This is the beginning of what congressional leaders hope will be the final three weeks of the current Congress. Taxes are on the agenda, including the now-famous expiring “Bush tax cuts” – that is, income tax cuts – that could be the vehicle for addressing the estate, gift, and GST taxes too, but probably won’t be. Other things that seem at least moderately important, like passing a budget or a continuing resolution that will keep the government open, are pressing too, along with a host of arguably less time-critical but persistent measures.
If Congress is able to work a transfer tax fix into a tax bill in this Lame Duck session, it is possible that it would do no more than revive 2009 law and extend it for two or three years, giving the executors of decedents who have died since December 31, 2009, the opportunity to elect out of the estate tax and back into the 2010 carryover basis law. Such a short-term extension may have even less appeal than it would in an income tax context, because some in Congress may have figured out that the long-term perspective and long-term tax profile that characterize the transfer taxes are different from typical income tax policy considerations. But anything is possible. And no one is going to be surprised again if Congress does nothing at all this year.
If Congress does act and decides to try to make the fix a little more permanent (as permanent as any statute that Congress has the power to change), look for 2009 law to be the baseline, and some departure from that baseline – either an exemption higher than $3.5 million, or a rate lower than 45 percent, or both – to be a likely political price that has to be paid for permanence. After all, in aspirational budget resolution amendments, 71 current Senators voted for a $5 million exemption and 35 percent rate in at least one of two separate votes on March 12, 2008, and 51 current Senators voted for a $5 million exemption and 35 percent rate in the same vote on April 2, 2009 (discussed in Capital Letter Number 16).
“Pay For” Challenges, Including Possible Effective Date Surprises
There are several ways Congress might choose to mitigate the revenue cost of transfer tax reform. An obvious way is to raise the exemption above $3.5 million but not as high as $5 million or to lower the rate below 45 percent but not as low as 35 percent, although such a compromise is not likely to have enough appeal for all sides. Another way is to phase in any relief over several years, such as the ten-year phase-in of the $5 million exemption and 35 percent rate in the “Estate Tax Relief Act of 2009” (H.R. 3905) introduced by Ways and Means Committee Members Shelley Berkley (D-NV), Kevin Brady (R-TX), Artur Davis (D-AL), and Devin Nunes (R-CA) on October 22, 2009, but by all means avoiding a cliff or sunset like Congress enacted in 2001.
It is also possible to reduce the cost of tax reform at the front end. There is not much of 2010 left, but if Congress can actually find a way to enact something in the next couple weeks, surely they can spot the revenue to be gained by making the reinstatement of 2009 law effective immediately. That could be good news for those who are looking for GST exemption in 2010, and bad news for those who have designed gifts to take effect on December 31. But it would at least end the bawdy speculation about year-end suicides or even homicides to save estate tax.
Still another way to “pay for” tax relief, at least in part, is the old-fashioned way of including selected revenue raisers. The problem is that there aren’t many available revenue raising suggestions that there is any reason to think Congress has any short-term interest in. But in a political climate in which Congress can bend “pay for” rules when it wants to, especially for a tax cut, a partial offset might be enough. The low-tax folks in Congress can take credit for lowering taxes, while the high-tax folks can take credit that the loss of revenue wasn’t worse. So goes politics.
The Administration’s Revenue Proposals Revisited
The Treasury Department’s “General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals” (“2009 Greenbook”), published on May 11, 2009, and “General Explanations of the Administration’s Fiscal Year 2011 Revenue Proposals” (“2010 Greenbook”), published on February 1, 2010, both proposed three revenue raisers relating to the estate and gift taxes – requiring consistency in basis reporting, modifying the rules for valuation discounts, and requiring a minimum ten-year term for GRATs. Capital Letter Number 17 speculated about the purpose, scope, and effect of these proposals, but concluded that greater clarity would have to wait until they were reduced to statutory language and considered by Congress.
