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Estate Planning After the Tax Relief and Job Creation Act of 2010

by Stanley E. Bulua, Scott A. Lavin and Steve R. Graber

The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 Act”) significantly, and in some ways unexpectedly, changed the landscape for estate, gift and generation-skipping transfer (“GST”) taxes.  This article provides guidance on the 2010 Act, highlights significant changes and discusses planning implications.

By way of brief background, the federal estate tax applies to transfers at death, the gift tax applies to transfers during life, and the GST tax applies to transfers (during life or at death) to grandchildren or more remote descendants.  Under tax legislation enacted in 2001, the estate and GST taxes were gradually reduced from 2002 through 2009 by increasing the amount exempt from tax (from $1 million to $3.5 million) and reducing the rates (from 55% to 45%).  The gift tax remained intact with a $1 million exemption.  In 2010, the estate and GST taxes, but not the gift tax, were repealed for one year.  But in 2010, an appreciated asset no longer received a “step-up” in basis to the asset’s fair market value as of the date of death (or alternate valuation date) upon the owner’s death.  Instead, the recipients of appreciated property upon a decedent’s death in 2010 received property with a basis equal to the decedent’s basis in the property (a “carryover basis”).  Special rules allowed estates a special basis adjustment that could be allocated to increase the basis of property passing to anyone by $1.3 million, and a spousal basis adjustment that could be allocated to increase the basis of property passing to a surviving spouse by $3 million.  The gift tax rate was reduced to 35% for 2010. 

The 2010 Act repealed the one-year repeal, replacing it with a maximum estate tax rate of 35% over and above an individual’s $5 million exemption.  To prevent potential constitutional challenges and other uncertainties, Congress opted to give 2010 estates the right to elect out of the estate tax regime, and therefore be subject to the carryover basis rules.  If Congress fails to take action before December 31, 2012, the estate, gift, and GST tax laws as in existence before the 2001 Tax Act will return in 2013 with a $1 million exemption for estate and gift tax purposes, a 55% maximum rate, and a $1.36 million GST exemption.

Increased Exemptions

Under the 2010 Act, each of the federal estate tax, GST tax and lifetime gift tax exemptions has been increased to $5 million as follows:

  • In 2011 and 2012, there is a $5 million federal estate tax exemption (increased from $3.5 million in 2009) and a 35% top estate tax rate (decreased from 45% in 2009).
  • In 2011 and 2012, there is a $5 million GST tax exemption (increased from $3.5 million in 2009) and a 35% top GST tax rate (decreased from 45% in 2009).
  • In 2011 and 2012, there is a $5 million lifetime gift tax exemption (increased from $1 million) and a 35% top gift tax rate (decreased from 45% in 2009).

Of paramount importance is the “reunification” of the gift and estate tax exemptions.  Prior to the 2010 Act, the gift tax exemption was capped at $1 million, while the estate tax exemption was as high as $3.5 million in 2009.  Now, the exemption has been “reunified” at $5 million so every individual can make lifetime gifts or testamentary transfers of $5 million without paying gift or estate taxes.

The increased gift tax exemption of $5 million creates opportunities to make larger lifetime gifts, to leverage more assets through a variety of estate planning techniques (such as a sale to a grantor trust) and to shift income producing assets to individuals such as children or grandchildren who may be in lower income tax brackets and/or reside in states with a low income tax rate or no state income tax. The 2010 Tax Act did not eliminate the traditional gifting opportunities of the $13,000 per year annual exclusion or the unlimited educational and medical exemption for those amounts paid directly to educational or medical providers.

For married couples to take full advantage of the increased exemption amounts and subject to the portability rules discussed below, each spouse should have at least $5 million of assets in his or her own name.  To accomplish this, some married couples may need to re-title certain assets so that ownership is held by only one spouse.  In the case of a spouse owning significant retirement plan assets, special planning, including customized beneficiary designation forms, may continue to be necessary.

Portability

Another important change under the 2010 Act is the newly enacted system of portability.  For the first time in history, a deceased spouse’s unused estate and gift tax exemption is portable and can be used by the surviving spouse.  Portability is intended to prevent families from incurring gift and estate tax that could have been avoided through proper estate planning.  Since the 2010 Tax Act sunsets on December 31, 2012, portability only applies to second deaths on or before December 31, 2012.  The following is an example of portability:

  • Assume Husband and Wife each has $5 million of his or her own assets.  Husband dies in 2011 leaving his entire $5 million to his Wife.  There are no federal estate taxes imposed on the Husband’s estate because of the unlimited marital deduction.  Assume the executor of Husband’s estate makes a portability election.
  • Assume upon Wife’s later death in 2012, the $5 million she inherited from Husband has appreciated to $8 million and the $5 million of her own assets have appreciated to $6 million so that Wife’s total estate is worth $14 million.
  • Portability allows Wife to use her $5 million estate tax exemption as well as Husband’s $5 million estate tax exemption for a total estate tax exemption of $10 million. In this example, the Wife’s total estate is worth $14 million.  With portability, Wife has a $10 million estate tax exemption (her $5 million exemption and Husband’s $5 million exemption) which results in only $4 million being subject to estate tax. Assuming a 35% estate tax rate, the federal estate tax due is $1,400,000.
  • Portability does not apply for state estate tax purposes.

