Estate Planning

Senate Finance Committee Discusses Gift and Estate Tax Reform

By Gregory Herman-Giddens

Yesterday a public hearing on possible gift and estate tax reform was scheduled before the Senate Finance Committee.  Click "Continue Reading" for the full text of the report by the staff of the Joint Committee on Taxation.  I could not get the proper formatting to reproduce, so it's a bit difficult to read.

Of primary concern are potential limitations on Dynasty Trusts, discounts for Gifts of Interests in Family Limited Partnerships (and LLCs), and use of Crummy Withdrawal Powers in trusts (which allow use of the $12,000 annual gift tax exclusion for transfers to trusts).

Items for Immediate Consideration: 

1. Dynasty Trusts (page 33) - take action now to create or fully fund Dynasty Trusts.
2. Family Limited Partnerships (page 37) - those considering creating a Family Limited Partnership or  Limited Liability Company should do so now.  Those with existing entities should not delay making contemplated gifts of ownership interests. 
3. Crummy Powers (page 46) - fund Crummy trusts early in 2008 - review the three options.
   

TAXATION OF WEALTH TRANSFERS WITHIN A FAMILY:

A DISCUSSION OF SELECTED AREAS FOR POSSIBLE REFORM

Scheduled for a Public Hearing

Before the

SENATE COMMITTEE ON FINANCE

on April 3, 2008

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

April 2, 2008

JCX-23-08

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CONTENTS

Page

INTRODUCTION .......................................................................................................................... 1

I. WEALTH TRANSFERS AND THE UNIFIED CREDIT .................................................... 5

A. Overview......................................................................................................................... 5

B. Present Law and Recent Proposals Relating to Estate and Gift Tax Rates and

Exemption Amounts ........................................................................................................ 5

1. In general ................................................................................................................... 5

2. Increase in unified credit effective exemption amount and reduction in estate

and gift tax rates under EGTRRA.............................................................................. 5

3. Repeal of estate and generation skipping transfer taxes in 2010 ............................... 6

4. Reinstatement of the estate and generation skipping transfer taxes for decedents

dying and generation skipping transfers made after December 31, 2010.................. 6

5. H.R. 5638 and H.R. 5970........................................................................................... 6

C. Issues Related to Reunification of Estate and Gift Tax Exemptions and Rates and

Portability Between Spouses of Unused Exemption ....................................................... 8

1. Issues related to unification ....................................................................................... 8

2. Issues related to exemption portability ...................................................................... 9

D. Estimates of Utilization.................................................................................................. 12

II. WEALTH TRANSFERS AND LIQUIDITY...................................................................... 14

A. Overview....................................................................................................................... 14

B. Present and Prior Law for Special-Use Valuation, Installment Payments, and

Family-Owned Businesses............................................................................................. 15

1. Valuation.................................................................................................................. 15

2. Installment payment of estate tax for closely held businesses................................. 16

3. Qualified family-owned business interests .............................................................. 19

C. Issues and Data Related to Liquidity ............................................................................. 21

1. Criticisms of sections 2032A, 6166, and 2057 ........................................................ 21

2. Effects of present law on small and family-owned businesses................................ 24

APPENDIX: REFORM OPTIONS PREVIOUSLY PREPARED BY THE STAFF OF THE

JOINT COMMITTEE ON TAXATION ...................................................................................... 33

A. Limit Perpetual Dynasty Trusts (secs. 2631 and 2632) ................................................. 33

B. Determine Certain Valuation Discounts More Accurately for Federal Estate

and Gift Tax Purposes (secs. 2031, 2512, and 2624)..................................................... 37

C. Curtail the Use of Lapsing Trust Powers to Inflate the Gift Tax Annual Exclusion

Amount (sec. 2503)........................................................................................................ 46

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INTRODUCTION

The Federal estate and gift tax rules are in flux. Under the Economic Growth and Tax

Relief Reconciliation Act of 2001 (“EGTRRA”), the estate tax and the gift tax are partially

unified: a single tax rate schedule applies under the estate tax and the gift tax, but after 2003 the

exemption amounts differ. The highest rate of estate and gift tax has decreased in steps from 55

percent in 2001 to 45 percent last year, this year, and next year. The estate tax exemption

amount is increasing in several steps from $1 million in 2002 to $3.5 million next year. The gift

tax exemption amount remains at $1 million during that period. The credit against Federal estate

tax liability for State estate and inheritance taxes was phased down from 2002 through 2004 and

was replaced by a deduction starting in 2005. For 2010, the estate tax is repealed, but the gift tax

remains in effect with an exemption of $1 million and a maximum rate of 35 percent. In the year

of estate tax repeal, property transferred at death generally has the same basis in the hands of the

heir as it had in the hands of the decedent (that is, a carryover basis). Under the present estate

tax, by contrast, the heir’s basis generally equals the property’s fair market value at the time of

the decedent’s death. Estate tax repeal lasts only for one year. In 2011, the estate and gift tax

rules are scheduled to be the same as those that would have been in effect without enactment of

EGTRRA. Under pre-EGTRRA law, the estate and gift tax was fully unified: a single rate

schedule and exemption amount applied to gifts made during life and to transfers at death.

