“Taxmageddon” and Its Impact on Estate Planning
Taxmageddon is coming. This is the rather clever term being used to describe the impact of Congress’ apparent inability to address the self-created deadline of December 31, 2012, when all of the so-called “Bush Tax Cuts” from 2001 are sunsetted, and the self-imposed $1 trillion dollars in spending cuts from the federal defense budget and federal social programs to be implemented.
If Congress does nothing about the budget and tax issues, it is estimated that there will be a resulting $494 billion tax increase in 2013. Couple that increase with the $1 trillion cuts in spending, it is easy to understand why our economy will certainly be facing a Taxmageddon.
So, how does Taxmageddon impact decisions about estate and estate tax planning?
The federal estate taxes, which the Republicans wanted to abolish, the plan was to gradually reduce the estate taxes over a 10-year period, so that in the tenth year, they would no longer exist. The thought was that at some point during that 10-year continuum, the wisdom behind abolishing this tax would be recognized by enough members of the Senate the estate tax could be permanently ended.
The Bush Tax Cuts were passed in June 2001. The events of 9/11 occurred very soon afterwards, and history was changed forever. Unfortunately, the tax laws didn’t change accordingly.
Instead, the gradual reductions in the federal estate tax continued, as planned. Some states, like Maryland, felt compelled to “decouple” from the federal estate tax system. Prior to 2001, state estate taxes, such as Maryland’s, were treated as tax credits on the estate tax return. This meant that, dollar for dollar, any estate tax paid to a state was deducted from any federal estate due. Thus, the impact of the state estate tax was negligible on a deceased’s overall estate tax.
The Bush Tax Cuts changed the formula for state estate taxes. Under the new law, state estate taxes are treated as tax deductions from on a federal estate tax return. This means that whatever is paid to a state is treated as a reduction to the taxable estate of the deceased, not as a credit on the federal estate tax return. In other words, the state estate tax now has a real impact on the overall taxes being paid by an estate.
Furthermore, under the pre-2001 tax laws, most states did not impose its estate tax unless there was an estate large enough to be taxed at the federal level. In 2001, that amount was $675,000. The Bush Tax Cuts immediately increased the size of a taxable estate to $1 million in 2001, then to $1.5 million in 2004, then to $2.0 million in 2006, then to $3.5 million in 2009, and, finally, no estate tax in 2010.
Many states, including Maryland, foresaw too much potential tax revenue disappearing if Maryland stayed connected to the federal system. So, these states decoupled. Now, Maryland has its own estate tax that taxes any taxable estate in excess of $1 million, starting with a marginal tax rate of 5.5%, going up to 16% on estates larger than $10 million.
At the federal level, in 2010, President Barrack Obama and Congress could not agree on a permanent fix to our estate tax system. Instead, a creative but limited bandaid was proposed and, almost at the last minute, was passed on December 17th.
Under the 2010 tax resolution, the taxable estate of a deceased that could pass free of the estate tax was actually increased to $5 million, the tax rate for large estates was reduced to 35%, and a new method to allow a husband and wife to maximize their tax savings by allowing them to protect $10 million was implemented. And, very importantly, the federal gift and estate tax was reunified, so that a person could give away during lifetime or upon death a total of $5 million.
However, under the 2010 resolution, this new law terminates on December 31, 2012, and the estate tax law as it existed back in 2001 will be implemented. This means that only $1 million may be exempted from the federal estate tax, and the highest marginal tax rate will increase to 55%.
Congress is faced with a dilemma. If it does nothing and the 2001 law is brought back, the impact on our economic recovery could be dramatic. To do something, however, in the current polarized environment of Washington, may not be possible, especially before the November elections. Of course, after the November elections, with only a few short weeks and a lame duck Congress, what can be reasonably expected to happen?
This is the planning environment in which we currently find ourselves, and it is one with many potential pitfalls, tax traps, and possible lost opportunities.
We are advising our clients that if they have taxable estates in excess of $1 million, the current Maryland Estate Tax, which will not be changing anytime soon, still requires tax planning using the same basic tools as used for planning at the federal level. So, if you have such an estate, do not use the current uncertain tax environment as a reason not to design and implement your plan now.
For those who have larger taxable estates, an aggressive gifting program can take advantage of the current ability to give up to $5 million to your children or grandchildren. Indeed, with proper trusts for your children and grandchildren, there are opportunities to save even more using generation-skipping transfer trust provisions or life insurance to achieve even greater benefits.
Even in uncertain times, planning is important. While the challenges in our current tax-planning environment are very unsettling, and the impact of Taxmageddon may be looming, there are still opportunities in chaos.