The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “Act”) was signed by President Obama on December 17, 2010. Temporary is the key theme since most of its provisions are temporary two year fixes that impact 2011 and 2012 only.
All of the Bush-era tax cuts that were scheduled to expire at the end of 2010 will now expire at the end of 2012. From a tax planning perspective, taxpayers now have two more years of certainty for implementing tax strategies. While the primary feature of this Act is a two-year extension of the Bush-era income tax cuts, it also addresses the repeal of the estate tax for 2010 and its reinstatement in 2011.
Specific to estates, the Act reenacts the estate tax for 2010 (but grants an option to elect back into the repeal) and provides generous estate and gift tax exemptions and rates for 2010, 2011 and 2012. Nevertheless, the Act is just a temporary measure and in 2013, the pre-2001 estate and gift tax provisions are scheduled to return.
Without any further actions by the Congress, a much greater tax burden on estates and gifts will affect taxpayers beginning in January, 2013.
One can hardly generalize about the implications of these recent changes to individual estate plans and this information is certainly not intended as legal advice or as a substitute for a review of your particular situation by a qualified estate planner. Rather, this is only an effort to highlight some instances where changes to your plan might be beneficial.
Continue reading for brief summary of the Act and some of the opportunities and pitfalls it presents for personal estate planning.
Effectively planning your estate for the next two years
Before the passage of the Act, estates of those who passed away in 2010 faced much uncertainty. A 2001 law repealing the estate tax for persons dying in 2010 imposed a carryover basis regime that generally required heirs to use the deceased’s tax basis for inherited property. Prior to 2010, heirs received a basis step-up at the time of death.
In some cases, this 2010 requirement resulted in a greater tax than would have been imposed by the estate tax. Not only that, there was also the risk that the estate tax would be retroactively reinstated for 2010, leaving many executors in doubt as to what to do.
The Act removed this uncertainty for a person’s estate that passed away in 2010. The carryover basis has been repealed and the estate tax for 2010 reinstated with the $5.0 million exemption and 35% tax rate. These rates and stipulations are in effect through 2011 and 2012.
In addition, the new law also permits estates of persons dying in 2010 to opt-out of the estate tax and accept the carryover basis regime. For those dying in 2011 and 2012, the Act greatly reduces the reach of the estate tax by granting estates a $5 million exemption for property subject to the tax. This is a significant increase over the $3.5 million exemption allowed in 2009, the last year in which there was an estate tax.
The Act also introduces the concept of exemption “portability” between spouses, meaning if one spouse does not use all I of their $5.0 million exemption, it may be used by the estate of the surviving spouse. This effectively creates a $10.0 million exemption for married couples. Estates that exceed this $5.0/$10.0 million threshold will be subject to a new 35% tax rate which is considerably lower than the 45% rate that applied in 2009.
In addition, gift taxes are much less onerous under the new law. Since 2002, taxpayers have only had a $1 million lifetime exemption for gift tax purposes even as the estate exemption increased to $3.5 million. That lifetime exemption for gift tax purposes is now increased to $5 million for gifts made in 2011 and 2012, with a 35% tax on gifts over that amount. This reunification of the gift and estate exemption offers an excellent opportunity over the next two years for anyone wishing to make substantial wealth transfers.
The Act also makes several changes to the generation-skipping transfer (GST) tax, which is in essence an additional tax imposed on gifts and bequests to grandchildren and great grandchildren. The 2001 legislation repealed the GST tax for 2010 only. This causing great uncertainty in 2010 over the treatment of many of the common estate planning strategies designed to take advantage of one’s generation-skipping exemption.
The recent legislation eliminates that uncertainty by reinstating the GST tax for 2010, but with a 0% tax rate. This means that any generation-skipping transfers in 2010 were free of any generation-skipping tax, but that taxpayers could still take advantage of the various GST tax exemptions that could reduce or eliminate the tax in future years. For 2011 and 2012, the Act aligns the GST tax with the estate and gift taxes with a $5.0 million exemption and a tax rate of 35%.
Baring Congressional action between now and the end of next year, all of these exemptions will revert back to $1.0 million with a maximum tax rate of 55%. Most planners do not think we will return to those levels from where we are now but 2010 clearly shows us we should not bet on Congress. Full repeal should be considered a real possibility in view of the limited revenue that will be generated with exemptions at the current level. With the many possible outcomes, it will be prudent to design flexible estate plans and take advantage of today’s generous gift exemptions.
