After a decade of uncertainty, on December 17, 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “Act”). The Act provides guidance to taxpayers for tax years 2010 through 2012 and presents planning opportunities during this period of time. Reminiscent of the past decade, the law is not permanent and so Congress will need to pass further legislation to define the estate, gift, and generation-skipping transfer (“GST”) tax laws for 2013 and beyond. Therefore, if the Act expires at the end of 2012 without further action by Congress, the law will return to pre-2001 levels (with a $1,000,000 estate and gift tax exemption and a maximum rate of 55%). While we hope and expect that Congress will pass permanent legislation prior to the end of 2012, we are unable to predict whether the next Congressional act will be permanent or another short-term fix and what such legislation will entail.
Exemption and Tax Rate
The Act grants individuals a $5 million exemption for federal estate, gift and GST transfers and establishes the maximum federal estate and gift tax rate at 35%. This means that as of January 1, 2011, individuals can make lifetime gifts of up to $5 million (or $10 million for couples utilizing their separate exemptions or electing to gift split) without incurring gift tax liability. The exemption (also called the “applicable exclusion amount”) will be indexed for inflation for years after 2010. As a planning opportunity, many taxpayers will want to consider making gifts of the full $5 million (or $10 million per couple) exemption before the end of 2012, in case this opportunity then goes away. The Act reinstates the GST tax for transfers occurring after December 31, 2009, permitting a $5 million GST tax exemption to be used during lifetime or upon death. In order to reduce uncertainty regarding the application of the GST tax laws for transfers occurring during 2010, the Act reinstated the GST tax laws during 2010, but imposed a zero percent tax rate for transfers made in 2010. For transfers made in 2011 or 2012, the GST tax rate will be 35%. To put all of this in perspective, for many years the exemption for estate and gift tax was $600,000, and the GST exemption was $1,000,000. The estate and GST exemptions gradually increased to $3.5 million over the past decade or so, although the gift tax exemption remained at $1 million. This was presumably because Congress did not want taxpayers to give more during lifetime than they could if the law expired as scheduled in 2010 (should they outlive the law). Apparently, this was not a concern this time around, as taxpayers are now permitted to gift the full $5 million now even if the law does sunset in two years.
The maximum estate and gift tax rate (and the flat GST rate) was 55% for many years and over the past decade gradually declined to 45% last year. It is now 35% for the next two years. As a planning opportunity, many taxpayers will consider making taxable gifts while the maximum rate is 35% before the rate potentially increases.
Portability
The Act also introduces a new concept called “portability,” which applies to married couples whose deaths occur after December 31, 2010. In the past, an applicable exclusion was considered personal to an individual and, if not used during lifetime or at death, it would be lost. The Act permits a surviving spouse to make an election on the estate tax return of the deceased spouse (whose death occurs after 2010) to increase the survivor’s own estate and gift tax exemption by the amount of exemption the first spouse did not use. In the simplest example, one spouse dies, leaving all assets to the surviving spouse, never having used any of his or her exemption for lifetime taxable gifts. The surviving spouse can elect to use the deceased spouse’s entire $5 million exemption in addition to his or her own exemption (for a total exemption of $10 million available to the surviving spouse). Portability must be affirmatively elected on an estate tax return for the first deceased spouse or the opportunity will be lost. It is important to note that portability does not apply to the GST exemption. In other words, a surviving spouse is not permitted to elect to use the first deceased spouse’s unused GST exemption. Therefore, establishing one or more trusts upon the death of the first spouse is likely to remain an important element of estate planning for families wishing to utilize the GST exemptions of both spouses. While portability provides flexibility in estate planning, there are still many good reasons to utilize trusts as part of a comprehensive estate plan. Assets distributed to a residuary trust (sometimes called a “credit shelter trust”) upon the death of the first spouse will not be included in the surviving spouse’s estate. The assets held in such a trust will be available for the surviving spouse’s needs, but the appreciation will escape estate tax in the survivor’s estate. Further, because the Act is only in place for two years, it is difficult at this point to predict what the survivor’s exemption will be in the future. Remember, portability allows the survivor to tack on the unused exemption of the first deceased spouse, but if the assets have increased significantly in value, the appreciation may not escape estate tax in the survivor’s estate.
Income Tax Basis
In reinstating the estate tax, Congress also reinstated the rules that cause most inherited assets to receive a new fair market value basis (applied as of the date of death or alternate valuation date if elected). This “fair market value” basis will apply to assets inherited from a decedent. When an individual beneficiary (or trust) sells the asset, the fair market value basis can reduce capital gain. In contrast, assets transferred by gift during lifetime will retain the donor’s “carry-over” basis in the hands of the recipient. Therefore, when making decisions about what assets to transfer during lifetime versus at death, it is important to consider the likely impact of the income tax basis rules as well as the likelihood of appreciation. In very general terms, because income and capital gains taxes apply only to appreciation, it is usually advantageous to make lifetime gifts of assets likely to appreciate significantly. However, all carefully considered estate plans must take into account many factors including the interplay among the estate, gift, and income tax rules.
Choice of Law for 2010
For deaths that occurred during 2010, the Act allows executors to elect out of the new federal estate tax law. If such an election is made, no estate tax is payable; however, the income tax basis of inherited property will be the lesser of the decedent’s carry-over basis or the value of the property on the decedent’s date of death, as adjusted by the executor by an amount up to $4.3 million. $1.3 million of the basis adjustment may be applied to increase the basis of assets passing to anyone. An additional $3 million of basis adjustment may be applied to increase the basis of assets passing to a surviving spouse. If such an election is not affirmatively made, and the new tax laws apply, estate tax will be assessed at the rate of 35% of the value of all taxable property in excess of the applicable exclusion amount (which is $5 million less amounts used for taxable transfers during lifetime). If the new law applies, the fair market value basis rules also apply, causing the income tax basis of inherited property to equal the value of the property on the decedent’s date of the death (or the alternate value, if used). Executors will need to evaluate which option is more favorable to the estate beneficiaries and make an election (and pay tax, if any) before nine months after the enactment of the Act (September 17, 2011). The foregoing summary is a very general summary of the new tax laws. Due to the newsletter format, we have not gone into detail about the many questions raised by the new laws. The application of the laws to any particular situation will require careful analysis. A thoughtfully considered estate plan takes into account many factors, including overall estate planning goals, family circumstances, the nature of assets, and, of course, the application of tax laws. We recommend that clients review their estate plans at least once a year to determine if the plan requires updating due to changes in family circumstances or otherwise. The new tax laws provide interesting planning opportunities.
Please let us know if we can assist you to review and update your estate plan. For additional information regarding this topic, please contact Susan Hecker at shecker@williamsparker.com or 941-329-6625.