Tax Law Changes in New York, New Jersey, Minnesota, Vermont, Iowa, North Carolina and the District of Columbia
Although technically none of these jurisdictions changed their estate tax laws, the change in the federal estate tax laws for 2010 results in a change in the manner in which state death taxes in these states may be calculated.  Under federal estate tax law as it existed in 2009, it was possible to leave assets to your spouse or specially designed trusts for your spouse (often called “QTIP” or “Marital” trusts) and have such transfers qualify for the marital deduction from federal estate tax so that tax would not be imposed on these assets until the surviving spouse’s later death.

Many states with separate state-imposed death taxes also have such a marital deduction.  However, in New York, New Jersey, Minnesota, Vermont, Iowa, North Carolina and the District of Columbia the mechanism for qualifying a QTIP or Marital Trust for the marital deduction for state purposes is tied to making an election on the estate’s federal estate tax return.  In 2010, there is no federal estate tax return.  It is not clear how each of these states will treat property passing to a QTIP or Marital Trust for state death tax purposes in 2010, but it leaves open the possibility that one or more of these states will impose taxes that clients thought had been postponed until the surviving spouse’s later death.

HOW DO THE CHANGES IN THE FEDERAL TAX SYSTEM AFFECT EXISTING ESTATE PLANS?
Credit/Marital Formula Clauses
Many married clients have estate planning documents that divide the residuary estate of the first spouse to die by a tax formula clause between the largest share that may pass free of estate tax (typically called either the “unified credit share” or the “estate tax sheltered share”) and the balance of the residuary estate (the “marital share”).  Often, the unified credit share is left to a trust in which the surviving spouse is the primary beneficiary and the marital share either passes outright to the surviving spouse or to a QTIP or Marital Trust for the sole benefit of the surviving spouse.

Because these kinds of formulas are based on the federal tax system, a client dying in 2010 when there is no federal estate tax at the client’s death, cannot be absolutely certain whether the formula tax clause will be interpreted as passing the entire residuary estate to the unified credit share or the marital share.  This raises a number of potential concerns with regard to how property in such an estate might be divided.

If your entire estate is determined to be the unified credit share and that share passes to individuals or trusts that you did not want to receive the entire estate, your wishes will be thwarted, and, in some cases, beneficiaries such as a surviving spouse or others might be entirely disinherited.  In states with a separate death tax system, this result might be avoided if the estate plan calls for the division of assets to be based on the lesser of the unified credit share and the amount that can pass free of state death taxes.  However, in states such as Florida where there is no separate state death tax system, the entire estate may pass to one set of beneficiaries, despite your intention for a different distribution of assets.

On the other hand, if the entire estate is determined to be the marital share, all of your assets would pass outright to the surviving spouse or to a trust for the spouse’s benefit.  This could result in the loss of flexibility for the executor of the estate and your family to maximize shelter from future taxes.  It also may result in unintentionally disinheriting those who would otherwise have received the unified credit share, which is of particular concern if these are not the same beneficiaries who would receive the assets remaining in the martial share at the surviving spouse’s later death.

The overfunding of the marital share raises additional tax concerns, discussed above, for clients who reside in states that do not allow a separate marital deduction election for QTIP or Marital Trusts if some or all of the martial share is directed to such a trust rather than outright to the surviving spouse.

GST Exemption Formulas
Many client’s estate plans divide assets between the share that is exempt from generation-skipping transfer tax (“GST Tax”) and the share that is not exempt from GST Tax.  Often, the GST exempt share passes to “Lifetime Trusts” for descendants, and the share not exempt from GST tax passes outright to descendants at some point.  Sometimes plans call for descendants to receive the GST Exempt share with the balance to be distributed to others beneficiaries or further divided and distributed in a different manner.  Plans based on GST exemptions are common for both married clients and those who are not married at the time of their death.

If you have such a plan and you die before the federal generation-skipping transfer tax is reenacted, it is possible your assets will be distributed in a manner other than you originally intended or may not be distributed in as tax-efficient a manner as possible.  This is because, like the unified credit share described above, it is not clear how formulas dependent on a reference to a GST tax will be interpreted in an estate to which the tax does not apply.