Requiring Consistency in Basis Reporting
Emerging statutory language regarding consistent basis reporting is found in section 6 of the “Responsible Estate Tax Act” (S. 3533), a bill the press dubbed “the liberals’ bill” when it was introduced on June 24, 2010, by Senators Sanders (I-VT), Whitehouse (D-RI), Harkin (D-IA), Brown (D-OH), and Franken (D-MN). A companion bill, H.R. 5764, was introduced in the House by Rep. Linda Sanchez (D-CA) on July 15, 2010. Among other things, these bills would restore a unified credit equivalent to a $3.5 million exemption, with a flat 39 percent rate used to calculate the pre-unified credit tax on the amount of the taxable estate from $750,000 to $3.5 million. The tax would then be imposed at rates of 45 percent over $3.5 million, 50 percent over $10 million, 55 percent over $50 million, and 65 percent over $500 million.
One of the mysteries of the consistent basis proposal has been how basis would be affected by increases in estate tax value resulting from an estate tax audit. For example, on September 8, 2009, the staff of the Joint Committee on Taxation released a publication entitled “Description of Revenue Provisions in President’s Fiscal Year 2010 Budget Proposal, Part One: Individual Income Tax, Estate and Gift Tax Provisions.” Regarding the basis proposal, the JCT publication ominously stated (emphasis added):
The proposal requires that the basis of property received by reason of death under section 1014 generally must equal the value of that property claimed by the decedent’s estate for estate tax purposes.…
Under the proposal there would be instances in which the value of an asset reported by an executor to an heir differs from the ultimate value of the asset used for estate tax purposes. For example, if the IRS challenges an estate valuation and prevails, the executor will have reported to the heir a valuation that is artificially low, and the heir may arguably be overtaxed on a subsequent sale of the asset. This same problem exists under present law to the extent the initially reported estate tax value is presumptively the heir’s basis. To provide complete consistency between estate tax valuation and basis in the hands of an heir may be impractical as ultimate determination of value for estate tax purposes may depend upon litigation, and an heir may sell an asset before the determination of value for estate tax purposes.
By requiring the value of an asset reported for transfer tax purposes to be reported and used by the heir or donee in determining basis, however, the proposal has the salutary effect of encouraging a more realistic value determination in the first instance. This salutary effect would be lost if there were a relief mechanism for transferees and transferors (and recoupment for the government) if the basis used by transferees differed from the fair market value ultimately determined for transfer tax purposes. Thus, the proposal does not contain any such relief mechanism.
It is hard to reconcile this with the Greenbook’s statement that “[t]his proposal would require that the basis of the property in the hands of the recipient be no greater than the value of that property as determined for estate or gift tax purposes …” (emphasis added).
Under section 6 of the Responsible Estate Tax Act, a new section 6035(a) would require executors to report to the Service and to each person receiving property from a decedent the fair market value (or other relevant attributes) of all such property, and a new section 6035(b) would require donors of gifts to report comparable information, including the donor’s adjusted basis in every case, to the Service and to donees. As anticipated in the Greenbooks, Treasury would be authorized to prescribe regulations (1) applying the rules to situations where no estate tax return is required or to gifts excluded by section 2503, (2) addressing “situations in which the surviving joint tenant or other recipient may have better information than the executor,” and (3) addressing “the timing of the required reporting in the event of adjustments to the reported value subsequent to the filing of an estate or gift tax return.”
The reference to “the timing of the required reporting in the event of adjustments to the reported value subsequent to the filing of an estate of gift tax return” appears relevant to the JCT staff’s suggestion that basis must be the value originally claimed on an estate tax return, without regard to subsequent adjustments. But, being cast in terms of the “timing” of the “reporting,” it provides little clarity. The statutory language does not use the phrase “as determined for estate or gift tax purposes” that the Greenbooks use, and even the Greenbooks do not use the familiar well-understood phrase “as finally determined for estate or gift tax purposes.” The evolution of this issue bears watching.
Modifying the Rules for Valuation Discounts
As for the Administration proposal on valuation discounts, S. 3533 and H.R. 5764 are no help. They recapitulate the same valuation discount provisions included in the first Pomeroy bill, H.R. 436, discussed in Capital Letter Number 14, basically a combination of look-through rules and family attribution rules traceable back to the Clinton Administration and even the Reagan Administration. The current Administration’s proposals depend exclusively on bulked-up regulatory authority to define a new category of “disregarded restrictions” (measured against standards prescribed in regulations, not against default state law) and related operating rules and safe harbors. As such, they remain somewhat of a mystery, although Treasury and the Service have no doubt been working on the outline of these regulations for some time under the regulatory authority already conferred by section 2704(b)(4).