Consequently, unless rules are changed, starting in 2011 the estate and gift tax exemption

amount will be $1 million, and the highest estate and gift tax rate will be 55 percent. The credit

for State estate and inheritance taxes will return, and property acquired from a decedent will take

a fair market value basis rather than a carryover basis.

It is in this context of changing Federal estate and gift tax rules that Congress is

considering reform of the system for taxing transfers of wealth. The Committee on Finance is

holding a series of public hearings to examine the current system and possible changes to, or

replacements of, that system. A November 14, 2007 hearing addressed broad design issues such

as rates, exemption amounts, and the treatment of farms and family businesses.

March 12, 2008 studied alternatives to the present estate and gift tax system. These alternatives

include an inheritance tax, an income inclusion approach (under which gifts and bequests are

included in the income of the recipient), and a deemed realization system (under which a

gratuitous transfer is treated as a realization event and the transferor is taxed on any gain in the

property transferred, generally at rates applicable to capital gains).

countries of the Organisation for Economic Co-operation and Development (“OECD”), only the

United States and the United Kingdom have estate and gift tax systems. The majority of OECD

countries have inheritance taxes. A public hearing scheduled by the Finance Committee for

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Present Law, and Analysis of the Federal Wealth Transfer Tax System

2007. That document describes the history of the U.S. Federal estate and gift tax system, summarizes the

present estate and gift tax rules, and sets forth data and an economic analysis related to wealth transfer

taxation.

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and Analysis of Alternative Wealth Transfer Tax Systems

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April 3, 2008 will include a discussion of possible reforms to the existing Federal estate and gift

tax rules. This document,

Committee on Taxation pamphlets prepared in connection with the two previous hearings,

provides an overview of several selected areas for possible reform.

This document is divided into two parts. The first part describes a prominent feature of

the current Federal estate and gift tax system, the partially unified credit against estate and gift

tax, and evaluates two possible reforms to that credit. The credit against estate and gift tax is

partially unified under present law because a single tax rate schedule applies to gifts made during

life and transfers at death but the effective exemption amount under the gift tax ($1 million) is

different from the effective exemption amount under the estate tax ($2 million in 2008).

One possible reform to present law’s partially unified credit would be to make the credit

fully unified. Under a fully unified credit, a common rate schedule and a single exemption

amount would apply to gifts made during life and transfers at death. Two bills that passed the

House of Representatives in 2006 included provisions for a fully unified credit. Arguments in

favor of replacing the current credit with a fully unified credit are that a fully unified credit

would simplify planning and that the current credit distorts behavior by encouraging taxpayers to

hold onto property until they die to take advantage of the higher exemption amount under the

estate tax than under the gift tax. The extent to which raising the gift tax exemption amount so

that it equaled the estate tax exemption amount would counteract the gift tax’s role in preventing

income tax avoidance is unknown. In the absence of a tax on gifts, income tax liability may be

reduced when high-income individuals make gifts to lower-income individuals. An increased

gift tax exemption amount permits an increased amount of this income shifting. A fully unified

credit also could encourage gifts over bequests, the opposite of the distortion that may be caused

by present law’s significantly larger exemption amount under the estate tax than under the gift

tax. The distortion in favor of lifetime gifts would arise because the tax exclusive nature of the

gift tax (tax is not imposed on funds used to pay the gift tax) and the tax inclusive nature of the

estate tax (tax is imposed on funds used to pay the estate tax) causes the effective rate of tax on

gifts to be lower than the effective rate of tax on bequests.

A second possible reform to the unified credit, referred to as portability, would allow a

surviving spouse to benefit from unused exemption amount of the first spouse to die. The 2006

bills that passed the House of Representatives also included provisions making unused

exemption portable from one spouse to another. As for a fully unified credit, a principal

argument for portability of unused exemption is that portability would simplify wealth transfer

tax planning. Portability, however, raises concerns about the IRS’s ability to administer the

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Within a Family: A Discussion of Selected Areas for Possible Reform

document also is available on the internet at

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transfers from tax. In 2008 the estate tax effective exemption amount is implemented by means of a

$780,800 credit against tax.

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transfer tax rules. Certain design features, such as the treatment of multiple marriages, also may

create difficulties.

The second part of this document sets forth a discussion of liquidity to pay estate tax

when estates consist largely of farms or other businesses. Congress at various times has passed

reforms intended to mitigate the effect of the estate tax on family farms and other family-owned

businesses. A particular concern has been that if the value of an estate is largely attributable to a

farm or other business, heirs of the estate may be forced to sell the business to pay the estate tax.

Forced sales of family businesses are seen as undesirable in part because of possible job losses

and other disruptions to communities.

This document describes three provisions intended to mitigate the effect of the estate tax

on farms and other family-owned active businesses. One provision (in section 2032A) permits

real property to be valued for estate tax purposes at its current-use value (for example, as a farm)

rather than at a higher market value (for example, the price that could be received in a sale to a

developer). A second provision (in section 6166) allows payment of estate tax attributable to

certain family businesses to be deferred for five years and then made in installments over the

succeeding ten years. A third provision (in section 2057, terminated after 2003 but scheduled to

be in effect after 2010), grants a deduction from the value of the gross estate for the value of

certain family-owned business interests.

