ESTATE AND GIFT TAX ALERT
To Our Friends and Colleagues:
On December 17, 2010, President Obama signed The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the "Act"). In addition to extending President Bush's income tax cuts, the Act addresses the Estate, Gift and Generation-Skipping Transfer ("GST") tax laws for 2010, 2011 and 2012. The purpose of this letter is to provide a summary of the Estate, Gift and GST tax provisions in the Act, and to offer our insight into the opportunities and pitfalls that they create.
THE FEDERAL ESTATE TAX
Under prior law, the federal estate tax did not apply for 2010 but was to be revived in 2011 with a $1,000,000 exemption and a top tax rate of 55%. Under the Act, however, the estate tax is once again applicable for persons dying in 2010 and beyond. However, the exemption amount is set at $5,000,000 and the top estate tax rate is 35%. The $5,000,000 exemption amount will be indexed for inflation in 2012. Absent further legislation, in 2013 the exemption amount will be reduced to $1,000,000 and the top tax rate will once again be 55%.
The 2010 repeal of the federal estate tax was accompanied by a change in the income tax basis rules. Specifically, the "step-up" in basis to date-of-death fair market value was eliminated on amounts in excess of $1,300,000 ($4,300,000 on bequests to spouses). Therefore, although no federal estate tax was to be imposed by the federal government, inherited assets with capital gains in excess of $1,300,000 ($4,300,000 for assets passing to spouses) were to be subject to capital gains tax upon their subsequent sale since the beneficiaries of a decedent's assets were to assume a modified carryover basis (i.e., the basis the decedent had in the assets plus the limited "step-up" discussed above). Under the Act, however, because the estate tax is revived, so too are the former "step-up" rules, so that all of the estate's assets receive a full "step-up" (or "step-down") in cost basis to the value of such assets at the decedent's death.
The Act provides a special election for the executors of estates of decedents dying in 2010. Specifically, the decedent's executor can "opt out" of the estate tax, meaning that no estate tax would be due for 2010 (even if the value of the estate exceeds $5,000,000), and the estate would be subject to the 2010 rules as if the Act had not been implemented. For example, estates of decedents whose estates are well in excess of $5,000,000 may wish to opt out of the estate tax and forego the full cost basis "step-up" because the overall tax that would be due on the recognition of gain at a later date would be less than the estate tax that would be due on the decedent's death. Conversely, the executor of a single individual who dies with an estate of $4,000,000 and which has $2,000,000 of built-in gains (which is in excess of the available $1,300,000 adjustment amount) may decide not to make the election so that the estate would be subject to estate tax; in this instance, however, the total estate is less than the exemption amount, so no estate taxes would be due, and all assets would receive the cost basis "step-up," thereby eliminating the $2,000,000 of built-in gains.
As of now, it is not known how the "opt-out" election will be made. The Internal Revenue Service (the "IRS") will likely publish rules and forms guiding taxpayers on the election in the near future. Finally, estate tax returns for estates of decedents dying in 2010 will be due by the later of 9 months after the decedent's date of death or 9 months after the Act is enacted (September 19, 2011).
The Act also introduces, for the first time, the concept of "portability". By way of background, under prior law, if an individual died and failed to utilize all of his or her gift and estate tax exemption, this exemption was forever lost. Under the Act, a surviving spouse will be able to utilize the unused exemption of his or her deceased spouse if the deceased spouse dies after 2010. This means that, with respect to a married couple, if, in 2011, the husband dies and does not fully use his estate tax exemption, the unused exemption is then available to the wife, so that when she dies, her estate plan can use both her estate tax exemption and her late husband's unused estate tax exemption.
Portability must be affirmatively elected, meaning that the deceased spouse's executor will be required to indicate the election on the deceased spouse's estate tax return, signifying that the surviving spouse may utilize the deceased spouse's unused estate tax exemption. This means that the deceased spouse's estate will need to file an estate tax return regardless of the value of the estate. We suspect the IRS will issue a simplified estate tax return for this purpose but no such return is available as of the date of this letter.
THE FEDERAL GIFT TAX
Under prior law, each individual had a lifetime exemption from the Federal gift tax of $1,000,000. This meant that an individual could make taxable gifts of up to $1,000,000, in the aggregate, during his or her life before having to pay any gift tax. In addition, an individual could gift up to $13,000 per year to any other person ($26,000 in the case of a married couple) free from any gift tax and could make unlimited transfers for medical expenses and tuition for education without any gift tax consequences if the transfers are made directly to the health care provider and/or educational institutions.