Charitable Deduction Formulas and Other Formulas with “Caps”
It is not uncommon for clients with charitable intentions to have estate plans that provide for assets to be divided between individual beneficiaries and charities or otherwise between two different groups of beneficiaries based on a formula tax clause in which one group receives the excess after the other beneficiaries’ amount is determined and the amount passing to the first group is not capped at a fixed amount.  It is not clear how such formulas and caps will be interpreted when no federal estate tax exists if the formulas refer to federal estate and/or GST tax values or exemption amounts.

Carryover Basis
As discussed above, if you die in 2010 and the federal estate tax does not apply to your estate, your appreciated assets will not receive a step-up in basis at death that may increase the capital gains taxes payable upon future sale by the beneficiaries.  If you are married and (1) you or your spouse dies before reenactment of the estate tax, (2) the deceased spouse has more than $1,300,000 of unrealized capital gains in assets in his or her sole name and (3) the estate plan does not result in the surviving spouse, or a qualifying trust for the surviving spouse, receiving assets with $3,000,000 or more of unrealized gains, it may be that capital gains tax could have been reduced by changing the plan before death. 

POTENTIAL GIFTING OPPORTUNITIES UNDER CURRENT LAW
Gifts to Reduce Gift and Estate Tax
Many clients have at some point considered or are considering making lifetime gifts in excess of their lifetime exemptions and paying a current gift tax in order to reduce estate taxes.  For those who are willing to pay gift tax on large gifts that are not covered by the remaining gift tax exemption, making such gifts soon after January 1 might be attractive.  Although the gift tax remains in place in 2010, the rate of tax on gifts is lower than it has been in a decade.  The 2010 gift tax rate is 35%, as compared to a 45% rate in 2009 and a 55% maximum rate scheduled for 2011 and beyond.

In addition to the lower rates, payment of gift tax is one method of potentially decreasing the overall transfer taxes incurred during your life and after your death, if (1) you survive for three years after making the gift, and (2) there is a federal estate tax imposed on your estate at your death.

This advantage is created by a difference in the way the gift tax and the estate tax are calculated.  The gift tax is calculated on a “tax exclusive” basis.  That means the donor pays the tax on the amount the recipient actually receives.  In contrast, the estate tax is calculated on a “tax inclusive” basis that means the estate pays the tax on the amount in the decedent’s taxable estate at his or her death regardless of the amount the beneficiaries of the estate actually receive. 

For example, if a person who has used his or her lifetime gift exemption decides to make a taxable gift of $1,000,000 in 2011, the gift tax due will be $550,000 ($1,000,000 x 55%).  The beneficiary of the gift receives $1,000,000 and the IRS receives $550,000.  The total outlay is $1,550,000.  If that same person died in 2011 without making the gift and paying the gift tax, the estate tax would be calculated on the full amount of $1,550,000 resulting in a tax of $852,000 ($1,550,000 x 55%).  Put another way, if you want a particular beneficiary to receive $1,000,000, it will “cost” you $1,550,000 to make that gift during your lifetime but it will take $2,222,222 to make that same $1,000,000 after-tax distribution at your death ($2,222,222 less ($2,222,222 x 55%)).

The difference between the calculation of gift tax and estate tax is increased in the taxpayer’s favor if the gift tax rate is lower than the estate tax rate which is ultimately imposed on the donor’s estate.  In the above example, a gift of $1,000,000 today at 35% rates would result in a gift tax of $350,000.  If that same transfer were made from an estate when the estate tax rate were 55%, the tax would be $852,000.

In order to discourage deathbed transfers, your taxable estate includes the amount of gift tax you paid ($550,000 in the 2011 example above) within the last three years of your life.  However, even if you do die within 3 years of the gift, you could still be in a better tax position because any appreciation on the assets that were gifted as well as appreciation on the gift tax would escape estate taxation.

Caution:  Prior to making any taxable gifts in 2010, you should consider that Congress may retroactively raise the gift tax rate for gifts made in 2010 which would require you to pay gift tax at a rate higher than 35%.  The possibility of retroactive application of new tax law is discussed in more detail below. 

In addition, Congress or the IRS may alter the way lifetime gifts are included in the estate tax calculation at your death, thus eliminating much of the arbitrage opportunity described above.  Under the tax law in 2009, the credit for “gift tax payable” which was used in calculating the estate tax was determined using the gift tax rate in existence at death.  Essentially, Congress could pass a new law that would collect the difference between the lower gift tax actually paid during lifetime and a higher estate tax rate imposed at death.