This document evaluates criticisms of these three provisions. The principal criticisms

have been that the provisions are complex and distort taxpayers’ behavior by encouraging them

to hold active business assets rather than other assets. This document concludes that although

there may be validity to those criticisms, the policy goals underlying sections 2032A, 6166, and

2057 inherently involve complications and distortions. The discussion of liquidity closes with a

presentation of data showing relative liquidities of estates that include closely held businesses

and showing certain characteristics of estates for which the benefits of sections 2032A, 6166, and

2057 have been elected. This data presentation includes an analysis of the possible effects of the

estate tax on closely held businesses. This analysis concludes that many estates that include

farms and other businesses have enough liquidity to fund their estate tax liabilities. The estate

tax may, however, harm the ongoing operations of these businesses by reducing cash available

for investment and day-to-day needs.

This document includes an appendix. The appendix reprints previous Joint Committee

on Taxation staff options for reforms of certain estate, gift, and generation-skipping transfer tax

rules. These options were offered as part of a 2005 report prepared at the request of Senator

Charles Grassley and Senator Max Baucus, at that time Chairman and Ranking Member,

respectively, of the Senate Finance Committee.

intended to reduce the size of the tax gap by curtailing tax shelters, closing unintended loopholes,

and targeting other areas of noncompliance with the tax laws. Proposals addressed the estate and

gift tax and also, among other areas, the individual income tax, corporate and partnership

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Expenditures

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taxation, and international taxation. The estate, gift, and generation-skipping transfer tax

proposals republished in this document deal with certain trust arrangements and with valuation

discounts.

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I. WEALTH TRANSFERS AND THE UNIFIED CREDIT

A. Overview

Some commentators argue that present law encourages costly and inefficient planning to

maximize use of estate and gift tax exemption amounts, particularly in the case of certain

transfers among family members. This section describes and discusses two proposed reforms

that are designed at least in part to simplify tax planning with respect to estate and gift tax

exemptions. The first reform would provide for “portability” between spouses of any unused

exemption. In other words, a surviving spouse would be permitted to use, in addition to his or

her own estate and gift tax exemption, the amount of any such exemption that had not been used

by the deceased spouse at or prior to the deceased spouse’s death. The second reform would

fully “reunify” the estate and gift taxes, such that a common exemption amount and rate schedule

would apply for both estate tax purposes and gift tax purposes.

B. Present Law and Recent Proposals Relating to Estate

and Gift Tax Rates and Exemption Amounts

1. In general

Under present law in effect through 2009 and after 2010, a unified credit is available with

respect to taxable transfers by gift and at death. The unified credit offsets tax computed at the

lowest estate and gift tax rates.

Prior to 2004, the estate and gift taxes were fully unified, such that a single graduated rate

schedule and a single effective exemption amount of the unified credit applied for purposes of

determining the tax on cumulative taxable transfers made by a taxpayer during his or her lifetime

and at death. For years 2004 through 2009, the gift tax and the estate tax continue to be

determined using a single graduated rate schedule, but the effective exemption amount allowed

for estate tax purposes is increased above the effective exemption amount allowed for gift tax

purposes, as described below.

2. Increase in unified credit effective exemption amount and reduction in estate and gift

tax rates under EGTRRA

Under EGTRRA, the estate, gift, and generation skipping transfer taxes are gradually

reduced between 2002 and 2009. In 2002, the unified credit effective exemption amount (for

both estate and gift tax purposes) increased to $1 million, and the highest estate and gift tax rate

was 50 percent. In 2003, the highest estate and gift tax rate was 49 percent. In 2004, the highest

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imposed using a flat rate equal to the highest estate tax rate on cumulative generation skipping transfers in

excess of the exemption amount in effect at the time of the transfer. The generation skipping transfer tax

exemption for a given year (prior to repeal, discussed below) is equal to the unified credit effective

exemption amount for estate tax purposes.

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estate and gift tax rate was 48 percent, and the unified credit effective exemption amount for

estate tax (but not gift tax) purposes increased to $1.5 million. In 2005, the highest estate and

gift tax rate was 47 percent. For 2006, the highest estate and gift tax rate was 46 percent, and the

unified credit effective exemption amount for estate tax purposes was increased to $2 million,

also the amount for 2007 and 2008. In 2007 and 2008, the highest estate and gift tax rate is 45

percent. In 2009, the unified credit effective exemption amount for estate tax purposes is

scheduled to increase to $3.5 million.

The unified credit effective exemption amount for gift tax purposes remained at $1

million in 2004 and later years, as the exemption amount for estate tax purposes increased above

$1 million.

taxes are not fully unified because the estate and gift tax effective exemption amounts differ.

