If I were a betting man, I would have lost this bet a long time ago. After all, just who would have wagered any money that President Barack Obama would have agreed to one of the most far reaching and affluent friendly pieces of estate and gift tax legislation of the past decade? It just goes to show that trying to predict what our politicians are going to do is an impossible task. With that said, our clients are in a unique period of unparalleled opportunity to transfer wealth to their descendants.
The new law known as The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “Act”) might just be the greatest opportunity for affluent Americans to transfer significant amounts of wealth to their descendants without incurring gift and estate taxes. However, the provisions of this law only remain in effect through 2012.
It has long been argued that the estate and gift tax regimes serve an antiquated social purpose (trying to guard against the dynastic accumulation of wealth in America) and generate only a small amount of revenue in the overall budget. (The IRS reported there were only 14,173 taxable estates in 2009 or, said another way only 0.6 percent of deaths in the U.S. in 2008 resulted in an estate tax liability.) So could this be the beginning of the end of this tax making it so irrelevant to the vast majority of Americans that few families care about it?
Detailed below are some important aspects of the new Act that are critical for our clients and their families to understand.
A MARRIAGE MADE IN HEAVEN: GIFT & ESTATE TAX EXEMPTION IS REUNIFIED!
The estate tax exemption has been increased to $5 million. (In 2009, it was $3.5 million). The gift exemption has also been increased from $1 million to $5 million. Maximum gift, estate and generation skipping tax rates are reduced to 35 percent.
As most of our clients are aware, under prior law each individual had a lifetime exemption from federal gift taxes of $1 million. This lifetime exemption excludes the $13,000 gift tax annual exclusion that is allowed to be made to each donee (plus certain direct payments of medical expenses and a large tuition). Many argued that the $1 million lifetime exemption served two powerful purposes – it gave headaches to every trusts and estates attorney trying to figure out how to enhance the effectiveness of the $1 million gift; and it of course kept most clients’ estates inflated and quite large, ultimately subjecting them to large future estate tax.
So the good news is that clients can now make lifetime gifts of $5 million individually, or $10 million for a married couple, to their descendants without incurring federal gift taxes. Moreover, the $5 million gift exemption is also indexed for inflation beginning in 2012. For those clients who have made prior taxable gifts and used some or all of their $1 million gift exemption, the amount of these gifts is merely subtracted from the $5 million allowable exemption under the Act to determine their remaining exemption.
Under the Act, for the years 2010, 2011 and 2012, the Generation Skipping Tax exemption is also increased to $5 million.
The good news gets even better. Many lawyers (and many in the media) thought that any new estate tax legislation would contain serious restraints on a number of very popular planning techniques. Many politicians wanted to severely limit (or even eliminate) how valuation discounts were utilized in estate planning strategies. There were also proposals to severely limit the effectiveness of Grantor Retained Annuity Trusts (“GRATs”) by placing a minimum number of years that the trust must remain operative, thus increasing the likelihood of the grantor dying during the term of the trust and having the distasteful outcome of some or all of the trust assets included in the decedent’s taxable estate. The Act contains no mention of any limitation on any of these strategies.
With the good news comes the proverbial bad news for some of our clients who live in New York, New Jersey and Connecticut or in other states that still impose state estate taxes. These states are still addicted to the revenue generated by state death taxes.* For instance, New York still only has a $1 million estate exemption. In prior years fully funding a By-Pass (or Credit Shelter trust) with the maximum allowable amount ($3.5 million in 2009, less prior taxable gifts) would cause a state estate tax of approximately $229,200 to be incurred. The general thinking by counsel was that paying a relatively small tax on the estate of the first spouse to pass was a modest price to pay to allow these assets to grow estate tax free for the next generation, thus skipping inclusion in the surviving spouse’s estate. Obviously the stakes will grow larger for these same clients in this discussion if they decide to fully fund the exemption amount, which will trigger significantly higher state estate taxes.
For our clients residing in states that still impose state estate taxes, we recommend you contact us to carefully review your planning to ensure that there are no tax surprises for your family and beneficiaries.