GIFTS TO REDUCE GIFT, ESTATE AND/OR GST TAXES
Gifts Specifically to Reduce GST Taxes - Background
The GST tax does not apply to 2010 transfers.  Arguably, transfers made to your descendants, or to trusts for their benefit, can be made in 2010 without any GST tax being imposed or any GST exemption being used to shelter gifts from the GST tax.  This makes early 2010 an attractive time to consider gifts that are intended to benefit multiple generations. 

In 2010, gifts made in excess of the $1,000,000 gift tax exemption will be subject to gift tax at 35%.  In 2009, such gifts would have been subject to a gift tax of 45% and, if the gift was intended to benefit grandchildren and more remote descendants, the gift also would have been subject to an additional GST tax of 45%, or would have used a portion of your GST tax exemption.  Currently, the law provides that the GST tax does not apply in 2010.  Therefore, transfers made in 2010 to benefit multiple generations may never be subject to GST tax.

Caution:  As with the gift tax, Congress could act to retroactively impose the GST tax to transfers made in 2010 when the tax did not apply.  Due to this possibility you may want to keep your lifetime gifts under the generation-skipping transfer tax exemptions of 2009 ($3,500,000) in order to avoid GST tax being due if Congress acts retroactively.  If Congress does not retroactively reenact the GST tax, but allows the GST tax to return in 2011 as currently scheduled, it is not clear whether transfers made in 2010 will have permanently escaped GST taxation.  While we believe that direct gifts to grandchildren which were not subject to GST tax in 2010 cannot later be taxed under the GST regime, it is not clear that transfers made to a trust for the benefit of grandchildren would similarly be out of the GST system for all time. 

It is possible that Congress and the IRS would treat distributions from the trusts as GST taxable transfers at the time the distributions were made (in 2011 and beyond) and would not treat the initial funding of those trusts as having carried permanent GST exempt status through to the distributions.  Clients considering making gifts to multiple generation trusts may find that 2010 is an attractive time to attempt GST programs, so long as they are comfortable that future trust distributions may not be protected from GST tax.  This is no worse than the treatment of such transfers prior to 2010, however, so those who were considering such gifts before might find this a particularly attractive time to make them.

On a related note, for clients who have trusts in existence, either for family members or for themselves, distributions from which would have been treated as GST distributions prior to January 1, 2010, now might be the right time to make distributions from those trusts to beneficiaries.  Under the law as it existed in 2009 and as it is scheduled to exist in 2011, the distribution from trusts not otherwise exempt from GST tax to beneficiaries more than one-generation below the grantor are taxed at the GST rate (45% in 2009) when the distributions are made.  In 2010, the GST tax does not apply so arguably distributions from these trusts would not incur a GST tax if made in 2010.  Again, the possibility that the GST tax might be retroactively reinstated requires careful consideration as to the advisability of making such distributions and their amounts.

GIFTS SPECIFICALLY TO REDUCE GST TAXES - TECHNIQUES
Outright Gifts to Grandchildren and Others Without GST Tax
For those who would like to make gifts to grandchildren without paying gift tax or GST tax, 2010 would be an attractive time to make gifts as the generation-skipping tax does not apply.  Gifts to your grandchildren can be structured to qualify for both the gift tax annual exclusion and the generation-skipping tax annual exclusion to protect yourself from any retroactive changes in the law. 

Grantor Retained Annuity Trusts (“GRATs”)
A Grantor Retained Annuity Trust or “GRAT” is a trust to which you transfer an asset from which you will receive a fixed amount annually (an “annuity”) for a set number of years.  At the end of the period of years, if the you are alive, the trust beneficiaries will receive the assets remaining in the GRAT free of gift and estate tax.  The tax advantage of this technique is derived principally from the way in which the value of the gift to the GRAT is calculated:  the value of the gift for gift tax purposes is not the value of the assets transferred but rather is the value of the right of the remainder beneficiaries to receive the assets after the period of years has expired and the annuity payments have been made to you.  If the duration of the GRAT is long enough or the annuity amount is high enough, the value of the gift is essentially zero.