3. Repeal of estate and generation skipping transfer taxes in 2010

Under EGTRRA, the estate and generation skipping transfer taxes are repealed for

decedents dying and generation skipping transfers made during 2010. The gift tax remains in

effect during 2010, with a $1 million exemption amount and a gift tax rate of 35 percent.

4. Reinstatement of the estate and generation skipping transfer taxes for decedents dying

and generation skipping transfers made after December 31, 2010

The estate, gift, and generation skipping transfer tax provisions of EGTRRA are

scheduled to sunset after 2010, such that those provisions (including repeal of the estate and

generation skipping transfer taxes) will not apply to estates of decedents dying, gifts made, or

generation skipping transfers made after December 31, 2010. As a result, in general, the unified

estate, gift, and generation skipping transfer tax rates and exemption amounts as in effect prior to

2002 will apply for estates of decedents dying, gifts made, or generation skipping transfers made

in 2011 or later years. A single graduated rate schedule with a top rate of 55 percent and a single

effective exemption amount of $1 million will apply for purposes of determining the tax on

cumulative taxable transfers made by a taxpayer by lifetime gift or bequest.

5. H.R. 5638 and H.R. 5970

In 2006, the House of Representatives passed two bills, each of which contained two

provisions designed at least in part to simplify planning, principally in the case of intra-family

transfers.

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House).

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Reunification of the estate and gift taxes

The first such reform would have reunified the estate and gift taxes such that a common

rate schedule and a single effective exemption amount would apply for purposes of determining

the cumulative tax on taxable transfers. In general, H.R. 5638 would have increased the

effective exemption amount for estate and gift tax purposes to $5 million for transfers after 2009,

whereas H.R. 5970 would have phased in a $5 million effective exemption amount over a period

of years. Each bill would have applied an estate and gift tax rate equal to the long-term capital

gains rate specified in section 1(h)(1)(C) (currently 15 percent in 2010 and 20 percent thereafter)

on the first $25 million in taxable transfers. For transfers in excess of $25 million, H.R. 5638

would have applied a rate equal to twice the long-term capital gains rate described above,

whereas H.R. 5970 would have phased in a 30-percent rate over a period of years.

Portability between spouses of unused exemption

Second, H.R. 5638 and H.R. 5970 each contained a provision that generally would permit

a surviving spouse to use any effective exemption amount that was not used by the predeceased

spouse. Under the bills, for gift and estate tax purposes, the unified credit effective exemption

amount that remains unused as of the death of a spouse who dies after December 31, 2009 (the

“deceased spousal unused exclusion amount”), generally would be available for use by such

spouse’s surviving spouse, in addition to such surviving spouse’s own exemption amount.

The aggregate amount of unused exemption equivalent (the “aggregate deceased spousal

unused exclusion amount”) that would be available for use by a surviving spouse from all

predeceased spouses could not exceed the basic exclusion amount in effect at any given time

(e.g., $5 million in H.R. 5638). The bills would permit a surviving spouse to use the aggregate

deceased spousal unused exclusion amount for taxable transfers made during life or at death.

Under the bills, a deceased spousal unused exclusion amount is available to a surviving

spouse only if an election is made on a timely filed estate tax return (including extensions) of the

predeceased spouse on which such amount is computed, regardless of whether the predeceased

spouse otherwise is required to file an estate tax return. In addition, notwithstanding the statute

of limitations for assessing estate or gift tax with respect to a predeceased spouse, the bills

provide that the Secretary of the Treasury may examine the return of a predeceased spouse for

purposes of determining the deceased spousal unused exclusion amount available for use by the

surviving spouse.

Example 1.

million and having no taxable estate. Assume further that the basic exclusion amount under the

above-referenced bills would be $5 million as of that time. An election is made on Husband 1’s

estate tax return to permit Wife to use Husband 1’s deceased spousal unused exclusion amount.

As of Husband 1’s death, Wife has made no taxable gifts. Thereafter, Wife’s applicable

exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased

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unused exemption for generation skipping transfer tax purposes.

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spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for

transfers at death.

Example 2.

marries Husband 2. Husband 2 predeceases Wife in a year in which the basic exclusion amount

is assumed for purposes of this example to be $5 million, having made no taxable gifts and

having no taxable estate. An election is made on Husband 2’s estate tax return to permit Wife to

use Husband 2’s deceased spousal unused exclusion amount. Although the deceased spousal

unused exclusion amount from Husband 2 is $5 million (the amount of his unused exclusion),

only $3 million of this amount is available for use by Wife, because she previously received the

benefit of $2 million of deceased spousal unused exclusion amount from Husband 1, and the bills

place a limit equal to the basic exclusion amount ($5 million for purposes of this example) on the

aggregate deceased spousal unused exclusion amount available to a surviving spouse from all

predeceased spouses.

Example 3.

Husband 2 in a year in which the basic exclusion amount is assumed for purposes of this

example to be $5 million. Husband 2 had no prior spouses. An election is made on Wife’s

estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion amount.

Wife made no taxable gifts and has a taxable estate of $3 million. Under the provision, Husband

2’s applicable exclusion amount is increased by $4 million, i.e., the amount of the deceased

spousal unused exclusion amount from Wife (computed as Wife’s $7 million applicable

exclusion amount less her $3 million taxable estate).

