In December, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the "Act") was enacted. Before the Act, the federal estate tax had been gradually reduced over several years and then eliminated, for one year only, for persons dying in 2010.
As a result of the failure of Congress to act in 2009, for most of 2010 the law applicable to estate, gift and generation-skipping transfer ("GST") tax was in a state of turbulence.
For 2010, prior to the enactment of the Act, there was a one-year repeal of estate and generation skipping transfer tax and a tax on gifts in excess of $1 million at a 35% rate. Also, before enactment of the Act, the estate and GST taxes were scheduled to return on January 1, 2011, with a $1 million exemption and a 55% tax on all amounts transferred in excess of that exemption amount.
The Act significantly changes the federal estate and gift tax in the following key respects:
- The estate tax exemption amount increases to $5 million per person for 2010 through 2012.
- The gift tax exemption increases to $5 million per person for 2011 and 2012.
- The maximum estate and gift tax rate is reduced from the 55% maximum rate under prior law to a maximum estate and gift tax rate of 35% for 2011 and 2012.
- A "portability" provision is included, which allows surviving spouses to use any exemption amount that is not used by the estate of the first spouse to die.
- The GST exemption amount is increased to $5 million for 2010 through 2012.
- The Act sunsets at the end of 2012, thus making the foregoing changes temporary in nature.
The purpose of this memo is to summarize the key changes to the estate, gift and GST tax laws that result from the Act and to identify planning opportunities that should now be considered.
Summary of Key Estate, Gift and GST Tax Provisions of the Act
Estate Tax
For 2011 and 2012, and for 2010 (retroactive to January 1, 2010), the estate tax exemption is set at $5 million per person and the tax rate on amounts above that exemption amount is 35%. Although this increased exemption and reduced rate is scheduled to expire on December 31, 2012, the Act also provides that exemption amounts will be indexed for inflation beginning in 2012.
The Act eliminates the modified carry-over basis rules applicable under prior law for 2010 and replaces them with the stepped-up basis rules that had applied before 2010. The basis of inherited assets for income tax purposes will be stepped up to their fair market value at date of death.
Although the new estate tax was made retroactive to January 2010, the Act also provides that for decedents dying in 2010, the estate will have the ability to make an election to be taxed under the estate tax provisions of the Act (a $5 million exemption and a 35% tax on any amounts above $5 million), or to have no estate tax (the law in effect prior to December 17, 2010), but with a modified carry-over basis for income tax purposes. Under the modified carryover basis rules that applied during 2010 before the Act, executors could increase the basis of estate property only by a total of $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 property’s fair market value on the decedent’s death. The most likely result of this election will be that if a decedent’s estate is greater than $5 million, the election will be made for no estate tax to be paid but carry-over basis for income tax purposes will apply.
The Act provides that unless an affirmative election is made, the estate tax exemption of $5 million will apply and amounts above the exemption will be taxed at 35% for deaths occurring in 2010. Thus, if an estate of a decedent dying in 2010 was less than $5 million, no action needs to be taken in order to avoid estate tax and to receive the step-up in basis for income tax purposes. With rare exceptions, no election out of the new estate tax provisions would be warranted. However, for estates of decedents dying in 2010 with assets greater than $5 million, the correct action is not a simple determination. A careful review needs to be made of the applicable tax consequences for those estates.
Gift Tax
For gifts made in 2010, the maximum gift tax rate is 35% and the exemption amount is $1 million. For gifts made in 2011 and 2012, the Act limits the maximum gift tax rate to 35% and increases the exemption amount to $5 million. As discussed below, this change provides an opportunity to move significant amounts of wealth free of estate and gift taxes.
Donors continue to be able to use the annual gift tax exclusion before having to use any part of their lifetime exemption amount. For 2010 and 2011, the annual exclusion amount is $13,000 per donee (married couples may continue to "split" their gift and may make combined gifts of $26,000 to each donee).
Generation Skipping Transfer Tax
The Act provides a $5 million GST exemption amount (equal to the exemption amount for estate tax purposes) with a GST tax rate of zero percent for 2010. For transfers made after 2010, 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 Act also extends certain technical provisions under prior law affecting the GST tax.
There is no elect-out provision with respect to GST tax for 2010 and as a result there will still need to be an allocation of the $5 million GST exemption for transfers made in trust during 2010 in order to fully utilize the decedent’s GST exemption and allocate that exemption to certain assets.
