Tennessee Estate Planning Law : Tennessee Estate Planning Lawyer & Attorney : Bryan Howard : Howard & Mobley Law Firm : Nashville, Chattanooga, Memphis

Citizens for Tax Justice has published an article which lists the number of residents of each state who paid estate taxes between the years 2000 and 2010. In 2000, there were 662 Tennesseans who paid estate taxes. This represented 1.2% of all the Tennesseans who died during the preceding year. This number gradually decreased during the following decade until only 40 Tennesseans paid taxes in 2010. This represented 0.1% of the Tennesseans who died in 2009.

The number of Tennesseans who will pay federal estate taxes in 2011 should be even less due to the one-year repeal of estate taxes for decedents dying in 2010.

Even though the number of estates paying federal estate taxes has declined, the number of estates paying Tennessee inheritance taxes has remained constant. Tennessee has not changed its estate tax laws since the 20th century. The Tennessee inheritance tax exemption is only $1 million. 

Citizens for Tax Justice advocates decreasing the estate tax exemption. It supports a proposal introduced by Congressman McDermott named “The Sensible Estate Tax Act of 2011.” This proposal would reduce the federal estate tax exemption from $5 million to $1 million per person.  Fortunately, noone expects this Act to be approved. 

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The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 authorized portability of the federal estate and gift tax exemption for married couples. This means that if one spouse dies without having used his or her entire exemption, the survivor may use it.

Portability has been widely hailed as a great estate planning benefit. The benefit is that the first spouse to die can leave everything to the survivor rather than having to create a credit shelter trust. 

Our view is that the benefit of portability is overrated; furthermore, it creates a trap for the unwary. We are not advising any of our married clients to plan on using portability.

The foremost reason that we do not favor portability is because the statute that created it also required the law to expire on December 31, 2012. President Obama and many members of Congress have indicated that they would like to extend portability beyond this sunset date; however, we have learned that it is foolhardy to plan on the assumption that future tax laws will be consistent with sensible statements made by politicians. 

Even if portability is made “permanent” by future legislation, there are many pitfalls to using portability. First, there is no inflation adjustment. For example, assume a married man dies this year and leaves his entire $5 million estate to his wife. When the wife dies, she will be able to use her husband’s unused exemption, but without any adjustment for inflation. If the husband had placed the $5 million in a credit shelter trust instead of transferring it to his wife, appreciation of the value of the trust during his wife’s remaining lifetime would have also escaped estate taxes.

The Tennessee inheritance tax exemption is not portable. If you fail to use the exemption in the estate of the first spouse to die, it will be lost forever. This will result in higher Tennessee inheritance taxes for the survivor’s estate.

Those who plan to establish trusts that last for the lifetimes of their children and beyond, are concerned about generation-skipping transfer tax exemption. The GST exemption is not portable. However, if the first to die establishes a trust and allocates GST exemption to the trust, the trust will be exempt from generation-skipping taxes for up to 360 years.

In order to claim portability, the estate of the first spouse to die must file a timely federal estate tax return. I predict that a lot of surviving spouses who are not otherwise required to file an estate tax return will fail to file timely returns in order to claim portability. 

There are numerous portability issues associated with the remarriage of the surviving spouse. It will likely take years for regulations and court cases to fully flesh out these issues. All things considered, we recommend that you disregard portability as a planning tool, at least until the law is made permanent.

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 In less than 6 months, federal estate taxes are scheduled to return with an exemption of $1 million and a maximum rate of 55%. Numerous bills have been submitted to provide relief from these taxes. Most of the bills would increase the exemption to $3.5 million or more and decrease the top rate to 45% or less.

These bills have not passed because they would significantly decrease tax revenues. The latest such failure was an amendment offered to a Jobs Bill by Senators Jon Kyl of Arizona and Blanche Lincoln of Arkansas. Apparently the Senate decided against combining a large tax decrease with a bill that proposes to increase spending by $33.9 billion.

A lot of Senators are hesitant to pass another large spending bill. Many of these same Senators believe that taxes, including estate taxes, should be reduced. In the enclosed LA Times article, Tennessee’s Lamar Alexander explained why it is logical to support decreasing taxes while at the same time fighting increasing spending as follows: “If you’re going to spend more, you have to have a revenue source or you run up the debt.” Reducing taxes "reduces the amount of revenue we have to spend, and we should reduce spending by the same amount.”

What Lamar says by implication is that the national debt will increase if you reduce taxes without reducing spending. There appears to be a lot of support for reducing taxes. There does not appear to be a lot of support for spending less. It will be very difficult to solve the estate tax dilemna if the fix requires a commitment to decrease spending. I am counseling my clients to be prepared for the return of federal estate taxes in 2011 with the $1 million exemption and 55% top rate.

