Federal Transfer Tax Law and the Recent and Coming Elections

Overview           

This listing is the first in a series of columns that Mr. Levendis will publish periodically in the online publication, Wealth Strategies Journal.  Each article will be on a subject of his selection taken from Mr. Levendis' experiences over the past 35 years in representing client families, private businesses, individuals and charitable entities, in the broad area of wealth preservation, or, as in the case of this first piece, each will offer Mr. Levendis' view on a significant subject within that broad area.  While the pieces will be prompted by Mr. Levendis' experiences, attempt will be made to focus each article in a manner that will make it useful and productive in the context of contemporary practice.            

This first offering addresses the status of federal tax law applicable to the wealth preservation area, with emphasis on the federal transfer taxes and their future in the context of past, current and projected Congressional activity.
 
FEDERAL TRANSFER TAX LAW AND THE RECENT AND
COMING ELECTIONS

A. Introduction

This article provides the author's thoughts on the current and projected status of the body of federal tax law that primarily impacts estate planning and related areas, i.e., the federal transfer taxes (the "Transfer Taxes"; IRC Chapters 11, 12, 13), which include the federal gift tax (the "Gift Tax"; IRC Chapter 12), the federal estate tax  (the "Estate Tax"; IRC Chapter 11) and the federal generation-skipping transfer tax (the "GST Tax"; IRC Chapter 13).  Before reaching specific discussion of the future of the Transfer Taxes, this article, in sections B and C below, summarizes basic facts and provides brief commentary respecting the Transfer Taxes and their history.
 
B. The Law

1. Transfer Taxes.  The United States Transfer Taxes, consisting of the Gift Tax, the Estate Tax and the GST Tax, in their current form came into existence with federal legislation enacted in 1976 (the Tax Reform Act of 1976, P.L. 94-455; the "1976 Law") and 1981 (the Economic Recovery Tax Act of 1981, P.L. 97-34; the "1981 Law").  These statutes converted an area of federal law, which theretofore had been an incidental (although definable) aspect of tax law, to a separate, involved and comprehensive body of tax law.  The statutes introduced a new, significant integration of the Gift Tax and Estate Tax, together with an altogether new tax, the GST Tax.  For the first time, practitioners in the area of Trusts and Estates, or, in the legal profession, "probate lawyers", were obliged to become "tax lawyers". 

Many refinements have been introduced to the Transfer Taxes over the years since 1976, to bring them to their current status.  These changes have involved, among others, a continual and continuing increase in the levels of the basic exemptions from the Transfer Taxes and the basic allowable deferrals of Transfer Taxes.  Those exemptions and deferrals include, under current rules, the Applicable Exclusion Amount for the Gift Tax, the Applicable Exclusion Amount for the Estate Tax, and the GST Tax Exemption, see IRC § 2010, as to the Estate Tax, § 2502, as to the Gift Tax, and § 2631(c), as to the GST Tax; and the Marital Deduction for the Gift Tax and the Estate Tax and the Charitable Deduction for the Gift Tax and the Estate Tax, see IRC §§ 2056 and 2523, as to the Marital Deduction, and §§ 2055 and 2522, as to the Charitable Deduction.  The changes also have included a continual and continuing reduction in the tax rates applicable to the Transfer Taxes.  See IRC § 2001(c)(2), respecting the Estate Tax, § 2502, respecting the Gift Tax, and § 2641, respecting the GST Tax.

Some things, though, have remained constant throughout the current era of changes.  The GST Tax always has been applied at the highest applicable federal  Estate Tax rate; and the Gift and Estate Tax Charitable Deductions always have been a "full" deduction each (with, however, certain significant exceptions involving primarily so-called split-interest charitable gifts), i.e., in general the full amount of any charitable gift is excluded from taxation under the Transfer Taxes.   Further, the current Marital Deduction also is (and has been for many years) a full "deduction", with the caveat, though, that it does not, of itself, result in the exclusion of property from transfer taxation; rather, it is merely a deferral of the requirement to pay taxes on the property concerned until the spouse who is the recipient of the gift or legacy himself or herself transfers the property, again, by inter vivos gift or testamentary bequest or devise.