C. Issues Related to Reunification of Estate and Gift Tax Exemptions and Rates

and Portability Between Spouses of Unused Exemption

1. Issues related to unification

As described above, under present law as in effect from 2004 through 2009, the gift tax

effective exemption amount remains $1 million, while the estate tax effective exemption amount

rises above $1 million (ultimately to $3.5 million in 2009). Commentators have argued that this

decoupling of the estate and gift tax exemption amounts complicates wealth transfer tax planning

and raises administrability issues.

For example, some commentators argue that, as a result of the lower gift tax exemption

amount, taxpayers are likely to engage in complicated and costly planning to avoid gift tax.

They argue that the lower gift tax exemption (and resulting higher cost of the gift tax) could

encourage taxpayers to create complicated long-term trusts at death designed to avoid gift tax on

transfers to successive generations. They further argue that the lower gift tax exemption will

encourage taxpayers to delay transfers until death, “encouraging family wealth to remain ‘locked

in’ older generations.”

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The extent to which such practices have increased in use since the exemption amounts

were decoupled in 2004 is uncertain. In addition, the effect of the lower gift tax exemption

amount from 2004 through 2009 is partially mitigated by a structural difference between the

estate tax and the gift tax that generally benefits taxpayers who make inter vivos gifts: the gift

tax is “tax exclusive,” whereas the estate tax is “tax inclusive.” In other words, under the estate

tax, the assets used to pay the tax are included in the estate tax base. Thus, if the estate and gift

taxes were fully reunified, the gift tax would be a less costly tax.

Furthermore, the gift tax often is viewed as being necessary to protect the income tax

base. In the absence of a gift tax, it may be possible for a taxpayer to transfer an asset with builtin

gain or that produces income to a taxpayer who is in a lower tax bracket, where the gain or

income would be realized and taxed at a lower rate before the asset is returned to the original

holder. Therefore, if the gift tax effective exemption amount were increased to equal the higher

estate tax exemption amount, the effectiveness of the gift tax as a tool to protect the income tax

base may be diminished.

2. Issues related to exemption portability

Simplification of wealth transfer tax planning

Proponents of portability between spouses of unused exemption generally argue that it

eliminates the need for inefficient and costly tax planning and results in similarly situated

taxpayers being treated equally.

Assume, for example, that Husband and Wife each have $2 million in assets titled in their

separate names. Husband and Wife both die in 2008 (when the effective exemption amount is $2

million), and each bequeaths $2 million to Son. Husband and Wife collectively have used $4

million in exemption, successfully maximizing use of their available exemptions. Now assume

that Husband dies in early 2008 and bequeaths his $2 million estate to Wife. No estate tax is due

on the transfer, because the transfer qualifies for the 100-percent marital deduction. Wife, who

now owns $4 million in assets, dies in late 2008 and bequeaths her entire estate to Son. Wife has

available only her own $2 million exemption to offset the transfer to Son; the additional $2

million transferred to Son will be subject to estate tax. Husband’s estate tax exemption was not

used.

To maximize the use of a couple’s estate tax exemption amounts, couples frequently

employ a tax planning strategy under which assets of the first spouse to die pass into a “credit

shelter trust” at the time of that spouse’s death. The trust is designed to benefit the surviving

spouse during his or her lifetime while using the exemption of the first spouse to die to shield

trust assets that ultimately will pass to another beneficiary (such as Son in the above example)

from estate tax. To take advantage of this strategy, couples generally must hire a lawyer to draft

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Recommendations (Apr. 30, 1997), reproduced in 97 TNI 95-21 (May 16, 1997); American Bar

Association Task Force on Federal Wealth Transfer Taxes, Report on Reform of Federal Wealth Transfer

Taxes (2004) (hereafter, “ABA Task Force Report”), pp. 99-101.

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the trust documents and also must ensure that each spouse has sufficient assets titled in his or her

separate name to fund a credit shelter trust up to the full amount of his or her exemption amount.

Couples who do not have such trusts in place at the death of the first spouse to die may not be

able to take full advantage of both spouses’ exemption amounts. Even where couples do have

such trusts in place, if the first spouse to die does not have sufficient assets titled in his or her

own name at the time of death to fund the trust up to the amount of the then-applicable

exemption amount, a portion of such spouse’s exemption amount may be lost.

For these reasons, the American Bar Association Task Force on Wealth Transfer Taxes

(the “ABA Task Force”) has argued that “the law rewards both sophisticated planning and

constant reallocation of wealth, but does not offer the same benefits to couples who do not

engage in sophisticated planning or whose assets do not lend themselves to appropriate

allocation, such as property held in a qualified retirement plan.”

portability between spouses of unused exemption arguably would contribute to simplicity and

facilitate compliance with the law, because it largely would eliminate the need for couples to

employ the credit shelter trust strategy or to monitor and adjust the titling of assets.