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Congress has learned that maintaining the uncertainty in the future of the federal estate tax system allows them to collect substantial campaign contributions from special interest groups. Federal estate tax laws have been in a state of flux since the passage of a 2001 law that gradually increased the estate tax exemption, decreased rates, and totally repealed estate taxes for the year 2010. The 2001 law was the result of an intense lobbying effort by a group of wealthy families that have spent more than $500 million in lobbying expenditures. These families want Congress to eliminate federal estate taxes. While certain Congressmen have benefited from these lobbying expenditures, other Congressmen have benefited from lobbying expenditures from various groups that wanted to retain the estate tax.

The enclosed article by the National Center for Policy Analysis titled The Politics of Estate Tax Reform predicts that Congress will reinstitute the estate tax at 2009 levels with an exemption of $3.5 million per person and a maximum rate of 45%, retroactive to January 1, 2010. Indeed, the President’s budget proposal favors this approach and the President recently signed legislation which increases the likelihood that exemptions and rates will be returned to the 2009 rates for the years 2010 and 2011 only. Under this approach, the estate tax exemption would decrease to $1 million and the maximum rate would increase to 55% beginning in 2012. Such a short-term fix would keep the issue alive so that Congressmen would be able to collect additional campaign contributions.
 

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2010 is the year where there will be no federal estate taxes due to a law that was passed in 2001. The heirs of wealthy individuals who die this year are set to enjoy a huge windfall.

Several congressmen have vowed to reinstate estate taxes during the year. Indeed, the Senate Finance Committee Chairman, Max Baucus, has vowed that Congress will reinstate federal estate taxes retroactive to January 1, 2010.

The one year repeal of federal estate taxes and the threat of a retroactive repeal of the repeal requires planning for three separate tax systems that have very significant differences. System #1 is the law that currently exists for 2010. Even though you do not have to “worry” about federal estate taxes, planning for someone’s death in 2010 is challenging for several reasons.

First, Tennessee still has an inheritance tax with an exemption of only $1 million. Second, there are numerous Wills containing formulas that will not work if the testator dies in 2010. Third, most outright bequests should be converted to trust bequests in order to avoid estate or generation-skipping tax upon the subsequent death of the beneficiary.

Finally, System #1 eliminates the automatic step-up in basis for inherited assets. Heirs will need to obtain records that establish the decedent’s historical cost basis in his or her assets. Furthermore, if there was substantial appreciation, the heirs will incur capital gains tax when they later sell the assets. Each decedent has $1.3 million worth of basis increase that can be allocated by the executor. There is an additional $3 million worth of basis increase that can be allocated to assets passing to a surviving spouse. These “basis exemptions” will solve problems for most families, but will have numerous complications in their application.

System #2 is the law that will apply beginning in 2011, when the federal estate tax will reappear with a $1 million exemption and a top marginal rate of 60%. Planning for System #2 is very familiar because this system was in place prior to the changes made in 2001. A lot of families have assumed that the federal estate tax exemption was always going to be significantly higher than $1 million. They have failed to take planning steps that seemed to be unnecessary.

System #3 is what Congress might put into place later this year. My best guess is that System #3, if enacted, would be similar to the system that was in place for 2009. The House passed such a bill in December of 2009. The Senate elected not to pass this bill, but could change its mind. If there is a System #3, it is possible that it could make changes that were not part of the bill passed by the House in December of 2009. For example, discounts for Family Limited Partnerships could be eliminated.

Many people will assume that System #1 will not be relevant for them, because they will not die this year and/or the law will be changed before they die. If the law is not changed retroactively, it is inevitable that the families of some wealthy individuals who die this year will be disappointed despite the absence of federal estate tax.

There is widespread sentiment that System #2 will not arrive. I now believe that System #2 might arrive in 2011 because I have no confidence that the Senate will be able to get the 60 votes necessary to enact System #3.

You need to be prepared for all 3 systems. Fortunately, there are practical steps that can be taken to minimize taxes under all 3 systems.

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It now appears very likely that we will begin the new year with no Federal estate tax in place. A law passed in 2001 repealed Federal estate taxes for the year 2010. That same law provided that the estate tax would reappear in the year 2011 with a $1 million exemption amount and a top rate of 55%.

Congress has known about this anomaly for the last 8 years. There has been universal agreement that the law needed to be amended in some fashion. Nevertheless, the law has not been changed because Congress could never agree on how to change it.

One group of legislators wants to permanently repeal estate taxes. Another group wants to retain estate taxes with a higher exemption amount than $1 million. It is widely predicted that Congress will address this issue early in 2010 and perhaps reinstate estate taxes effective as of January 1, 2010. An attempt to enact a retroactive tax might be a violation of the United States Constitution. There is some precedent suggesting that a retroactive tax would be allowed if enacted.