2. Income Taxes Related to the Transfer Taxes.  A significant number of federal income tax (the "Income Tax"; IRC Chapter 1) provisions either relate directly to the Transfer Taxes or are complementary of the Transfer Taxes.  Familiar areas of that related body of the Income Tax include, for example, the income taxation of estates and trusts, see IRC Subchapter J of Chapter 1, and the income taxation of tax-exempt organizations, see IRC Subchapter F of Chapter 1. 

C. Transfer Taxes in Context  
          
1. Historical Context. The Transfer Taxes, historically, were invoked by the federal government as a "special" tax designed to fund primarily short-term or emergency needs. See, generally, Federal Taxation of Income, Estates and Gifts,  B.I. Bittker and L. Lokker, Warren, Gorham & Lamont (2nd ed. 1993).  Before thirty years ago, when the 1976 Law came into existence, the principal public policy purpose for the Transfer Taxes (as contrasted with any actual need for the taxes) was the prevention of the accumulation by taxpayer families of so-called "dynastic" wealth.  Id .
 
The Transfer Taxes, however, have been viewed differently in recent years.  Notably, they have been evaluated as a potentially much more significant source of federal revenue.  See, e.g., "The High Cost of Estate Tax Repeal", by Joel Friedman, Center on Budget and Policy Priorities, June 15, 2006, discussing cost estimates and other figures published by the federal government.  This development has influenced debate on the subject of the Transfer Taxes.

2.  Current Status of the Transfer Taxes.  Currently, the Transfer Taxes, pursuant to the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16), the "Act", contain the following principal features:

a. Estate Tax. The Estate Tax is imposed on the full value, as of date of death, of the assets of each decedent who is either a citizen or permanent resident of the United States.  IRC § 2001.  The Estate Tax is progressive and has a current maximum marginal rate of 46% (a "descent", under the Act, from 55% (the highest possible rate prior to the Act, see IRC § 2001(c)(2), which imposed a surtax, on estates large enough to be subjected to it, resulting in an effective 60% marginal rate until an effective 55% flat rate was assessed on the entirety of the property subject to tax) which will end, in 2007, at 45%).  Currently, for the Estate Tax, the Marital Deduction (the "Marital Deduction") is unlimited; the Charitable Deduction (the "Charitable Deduction") is unlimited; and the Applicable Exclusion Amount (the "Exclusion Amount") is $2 million (an increase from the maximum scheduled amount of $1 million under prior law, which, under the Act, will continue to increase to a maximum of $3.5 million in the year 2009).
 
b. Gift Tax.  The Gift Tax also is progressive and is imposed at the same maximum marginal rate as the Estate Tax.  Under the Gift Tax, the Marital Deduction is unlimited; the Charitable Deduction is unlimited; and the Exclusion Amount is $1 million (the same as the maximum amount that had been scheduled under prior law, and an amount that will not increase further under the Act).

NOTE: A significant distinction between the Gift Tax and the Estate Tax applies in the context of their respective exemptions, i.e., the Estate Tax Exclusion Amount currently is twice the amount of the Gift Tax Exclusion Amount and the Estate Tax exemption will continue to rise, under current law, while the Gift Tax exemption is capped, under current rules, at the $1 million amount.  Another significant distinction between the Gift Tax and the Estate Tax is the fact that, while all property included in a decedent's gross estate, under federal law, is subject to the Estate Tax, property of a taxpayer that is used to pay federal gift taxes during the taxpayer's lifetime, on gifts made by that taxpayer more than three years prior to the taxpayer's death, is excluded from both the Gift Tax and Estate Tax.  IRC § 2035.