The federal estate tax no longer needs be considered in planning many estates. If your estate plan has provisions designed to minimize the estate tax and your total assets are less than $5 million (or $10 million for married couples), you should consider simplifying your plan.
If you’re married and your will contains a “formula” tax exemption trust tied to the estate tax exemption amount, the increased exemption will automatically be taken into account. Most tax exemption trusts provide that the surviving spouse will receive all of the income from the trust but may receive principal distributions only for health, support and maintenance, particularly if the spouse is the sole trustee. If your spouse’s access to the income or principal of the trust is limited, or if your will or trust provides that the exemption amount will pass to your children or to other beneficiaries, you should review your financial situation and make certain that the reduced disposition to your spouse is consistent with your intentions.
And of course estate plans should take into account applicable state estate taxes as well
Estate plans often include disclaimer trusts allowing the surviving spouse to decide whether to direct some or all of the estate of the first spouse to die into a tax exemption trust. Such a plan will accommodate the recent changes in federal law very well and may also accommodate a disparity in the federal estate tax and a state’s inheritance tax exemptions. While the disclaimer trust plan is the most flexible for married couples, the many technical requirements that must be followed make it imperative that the surviving spouse contact their estate planner at the time of the first death in order to insure compliance.
Frequently, married individuals with exposure to the estate tax have been advised to keep property in their separate names to facilitate utilizing each spouse’s exemption amount regardless of who dies first. To avoid inadvertent wasting of the deceased spouse’s exemption amount, the Act provides for the portability of exemption amounts between spouses.
However, this portability is scheduled to disappear in 2013.
Even though this may prove to be invaluable in the future, it may be prudent to keep property in your separate names unless portability is made permanent. However, if exposure to the federal estate tax is not likely to be an issue, joint ownership to facilitate transfer to the surviving spouse outside of the probate system may now be appropriate, particularly in states that have onerous probate systems.
You should know that the amount of the deceased spouse’s exemption is only portable to the surviving spouse if the executor of the deceased spouse’s estate files a Form 706 federal estate tax return declaring the amount of unused exemption. Unless the Internal Revenue Service offers a simplified estate tax return form for this purpose, some relatively simple estates may have to incur additional administration costs where no estate tax return would otherwise be required
Since it appears the estate tax will be around for the foreseeable future, individuals with large estates who have been holding off on planning in anticipation of its possible permanent repeal should now address strategies such as lifetime gifts, irrevocable trusts, generation skipping trusts, grantor retained annuity trusts, qualified personal residence trusts, charitable split interest trusts, and business succession plans designed to minimize transfer taxes.
In addition, proper life insurance planning remains important where liquidity to pay debts or estate taxes is an issue.
Lifetime gifting should be addressed during 2011 and 2012 since no matter how many prior gifts there have been, each individual will have an additional $4,000,000 in federal lifetime gift tax exemption to work with in the next two years. The larger gift tax exemption amounts will allow individuals and couples to create trusts and investment opportunities for their children and descendants which would have incurred prohibitively high gift taxes in past years.
With a reduced estate tax burden, individuals should find it easier to achieve their wealth transfer objectives for family members.
This should also be a good time to review and consider a wide variety of charitable giving techniques ranging from outright gifts to establishing and administering private family foundations, donor advised funds and charitable split interest trusts.
Planning for estate tax inclusion to get a basis step up will come with much less estate tax exposure with the now increased exemptions. Additionally, there are many irrevocable and testamentary trusts in existence that were designed to hold property for beneficiaries without being included in the beneficiaries’ taxable estates. A beneficiary’s projected taxable estate may now be well under the estate tax exemption even if the trust property were included.
If so, depending on the terms of the trust and other purposes of the trust, it may be possible to terminate the trust or to distribute specific property to the trust beneficiary for inclusion in his estate in order to get the step-up in basis for income tax purposes.
Even without taxes, estate planning and administration is extremely complicated. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 presents taxpayers with a number of estate planning opportunities that may well produce significant savings.
Failure to consider and correctly interpret all of the applicable issues could be very costly so consultation with a qualified estate planner familiar with your circumstances and state’s laws is advisable.