Although proponents of portability generally assert that portability simply allows spouses

to achieve the results that otherwise would have been achieved through costly tax planning and

re-titling of assets, a portability provision (depending on how it is drafted) may allow couples to

achieve better results than they could have achieved through the best estate planning. Assume,

for example, that Wife dies when Husband’s and Wife’s collective assets were $4 million. The

most exemption that Wife’s estate could have used is $4 million (which could, for example, be

achieved by titling all of the couple’s assets in Wife’s name). Husband dies a decade later with

$10 million in assets, $5 million of which would be exempt under his own $5 million exemption.

Combined, the maximum amount of exemption Wife and Husband could have used without

portability would have been $9 million. With portability, it may be possible for Husband and

Wife to use a combined amount of $10 million (assuming that Wife used none of her $5 million

exemption because she had made no taxable gifts and either had no taxable estate at death or

bequeathed all assets to Husband). If this situation were viewed as problematic, it could be

addressed through a rule that would limit the amount of exemption that could be passed to a

surviving spouse to the lesser of (1) the combined value of the spouses’ assets as of the death of

the first spouse to die or (2) the unused exemption amount of the first spouse to die. However,

such a rule would add complexity and raise administrability concerns, as one would need to

value the assets of both the decedent and the surviving spouse as of the death of the first spouse

to die.

Administrability issues

Portability of unused exemption raises a number of other administrability issues. For

example, to determine the amount of additional exemption available to a surviving spouse, one

must know the amount of unused exemption remaining at the death of the first spouse to die.

Under the above-described House-passed bills, for example, unused exemption may be made

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available to a surviving spouse regardless of the value of assets owned at the time of the first

spouse’s death, e.g., even where the first spouse to die otherwise would not have been required to

file an estate tax return because the estate assets were below filing thresholds. If no return were

filed, it would be virtually impossible at the death of the surviving spouse to determine the

amount of unused exemption that remained at the death of the first spouse to die, which may

have occurred years or even decades earlier.

(as in the House-passed bills) that, in order to preserve unused exemption for a surviving spouse,

the estate of the first spouse to die file a return computing the amount of unused exemption.

However, such a return requirement likely would result in the filing of numerous returns solely

to preserve exemption for a surviving spouse, potentially burdening the IRS. In many cases, the

filings will prove to have been unnecessary, as the surviving spouse ultimately will have no need

for additional exemption to offset transfers. Nevertheless, estates are likely to file prophylactic

returns to preserve unused exemption, because of the possibility (however remote) that a

surviving spouse may accumulate significant additional wealth by the time of his or her

subsequent death.

Furthermore, even if a return is filed to preserve unused exemption, the IRS likely will

have little incentive to examine the return at the death of the first spouse to die. The IRS has

limited resources, and examination of a return filed solely to preserve unused exemption

generally would not lead to additional tax due from the estate of the first spouse to die. In

addition, by the time the surviving spouse dies, the statute of limitations with respect to the estate

of the first spouse may have expired. The House-passed bills attempt to address this issue by

providing that, notwithstanding any statute of limitations that may apply with respect to the

estate of the first spouse to die, the IRS may examine the return of the deceased spouse for

purposes of determining the amount of unused exemption available for the surviving spouse

(though not for purposes of adjusting the liability of the estate of the first spouse to die). Even

so, it could be difficult for the IRS to adjust the claimed amount of unused exemption.

Particularly in situations in which the spouses die many years apart, there may not be

contemporaneous records to support the claimed unused exemption amount.

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using ported exemption.

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gift tax exemption and rates are different from the estate tax exemption and rates) would raise additional

policy issues. For example, assume the estate tax exemption is $5 million and the gift tax exemption is $1

million. Husband dies with no taxable estate, but he used $500,000 of exemption on lifetime taxable

gifts, such that he passes a total of $4.5 million unused exemption to Wife. Should Wife be permitted to

use only $500,000 of this amount to offset lifetime taxable gifts (the amount of Husband’s unused gift tax

exemption), with the remainder available for use only at Wife's death? Should such a regime include a

gift tax cap and a separate cumulative cap on the amount of exemption a person can receive from

predeceased spouses?

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Multiple marriage situations

Portability of unused exemption presents additional policy and complexity issues in

multiple marriage situations. Assume, for example, the estate tax effective exemption amount is

$5 million, as under the House-passed bills containing portability provisions. If a surviving

spouse is predeceased by more than one spouse, should that surviving spouse be allowed to use

the full amount of unused exemption of all predeceased spouses (e.g., should the surviving

spouse have available (in addition to his own $5 million exemption) as much as $5 million from

each of two predeceased spouses, for a total of $15 million)? The House-passed bills partially

address this question by capping the cumulative amount of additional ported exemption from all

predeceased spouses from which a surviving spouse may benefit at the basic exemption amount

then in effect ($5 million in the example here).