Under the Act, the primary change with respect to the gift tax is that, as of 2011, the gift tax lifetime exemption amount is "unified" with the estate tax exemption, meaning that the amount of the gift tax exemption increases from $1,000,000 to $5,000,000. Accordingly, as of 2011, an individual may make total gifts, excluding annual exclusion gifts or direct transfers for medical or educational purposes, of up to $5,000,000 (reduced by any lifetime exemption previously used) during his or her life before owing any gift taxes. This $5,000,000 gift tax exemption is adjusted for inflation in 2012. Because it is unclear if this generous lifetime exemption will last beyond 2010, clients who are willing and able to make substantial gifts are well advised to do so before 2013. Lastly, the concept of portability described above also applies to the gift tax exemption.
THE FEDERAL GENERATION-SKIPPING TAX
By way of background, the GST tax applies to a transfer (whether by gift or bequest) from an individual to his or her grandchild. Such a gift or bequest essentially "skips" the Grantor's child, and avoids the imposition of gift or estate tax at that child's generational level. In order to ensure the fair and even application of tax laws, public policy dictated that there be an estate or gift tax upon the passing of property between each generation and Congress therefore enacted the GST tax. Traditionally, the GST tax is assessed at the highest applicable estate tax rate.
Under prior law, the GST tax, like the estate tax, was not applicable for property transfers in 2010. In 2011, the GST tax was to be revived and, like the estate and gift tax exemption amounts, individuals were given a GST exemption amount equal to $1,000,000 (as indexed for inflation since 2001, or approximately $1,360,000 million).
Under the Act, however, the GST tax was revived for 2010, but with a rate of 0%. For 2011 and 2012, the GST exemption amount is increased to $5,000,000, and is indexed for inflation in 2012. Portability does not apply to the generation-skipping tax exemption.
STATE ESTATE TAX
In addition to the federal estate tax, the State of New Jersey (and several other states including New York) has its own estate tax. The New Jersey Estate Tax applies when a decedent's gross estate exceeds $675,000 ($1,000,000 for New York). This inconsistency with the federal estate tax, known as "decoupling", impacts many New Jersey resident estate plans and, in some cases, may cause unintended results. The pitfall created by decoupling, while not new, is made more severe by the significant increase in the federal estate tax exemption and could create a significant New Jersey estate tax liability which can otherwise be avoided.
By way of example, assume Husband dies in 2012 with assets valued at $5 million. His Will, which was drafted in 1999 (when the federal estate tax exemption was $650,000), provides, by formula, that the maximum amount possible without creating a federal estate tax should pass to a credit shelter trust for the benefit of his spouse. Based upon that formula, upon Husband's death, the trust will be funded with $5 million and $391,600 in New Jersey Estate Tax will be due. If Husband's Will had instead provided that only the maximum amount possible that can pass free of New Jersey Estate Tax should fund the credit shelter trust and that the balance of his estate should pass outright to his spouse, no federal or New Jersey tax would be due upon his death. Of course, avoiding New Jersey Estate Tax may not necessarily be the best result if it creates additional federal estate tax and/or New Jersey estate tax at the death of the surviving spouse. This determination, however, is unique to each situation and must be evaluated on a case by case basis.
As you can see from the above example, the significant changes to the federal estate tax could create unfavorable results for individuals living in so-called decoupled states including New Jersey and New York. It is possible that Husband and Wife in our example would be better served by fully funding the trust and paying New Jersey estate tax. That determination, however, is unique to every client and should, at minimum, be postponed until after Husband's death so that all of the facts and circumstances can be considered.
The changes imposed by the Act may not be relevant to every taxpayer and do not impact all existing estate plans. However, we strongly recommend that taxpayers revisit their current estate planning documents to be sure that the higher exemptions provided for under the Act do not substantially impact the disposition of assets under current documents or create an otherwise avoidable State estate tax. This letter is only intended as a summary of the Act and does not cover every advantage or potential problem that the Act creates. That said, we are available to assist with any questions you may have. We are also making ourselves available to various organizations and practice groups to present a more thorough discussion of the Act. Accordingly, do not hesitate to contact us if you have any questions or if you would like to schedule a presentation for your organization or professional practice.