Portability
One of the more notable provisions contained within the Act is the "portability" provision, which provides in general terms that if one spouse does not fully utilize his or her entire $5 million exemption amount, the unused portion can be used by the surviving spouse’s estate. Therefore, even if the assets of the first spouse to die are not sufficient in amount to fully utilize that spouse’s exemption ($5 million in 2011 and 2012), for those two years there is a portability provision so that by the making of a proper election, the surviving spouse will be treated as having acquired any unused exemption of the spouse who was the first to die. While currently this is only in the law for two years, this is a very significant change that will affect the way in which assets owned by respective spouses, or their trusts, are titled. In the past there has been an effort to divide assets between spouses so that the full exemption amount, or as much as possible of that exemption amount, can be used upon the first death. With portability, the way in which assets are titled is not critical to the ability of the couple to use the exemption amounts of both husband and wife.
Commentators have suggested that this provision is intended to avoid the need for credit shelter trusts in estate planning documents. However, unless the provisions regarding portability are extended, both spouses must die before 2013 in order to benefit from the portability provision.
In addition, credit shelter trusts continue to provide significant additional benefits beyond just the use of each spouse’s exemption amount. These include the following:
- Ensuring that appreciation on the assets contained within the credit shelter trust, which may exceed the exemption amount at the surviving spouse’s death, are not subject to estate tax at that time.
- Protection of assets in the credit shelter trust from creditors of the surviving spouse, including any marital claims of future spouses.
- Ensuring that assets contained in the credit shelter trust pass to children of the couple and not to any new spouse of the surviving spouse.
Given the fact that the portability provision will sunset in 2012, as well as for the reasons stated above, we are advising clients to continue to use estate plans that incorporate credit shelter trusts.
Things Not In The Act
Over the past several years as Congress has debated the extension of the estate and gift tax laws, there have been a number of substantive changes proposed that were not included in the Act. These have included:
- Restrictions on Grantor Retained Annuity Trusts ("GRAT") including requirements that the term of each GRAT would need to be not less than ten years
- Proposals to limit valuation discounts in connection with certain asset transfer planning such as sales to Grantor Trusts, gifting of closely held business interests, including family limited partnerships and other gift transactions
- A Treasury Department proposal, raised initially in 2005, that would limit GST tax exemption only to two generations
Planning Opportunities
- Document review: All estate planning documents should be reviewed and updated to make certain they are consistent with and take full advantage of the new estate, gift and GST provisions.
- Ownership of assets: Ownership of assets should be reviewed to determine whether assets previously divided between spouses or their respective trusts should be retitled, including transfer of certain assets back to ownership of the husband and wife as tenants by the entireties.
- Lifetime gifting: The increase in the gift and GST exemptions to $5 million under the Act provides an unprecedented opportunity to move substantial amounts of wealth out of individuals’ estates. There are several techniques that individuals can use to leverage this $5 million exemption amount, to move substantially more wealth out of their estates.
Lifetime gifting that should be considered includes:
- A gift of all or a substantial part of the gift and GST exemption amounts into a trust that will be exempt from all estate, gift and GST tax and which will remain in trust for the benefit of multiple generations.
- Implement lifetime gifting that utilizes valuation discounts to leverage the gift.
- Utilize short-term Grantor Retained Annuity Trusts which are not, under the Act, limited in term.
- Consider forgiveness of an installment note that may have been established to loan funds to descendants or an irrevocable trust for the benefit of descendants, including installment notes put in place to fund a sale of assets to a Grantor Trust.
Given the fact that the Act will sunset without further Congressional action in 2012, we are advising clients that it would be prudent to implement estate planning techniques utilizing lifetime gifts before the December 31, 2012 sunset date.
- Trust terminations: Where one spouse has died previously and there is now in existence a trust that is not includable in the surviving spouse’s estate (sometimes referred to as a residuary trust, family trust, or credit shelter trust) consideration should be given to distributing those assets from that trust outright to the spouse. Assets in a credit shelter trust would not be includable in the surviving spouse’s estate and therefore would not get a step-up in basis for income tax purposes. By distributing assets to the surviving spouse, those assets would be includable in the surviving spouse’s estate, and would receive a step-up in basis. As a result, future capital gains taxes may be avoided. This will need to be done with caution in view of the uncertainty about what the exemption amount will be for estate, gift and GST tax purposes after December 31, 2012.
- Life Insurance: Life insurance should be reviewed. To the extent that the exemption amounts are substantially increased, this may decrease the need for life insurance that was acquired for the sole, or principal, purpose of providing funds to pay estate tax. In addition, where there is an irrevocable trust in place that owns life insurance, the increased gift tax exemption amount may provide an opportunity to fund future insurance premiums into that trust.
- Marriage to utilize portability: In the right circumstances, a person with assets exceeding the gift and estate tax exemption amount may want to consider the advantages of marrying a person who owns only a small amount of assets, particularly if that person is not in good health. Obviously if this were to occur, the parties would need to consider whether a prenuptial agreement would be appropriate, and if so what terms should be included.
