New Tax Laws Impact Planning

On December 17, 2010, Congress and the President finally acted to extend the Bush era tax cuts that would have otherwise expired on December 31. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Tax Relief Act”) includes many taxpayer-friendly provisions for both individuals and businesses.

In this article we focus on how the new law impacts estate and gift tax planning.  Bear in mind, though, that these changes are good only through 2012.  At that point, we’ll either be back to square one, or Congress will again need to act.

$5 Million Estate Tax Exemption and 35% Rate.  The new law includes favorable estate tax provisions for individuals who died in 2010, as well as those who die in 2011 and 2012.  First, for individuals who die in 2011 or 2012, there is now a $5 million estate tax exemption and a 35% tax rate that applies to amounts over that. For estates of individuals who died in 2010, taxpayers can choose between (a) the new rules contained in the Tax Relief Act or (b) the rules that were otherwise in effect in 2010, which provided for no estate tax but modified the step-up in basis rules.

Portability of Unused Exemption.  Significantly, under the new rules, married individuals who don’t use up their estate tax exemption will be able to pass along the unused amount to a surviving spouse. In other words, unused exemptions of individuals who die in 2011 or 2012 (but not 2010) will be “portable.”

The ability to pass along unused estate tax exemptions to a surviving spouse is a very favorable development. It allows both spouses’ exemptions to be utilized without having to set up a credit shelter trust or engage in other tax planning maneuvers – as long as they both die in 2011 or 2012. Unfortunately, the new portability rules sunset after 2012, so it won’t help decedents who die after 2012. Also, the portability rules do not apply to the generation-skipping transfer tax exemption (gifts to grandchildren or to individuals who are more than 37½ years younger than the person making the gift).

Unlimited Basis Step-ups for Inherited Assets.  For heirs of decedents who die in 2011 and beyond, the Tax Relief Act reinstates the familiar rule that allows the federal income tax basis of inherited capital-gain assets (such as real estate and stock) to be stepped up to reflect fair market value on the date of death. This favorable rule is also reinstated for decedents who died in 2010, unless the estate elects to instead use the modified carryover basis rules that were otherwise in effect in 2010.  With the restoration of the unlimited basis step-up rules, heirs won’t owe any federal capital gains taxes on appreciation that occurs through the date of death.

Estate and Gift Tax Exemptions and Rates Are Equalized.  The Tax Relief Act also sets the lifetime federal gift tax exemption for 2011 and 2012 at $5 million, with the 2012 amount indexed for inflation (ditto for the generation-skipping transfer tax exemption). Thus, the gift and estate tax exemptions are again equalized for 2011 and 2012.

This is a huge improvement over the previous $1 million cap on the lifetime gift tax exemption (which continues to apply for 2010). An unmarried person can now give away up to $5 million while alive without paying any gift tax, and a married couple can give away up to $10 million.

However, keep in mind that, to the extent you dip into your gift tax exemption, your estate tax exemption is reduced on a dollar-for-dollar basis. The tax rate on 2011 and 2012 gifts in excess of the $5 million exemption is 35%, the same as the estate tax rate. Again, due to sunset provisions, the gift tax exclusion reverts to $1 million after 2012.

Clarity for Estates of 2010 Decedents and 2010 Generation-Skipping Transfers.  The Tax Relief Act clarifies the estate tax treatment of estates of individuals who died in 2010, and the generation-skipping transfer (GST) tax treatment of generation-skipping gifts made in 2010, but it does so in a weird way.  The new law reinstates both taxes for 2010 with $5 million exemptions for each.  But, executors have the option of electing out of the estate tax for 2010 in accordance with the 2010 repeal.

If executors elect out of estate tax, the aforementioned modified carryover basis rules apply to heirs for income tax basis purposes.  So, heirs of large estates can wind up owing capital gains taxes on appreciation that occurs through the decedent’s date of death, but there won’t be any federal estate tax. If the election out is not made for an estate, the $5 million exemption applies for 2010, and the income tax basis of inherited assets equals fair market value as of the date of death.

For 2010, the GST exemption is also $5 million.  However, the 2010 GST rate is deemed to be 0%, so there’s no actual GST liability for 2010. Therefore, large generation-skipping gifts could have been made in 2010, and only the gift tax will be owed (2010 gifts in excess of the $1 million gift tax exemption for that year are taxed at a flat 35% rate).  Unlike the estate tax exemption, though, the GST tax exemption is not subject to any portability.  As a result, gifts to grandchildren or younger generations must continue to be carefully planned.