A NEW WORD IN ESTATE AND GIFT TAX PLANNING IS BORN — “PORTABILITY”
Under the Act and beginning in 2011, if a predeceased spouse has failed to use his or her full $5 million dollar exemption, the remaining unused balance is added to the surviving spouse’s unused exemption, setting the stage for a significantly larger estate tax exemption on the death of the surviving spouse. Here is a simple example:
Husband dies in 2011 and has only utilized $2 million of his lifetime gift exemption. His wife, who never wanted to give away much money to her children for fear of being left penniless, only gave away $1 million in prior taxable gifts. On her death her remaining estate exemption of $4 million is increased by $3 million (her predeceased husband’s unused exemption), thus leaving her with a grand total of $7 million estate exemption.
Ever mindful of not wanting to be taken advantage of, our legislators wanting to prevent any type of serial marriages and the hoarding/accumulation of unused exemptions (Who would think of such an estate planning strategy?) have under one specific section of the new Act limited the unused exemption to the “last such deceased spouse of such surviving spouse”! Finally, and only as a footnote, portability of an unused exemption does not apply to any unused Generation Skipping Tax exemption. It must be affirmatively elected by the fiduciary of the surviving spouse’s estate on a timely filed estate tax return and is thus not automatic.
2010 ESTATE TAX WINDFALL?
Much has been written about the potential windfall that some of the wealthiest families would receive due to the deaths of their loved ones in 2010 under the assumption that the estate tax laws were repealed for this one year. Not so fast!
While it may not significantly impact many families, our clients should pay careful attention to the Act and how it impacts the estates of decedents passing in 2010. In sum, a unique situation exists where the fiduciaries of these estates are given a choice between how the assets of the decedent’s estate will be taxed. Unless they make an election to “opt out” of the estate tax, 2010 estates will be taxed using the new 2011 exemption amount and tax rates. This would be appropriate for taxable estates worth less than the $5 million dollar exemption and for properly planned estates where a surviving spouse remains and the combined assets do not exceed $10 million. Estate tax returns for estates of decedents dying in 2010 will be due nine months from the date the Act was enacted (as opposed to nine months from date of death).
Taxable estates valued above the $5 million exemption may choose to “opt out” of estate tax and use the 2010 rules that were in effect prior to the enactment of the Act. Under these rules, the basis of property held by a decedent at death will carry over to the person(s) who inherit the property. Each decedent is entitled to a $1.3 million “step up” exemption on testamentary property and an additional $3 million “step up” for property passing to a surviving spouse. Upon the sale of the inherited property, any additional gain beyond the stepped up value will be taxed as a capital gain. Although tax will be due, it will (in theory) be significantly less than the estate taxes that would be due in most estates that exceed the new estate tax exemption. The mechanism by which an estate can “opt out” of estate tax is not yet known, but we expect the IRS to publish rules on this election shortly.
It should be noted that the new portability rule discussed earlier in this article does not apply to decedents dying prior to January 1, 2011. Unless a decedent specifically left his or her exemption amount to a credit shelter trust, the surviving spouse will not be able to claim any part of the decedent’s exemption amount.
SOME FOOD FOR THOUGHT
In SGR’s opinion, the new Act is finally a breath of fresh air and opens up many more doors for a family to think about and plan for the transfer of its wealth to the next generation. As in any new legislation ,much will remain unknown until it is more carefully studied. Will the larger estate and gift exemptions imperil charitable gifting? We simply don’t know yet, although the new Act did extend tax free distributions for IRAs for charitable purposes. Also, as noted above, depending on your state of domicile, there are certainly large looming tax issues that will have to be carefully addressed.
Finally, we do urge our clients to be aware that despite what may be an unqualified victory for those politicians who despise the estate and gift tax regime, the fact remains that the Act expires at the end of 2012. It is thus imperative that clients pay attention to our future commentary and the planning opportunities.
Wishing you and your families a happy and healthy new year.
*By way of example, government statistics reveal that New York State had the third largest amount of taxable estate filings with 1,091, trailing only California (2,965) and Florida (1,367).<i/>