Trust & Estates: Congressional Action Prevented Higher Estate Taxes-But the Changes Are Effective Only Through 2012

07.01.11

In late December 2010, Congress made welcome changes to our gift, estate, and generation-skipping transfer tax system--at least during the period from 2010 through 2012. Gift, estate, and generation-skipping transfer taxes are imposed on transfers of wealth made during life and at death. If they apply, these transfer taxes are to be avoided to the extent possible because they historically have been assessed at relatively high rates. The new law brings welcome relief for individuals and families. It increases to $5 million the amount that an individual can shelter from gift, estate, and generation-skipping transfer taxes, and it facilitates the transfer of $10 million by a married couple without estate tax. For transfers over these sheltered amounts, the transfer tax rate is reduced to 35% (from the 2009 rate of 45% and a top marginal rate of 55% that had been scheduled to take effect in 2011).

Unfortunately, the legislation has a relatively short shelf life. The new transfer tax legislation was part of the tax package negotiated by President Obama and Congressional Republicans to extend the so-called "Bush tax cuts." While the income tax rate provisions simply extend current law for two more years, the new gift, estate and generation-skipping transfer tax provisions materially change prior law.

If Congress had not acted before the end of 2010, a 10-year period of estate, gift and generation-skipping transfer tax relief would have ended in 2011 when the rules applicable in 2001 were scheduled to return. This reversion back to 2001 would have provided each individual with only a $1 million exemption from estate and gift taxes and would have set a top marginal estate and gift tax rate of 55% on transfers of $3 million or more.

The new law includes the following taxpayer-friendly features:

In 2011 and 2012, the new $5 million exclusion amount and 35% rate apply. The exclusion also is indexed for inflation so that, in 2012, it may increase.

Consider this example of how the new law will work. Mrs. Smith, a widow, dies during 2012 with an estate of $5.1 million. Assuming no indexing of the exclusion amount occurs, the $5 million exclusion leaves only $100,000 of her assets exposed to estate tax at the 35% rate so that her estate tax would be $35,000. This estate tax could be reduced by deductions such as administrative expenses and any gifts to charity. Furthermore, if by 2012, there has been a sufficient increase in the cost of living, the indexed exclusion may cover Mrs. Smith's entire estate, regardless of any deductions. In any case, Mrs. Smith's beneficiaries will receive assets with adjustment in basis to their values on the date of Mrs. Smith's death.

Portability for married couples.

Beginning in 2011 and through 2012, a new concept, called "portability" eases the ability of a married couple to assure that, between them, $10 million will be sheltered from estate tax. Under our prior transfer tax system, a married couple generally has been counseled to split their assets between them so that, regardless of who dies first, each spouse would own sufficient assets to take advantage of the applicable estate tax exemption at death. The target was for each spouse to own assets at least equal to the estate tax exemption amount, but this target could be unattainable in cases where a spouse owned an asset that could not easily be transferred, such as closely-held stock or a large retirement accumulation. With portability, the second spouse to die may utilize, at his or her later death, any unused exclusion amount of the first spouse to die, and it becomes less important in many cases for spouses to divide their assets during t heir joint lifetimes. The traps and pitfalls to avoid when planning with "portability" are examined in greater detail in an article that appears below.

During 2011 and 2012, estate and gift taxes are unified.

During 2011 and 2012, the $5 million exclusion amount is available for lifetime gifts. Prior to the new legislation, the maximum lifetime taxable gift was fixed at $1 million even in 2009 when the estate tax exemption was $3.5 million. Consider this example. Mr. Brown, who had never made a lifetime taxable gift, decides to give $2.5 million to each one of his two children in 2011, for a total taxable gift of $5 million. Mr. Brown owes no gift tax because his transfers are sheltered by the $5 million exclusion. At Mr. Brown's later death, the lifetime gifts of $5 million return to his transfer tax base (along with the unified estate and gift tax exclusion), but any post-gift appreciation escapes the transfer tax system.

In 2011 and 2012, generation-skipping transfers will be exposed to a 35% rate, subject to a $5 million exclusion amount.

How should individuals and families respond to the new law?

The increased $5 million exclusion ($10 million for a married couple) will remove the vast majority of individuals and families from the estate, gift and generation-skipping transfer tax system at least during the period from 2010 through 2012.

Given the uncertainty of the transfer tax system after 2012, it will be important to review carefully whether tax-driven planning should be put in place now and whether planning undertaken in prior years should be retained or, if feasible, be un-done.

The new law includes important reporting requirements. Fiduciaries of individuals dying during the period from 2010 through 2012 should seek professional assistance to reap benefits of the new law. Similarly, individuals who make taxable gifts need to report those gifts accurately.

The new $5 million lifetime exclusion and today's low interest rate environment combine to make certain lifetime gifts particularly attractive, particularly gifts of assets that may be expected to appreciate over the longer term.

Jeffrey C. Rambach
(918) 591-5202
jrambach@dsda.com

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