Estate, Gift and Generation-Skipping Transfer Tax Provisions of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010

On December 17, 2010, legislation was enacted to implement the compromise reached by President Obama and Senate Republican leaders regarding the Bush tax cuts. The legislation addresses the unprecedented confusion that has existed in 2010 surrounding federal tax law. Highlights of the estate, gift and generation-skipping transfer tax provisions include:

• Reunification of the estate, gift and generation-skipping transfer taxes effective
  January 1, 2011:
  • Each taxpayer will have a $5 million exemption for gifts given either during life or at death; and
  • The same tax rates will apply to both lifetime gifts and estate transfers (maximum rate of 35 percent).
• For 2010, the generation-skipping transfer tax rate remains at 0 percent.
• Executors for estates of decedents who died in 2010 will have the option to choose between a $5 million estate tax exemption with a 35 percent top tax rate and a step-up in basis of the decedent's assets, or an unlimited estate tax exemption and the modified carry-over basis rules which have been in effect for most of 2010.
• Portability between married couples is available for decedents dying on or after January 1, 2011. In prior years, each person was entitled to use only his or her individual federal estate tax exemption, and any unused exemption would lapse. The new law allows the deceased spouse's estate to transfer any unused exemption to the surviving spouse.

Unless extended, these changes to the estate, gift and generation-skipping transfer tax laws are set to expire December 31, 2012.

What follows is a more in-depth analysis of these provisions.

Estate, Gift and Generation-Skipping Transfer Taxes Applicable During 2010

Estate Tax

Retroactive to January 1, 2010, the estate tax is reinstated with an applicable exclusion amount of $5 million and a top tax rate of 35 percent. Executors for estates of decedents dying in 2010 will have the option to choose between:

• An estate tax exemption of $5 million, with a 35 percent tax rate on estate transfers in excess of that amount, and a step-up in basis of the decedent's assets, or
• An unlimited estate tax exemption and the modified carry-over basis rules which have been in effect for most of 2010.

This election will have no effect on the continued applicability of the generation-skipping transfer tax. Once made, the election is only revocable with consent from the Internal Revenue Service.

Executors for estates of decedents dying between January 1, 2010, and December 17, 2010, have until September 17, 2011 (nine months from the date of enactment of the new legislation) to file a federal estate tax return, make payment of any required federal estate tax and make any disclaimers of interests in property passed by reason of the decedent's death.

Gift Tax

For 2010, the federal estate and gift tax remain disconnected. The applicable exclusion amount for gift tax purposes is $1 million, with a top gift tax rate of 35 percent. The gift tax on taxable transfers for an individual year is determined by computing a tentative tax on the cumulative value of current year transfers and all gifts made by the decedent after December 31, 1976, and subtracting from the tentative tax the amount of gift tax that would have been paid by the decedent on taxable gifts after December 31, 1976, if the tax rate schedule in effect in the current year had been in effect on the date of the prior-year gifts.

Individuals still have an annual gift exclusion amount of $13,000. Spouses can split gifts, which allows annual exclusions up to $26,000 per transferee for married couples.

Generation-Skipping Transfer Tax

The generation-skipping transfer tax exemption for decedents dying in or for transfers made in 2010 is $5 million; however, the effective tax rate is zero percent. Importantly, up to $5 million in generation-skipping transfer tax can be allocated to a trust created or funded in 2010, depending on how much of the exemption the settlor used prior to 2010. Similar to estate tax returns, the due date for filing any return required as a result of a generation-skipping transfer in 2010 is September 17, 2011.

Estate, Gift and Generation-Skipping Transfer Taxes Applicable During 2011 and 2012

Effective January 1, 2011, the estate, gift and generation-skipping transfer tax rates and exemptions will be reunified. Each taxpayer will have a $5 million exemption for gifts given either during life or at death, and the same tax rates will apply to both lifetime gifts and estate transfers in excess of that amount (35 percent). The exemption amount will be indexed for inflation beginning January 1, 2012. The "modified carry-over basis" rules that were in effect for most of 2010 will be repealed and replaced with the stepped up basis rules that applied in 2009. Accordingly, recipients of assets acquired from decedents dying in 2011 will receive a step-up in asset basis equal to the fair market value of the property on the decedent's date of death, rather than the decedent's basis.

In addition to the increased exemption, the new law adds what has commonly become known as "portability." In prior years, each taxpayer was entitled to use only the federal applicable exclusion amount allotted to him or her, and any unused exclusion amount would be lost. A married couple could ensure they fully used their respective exclusion amounts by implementing an estate plan that split a spouse's estate into a marital portion and credit shelter portion (this type of planning is often referred to as AB trust planning).