There is another significant issue for persons dying in 2010. Assets will no longer receive a basis equal to the date of death value of the assets, which is current law. Instead there will be a "carryover basis" regime, with the ability to obtain a "step-up" in basis for a limited amount of assets. A similar regime was briefly enacted in the 1970s, and was repealed almost immediately because it was so impractical. It is very difficult to establish the historical basis of inherited assets. Additionally, heirs of many estates that would not have been required to pay Federal estate tax under current law will now have to pay capital gains taxes when they sell inherited assets.

Planning your estate amidst this uncertainty is challenging. You need to be prepared for the law that is on the books, i.e., a federal exemption of only $1 million per person in future years. You also need to make sure that your Will will work in the manner intended if you die during the year 2010. In particular, you need to review any formulas in your Will that are based on an estate tax system that may not exist at the time of your death.

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The Congressional Research Service (“CRS”) has issued a report titled “Estate and Gift Taxes: Economic Issues.” The CRS is a “think tank” that provides reports to members of Congress on a variety of topics. Taxpayers spend over $80 million per year to fund the CRS. One controversial conclusion of the report is that

“…Only a tiny fraction of farms and small businesses face the estate and gift tax and it has been estimated that the majority of those who do have sufficient non-business assets to pay the tax. Moreover, only a small portion of the estate tax is collected from these family owned farms and small businesses, so that dramatically reducing estate tax rates or eliminating the tax for the purpose of helping these family businesses is not very target efficient.”

This report is supposedly based upon data from estate tax returns that have been filed. However, the conclusions drawn in the report are not realistic.

A lot of my clients have farms and small businesses. These clients worry a great deal about estate taxes. They purchase large life insurance policies to provide funds to be used to pay taxes. They establish and fund irrevocable trusts and various entities including limited liability companies and/or limited partnerships. They make gifts and sales to trusts for their children sooner than they would prefer if there were no estate taxes.

As mentioned in the report, some families are able to accumulate enough liquidity outside the business to pay taxes. In some cases, this means that the only asset left to pass on to children is the family business. When one or more children do not work in the business and cannot draw a salary from the business, this is not a happy result.

Perhaps my view is distorted because of the region in which I practice. Middle Tennessee probably has more valuable farmland than other areas of the country. The value is not necessarily based on the value of the land for farming. In many cases, the value of the farmland is artificially inflated by the development potential of the property.

Middle Tennessee also has a keen entrepreneurial spirit. I am constantly amazed by the ingenuity of my clients and how they have amassed a fortune from one or more business opportunities.

Nevertheless, the notion that reducing taxes on family businesses is not worthwhile clearly misses the mark. Owners of farms and successful family businesses spend a lot of time and money on planning strategies to cope with the liquidity crunch and distortions to their estate plan that are caused by estate taxes.

Members of the House of Representatives were not fooled by the Report. They understand that estate taxes create severe problems for owners of farms and family businesses. On December 3, 2009, they passed the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009. Though this bill does not eliminate estate taxes, it seeks to ensure that married couples will be able to leave up to $7 million to their children without paying federal estate taxes. This bill has been forwarded to the Senate, where it faces an uncertain fate.
 

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The estates of a lot of Tennessee decedents pay Tennessee inheritance taxes but do not pay federal estate taxes. The federal estate tax exemption is currently $3.5 million. As of the date of this article, various members of Congress favor extending this exemption amount indefinitely into the future. The Tennessee inheritance tax exemption is currently $1 million. There does not appear to be much likelihood that Tennessee will increase its exemption to match the federal exemption.

The difference between the federal and Tennessee exemptions means that unmarried decedents who die with a taxable estate with a value between $1 million and $3.5 million will pay Tennessee inheritance taxes but not federal estate taxes. There are several things that can be done to reduce the value of assets for Tennessee inheritance tax purposes.

Some of these steps can be taken shortly before death. As an example, a parent might make a deathbed gift of a fractional interest in real property to a child with the goal of capturing a fractional interest discount for the remaining portion of the property when the parent dies. There are also various post-mortem decisions that can affect the value of the assets owned by the estate.

Even though the estate is not subject to federal estate taxes, the date of death value of the assets becomes the basis of the assets for federal income tax purposes. Basis will be relevant when the estate or the beneficiaries later sell the assets. Federal capital gains taxes are 15% and are scheduled to increase to 20% in the year 2011. If the beneficiaries live in a state outside of Tennessee that imposes a capital gains tax, this will make the capital gains tax rate even higher. The maximum Tennessee inheritance tax rate is 9.5%.

Since capital gains tax rates are higher than the maximum Tennessee inheritance tax rate, it is generally not advisable to take steps that reduce the value of the decedent’s assets for Tennessee inheritance tax purposes, unless it is known that the beneficiaries will continue to own the assets in the estate for several years. The reduction in the value of the estate will increase capital gains taxes by more than the Tennessee inheritance taxes that are saved.

Making tax-free annual exclusion gifts is still a good idea. It is better to give cash as opposed to an appreciated asset that will receive a free basis increase upon death. A cash gift reduces Tennessee inheritance taxes without increasing capital gains taxes.
 

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