Although GRATs are popular and often successful vehicles for transferring assets to family members, they are not efficient GST vehicles because while the value of the gift for gift tax purposes can be essentially zero, for GST tax purposes the value of the gift is determined not at the beginning of the GRAT, but rather at the end when the GST tax to be imposed (or GST exemption used to shelter the gift from GST tax) is based on the value of assets actually received by the beneficiaries.  For this reason, many people provide that only their children and not grandchildren or more remote descendants will be the beneficiaries of a GRAT so that the GST tax does not apply to the GRAT assets. 

In 2010, the GST tax does not apply.  While retroactive application of the GST tax may apply to GRATs, if you are interested in attempting a GRAT for grandchildren and more remote descendants which would not incur GST tax or use GST exemption, the GRAT can be structured so that it terminates in favor of grandchildren if the transaction is immune from GST tax or in favor of children if GST tax otherwise would be imposed.  This opportunity is attractive if you believe there is a possibility the GST tax will not be retroactively imposed and you are willing to either incur the tax or have the GRAT assets pass to your children rather than your grandchildren if the tax is reinstated with retroactive application.

Charitable Lead Annuity Trusts (“CLATs”)
Similar to a GRAT, a Charitable Lead Annuity Trust or “CLAT” is a trust to which you transfer assets which then provides a stream of annuity payments for a number of years.  In this case, however, the annuity payments are made to charitable organizations rather than to you.  When the term of years is over, whatever assets in the trust remain are distributed to non-charitable beneficiaries.  As with the GRAT, the CLAT is ordinarily not an effective GST vehicle, but under the 2010 law with the suspension of the GST rules, it is possible that transfers to CLATs would be immune to the GST rules, even if reinstated.  Again, the possibility of retroactive application of the GST rules to a 2010 transaction would make it wise to provide flexibility for the CLAT to terminate in favor of children if the GST tax were to apply and only to grandchildren and more remote descendants if the GST tax will not be imposed on distributions to these family members at the end of the term.

Lifetime Marital Trusts or “QTIPs”
Certain types of trusts can be established by you during your lifetime for the benefit of your spouse to which you can transfer assets without gift tax because the trust qualifies for the marital deduction.  These trusts are commonly referred to as “QTIP” trusts.  Lifetime QTIP trusts allow you to take advantage of your GST exemption in a manner that allows your spouse, and through your spouse, you, to enjoy the assets while you are alive.  With no GST tax, the transfer to a Lifetime QTIP can be an especially effective GST tool.

The Lifetime QTIP would initially be a trust for your spouse that would pay the income of the trust to your spouse at least annually.  The Trustee of the trust would be able to make principal distributions to your spouse in any amount as well.  This trust would last for your spouse’s lifetime.  At your spouse’s death, the trust could continue on the same terms for your benefit, and at your later death (or at the death of your spouse if you predecease your spouse), the remaining trust property would be transferred to grandchildren and more remote descendants or to trusts for the benefit of multiple generations (which could include your children). 

Prior to 2010, you might have transferred assets to the trust that were equal in value to or less than your remaining GST exemption and you would have used that exemption to protect those assets from future GST taxation.  This was an effective GST vehicle because by creating the QTIP, it allowed the trust assets to grow during your and your spouse’s remaining lifetimes so that the appreciated value of the trust upon the death of the surviving spouse also would be exempt from generation-skipping tax.  In a 2010 world in which GST taxes do not apply to transfers, arguably the Lifetime QTIP trust would be exempt from GST tax without the use or allocation of any GST exemption.  If, in fact, the GST tax is retroactively applied to your transfer to the QTIP, you could either allocate GST exemption to the transfer to maintain the exempt status of the trust or the Trustee could decide to distribute the assets of the trust to your spouse, in effect closing out the transaction.  In either event, there would be no current tax cost to you or your spouse and you would have created the possibility of taking advantage of  GST tax savings during this period in which the tax does not apply.

Dynasty Trusts
As discussed above, you might want to consider making gifts to trusts for multiple generations to remove assets from your taxable estate.  Such gifts will use a portion of your maximum $1,000,000 federal gift tax exemption or will generate a federal gift tax if they exceed the maximum amount you can give to the trust under annual exclusion rules.  Despite the gift tax imposition (which, as noted above, would be at a 35% rate in 2010 if not retroactively reinstated to the 2009 rate of 45%), the gift can be extremely tax efficient from a GST tax standpoint. 