To highlight another issue, assume that the estate tax exemption amount is $5 million and

that Husband 1 dies with no taxable estate and having made no taxable gifts, such that his entire

$5 million exemption is available for Wife, in addition to her own exemption. Therefore, Wife

has $5 million for her use for purposes of making lifetime gifts or bequests. Further assume that

Wife remarries and predeceases Husband 2. From a policy perspective, one may question

whether the amount of unused exemption passed from Husband 1 to Wife should be available to

Husband 2 following Wife’s death. As noted above, the House-passed bills cap the amount of

exemption a person may receive from all predeceased spouses at $5 million (the basic exemption

amount under such bills when fully phased in), such that in this situation, Husband 2 could

benefit from only $5 million of Wife’s $10 million unused exemption. But the bills do not

differentiate between a decedent’s own exemption and ported exemption for this purpose. So,

for example, if Wife had made taxable gifts prior to Husband 1’s death and had only $2 million

of her own exemption remaining, and subsequently received $5 million of unused exemption

from Husband 1 (for a total of $7 million), she could still pass $5 million of unused exemption to

Husband 2 at her death, even though a portion of this amount originally had been the exemption

of Husband 1. The Congress could craft a rule to address this issue, but such a rule would raise

additional administrability issues. Such a rule, for example, would make relevant at the death of

Husband 2 the amount of unused exemption passed from Husband 1 to Wife at Husband 1’s

death. As an alternative, one simply could provide that unused exemption received from

Husband 1 expires if Wife remarries.

D. Estimates of Utilization

The following table provides estimates of the number of taxpayers that would potentially

benefit if exemption portability were in effect. The second column assumes that portability had

been enacted effective for decedents dying after 1998. The third column assumes that portability

will be enacted for decedents dying after 2008. Estimates are provided for two selected years:

2009 (when the effective exemption amount is scheduled to be $3.5 million) and 2012 (when the

effective exemption amount is scheduled to be $1 million). For purposes of determining the

number of estates that would benefit from enactment of exemption portability, the estimates

assume enactment of a provision substantially similar to the portability provisions included in the

above-described House-passed bills. The estimates assume that other aspects of present law

remain unchanged. The estimates in the second column (which assume portability had been

enacted for decedents dying after 1998) are intended to show utilization when a portability

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provision has been in effect for a number of years. Portability only is used at the death of a

surviving spouse, and a surviving spouse may survive a predeceased spouse by many years.

Therefore, the full benefits of portability likely would not be seen until portability had been in

effect for several decades. The estimates of utilization in 2012 (when the exemption is scheduled

to be $1 million) as compared to 2009 (when the exemption is scheduled to be $3.5 million)

generally show that more taxpayers will benefit from portability when the effective exemption

amount is lower because more estates will have estate tax liabilities.

Table 1.–Estimated Number of Estates Benefiting From Portability

Total number of

taxable estate tax

returns

Number of estates

that benefit

assuming

portability was

effective 1999

Number of estates

that benefit

assuming

portability was

effective 2009

Returns filed in 2009

($3.5 million exemption) 18,400 10,000 730

Returns filed in 2012

($1 million exemption) 66,500 41,000 3,900

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II. WEALTH TRANSFERS AND LIQUIDITY

A. Overview

At various times, Congress has expressed concern about the special burdens an estate tax

may place on farms and other family-owned businesses. A particular concern has been that if a

large part of the value of an estate subject to estate tax consists of a farm or another familyowned

business, the estate may not include sufficient liquid assets to fund estate tax liability. It

has been argued that if an estate lacks this liquidity, heirs may be forced to sell the business to

generate funds to pay the estate tax. Potential forced sales of farms and other family businesses

have been viewed as undesirable: farming and other family-owned businesses have been seen as

important to the U.S. economy and culture, and sales of those businesses might harm local

communities by causing job losses and other disruptions.

Congress has acted on its concerns about the effects of the estate tax on farming and other

family-owned businesses by passing bills with provisions that make it easier for certain estates

that include those businesses to satisfy their estate tax liabilities. One provision permits a farm

or other real property used in a business to be valued at the property’s current use rather than at

its higher market value.

closely held business to be deferred for five years and then paid in installments over the

following ten years.

the value of certain family-owned business interests in the estate.

Ways and Means Committee accompanying the bill that included current-use valuation and

installment payment rules largely similar to those in present law makes the following statement:

[T]he estate tax can impose acute problems when the principal asset of the estate is equity

in a farm or small business. Because assets are valued at their “highest and best use”

rather than on the specific use to which the assets are being put and because these assets

are illiquid, family members have been forced to sell farms and small businesses in order

to pay the estate tax. . . . The[ ] changes [to the current-use valuation and installment

payment rules] are intended to preserve the family farm and other family businesses, two

very important American institutions, both economically and culturally.

Similarly, the Senate Report of the Finance Committee accompanying the bill that led to the

enactment of section 2057 states:

The Committee believes that a reduction in estate taxes for qualified family-owned

businesses will protect and preserve family farms and other family-owned enterprises,

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and prevent the liquidation of such enterprises in order to pay estate taxes. The

Committee further believes that the protection of family enterprises will preserve jobs

and strengthen the communities in which such enterprises are located.

