The Tax Act of 2010 (the “Act”), signed by President Obama on December 17, 2010, makes important changes in our Federal estate, gift and generation-skipping transfer tax rules. In many situations, the new rules present significant estate planning opportunities during the next two years. This Report summarizes some of these changes.
I. Key Estate and Gift Tax Provisions
Background: Starting in 2001, the Federal estate tax was gradually reduced over several years and then eliminated for decedents dying in 2010. In its place, a “carryover basis” system became effective on January 1, 2010, with a decedent’s original cost basis in property for income tax purposes being carried over to his or her estate or beneficiaries, subject to certain modifications. Prior law also provided that the estate tax would be reinstated in 2011, with a maximum tax rate of 55% and a $1 Million applicable exemption. Planning was challenging prior to December, 2010, while tax practitioners awaited clarifying legislation of a more “permanent” nature.
The Act: The new legislation reinstates the Federal estate tax for decedents dying during 2010, but with a significantly higher exemption amount of $5 Million per taxpayer ($10 Million per married couple) and a lower maximum tax rate of 35%. This new estate tax regime also applies to the estates of decedents dying in 2011 and 2012. Unfortunately, this regime is temporary in that, absent future legislative action, it will sunset on December 31, 2012 when the prior estate tax rules (including a 55% maximum estate tax rate and a $1 Million exemption) again become applicable in 2013. Avoiding Constitutional concerns based on the argument that a new estate tax may not be applied retroactively to January 1, 2010, the Act offers estates of persons dying during 2010 the option to either (1) retroactively subject the estate to the Federal estate tax based on the new 35% top rate and $5 Million exemption, with stepped-up basis, or (2) pay no Federal estate tax but subject the estate assets to the modified carryover basis rules. Under the modified carryover basis rules that applied during 2010, Executors could elect to increase the basis of estate property by $1.3 Million (plus an additional $3 Million for assets passing to a surviving spouse, for a total increase of $4.3 Million), with other estate property taking a carryover basis equal to the lesser of the decedent’s basis or the fair market value on the
For years 2011 and 2012, the reinstatement of the estate tax means that inherited property subject to estate tax would again receive a “stepped-up” basis for income tax purposes. Property with a stepped-up basis generally receives a basis equal to the property’s fair market value on the date of the decedent’s death. The Act also provides for “portability” between spouses of a deceased spouse’s unused estate tax exemption for estates of decedents dying in 2011 and 2012. The election to transfer the unused portion to the surviving spouse must be made on an estate tax return filed for the estate of the deceased
spouse, even if a Federal return would not otherwise be required due to the size of the estate.
For gifts made in 2010, the maximum gift tax rate was 35% and the lifetime exemption was $1 Million. For gifts made in 2011 and 2012, the Act increases this exemption to $5 Million, or potentially $10 Million in the case of a married couple. This change provides an unprecedented opportunity to move substantial amounts of wealth out of individuals’ estates.
Donors may continue to use the annual gift tax exclusion before having to expend any part of their lifetime exemption. For 2010 and 2011, the annual exclusion amount is $13,000 per donee (married couples may continue to “split” their gift and make combined gifts of $26,000 to each donee). In addition, qualified direct tuition and medical payments on behalf of family members and others are still exempt from the gift tax.
Generation Skipping Transfer (“GST”) Tax
The Act provides a $5 Million GST exemption for 2010 with a GST tax rate of “zero”% for 2010. For transfers made after 2010, the exemption would continue at $5 Million and the GST tax rate would be equal to the highest estate and gift tax rate in effect for the year (35% for 2011 and 2012).
The new Federal estate, gift and GST tax provisions are generally very favorable to taxpayers because of the substantial increase in the exemption to $5 Million and the reduced tax rate of 35%. Taxpayers and practitioners need to be aware that the Act is a short-term solution that is scheduled to sunset on December 31, 2012, following the next Federal election. We cannot now predict whether it will be extended in either its current or some modified form, especially given the fact that
it is a sensitive issue with both political parties. If Congress fails to act as it did during the years 2002 through 2009, the new rules will lapse and the transfer tax system tax will revert to what it would have been under prior law (the $1 Million exemption and 55% maximum estate and gift tax rate).
