001, including the rules affecting the allocation of GST exemption. And it would provide for the long-awaited “portability” of the unused gift and estate tax unified credit of a deceased spouse to the surviving spouse and the surviving spouse’s estate.

Historical Perspective

The Capital Letter series was launched in the last months of the Republican-led Congress in 2006, not long after a Senate “cloture” vote had fallen short of the 60 votes needed to take up consideration of H.R. 5970, the “Estate Tax and Extension of Tax Relief Act of 2006” (“ETETRA”). An explicit commitment of Capital Letter No. 1 was to monitor what, if anything, ETETRA might teach us about future estate tax legislation. Compared to ETETRA, there are five important differences in S. 722. The exemption is frozen at $3.5 million; ETETRA would have raised it over a five-year period to $5 million. The rate remains 45%; ETETRA would have reduced the top rate over five years to 30% and would have applied a rate equal to the capital gain tax rate on amounts below $25 million. The section 2058 deduction for state death taxes is retained; ETETRA would have repealed it. And, as stated, unlike ETETRA, S. 722 removes the 2011 “sunset” on all transfer tax changes and ties the cap on the special use valuation reduction to the applicable exclusion amount.

Currently, the cap on the special use valuation reduction is $1 million, which is the stated statutory cap of $750,000, indexed for inflation since 1999. Under S. 722, it would be raised to $3.5 million, indexed after 2010. In effect, S. 722 would double the exemption for estates containing the right mix of farm or other special use property.

Portable Unified Credit

The portability provisions of S. 722 are identical to those in ETETRA, except that the iterative portability of the unified credit to spouses of spouses is prohibited. In other words, if Husband 1 dies after 2009 without using his full exclusion amount, and his widow, Wife, marries Husband 2 and then dies, Wife’s estate could use her own exclusion amount plus whatever amount of Husband 1’s exclusion amount was not used. Husband 2’s estate could use his own exclusion amount plus whatever amount of Wife’s basic exclusion amount was not used. But Husband 2’s estate could not use any of Husband 1’s unused exclusion amount transmitted through Wife’s estate. (Portability techies call this “requiring privity.”) Husband 2’s estate could still use the unused exclusion amount of any number of his predeceased wives (and S. 722 would make that explicit), subject only to the overall limitation that the survivor’s exclusion amount could be no more than doubled.

ACTEC recommended other changes to the ETETRA portability rules that are not incorporated in S. 722. For example, S. 722 does not extend portability to the GST tax; this has probably been given about as much congressional staff attention as can be expected and is unlikely to change. S. 722 still requires an affirmative election of portability on the estate tax return of the predeceased spouse; practitioners who remember bad experiences with other elections in the past will no doubt continue to criticize this requirement and advocate an election-out approach or at least a recognition of late elections, but the underlying requirement that a return be filed for the first spouse to die is unlikely to be relaxed.

S. 722 does retain a provision that the “[t]he Secretary shall prescribe such regulations as may be necessary or appropriate to carry out this subsection,” and that will provide a welcome second opportunity to address issues of administrability. ACTEC recommended adding “the purposes of” before “this subsection” to clarify Treasury’s ability to ease the administration of portability by “legislative regulations” (as in section 2663 with respect to the GST tax), but perhaps the congressional drafters believe that to be unnecessary.

Even if some form of portability is enacted, many of our clients will continue to use credit shelter trusts, in order to exclude from the surviving spouse’s gross estate what many hope to see as appreciation in the future (recognizing the impact of that choice on basis), and of course to allocate GST exemption if portability remains limited to the gift and estate taxes. But portability is both popular and “populist” (in the political sense), because it will mostly benefit folks at the lower end of estate tax payers – the closest the estate tax comes to a “middle class” impact.

Broad Appeal and Support

As “middle class” tax relief, S. 722 would also address the individual alternative minimum tax, the regular and capital gains tax rates for lower- and middle-income taxpayers, the child tax credit, marriage penalty relief, the dependent care credit, the adoption credit and adoption assistance programs, and the earned income tax credit. That grouping of hot topics, plus the support the bill has – in addition to Chairman Baucus, it is cosponsored by two other Finance Committee Democrats, Senators Rockefeller (D-WV) and Schumer (D-NY) – make S. 722 a serious legislative proposal.

S. 722 will not be enacted. Tax legislation, we remember, must originate in the House of Representatives. But we should watch it to see if it attracts full or partial support of other Finance Committee members, perhaps including Republicans, and to see how it is received and treated by the Senate leadership. Significant traction for S. 722 will be noticed by those who draft tax legislation in the House, especially since it includes AMT relief, which is a priority for Chairman Rangel (D-NY) of the Ways and Means Committee. Alternatively, all or part of S. 722 could be added as a Senate amendment to a House-passed tax bill. Either way, with 2009 already one-fourth gone, and with less urgency about the estate tax currently exhibited in the House, this could be an important step toward the stability we have sought for almost eight years. Ronald D. Aucutt