c. GST Tax.  The GST Tax, as indicated above, is, in historic terms, a new element of the Transfer Taxes. It imposes a complicated set of rules on a transfer of property that, in essence, passes from the transferor  taxpayer (a "first generation taxpayer") to a younger individual (a "third generation individual") who is a member (as defined in the Code, see IRC §§ 2613, 2651) of the generation that is two generations below that of the first generation taxpayer.  It is imposed in circumstances in which, historically (i.e., prior to enactment of the GST Tax in 1976), no tax had been imposed, i.e., in circumstances where the intervening generation, or "second generation individuals", are "skipped" by a property transfer in favor of a third (or more remote) generation individual or individuals.  The GST Tax is a "flat" tax, imposed, as indicated above (see Section B.1), at the maximum marginal Estate Tax rate in effect at the time of the transfer concerned.  Currently, as indicated above, that rate is 46%; it will reduce, under current law (i.e., under the Act), to a low of 45% as of 2007.   §§ 2001, 2641.  The GST Tax Exemption (the "GST Exemption") matches the Estate Tax Exclusion Amount.
 
3. The Transfer Taxes in Transition.  The Act created a "moving" body of law for the Transfer Taxes.  That is, the changes dictated through the Act are transitioning the Transfer Taxes from their status in 2001, immediately prior to enactment of the Act, to the point they will reach, under the Act, in the year 2010 (and possibly, if the direction of the Act is not altered by future legislation, to the point to which the Transfer Taxes will return, under the Act, as of 2011).  Because of the pressures of the budget reconciliation process (the "Budget Reconciliation Process") mandated by the Congress, the Congressional Budget Act of 1974 (P.L. 93-344, Titles I-IX), as amended, (the "Budget Act"); see, for discussion of the Budget Reconciliation Process, "The Budget Reconciliation Process:  House and Senate Procedures", CRS Report for Congress (Congressional Research Service of the Library of Congress, August 10, 2005), the Congressional majority has attempted to achieve the goal of repeal of the Estate Tax through this "phased" process.  It is for that reason that rates and exemptions, for example, have been changing since 2001 and will continue to change until the year 2010. Further, under the current rules, as imposed by the Act, as of the end of the year 2010 the law of the Transfer Taxes will revert to its status as of immediately prior to the enactment of the Act, unless Congress acts either to make the changes introduced by the Act  permanent or to enact an alternative to the Act.  The transitory condition of the Transfer Taxes has left that body of law in flux, not to say confusion, since the time of the enactment of the Act.  It has been anticipated that the Congress might accomplish, in advance of 2010, rectification of that situation; however, that has not occurred yet.  Further, the Act never contemplated complete elimination of the Transfer Taxes.  That is, the Estate Tax and the GST Tax would be eliminated (at least for the year 2010) under the Act, but the Gift Tax would continue, with the Gift Tax Exclusion Amount continuing to be capped at $1 million.
 
It now is widely felt that the Transfer Taxes will be addressed and the current situation brought to a "sensible" resolution by the Congress, and possibly a new administration, as of sometime before the year 2010.

D. Politics and the Transfer Taxes

1.  Conservatives v. Liberals.  The Act is the result of the tension between factions, i.e. conservatives (Republicans, in this discussion) and liberals (Democrats, in this discussion).  Absent strong resistance from the Democrats, the Republicans would have eliminated at least the Estate Tax and perhaps all of the Transfer Taxes with the 2001 legislation.  Indeed, the Republicans, believing they would gain the upper hand, refused a series of compromise possibilities with the Clinton Administration,  that would have greatly eroded the Transfer Taxes, in order to attempt wholesale elimination under (what turned out to be) the Bush Administration.  While the Republicans have realized success in attacking the Transfer Taxes under the Bush Administration, they have been impeded by the Budget Reconciliation Process, id., and their inability to meet the 60 vote requirement of the Senate, see § 313 of the Budget Act (the "Byrd Rule", originated by amendment to the Budget Act on October 24, 1985, as Amendment No. 878 (as modified) to S. 1730, the Consolidated Omnibus Budget Reconciliation Act of 1985 ('COBRA")), in this context, to change the Transfer Taxes.  Finally, the eroding national deficit made what had been a promising situation, for the Republicans, a very difficult problem in the context of tax reduction proposals.