As with the Lifetime QTIP trust, if the GST tax does not apply to the transfer to the Dynasty Trust, the gift to such a trust will remove the assets of the trust and their future appreciation from the GST tax system altogether.  If the GST tax is retroactively imposed on the transfer, and if the value of the assets transferred were less than your remaining GST exemption, no GST tax would be due and future appreciation on the assets still will escape GST taxation forever, but at the cost of using some or all of your remaining GST exemption.  Unlike the QTIP transaction, there is no “exit strategy” that would allow for the transaction to be completely unwound if it were later decided that this was not an optimal use of your exemption amount.

INTERNAL REVENUE SECTION 2011(C) - GIFTS TO GRANTOR TRUSTS
Included in the 2010 federal transfer tax law is a new section of the Internal Revenue Code which has resulted in much discussion and confusion:  Section 2011(c).  Although you may hear some assert that gifts to grantor trusts (trusts for which the creator is treated as the owner for income tax purposes but not for estate tax purposes) are not taxable gifts, we disagree.  We do not believe this is the correct interpretation of the statute or its intended meaning.  Accordingly, we do not recommend making any gift or structuring any transaction based on the possibility that a transfer will not be a gift simply because it is a transfer to a grantor trust for income tax purposes.

RETROACTIVE APPLICATION OF CHANGES IN TAX LAWS
Democratic Senate leaders have publically stated that they intend to work to reinstate the estate and generation-skipping transfer taxes in 2010 on a retroactive basis.  It is important to keep in mind that much current federal case law supports the constitutionality of retroactive application of tax law changes, unless that tax is a new tax altogether and is enacted without warning.  Supporting the argument that the retroactive reinstatement of the estate and gift taxes to transfers made after January 1, 2010 is not the imposition of a new tax is the fact that technically there has not been a “repeal” of the estate and GST tax.  The law more subtlety states that these taxes “shall not apply in 2010” and the Supreme Court has stated that a “new tax” is one in which the taxpayer had no reason to suppose that any transactions of the sort he was entering will be taxed at all.  While we believe that any retroactive imposition of these taxes will result in significant litigation, you should not enter any transaction relying on the 2010 law without consulting with your Cummings & Lockwood attorney to evaluate the pros and cons of each transaction as it relates to your particular circumstances.

SHOULD YOU CALL YOUR CUMMINGS & LOCKWOOD ATTORNEY?
As discussed in our January 2010 client letter, we recommend that you contact your Cummings & Lockwood attorney if you are interested in determining in more detail how the tax law changes affect your estate plan and your particular circumstances. 

It is imperative that you contact your attorney if you have reason to believe there is a significant possibility that you may not survive until January 1, 2011 or the earlier reinstatement of the federal estate tax so that we can assist you in a review of your current estate plan to determine if immediate changes are necessary or desirable based on the 2010 tax law and possible retroactive changes.

You also should contact your Cummings & Lockwood attorney immediately if you are married and are concerned that you have an estate plan that leaves the unified credit share to beneficiaries other than to a trust with the surviving spouse as the primary beneficiary or otherwise in a manner you do not desire or if you have an estate plan that divides your assets between individual beneficiaries and charities based on a formula and the amount passing to individual beneficiaries is not capped at a fixed amount.  If you are married and reside in New York, New Jersey, Minnesota, Vermont, Iowa or the District of Columbia (or if one of these jurisdictions might try to claim you are a resident for estate tax purposes), you should contact your attorney if your estate plan provides that the marital share of your estate is to pass to a marital trust for your spouse.

Of course, you should feel free to contact your Cummings & Lockwood attorney at any time if you are concerned about how the tax law may affect your estate and/or you would prefer to revise your documents to eliminate all ambiguity regarding the effect of the 2010 law on the distribution of your estate.  Your attorney also is available to speak or meet with you if you are interested in considering one or more of the techniques mentioned in this memo to determine if it is desirable for you to make changes to your estate plan and/or making lifetime gifts to individuals or trusts in order to potentially reduce estate, gift and/or GST taxes that will otherwise be imposed on you and your estate.