Latest Developments on Estate and Gift Tax Legislation

As of today, we still have no clear guidance on the Federal estate and gift tax rules for 2010. It was widely expected that Congress would enact legislation to extend these taxes into 2010, but no such extension was passed. In 2009 the Bush tax cuts allowed for a $3.5 million exemption with a maximum tax rate of 45%. Currently there is no estate tax on the estates of individuals who die in 2010, and no GST tax on transfers in 2010 from an individual to his grandchildren. There is also little guidance on how the carryover basis rules for one year will replace the previous step-up basis rules. The gift tax, however, is still in effect at a 35% tax rate for transfers made during a taxpayer’s lifetime in excess of the $13,000 annual gift tax exclusion per donee and the $1 million lifetime exemption. This might be an interesting year to make those gifts early and even pay gift tax (assuming we revert back to some form of estate tax and the gift tax rate is higher than 35% in the future). If Congress fails to pass estate tax legislation this year, the estate tax returns in 2011 with only a $1 million exemption and a maximum tax rate of 55%, which were the amounts under the law pre-2001 levels. The estate tax reform remains a stalemate due to lack of bipartisan support.

Senators Jon Kyl (R-Ariz.) and Blanche Lincoln (D-Ark.) have hatched a bipartisan plan that would create a permanent 35% on estates worth more than $5 million, but the plan did not move forward without Majority Leader Harry Reid (D-Nev.) backing the proposal.

Other Legislative Updates

By a vote of 215 to 204, the House of Representatives voted and passed The American Jobs and Closing Tax Loopholes Act of 2010, H.R. 4213, which would extend a number of provisions until December 31, 2010. The Senate is expected to consider the bill next week. To become law, identical legislation must be approved in both the House and Senate before it goes to the President for his signature. The bill aims to bring down the nation’s 9.9% unemployment rate. It includes $48 billion in new taxes to offset the $79 billion cost of tax breaks and safety-net spending.

Partial List of Expiring Provisions to be Extended

• Energy credits for business and personal use
• Special deduction for teachers
• Additional standard deduction for state and local property taxes
• Deduction for state and local sales taxes
• Tax free distributions from IRA’s to public charities, up to $100,000
• Research and experimentation credit
• Enhanced charitable deductions for contributions of food inventory, books, and computers
• Pension funding relief provisions
• Emergency Unemployment Compensation (EUC) benefits program (which was set to expire May 2010)

Partial list of Revenue Raising Provisions

• Carried interest rules modified
• Foreign tax provisions
• S Corporation shareholders providing professional services will be subject to self-employment tax on all income
• Creation of an oil spill liability trust fund to pay clean up costs in the gulf

The carried interest provisions will greatly affect Silicon Valley, home to a large number of venture capital and private equity firms driving innovation. The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services’ income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates (from 15% today to 20% next year). However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income (50% for taxable years beginning before January 1, 2013). The provision will be effective for taxable years ending on or after January 1, 2011. This proposal is estimated to raise $17.697 billion over ten years. It is unclear yet what impact this bill will have on the venture capital industry, or investments in early stage companies and how it hinders job growth. It would appear that at the very least there may be changes in how some investments in early stage companies are structured.

Small Business and Infrastructure Jobs Act of 2010

On March 24, 2010, the U.S. House passed the “Small Business and Infrastructure Jobs Act of 2010,” H.R. 4849, only eight days after its introduction. This bill is still under consideration by the Senate. The bill attempts to offset the cost of billions in new government spending with tax increases. Among other things, this bill would impose several restrictions on Grantor Retained Annuity Trusts (“GRATs”), making an estate planning technique that minimizes transfer tax liability for intergenerational transfers much less appealing. The bill would require a trust term minimum of at least ten years and that the remainder interest of the GRAT have a value greater than zero. This provision of the bill alone would raise an estimated $4.5 billion in ten years.

A GRAT is an irrevocable trust that pays its grantor annual annuity payments over a fixed trust term. If the fair market value of the property transferred to the GRAT equals the present value of the annuity payments based upon the prevailing IRS assumed rate, then the grantor pays no gift tax as the GRAT has been “zeroed-out,” making a zero dollar taxable gift. More importantly, if the rate of appreciation of the GRAT assets exceeds the IRS rate (currently, 3.2% for June 2010), then at the end of the trust term all remaining trust assets (less the required annuity payments) would pass to or for the benefit of remainder beneficiaries (such as the grantor’s children) with no gift tax consequences. In a year like 2009, many clients were able to facilitate successful transfers using a 2-year term GRAT to capture appreciation and upswing volatility. Consider that the S&P 500 total return in 2009 was over 26% compared to the 2.4% IRS assumed rate in January 2009. If, however, the rate of appreciation of trust assets is equal to or less than the IRS rate, or if the grantor fails to survive the trust term, then all trust assets may be returned to the grantor or the grantor’s estate and no tax savings may result. The mortality risk can be minimized with a short trust term of two years. Considering the low hurdle rates set by the IRS, we still have a small window of opportunity to benefit from GRATs before new legislation enactment.