The recent mid-term elections clearly have impacted the Transfer Taxes legislation discussion and the projected status of those taxes.  For one thing, the presumed orientation of the Congress, through the changed balance in the House of Representatives, will be shifted away from tax reduction options.  Further, and this would seem to be the most significant implication of the recent election cycle, the balance in the Senate is, in essence, mathematically unchanged - that is, the Senate, regardless of its current leadership, still is split 50-50, more or less, and cannot be expected to be able to muster as many as the 60 votes necessary to take action to eliminate the Transfer Taxes.  Accordingly, it can be assumed fairly, it would seem, that neither the Estate Tax nor the Transfer Taxes in their entirety will be repealed in the near future.  It also may be a fair assumption that, after the Bush Administration is completed, the Senate still will be essentially evenly divided between the two major parties, regardless of which faction controls the White House. If so, it would seem unlikely that the law might be eliminated during the coming administration.  This latter view, though, is not at all clearly focused, because other variables, not susceptible of convenient projection, will impact the process
over the longer term.  They include, among others, the economy's direction and the domestic social action and international intervention commitments of the United States.
 
Finally, there is one factor that, in the author's view, will take on enhanced significance now and as more time passes.  That is the mounting desire of all parties involved, including taxpayers, to return to a greater level of certainty as to the "rule" of the law of the Transfer Taxes. For several years, there has been uncertainty as to exactly how the Transfer Taxes, under the Act, should be handled by taxpayers and as to where, going forward, they are headed and what they will become.  All parties, we can believe, would like relief from that situation.
 
So, what, then, will happen in Congress with the Transfer Taxes?

2.  Possibilities.  Possible actions Congress might take in respect of the Transfer Taxes fall into three broad categories:  (i) no action; (ii) complete repeal; and (iii) short-term or long-term compromise.  While a number of proposals have been floated in Congress over the past year or so, the most significant of them fall into the last category.  That category of options, then, would provide a permanent resolution to the current situation, effective as of 2010 or earlier, with a solution short of repeal of the Transfer Taxes, but, in all likelihood, materially more favorable to the taxpayer than pre-Act law.  In general, under them, applicable exclusion amounts would be increased and rates of transfer taxation for all taxpayers would be reduced.  There is no assurance, of course, such a compromise approach may actually be the direction of ultimate Congressional action.  However, it is intriguing to consider that such an approach does represent a potentially workable compromise for both factions, where one insists that the Transfer Taxes are confiscatory and the other faction insists that, as a matter of sound public policy, the nation's wealthiest families must be subjected to meaningful transfer taxation.  A compromise approach that would leave the pre-Act Transfer Taxes system intact with increased applicable exclusion amounts and reduced tax rates, would (a) offer a solution consistent with the perceived general line of  conjecture among taxpayers, their advisors and, it is believed, federal legislators themselves;  (b) assure continued (if reduced) taxation for the largest of estates,¹  (c) eliminate taxation of almost all estates, and (d) return the Transfer Taxes to a generally familiar regime.  In other words, it would offer a significant compromise that would respond in some measure to the interests and concerns of all of the parties concerned.

3.  Probabilities.  Any assessment of the possible modifications to the Transfer Taxes next likely to be introduced through the Congress must evaluate two broad considerations - the "timing" of possible changes and the "nature" of possible changes.
              
a. Timing of Possible Changes.  As to timing, it is difficult to believe that action might be taken by a new Congress before the end of the third quarter of next year.  One must assume that the Democrats, at least in the near term, will be concerned about low- and middle-income taxpayers, before considering domestic tax issues outside that concern. [This point appears to have been made in connection with the enactment of the recent "extender" bill.  The Tax Relief and Health Care Act of 2006 (H.R. 6111, passed by the House of Representatives on December 8, 2006, and by the Senate on December 9, 2006, and signed by the President on December 20, 2006.  While an early version of that bill introduced this past summer, the Estate Tax and Extension of Tax Relief Act of 2006 (H.R. 5970) (as introduced by vote of the House of Representatives on July 29, 2006), addressed the Transfer Taxes issue in significant measure, the recently revised version, H.R. 6111, has omitted mention, in any meaningful way, of the Transfer Taxes.]