This section discusses wealth transfers and liquidity. It first describes sections 2032A,

6166, and 2057. It then evaluates criticisms of those provisions. Last, to help assess the extent

to which the estate tax creates cash flow problems for family businesses, it presents data showing

relative liquidities of estates with farms and other closely held businesses and showing certain

characteristics of estates for which benefits have been claimed under section 2032A, 6166, or

2057. The data suggest that many estates that are comprised largely of farms or other closely

held businesses have enough liquid assets to satisfy estate tax liabilities. Nonetheless, the

decreased liquidity attributable to payment of estate tax may impair a business’s ability to

function and grow. It is difficult to assess the extent of this impairment caused under the current

estate tax.

B. Present and Prior Law for Special-Use Valuation, Installment Payments,

and Family-Owned Businesses

1. Valuation

In general

For Federal estate and gift tax purposes, the value of property generally is its fair market

value, that is, the price at which the property would change hands between a willing buyer and a

willing seller, neither being under any compulsion to buy or sell and both having reasonable

knowledge of relevant facts. For Federal estate tax purposes, fair market value generally is

determined at either (1) the time of the decedent’s death, or (2) the “alternate valuation date,”

which is six months after the decedent’s death.

generally is determined on the date the gift is made.

Special-use valuation

If certain requirements described below are satisfied, an executor of an estate that

includes real property used in farming or another trade or business generally may elect for estate

tax purposes to value the property based on its current-use value, rather than based on its highest

and best use.

reduction in value for this real property resulting from an election under section 2032A is

$960,000.

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An executor of an estate may elect application of the special-use valuation rules if,

among other conditions, the following chief requirements are satisfied:

•

and the real property qualifying for special-use valuation must be located in the

United States;

•

real or personal property being used at the time of the decedent’s death as a farm or in

another trade or business;

•

property that passes to a qualified heir and that was used as a farm or in another

closely held trade or business by the decedent or a member of the decedent’s family

for at least five of the eight years ending on the date of the decedent’s death;

•

property qualifying for current-use valuation must have been owned by the decedent

or a member of the decedent’s family and must have been used by the decedent or a

member of the decedent’s family as a farm or other business (a “qualified use”), and

the decedent or a member of the decedent’s family must have materially participated

in the operation of the farm or other business;

•

If, after an election is made to value property at its current-use value, the heir who

acquired the real property disposes of the property or ceases to use it in its qualified use within

10 years after the decedent’s death, an additional estate tax is imposed as a way of recapturing

the estate tax benefit of the current-use valuation.

Recipients of property for which special-use valuation is elected take a basis equal to the

property’s special-use value, rather than its fair market value.

2. Installment payment of estate tax for closely held businesses

In general, an estate tax return must be filed, and estate tax is due, within nine months of

a decedent’s death.

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gross estate are determined (1) based on property’s highest and best use rather than on its current-use

value, and (2) by subtracting the amount of any indebtedness in respect of property.

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self employment).

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acquires the property. For this purpose a member of the family includes, among others, the spouse of the

decedent, lineal descendants of the decedent or the decedent’s spouse, or the spouse of any of these lineal

descendants.

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generally may elect to pay estate tax attributable to an interest in a closely held business in two

or more, but in no more than 10, equal installments.

installment of tax must be paid within five years after the normal nine-months-after-date-ofdeath

deadline for payment of estate tax. Each succeeding installment must be paid within one

year after the preceding installment.

If payment of tax is deferred during the initial five-year period, interest on the unpaid tax

amount must be paid annually during that period. After the initial five-year period, interest on

the remaining unpaid tax amount must be paid at the time each installment payment is made. For

an estate of a decedent dying in 2008, interest on the amount of deferred estate tax attributable to

a maximum of $1.28 million in taxable value of a closely held business is computed at a twopercent

rate.

adjusted annually for inflation. If the taxable value of a closely held business exceeds the

maximum amount for which the two-percent rate is available, the interest rate applicable to

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extended in certain circumstances. The Treasury Secretary may extend, for reasonable cause, the time for

payment of estate tax or for payment of an installment under section 6166 for a reasonable period not in

excess of 10 years. Sec. 6161(a)(2). Under regulations, the district director or the director of a service

center may grant, at the request of the estate’s executor, an extension of time to pay estate tax for a

reasonable period of time not to exceed 12 months if such request, based on all the facts and

circumstances, is based on reasonable cause, such as liquid assets being located in several jurisdictions

and not being immediately subject to the control of the executor. Treas. Reg. sec. 20.6161-1(a)(1). If the

district director determines that payment of estate tax, payment of a deficiency for estate tax, or an

installment payment of estate tax under section 6166 would impose undue hardship on the estate, the

district director may extend the time for payment for a period not to exceed 10 years. Undue hardship

must be more than an inconvenience or the sale of an asset at its fair market value. Undue hardship may

exist where the executor needs additional time to raise funds instead of selling a farm or other closely held

business to an unrelated person or where assets of the estate can only be sold at a sacrifice price. Treas.

Reg. sec. 20.6161-1(a)(2).

The Treasury Secretary also may extend, for reasonable cause, the time for the payment o

Full post as published by North Carolina Estate Planning Blog on April 04, 2008 (boomark / email).