Several techniques can be used to leverage the $5 Million gift tax exemption to move substantially more than this amount to junior family members and other beneficiaries. See Planning Tools Still Available, below.
State Estate Taxes
Many states have separate estate tax rules with exemptions that are lower than the $5 Million Federal exemption amount. These include Connecticut ($3.5 Million), New Jersey ($675,000), and New York ($1 Million), among others. It is important that individuals living in or owning property located in such states consider the planning options for dealing with such state estate tax exposure.
One salient provision in the Act is the “portability” concept. In general, if one spouse does not fully utilize his/her entire $5 Million exemption, the unused portion can be transported to and used by the surviving spouse either through lifetime gifts or by transfers at death. It is not clear that this portability of the exemption will apply after 2013.
The portability provision may have been intended to avoid the need for Credit Shelter Trusts in estate planning documents. And yet, Credit Shelter Trusts should continue to provide significant additional benefits beyond just maximizing the use of each spouse’s exemption. These include the following:
(1) Ensuring that assets contained in the Credit Shelter Trust pass to descendants of the couple and not to a second spouse.
(2) Ensuring that appreciation on the assets funding the Credit Shelter Trust is not subject to estate tax at a later date.
(3) Protecting assets in the Credit Shelter Trust from creditors of the surviving spouse or other
Planning Tools Still Available
Practitioners felt two important planning techniques would no longer be possible under the new law, but both survived intact for the time being. Legislative proposals were made last year to place limits on Grantor Retained Annuity Trusts (“GRATs”), which trusts allow individuals to transfer wealth out of their estates with as little as a zero estate or gift tax cost. Proposals have also been made to limit valuation discounts in connection with certain estate planning techniques such as family limited partnerships. No such provisions appear in the Act, so these techniques continue to be available to move wealth to junior family members.
Temporary Relief Does Not Extend to Non-U.S. Citizens Who Are Not Resident for Estate Tax Purposes
The increased Federal estate tax exemption of $5 Million does not apply to non-U.S. citizens who are not residents. U.S.-situs property exceeding $60,000 in value is again subject to Federal estate tax beginning at graduated marginal rates of 18%. Accordingly, particular care needs to be exercised in structuring the acquisition of any assets having a U.S.-situs, including but not limited to real property.
- The Federal estate tax exemption has been increased to $5 Million and the maximum rate reduced to 35% for persons dying in the years 2010 through 2012. For estates of persons dying in the year 2010, the estate will have an election to apply either the new estate tax rules retroactively with stepped-up basis or a carryover basis regime.
- The lifetime gift tax exemption is increased to $5 Million and maximum gift tax rate is reduced to 35% for gifts made in 2011 and 2012.
- A “portability” provision would allow surviving spouses to use any exemption that is not used by the first spouse to die. Portability applies to the estate and gift tax exemptions but not the GST exemption.
- The GST exemption is increased to $5 Million for the years 2011 through 2012.
- Absent further legislative changes, the new Federal rules would expire at the end of 2012 and we would generally revert to the exemptions and rates that applied prior to 2001.
We encourage clients to review their estate plans periodically and/or whenever a significant life event occurs (e.g., birth of a child, death of a spouse, purchase of new home, change of state of residence, etc.). Individuals with substantial amounts of wealth should consider using lifetime gifts to take advantage of the current $5 Million gift tax exemption, which will expire
absent further Congressional action at the end of 2012.
Please do not hesitate to contact us with any questions that you might have or if you would like to discuss your estate plan in light of the Act.
This Advisory is provided as general information only. No action should be taken solely on the basis of its contents. To ensure compliance with IRS requirements, we inform you that any tax advice contained in this communication was not intended or written to be used and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing or recommending to another party any transactions of matter addressed herein.
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