Once Congress gets to the matter of changes to the Transfer Taxes, significant modification almost certainly will require a proposal that both factions (i.e., conservatives (Republicans) and liberals (Democrats)) view as acceptable, or there will be a protracted battle.  This follows, if for no other reason, because the Senate must muster at least 60 votes to be able to approve changes to the current law.  [Before Congress gets to a Senate vote, both Houses must get bills through Committee, a daunting task in itself, based on applicable committee rules (notably the Ways & Means Committee of the House), if there is not accord between the parties; and, if the Senate does act, it and the entire Congress must anticipate the possibility of a Presidential veto if there is a split in control between the White House and one of the branches of Congress.]  If such a "battle" were to occur, it would end, presumably, at the "last minute", i.e., at the end of 2009, just before the Estate Tax is to be repealed under the Act; and likely it would embody only a "simplistic" or limited set of changes (unless one faction is able to force the other to capitulation by tying major Transfer Taxes change to another issue (and its related legislation) of greater significance to that other faction).

The foregoing assessment as to timing assumes that the Senate will remain more or less evenly "split" after the 2008 elections.  If that proves not to be the case, the party with an increased majority in the Senate, of course, could act early in 2009 and do so in a
manner that dramatically alters the law, by either achieving complete repeal of at least the Estate Tax or moving the law back to the approach of significant transfer taxation of large estates (however "large" might, in that case, be defined).  It does not appear probable (although it certainly is possible) that such a significant Senate majority might be achieved by either party in the coming election cycle. 
            Timing of the next set of changes in the Transfer Taxes, in all probability, therefore, will occur (except possibly as to routine or incidental points) no earlier than about the last quarter of 2007, but will occur with almost complete certainty by the end of 2009².
 
b. Nature of Possible Changes.  The nature of the next set of changes to the Transfer Taxes also is susceptible of assessment.  As indicated, no significant changes can be achieved absent essential accord between the Republicans and Democrats so long as the Senate remains essentially evenly apportioned between the two parties.  Further, the Budget Reconciliation Process, especially if it actually is tightened by current "pay as you go" proposals, see S. Amdt. 3013 to S. Con. Res. 83 (Mar. 16, 2006); "The Need to Restore Pay-As-You-Go Budget Enforcement for Tax Cuts and Entitlements", by Richard Kogan (Center on Budget and Policy Priorities, Mar. 14, 2005), mitigates against dramatic changes that potentially would significantly reduce federal revenue, notwithstanding the background provided through the Act.  Therefore, the direction of the economy, the impact of developments in federal government commitments generally, and the direction of the size of the deficit all will have a major impact both on the options available through the rules governing Congress' budgetary process and on the thinking and mood of the members of Congress.
 
The current state of the deficit, other related monetary and fiscal factors, and the  general direction of the economy, taken in the context of U.S. international commitments, mitigate, it seems, against significant reduction in taxation levels.  Therefore, absent dramatic changes in those factors between now and 2010, it does not seem likely that Transfer Taxes changes will move in the direction of further reduction of tax rates.  This conclusion is buttressed, of course, by the presumed disinclination of the Democrats to eliminate the Estate Tax.
 
There is, of course, still room for a compromise agreeable, more or less, to both parties.  However, one party or the other may not be willing to compromise in the near term.  The Democrats (like the Republicans in 2000, see discussion above at section D.1), for example, may wish to wait until the 2008 elections are completed, on the theory that they then will control both the White House and the Congress.  The Republicans, assuming they may be projecting a 2008 victory for the Democrats, certainly have more leverage now in the context of reaching a compromise solution, but may feel that tactically they must continue to support possible repeal of the Estate Tax, until after the 2008 elections.