Requiring a Minimum Ten-Year Term for GRATs
With respect to the requirement that GRATs have a minimum term of ten years, the 2010 Greenbook also would require that the remainder interest have a value greater than zero and would prohibit any decrease in the annuity during the GRAT term. Implementing statutory language was included in the “Small Business and Infrastructure Jobs Tax Act of 2010” (H.R. 4849), which the House of Representatives passed by a vote of 246-178 on March 25, 2010, in the “Small Business Jobs Tax Relief Act of 2010” (H.R. 5486), which the House passed by a vote of 247-170 on June 15, 2010, and in the supplemental appropriations bill (H.R. 4849) that the House approved on July 1, 2010. The same language was also in section 8 of “the liberals’ bill” (S. 3533 and H.R. 5764).
The statutory language in these bills is neither surprising nor alarming. Paragraphs (1), (2), and (3) of section 2702(b), which now set forth the three types of “qualified interests,” would become subparagraphs (A), (B), and (C) of section 2702(b)(1), with subparagraph (A) preserving the GRAT standard of “any interest which consists of the right to receive fixed amounts payable not less frequently than annually.” A new section 2702(b)(2) would simply add that “an interest [otherwise] described in paragraph (1)(A) … shall be treated as described in such paragraph only if—(A) the right to receive the fixed amounts referred to in such paragraph is for a term of not less than 10 years, (B) such fixed amounts, when determined on an annual basis, do not decrease relative to any prior year during the first 10 years of the term referred to in subparagraph (A), and (C) the remainder interest has a value greater than zero determined as of the time of the transfer.”
While it is not explained, the prohibition on decreased annuity payments is presumably aimed at preventing a GRAT from being designed in the conventional way for the first two years and then pay a dollar a year in the third through tenth years, thereby arguably limiting the estate tax exposure under Reg. § 20.2036-1(c)(2)(i) after the second year to the amount needed to produce an annuity of one dollar in perpetuity – fifty dollars under this month’s 7520 rate of 2 percent.
Similarly without explanation, the requirement of a remainder interest greater than zero presumably targets the truly zeroed-out GRAT, which could be thought to escape section 2036 altogether because an annuity stream exactly equal in value to the transferred property constitutes “adequate and full consideration” within the meaning of section 2036(a). Significantly, however, the pending legislation does not require the present value of the remainder interest to exceed zero by any prescribed amount, such as 10 percent as has sometimes been posited. Such a requirement may still be added at some point, although it could be counterproductive from the perspective of raising estate tax revenue over the next ten years if it discourages the use of GRATs altogether and merely redirects planning efforts to other techniques such as installment sales.
Back to “Pay For” Challenges
As the Administration proposals are considered in the context of a transfer tax fix, the revenue estimates, of course, are relevant. The 2010 Greenbook estimates that, over ten years, consistent basis reporting will raise about $2 billion, modified valuation rules will raise about $19 billion, and a minimum ten-year term for GRATs will raise about $3 billion. But other revenue estimators, including the staff of the Joint Committee on Taxation, are unable to confirm a revenue estimate for the valuation proposal that depends on regulations that are not yet promulgated. Even without that problem, the valuation proposal itself appears to have little appeal to lawmakers who are likely to forge any compromise. That leaves about $5 billion from the other two proposals. In contrast, 2009 estimates of the ten-year loss of revenue from simply making 2009 law permanent, even including the revenue gain from continuing the 2009 estate tax through 2010, ranged from $230 billion to $260 billion. Many estate planners thought that those revenue loss numbers seemed to be on the high side, but they would have to be way off before $5 billion would be even a credible down payment.
Thus, the most obvious revenue raisers will not help Congress much. But, again, it is the nature of politics that any effort to include even grossly mismatched revenue raisers can justify a claim of victory. So it could still be a good idea to expeditiously complete the two-year GRAT, or even the transfer of family limited partnership interests, that is now in progress.