Shortly before the end of 2010, when several income tax provisions were set to expire, a temporary compromise on the extension of income tax rates and unemployment benefits was reached. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the "Tax Relief Act" or "TRA") was enacted on December 17. In addition to the income tax provisions and unemployment benefit extensions, the TRA substantially modifies the federal estate, gift, and generation-skipping transfer tax exemptions, rates and rules, with major implications for estate planning. These implications are highlighted below.
Transfer Tax and Other Changes in the TRA
Increase in Exemption Amounts: Most notably, the Tax Relief Act increases the federal estate and generation-skipping transfer tax exemptions to $5 million per person. The TRA also increases the federal gift tax exemption to $5 million per person, reunifying it with the estate tax exemption -- as had been the case prior to 2004. Married couples can combine their exemptions to transfer up to $10 million of wealth to heirs without incurring any federal gift, estate or generation-skipping transfer taxes. In 2009, the gift, estate, and generation-skipping transfer tax exemptions were $1 million, $3.5 million, and $3.5 million, respectively, and prior to enactment of the TRA, the exemptions were slated to decrease to approximately $1 million each in 2011.
Decrease in Rates: The Tax Relief Act reduces the rate for gift, estate, and generation-skipping transfer taxes to 35%. In 2009, the gift, estate, and generation-skipping transfer tax rates were 45%, and the rates were slated to increase to 55% in 2011 prior to enactment of the TRA.
Restoration of "Step-Up" in Basis: While there was no federal estate tax in 2010 prior to enactment of the TRA, the law substantially limited the ability to increase the income tax basis of assets inherited from a decedent. The TRA reinstates the pre-2010 basis adjustment rules (commonly referred to as the "step-up" in basis since assets are more likley than not to have appreciated in value) so that the value of an asset for estate tax purposes constitutes the new basis of that asset for capital gains tax purposes.
2010 Estates Can Choose Estate Tax or Carryover Basis: The TRA permits estates of decedents who died in 2010 to elect to be subject to the estate tax (with the new rates and exemption amounts) or to be subject to the rules in effect before enactment of the TRA. Estates choosing the latter option will not be subject to federal estate tax, and will not have to file a federal estate tax return; however, those estates will receive only a limited step-up in basis. As such, most of the assets of the estate will have the same income tax basis as they had in the hands of the decedent – commonly known as "carryover basis." Under the TRA, the default rule for 2010 estates is that the estate tax will apply. Therefore, estates wishing to opt out of the estate tax (and into the carryover basis system) will have to make an affirmative election by filing an IRS form).
Portability of Estate Tax Exemption: The TRA introduces a new option for married couples to defer estate taxes until the death of the surviving spouse, called "portability." Portability permits the estate of a surviving spouse to claim not only the surviving spouse's estate tax exemption, but also the unused estate tax exemption of the predeceased spouse. Before the TRA, the only way to achieve this result was by creating a trust (typically called a credit, disclaimer, or bypass trust) under the will of the predeceased spouse. For reasons described below, spousal bypass trusts have several advantages over the portability option. Therefore, bypass trusts will still be the recommended option in many cases, notwithstanding the advent of portability.
Qualified Charitable Distribution From IRAs: The TRA extends the opportunity for individuals age 70 1/2 or older to make tax-free direct qualified charitable distributions from their individual retirement accounts of up to $100,000 per year, and to elect to have the distribution count against their required minimum distribution for the year Absent another extension, this benefit expires December 31, 2011.
Qualified Convervation Easements: The TRA extends certain incentives for gifts of qualified conservation easements first introduced in 2006, namely, the ability to claim an income tax deduction of up to 50% of the donor's adjusted gross income for the year (up from 30%) and the ability to carry forward any unused deduction for up to 15 years (up from 5 years). Absent a further extension, these incentives will expire on December 31, 2011.
TRA Provisions Are Temporary
Except for the tax breaks expiring at the end of 2011, all of the other provisions described above apply for only two years and are set to expire at the end of 2012. Unless further action is taken by Congress, the gift, estate, and generation-skipping transfer tax exemptions will revert to approximately $1 million each and the tax rates will jump to 55%.