E.  Prognostication

No one, of course, can predict with certainty the next set of changes to the Transfer Taxes.  This is particularly the case given the occasional historic diversion, from its apparent prior line of discourse, that sometimes is reflected in Congressional tax legislation.  E.g., the 1981 Law, which introduced the so-called qualified terminable interest property ("QTIP") option for the Marital Deduction with, essentially, no notice to taxpayers that the new concept might be included in the enacted legislation.

A reasonable prognostication, based on the foregoing assessment and instinct derived from experience, can be made in the matter, though, in the author's opinion.  Any
such forecast, of course, can be no more than a set of guesses, no matter how carefully and thoughtfully formed.  With all that in mind, the author provides the following conjecture as to the legislation Congress will enact in response to the situation created by the Act:

a.  No significant change will  be enacted before the fourth quarter of 2007.

b.  Significant action will be taken by no later than the end of 2009; i.e., at a minimum, by the end of 2009 Congress will act to extend, at least through 2010, either (i) the law that will come into place under the Act as of  2009 or (ii) the law as it will exist, under the Act, immediately prior to the changes required by the Act to take effect as of the beginning of 2009.

c.  The integration of the Gift Tax and the Estate Tax, as framed under the 1976 Law, will be retained and continued.

d.  The GST Tax will be retained and continued, although it is always possible, in this context or any other, that an incidental result of Congressional action will be elimination of the GST Tax, which generally is considered to be overly complicated and confiscatory.

e.  The Gift Tax Applicable Exclusion Amount will remain capped at $1 million.
 
f.  The Estate Tax Applicable Exclusion Amount will be no less than $2 million and no more than $5 million.  A logical solution for the Estate Tax Applicable Exclusion Amount is to set it at $3.5 million, because that is the maximum transitional figure, as of 2009, under the Act and, as such, is a level both previously considered by and familiar to the parties concerned.  [A $2 million Estate Tax Exclusion Amount also is a logical option for a new law from Congress, given its rational progression in the run of recent increases in that exclusion under the Act and given the fact that, as of the time, more or less, that a new law may take effect, the $2 million exclusion will have been in existence for three years (2006-08).]

g.  Stepped up basis, IRC § 1014, will continue, and discussion of "carryover basis" will be discontinued at least until and unless there is a serious discussion of overall reform of the Transfer Taxes in the broader discussion of overall reform of the tax code.
 
h.  The State Death Tax Credit, IRC § 2011 (as it read prior to the Act), will be reinstated in its prior form.  (The author does not believe that, in the end, the federal government actually will leave the state governments and their taxpayers to enact wholly separate local transfer tax bodies of law unsupported at all by the federal rules.)

i.  Rates of taxation will be lowered, but not much below the level (i.e., 45%) of the final reduction, under the Act, in the maximum marginal Estate Tax rate, and they will be applied progressively on the same schedule for both the Gift Tax and the Estate Tax.  While the area of the GST Tax rates is a little more uncertain, they probably will continue, as they were, with a flat rate at the level of the highest marginal rate of the  Estate Tax.

Arguments can be made for a low rate, e.g., parity with the capital gains tax rate, or for a high rate, e.g., concern over the formation of dynastic wealth.  However, in the end, the author believes that the parties will have to compromise between the desire of the Republicans to lower rates and the concern of the Democrats that the truly wealthy be obliged to support the public either by giving their property directly to charitable activities or by paying taxes.
 
Accordingly, the 45% figure of the Act, referred to above, and the current maximum marginal federal income tax rate of 35%, IRC §1, seem to offer a familiar and logical range for a compromise solution on rates.  The maximum income tax rate is a more likely choice, if either of the two actually is taken ahead of a compromise figure between the two, inasmuch as it has a certain historical "logic" when compared to the final rate under the Act, which, because it is part of a transitional system, logically might be viewed as having been arrived at without the benefit of full consideration in the context of a process for setting permanent rates.

We shall see.