President Obama's signing of theTax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 on Dec. 17, 2010, generally extended the Bush-era income tax rates, but also included sweeping changes to the federal estate and gift tax rules. The new rules are effective only through Dec. 31, 2012. An extension beyond that date is likely to be debated during the next election cycle.
Estate Tax Relief
Effective retroactively to Jan. 1, 2010, the federal estate tax exemption has been increased to $5 million per person ($10 million for a married couple), indexed for inflation beginning in 2012. This change represents a major increase over previous exemption levels, as illustrated in the table below.
As the table also indicates, the estate tax rate has been lowered to 35%, the lowest it has been since 1931. These changes are quite dramatic considering that the exemption would have reverted to $1 million and the top estate tax rate would have ballooned to 55% if the White House and Congress had not agreed to the bipartisan compromise.
According to IRS data, only 4,296 estates over $5 million paid federal estate taxes nationwide in 2009 (the most recent year data is available). This figure indicates that more than 99.8% of all estates will escape federal estate taxes under the new $5 million exemption (based on U.S. Census estimates of approximately 2.4 million deaths each year).
Special Election for Deaths in 2010
In the case of someone dying in 2010, the executor of the estate may choose between the new rules and prior law. Under prior law, the federal estate tax was temporarily repealed for deaths occurring in 2010.
The trade-off for electing to apply the Internal Revenue Code as if there is no estate tax for deaths in 2010 is that appreciated assets included in the decedent's estate receive only a "modified carryover basis" adjustment of up to $1.3 million (more for spousal transfers). In contrast, choosing the default rule of estate tax on amounts above $5 million for deaths in 2010 provides the benefit of an unlimited basis increase on all of the decedent's property.
The executor of the estate of someone dying in 2010 will need to weigh the results under both scenarios before deciding which option is more favorable. However, opting for no estate tax will generally favor very large estates.
For example, the executors of the estate of textile tycoon Roger Milliken, who died on Dec. 30, 2010, will most likely opt for no estate tax on assets Forbes magazine estimated were worth more than $1 billion. Had Milliken died less than 48 hours later, opting for no estate tax would not be available and the estate might have owed as much as $350 million in federal estate taxes.
Other important changes
Reunification. The new legislation "reunifies" the estate and gift tax rules and permits the use of the entire $5 million exemption to make lifetime gifts. (The 2001 Tax Act had "de-coupled" the estate and gift tax systems, limiting the gift tax exemption to $1 million, while incrementally increasing the estate tax exemption to as high as $3.5 million for 2009.) This important change creates tremendous opportunities for higher net worth individuals and families to leverage the $5 million exemption amount through lifetime gifting.
Portability. The new legislation allows the executor of a deceased spouse's estate to transfer any unused portion of the deceased spouse's exemption amount to a surviving spouse. (Under the old rules, careful trust planning was required to ensure that married couples did not "under-use" their respective estate tax exemptions at the death of either spouse.)
For example, assume Husband dies in 2011 having made lifetime gifts to his children, consuming $2 million of his exemption. At death, he leaves his remaining $3 million estate to his surviving spouse. The executor of Husband's estate may elect to permit the surviving spouse to use Husband's unused $3 million exemption, giving the surviving spouse an $8 million exemption (her original $5 million exemption, plus the deceased spouse's $3 million unused exemption).
Although the new "portability" of the estate tax exemption is designed to prevent married couples from wasting some or all their respective exemption amounts, trust planning for married couples may still provide meaningful benefits, such as eliminating estate taxes on post-mortem appreciation and protecting the inheritance of heirs.
What was not included in the legislation
No GRAT limitations. The new law did not contain restrictions or limitations on the use of Grantor Retained Annuity Trusts (GRATs), which had been debated in Congress earlier in 2010.
As a result, short-term GRATs are still a viable strategy to transfer wealth in a tax-efficient manner. GRATs are typically designed to shift the appreciation on assets to children or other beneficiaries as a tax-free gift. For example, an individual may transfer $1,000,000 to a GRAT in exchange for the right to receive a stream of annual annuity payments that will return the original $1,000,000 principal, plus a small percentage of appreciation measured by a government interest rate published each month. If the assets appreciate above the government rate, a tax-free gift will pass to the beneficiaries after the final annuity payment has been made.
No valuation discount limitations. The new law did not contain restrictions or limitations on the applicability of valuation discounts to intra-family transfers of business interests. Such limitations have been proposed periodically in Washington dating back to the Clinton administration.
Under the changes to the federal estate and gift tax rules, the vast majority of Americans will not be subject to the federal estate tax. Nevertheless, the benefits of having a qualified estate planning attorney prepare a comprehensive and thoughtful estate plan will continue to be important and beneficial to individuals and families. A good set of estate planning documents should generally include: a revocable living trust, a pour-over will, a power of attorney for financial matters, and advanced health care directives. In light of the rule changes outlined above, existing estate planning documents should be reviewed by a qualified attorney.
Richard A. Behrendt is Baird's Senior Estate Planner.
Prior to joining the firm in 2006, he was an estate tax
attorney at the IRS for 12 years. Baird does not provide tax or legal advice.