Provisions Not Included in the TRA
The TRA is notable for what it did not include. Several bills introduced in Congress in 2010 would have eliminated the popular technique of short-term grantor-retained annuity trusts (GRATs) or would have restricted the ability to apply valuation discounts for transfers of interests in family entities. Neither of these limitations is contained in the TRA.
Washington State Estate Tax Remains
Notwithstanding the federal changes under the TRA, Washington continues to impose a state estate tax with an exemption of $2 million and progressive rates from 10% to 19%. Washington currently does not impose a gift tax or a generation-skipping transfer tax. The portability option is not available for the Washington estate tax.
Planning Considerations and Opportunities
Formula Gifts and Bequests: Many individuals make gifts in their estate planning documents based on formulas tied to the various estate tax exemption amounts. For example, a person might make a gift equal to the generation-skipping transfer tax exemption to a trust for his or her grandchildren and more remote descendants. Another might leave the estate tax exemption amount to his or her children and give the remainder of his or her estate to a spouse or to charity. The increase in the estate and generation-skipping transfer exemptions will naturally increase the amounts that pass under these formula amounts. Individuals should be aware of these increases in exemptions and confirm that the higher amounts are consistent with their wishes.
Portability: As mentioned above, while the TRA introduces portability to allow married couples combine their estate tax exemptions, the use of spousal bypass trusts may nevertheless continue to be the preferred method for minimizing estate taxes for a married couple. Since the portability option expires at the end of 2012, couples who rely on it may not have the benefit of portability on the surviving spouse's subsequent death if Congress does not take further action to extend portability or make it permanent. In addition, a spousal bypass trust enables the couple to exclude not only the dollar amount of the first spouse's estate tax exemption but also all appreciation in the value of that amount that occurs between the deaths of the first and the second spouse, increasing the benefit of the exemption. Further, portability is not available for the $2 million Washington estate tax exemption, so a spousal bypass trust is already required for married couples in Washington to combine their Washington estate tax exemption amounts. Finally, the use of a bypass trust provides a degree of creditor protection to the surviving spouse that an outright gift, relying on portability, would not.
Gifts: The increase of the lifetime gift tax exemption to $5 million under the TRA provides significant wealth transfer planning opportunities for individuals and families. The increased exemption means that "taxable gifts" (that is, gifts in excess of the annual gift tax exclusion of $13,000 and certain other exclusions) incur no gift tax obligation until they exceed, cumulatively, $5 million over the donor's lifetime. Married couples may combine their lifetime gift tax exemptions to give up to $10 million to children or grandchildren, outright or in trust, without having to pay any federal gift tax. Individuals who had used up their entire $1 million of lifetime gift tax exclusion prior to enactment of the TRA, now have an additional $4 million of gift tax exemption to apply against future gifts.
Lifetime gifts offer several estate tax advantages. To the extent a gifted asset appreciates in value after the date of the gift, that appreciation in value is not subject to estate tax as it would have been had the asset been included in the donor's estate. Further, because Washington does not have a separate gift tax, lifetime gifts reduce the Washington estate tax due at death. Independent of the tax advantages, many donors find lifetime giving to be gratifying.
There are numerous gifting strategies that continue to be highly effective for transferring assets efficiently and making the most of the donor's lifetime gift tax exemption. Qualified personal residence trusts ( QPRTs) permit transfers of personal residences with estate and gift tax savings, and they may now take advantage of the $5 million gift tax exemption. Grantor retained annuity trusts ( GRATs) continue to be an effective means of transferring assets likely to appreciate in value at a reduced or even zero gift tax cost. Charitable lead trusts ( CLTs) and charitable remainder trusts ( CRTs) provide an opportunity to combine family gifting strategies with charitable giving. Gifts to irrevocable life insurance trusts ( ILITs) continue to be an effective means of purchasing and maintaining life insurance policies in a way that keeps the policy proceeds out of the donor's estate. Gifts to another type of trust, often called an intentionally defective grantor trust, can be structured to leverage the benefit of the donor's gift and generation-skipping transfer tax exemptions by having the trust purchase assets from the donor in a non-taxable transaction. All of these techniques can be much more powerful means of transferring wealth with the increase in the gift tax exemption under the TRA.
The foregoing is intended to be a general discussion of the provisions in the new law. For specific information or questions about how these changes may effect your estate plan, please call one of the attorneys in our Personal Planning Group.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