Bypass Trust

A bypass trust can still be used to allow assets to “bypass” the federal estate tax that otherwise would be imposed when the second spouse dies.  While portability may simplify estate planning and be useful to married couples who do not engage in proper estate planning, there are several advantages to using a bypass trust including protecting assets from creditors, sheltering the appreciation of assets from estate tax and ensuring that the assets are ultimately distributed to the first dying spouse’s intended beneficiaries.  For example:

  • Assume the same facts as above, except that Husband leaves his $5 million to Wife in a bypass trust rather than outright.  The assets in the bypass trust are protected from Wife’s creditors and will ultimately pass to Husband’s children.  On Husband’s death, no federal estate tax is due because of Husband’s $5 million estate tax exemption.
  • Assume upon Wife’s death, the $5 million in the bypass trust has appreciated and is worth $8 million.  Since the assets are held in a bypass trust, the $8 million in the bypass trust is not subject to estate tax in Wife’s estate.  Wife’s total assets for estate tax purposes is $6 million which means that the federal estate tax on her estate would be $350,000 since she can use her $5 million estate tax exemption.  By using a bypass trust, Husband and Wife pay a reduced federal estate tax, obtain creditor protection for the assets held in trust and the assets remain in the bloodline.  A bypass trust generates state estate tax savings as well.

How do these changes affect your existing estate-planning documents?

Wills and Revocable Trusts for a married couple are often structured to include a bypass trust for the surviving spouse (discussed above) and GST tax-exempt trusts for their descendants upon the death of the surviving spouse so that both spouses can utilize their maximum federal estate tax and GST tax exemptions.

A GST tax-exempt trust is drafted so that an individual can pass the maximum amount of property that is exempt from the GST tax in trust tax-free from generation to generation.  Generally speaking, the GST tax applies when a person transfers property to someone who is at least two generations younger than the transferor (or to a trust which eventually benefits such individual).  The GST tax is designed to tax the transfer of property which effectively “skips” one or more intervening generations.

Many documents were drafted with formulas which allow the bypass and GST tax exempt trusts to be funded with assets equal to the maximum tax exemptions applicable at the time of an individual’s death.  These formulas adjust automatically if the amount of the tax exemption changes.

Accordingly, a typical Will or Revocable Trust which was signed before the 2010 Act would still be effective and the bypass trust and GST exempt trusts would be funded with the maximum exemptions now allowable.  For example, suppose Husband and Wife had signed a typical Will in 2009 when the estate tax and GST tax exemptions were $3.5 million.  If Husband died in 2009, the bypass trust for Wife would be funded with $3.5 million and would be exempt from estate taxes in both Husband and Wife’s estate and from GST tax. If Husband dies in 2011, the bypass trust would be funded with $5 million and would be similarly exempt from estate taxes and GST tax.

Overall, the increased exemption amounts under the 2010 Act mean that trusts created under your Will or Revocable Trust may be funded with significantly more assets than was previously possible.  Generally, this allows you to protect more assets from estate and GST taxes.

However, there may be instances where you will want to update your documents because the new larger exemption amounts result in too much money passing to particular individuals.  For instance, if your bypass trust was left for the benefit of your children only instead of for the lifetime benefit of your spouse, you may want to revise your documents to make sure that there are enough assets available to your spouse at your death.  Additionally, if you are a married couple and live in a state with a state estate tax (such as New York, New Jersey and Connecticut among others), there may be provisions that should be added to your documents which could save state estate taxes at the death of the first spouse.

Please do not hesitate to call us so that we can review your documents and make sure that they are up-to-date and reflect your current wishes.

Tax Return Filings and Other Reminders

Gift Tax Returns for 2010 Gifts

Gift tax returns for gifts that you made in 2010 were due on Monday, April 18, 2011.  The due date for those who filed extensions is October 17, 2011.  To have taken advantage of the extension, you must have timely filed a request for an automatic extension of time to file your 2010 income tax return.  That also extended the time to file your gift tax return.

Allocation of GST in 2010

You may have heard that for 2010 the GST tax rate for direct skips was zero and incorrectly assumed that you need not file a gift tax return in order to elect in or out of GST allocation for 2010 trusts.  The GST tax was still applicable in 2010, albeit with a zero tax rate.  Thus, it remains critical that you file your 2010 gift tax return and opt out of automatic allocations of GST exemption to trusts where all of the beneficiaries are two generations below you (known as “skip persons”).

You should file a gift tax return for those purposes even if your gifts did not exceed the annual gift tax exclusion and, therefore, you would not otherwise be required to file a gift tax return.

Please call one of our attorneys if you have any questions about your GST tax exemption allocation.

Conclusion

As a result of (1) the changes made by the 2010 Act; (2) the continued availability of discounting techniques; (3) interest rates remaining for the foreseeable future at low levels; and (4) continued depressed asset values, there are significant planning opportunities and strategies available to take advantage of the increased $5 million life time exemption.  Please contact one of our attorneys if you would like to discuss these at further length.