In 2012, planners and clients once again face the proposition of the estate tax 'sunset' that next year may revert the estate tax exemption and rate back to their 2001 levels. This impermanence in the current rules, with a scheduled lapse to a less favorable environment, creates an opportunity for clients to take decisive action while the current rules hold. Yet at the same time, if Congress ultimately does extend the current rules, decisive action may simply lead to irrevocable transfers that prove to be unnecessary, but cannot be unwound after the fact - a potential hardship for all but the wealthiest of ultra high net worth clients. And the reality is that there is little historical precedent for Congress to actually decrease the estate tax exemption or increase the estate tax rate - such a shift hasn't occurred since World War II! Accordingly, some planners have begun to lean in the opposite direction - viewing the current environment not as one for decisive action, but one for tentative flexibility and a wait-and-see approach. 

The inspiration for today's blog post is some recent material I've been working on for the April issue of The Kitces Report, examining the history of legislative changes to the estate tax system and what is, and is not, likely to expire or get extended beyond 2012. For instance, under current law, the estate tax exemption is scheduled to fall from its current level of $5,120,000, down to only $1,000,000 in 2013, along with the gift tax (and GST) exemptions. As a result, many estate planners have been calling for clients to fully fund bypass trusts, or even gift away up to $5.12 million in assets while alive, to utilize the current exemptions while possible.

An Historical Look At The Estate Tax

Yet when we examine the history of the estate tax exemption, the reality is that the exemption has only actually been decreased twice in the nearly 100-year history of the current estate tax: once in 1932, and again in 1934, on the back of an overwhelming landslide victory of Democrats in the 1932 Congress in the midst of the Great Depression, as the country struggled to raise the revenue necessary to stimulate the country out of its economic funk. And even then, the estate tax exemption cuts were only 50% and 20%, respectively; not the 80%+ cut that is scheduled for 2013. A full history of the estate tax exemption - and rates - is shown below.

 Year Estate Tax Exemption  Top Estate Tax Rate 
 1916  $50,000  10% 
 1917-1923 $50,000  25% 
 1924-1925 $50,000  40% 
 1926-1931 $100,000  20% 
 1932-1933 $50,000  45% 
 1934 $50,000  60% 
 1935-1940 $40,000  70% 
 1941 $40,000  77% 
1942-1976 $60,000  77% 
 1977 $120,000  70% 
 1978 $134,000  70% 
 1979 $147,000  70% 
 1980 $161,000  70% 
 1981 $175,000  70% 
 1982 $225,000 65% 
 1983 $275,000  60% 
 1984 $325,000  55% 
 1985 $400,000  55% 
 1986 $500,000  55% 
 1987-1997 $600,000  55% 
 1998 $625,000  55% 
 1999 $650,000  55% 
 2000 $675,000  55% 
 2001 $675,000  55% 
 2002 $1,000,000  50% 
 2003 $1,000,000  49% 
 2004 $1,500,000  48% 
 2005 $1,500,000  47% 
 2006 $2,000,000  46% 
 2007-2008 $2,000,000  45% 
 2009 $3,500,000  45% 
 2010 $5,000,000 or $0  35% or 0% 
 2011 $5,000,000  35% 
 2012 $5,120,000  35% 

As the chart highlights, while we have repealed and un-repealed the estate tax in 2010, our history of allowing the exemption to drop is far more limited. Furthermore, the reality is that in terms of revenue to the Federal government, the estate tax rate can actually be a far greater impact than the estate tax exemption amount. Accordingly, there may be greater risk that the estate tax rate is allowed to lapse back to 55%, rather than allowing the estate tax exemption to lapse back to $1,000,000. On the other hand, it's notable that the estate tax rate hasn't actually been increased since World War II, either.

Strategies That Can't Be Undone

The greatest challenge in planning for the estate tax amid uncertainty is that while the tax rates, exemptions, and other rules may change over time and be altered or revoked by Congress, many of the strategies used to try to 'take advantage' of the rules are far more permanent.

For instance, clients who aggressively gifted back in late 2010 - the last time we were on the eve of a sunset that would revert the estate tax back to the $1,000,000 limit - subsequently had their plans foiled when Congress decided to preserve the precedent of not allowing the exemption to fall by extending it, and even raising it, in the final weeks of December, 2010. As a result, the gift turned out to be unnecessary as the laws changed... but gifts that are bona fide for tax purposes are generally irrevocable once done.

Similarly, clients who drafted Wills or Revocable Living Trusts to fully fund bypass trusts may end out placing far more in assets into the trust than prove to be necessary - ultimately limiting the surviving spouse's access to the money for no material tax reason (although obviously, in some cases there are legitimate non-tax reasons for bypass trusts). While the strategy may be effective regardless for ultra-high-net-worth clients, arguably many clients with "just" a few hundred thousand dollars, or perhaps a million or few, are funding bypass trusts that create restrictions on assets that will never actually be necessary or yield any estate tax benefit (and may even cause income tax harm, unless there's a state estate tax benefit to offset it).

Planning For Impermanence

In light of the fluctuating estate tax laws, there appear to be two general strategic approaches for planning.

The first views impermanence as a planning opportunity to be taken advantage of. High gift tax exemptions, or low gift tax rates, are an opportunity to gift. High estate (and GST) exemptions are an opportunity to fund trusts during life or at death to shelter assets for one or several future generations.

The second approach views impermanence as a call for flexibility and being more tentative in estate planning. It eschews the permanence of actionable strategies that cannot be unwound in the future, in exchange for flexibility to deal with new laws and circumstances as they may arise. Thus, for instance, while the prior strategy focuses on maximizing current gifts and funding trusts, the latter is more oriented towards strategies like disclaimer planning to defer decisions as long as possible.

Where Do You Stand?

I have to admit that personally, in the current environment, I feel more inclined towards the second strategy than the first. Notwithstanding the "risk" that rates may rise or exemptions may fall, several generations of estate tax legislation suggests this is highly unlikely. Or alternatively, even if the rates do rise and/or the exemption does fall, the trend may reverse itself before the client actually passes away, which makes the near-term change still a moot point for all but the unhealthiest and/or oldest of clients.

Furthermore, if Congress merely chooses to raise revenue by increasing the estate tax rate but preserves the current $5 million exemption to avoid hitting the "middle class", aggressive gifting and bypass trust funding strategies may still not be necessary, except perhaps by the wealthiest of individuals, who may still wish to fund trusts, maximize gifts, and even take advantage tax exclusive nature of the gift tax system (in no small part because they really have the wealth to afford to do so).

For most clients of more modest means, though, gifting in anticipation of a lower exemption that never comes, or permanently locking up assets in a bypass trust without need, just leaves those clients with limited or no access to money they tied up, for no actual estate tax benefit.

So what do you think? What's your approach to estate planning - especially regarding estate taxes - in an environment of such uncertainty? Do you view the impermanence of current estate tax laws as an opportunity to take advantage of with decisive and permanent action, or an uncertain environment that requires flexibility instead?

  • Joseph Perrotta

    I agree that for most middle-income American’s, attempting to predict the future path of estate taxes is impractical, and may have negative consequences in the future. There are many better techniques available to help avoid/finance estate taxes than gifting or placing assets in a trust.

    However, for those with estate in excess of the $5,000,000 exemption, who are able to fund their living expenses without certain assets, there is little reason not to take advantage of the exemption while it is here today. Worst case scenario, the exemption is extended/raised in the future in which case they can adjust their plans as necessary.

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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