ESTATE TAX CHANGES UNDER THE 2010 TAX RELIEF ACT

On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization and Job Checklist (the “Tax Relief Act”).  Title III of the Tax Relief Act is entitled “Temporary Estate Tax Relief”.  This compromise legislation provides for a short-term extension of Bush era tax cuts enacted in 2001.  In some ways, however, the provisions related to estate and gift tax law go much farther than the Bush-era tax cuts, at least for two years.  Here’s summary of the big changes to estate and gift tax law brought to us by the new law:

 Higher Exemption

 The Estate and Gift Tax exemption is set at $5 million per person, which is indexed in inflation beginning in 2012.  The Generation Skipping Transfer Tax exemption is also set at $5 million. 

 Reunification of Estate and Gift Taxes

 Prior to the 2001 tax cuts, the estate and gift tax exemption amounts were unified.  From 2001 – 2010, the two exemptions were “decoupled”.  This means that while the estate tax exemption gradually moved from $1 million in 2001 to $3.5 million in 2009 (and disappeared altogether for 2010), the gift tax exemption remained at $1 million all those years.  The new law reunifies the two exemptions so that a person can give any combination of lifetime gifts and estate bequests up to $5 million free of transfer tax.

 Lower Rate

 Effective January 1, 2011, the new top tax rate for estate, gift and generation skipping taxes is 35%.  This is a historic low.  In 2001, the top rate was 55% was gradually reduced to a previous low of 45% in 2009.

 Portability of Exemption for Married Couples

 Although much talked about in the past, this is the first time portability has been introduced into estate and gift tax law.  Under the new law, any estate and gift tax exclusion amount that remains unused as of the death of a spouse who dies after December 31, 2010 may be transferred over to the surviving spouse and added to the surviving spouse’s applicable exclusion amount.  “May” is an important word here because portability is elective.  To make this election, an estate tax return must be timely filed for the predeceased spouse even though the estate of the predeceased spouse otherwise be large enough to require the filing of an estate tax return.

 The following examples as provided by Congress’s Joint Committee on Taxation help explain how portability would work:

Example 1:  Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate.  An election is made on Husband 1’s estate tax return to permit Wife to use Husband 2’s deceased spousal unused exclusion amount.  As of Husband 1’s death, Wife has made no taxable gifts.  Thereafter, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.

Example 2:  Assume the same facts as in Example 1, except that Wife subsequently marries Husband 2.  Husband 2 also predeceases Wife, having made $4 million in taxable transfers and having no taxable estate.  An election is made on Husband 2’s estate tax return to permit Wife to use Husband 2’s deceased spousal unused exclusion amount.  Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2’s $1 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse of the surviving spouse (here, Husband 2’s $1 million unused exclusion).  Thereafter Wife’s applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.

Example 3:  Assume the same facts as in Examples 1 and 2, except that Wife predeceases Husband 2.  Following Husband 1’s death, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1).  Wife made no taxable transfers and has a taxable estate of $3 million.  An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion amount, which is $4 million (Wife’s $7 million applicable exclusion amount less her $3 million taxable estate).  Under the provision, Husband 2’s applicable exclusion amount is increased by $4 million, i.e., the amount of deceased spousal unused exclusion amount of Wife.

THE PRACTICAL IMPACT OF THESE CHANGES

Marital Tax Planning Living Trusts Become Obsolete

Because of the rising estate tax exemption amounts created by the Bush-era tax cuts, the importance of incorporating tax planning provisions in marital revocable living trusts has declined.  Portability significantly accelerates this decline.  In a world without portability, the estate tax exemption was a “use it or lose it” proposition.  So called “AB” Trusts were a way to “use it”.  With this type of trust, an irrevocable “B” trust would be funded with the deceased spouse’s share of the trust in an amount not to exceed the deceased spouse’s available exemption.  If the living trust had no provisions for the creation of a B Trust, the entire estate would generally be treated as passing directly to the surviving spouse for tax purposes.  There would be no estate tax due on the death of the deceased spouse because of the unlimited marital deduction for transfers between spouses, but the deceases spouse’s exemption would be forever lost.  In the new portability world, the surviving spouse can always elect to use the deceased spouse’s unused exemption amount for his or her estate without the need of creating a “B” Trust.  That said, there may other nontax reasons for the continued use of an AB Trust such as second marriages and partial creditor protection for surviving spouses.

Estate Tax Returns Need to be File to Take Advantage of Portability

For a surviving spouse to take advantage of portability, the law requires that an estate tax return be filed for the surviving spouse.  Otherwise, the IRS would have no effective paper trail to track the correct amount of unused exemption transferred to the surviving spouse.  Many surviving spouses of even moderate wealth will want to ensure that an estate tax return is filed for the deceased spouse, especially in the event that exemption amounts are reduced post-2012 but portability still remains the law.

Gifting

Beginning January 1, 2011, the Gift Tax exemption amount will increase from $1 million to $5 million.  Given a potential post-2012 world where we could revert back to 2001 law with its $1 million exemption and 55% top tax rate, it critically important to consider making lifetime gifts in the next two years as a means of reducing a potentially taxable estate.

HOW COPELAND & TIERMAN, LLP CAN HELP

Now is the time to review your estate plan to determine if your documents as drafted are consistent with these new changes in the estate tax law.  Each attorney at Copeland & Tierman is a certified by the California State Bar Board of Legal Specialization as a specialist in estate planning, trust, and probate law, and has the knowledge and experience to provide the necessary counsel and assistance to ensure that your estate planning documents are complete and up-to-date.  Copeland & Tierman, LLP also provides a wide range of trust and estate administration services, including the preparation of estate tax returns.