The new law may reduce the need for AB trust planning, because it allows the executor of the first deceased spouse's estate to transfer any unused exclusion amount for use by the surviving spouse as an addition to such surviving spouse's own exclusion amount. This feature of the new law is effective January 1, 2011. The deceased spouse's unused exclusion amount that can be used by the surviving spouse is limited to the lesser of (a) the basic exclusion amount ($5 million, adjusted by inflation) or (b) the unused exclusion amount of the last deceased spouse of the surviving spouse. The executor of the first deceased spouse's estate must file an estate tax return on a timely basis and make an election to permit the surviving spouse to use the deceased spouse's unused exclusion amount.

Assuming both spouses pass away with their exclusion amounts fully intact, portability basically allows the second spouse to die to dispose of $10 million worth of assets, estate tax free, without the need of planning other than making a timely election on the first spouse's estate tax return. As a result, an initial reaction of a married spouse may be to simply distribute all of his or her assets to his or her surviving spouse and do away with AB trust planning. However, even with portability, there may be other tax and non-tax reasons to implement AB trust planning. For example, consider the following issues:

• Appreciation. Under the new law, the deceased spousal unused exclusion amount is indexed to adjust for inflation beginning January 1, 2012. However, the inflation adjustment could be less than the amount in which the deceased spouse's assets appreciate. In this case, a credit shelter trust can shelter the difference between the inflation and appreciation from estate tax, whereas depending solely on the portability of the deceased spousal unused exclusion amount will not. For estates with assets that are likely to appreciate at a rate that exceeds inflation, a credit shelter trust is still a viable option.
• Spendthrift and Creditor Protection. A credit shelter trust can protect assets from the surviving spouse's spending behavior and creditors; depending solely on the portability of the deceased spousal unused exclusion amount does not offer such protection.
• Control of Assets after Death. A spouse may prefer to ultimately dispose of his or her assets to beneficiaries other than those of his or her surviving spouse. In this case, a credit shelter trust can be used to allow the surviving spouse to use the assets for his or her life, and any assets remaining after the surviving spouse's death can be distributed to the first spouse's desired beneficiaries. Again, this is not possible if a spouse relies solely on the portability of the deceased spousal unused exclusion amount by distributing all of his or her assets outright to his or her surviving spouse.
• Remarriage. The deceased spousal unused exclusion amount available to a surviving spouse is limited to the lesser of the basic exclusion amount ($5 million, adjusted by inflation) or the unused exclusion of the last deceased spouse of the surviving spouse. Mere remarriage will not result in the loss of the deceased spousal unused exclusion amount available to the surviving spouse from his or her first predeceased spouse. However, the unused exclusion amount available to the surviving spouse from his or her predeceased spouse could be lost if the surviving spouse remarries a person who has less unused exclusion amount available to him or her than the first deceased spouse, and the second new spouse also predeceases the surviving spouse. In this case, the surviving spouse will be able to utilize only the unused exclusion amount.
• Sunset Provision. As the new law is currently drafted, portability applies only to estates where the decedent's death occurs on or between January 1, 2011, and December 31, 2012. It is uncertain how portability will survive in the event Congress does not again extend the sunset provision.

As the above issues illustrate, depending solely on the portability of the deceased spouse's unused exclusion may not be the wisest course of action. For this reason, it is important that you discuss with your estate planning attorney the viability of relying solely on portability.

Beyond 2012

The new legislation only applies until December 31, 2012. Neither the prior laws nor the new laws will apply to estates, gifts or generation-skipping transfers after that date. Congress is expected to act sometime in 2012 to extend the new laws, repeal them or draft new legislation governing wealth transfer.

What Do These Changes Mean for Your Estate Plan?

While these new tax laws apply only through December 31, 2012, there are a number of lifetime gift opportunities to be examined and implemented prior to that date. In addition, you may be able to simplify your estate plan and do away with provisions in your estate planning documents that contemplated the possibility of a much lower exemption amount. These points are especially significant if your estate plan includes federal estate tax planning provisions but has not been reviewed in the past 5-10 years. We recommend you meet with a trusts and estates professional to learn:

1. The implications of the new legislation to your current estate plan; and
2. How your estate might be better streamlined.

There are a number of questions to answer when you review your current and future estate planning needs:

• Should the same trust arrangement be used to reduce federal estate tax liabilities?
• What are the alternatives to allow a married couple to utilize fully the new federal estate tax exemptions of $5 million each and the newly-added portability feature, taking into account the investments and other assets currently owned?
• What impact will this new federal estate tax exemption have on future capital gains tax liability if heirs should sell inherited assets after your death?
• Should you continue making annual gifts to your children or grandchildren?
• Should you continue to own life insurance on your life for tax planning purposes?
• With the increased exemptions, should you:
  • Increase or decrease charitable transfer provisions taking effect at death?
  • Make lifetime gifts to your children and grandchildren?
• What, if any, impact will the increased federal exemptions have upon the Indiana inheritance tax or other state inheritance or estate tax payable from your estates?

This update is not intended as tax advice, and we strongly encourage you to discuss these changes with your estate planning attorney.