2010 Tax Relief Act: Estate, Gift and Generation Skipping Transfer Tax Provisions
The 2010 Tax Relief Act provides significant estate, gift and generation skipping transfer (“GST”) tax relief for 2011 and 2012, at which time, the new laws will sunset.
On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Tax Relief Act”). Among its many provisions, the 2010 Tax Relief Act provides significant estate, gift and generation skipping transfer (“GST”) tax relief for 2011 and 2012, at which time, the new laws will sunset. The 2010 Tax Relief Act preserves the estate tax repeal for 2010; however, estates wanting zero estate tax for 2010 must elect that option, along with the modified carryover basis rules that were previously applied in 2010. Otherwise, by default, the estate tax is revived for 2010, with a $5 million exemption, a top tax rate of 35%, and a step-up in basis. Further, for estates of decedents dying after December 31, 2010, the executor of a deceased spouse may shift unused estate and gift tax exemption (but not GST tax exemption) to the surviving spouse. However, these generous rules, which are explained below, are temporary—much harsher rules are slated to return after 2012.
Increased Estate and GST Tax Exemption and Reduced Top Rate
The 2010 Tax Relief Act substantially lowers estate and GST taxes for 2011 and 2012 by increasing the exemption amount from $1 million to $5 million per person ($10 million for a married couple) and reducing the top tax rate from 55% to 35%. By default, the $5 million exemption applies to estates of decedents who die beginning January 1, 2010, and heirs receiving property from a decedent’s estate take the property with a fair market value (i.e., “stepped up”) basis. However, an executor may opt out of this $5 million exemption, and instead elect for the modified carryover basis rules to apply to the estate of a decedent dying during 2010.
Choice of Estate Tax Exemption for 2010
The 2010 Tax Relief Act allows estates of decedents dying in 2010 to choose between (1) estate tax (based on a $5 million exemption and 35% top tax rate) and a step-up in basis, or (2) no estate tax and modified carryover basis. In technical terms, the 2010 Tax Relief Act achieves this choice by making the estate tax and basis changes effective retroactively for estates of decedents dying after 2009, but allowing the opt-out choice for estates of decedents dying in 2010. The IRS is yet to determine the time and manner for making the modified carryover basis election. However, one thing is clear, once the election is made, it is revocable only with IRS consent. Therefore, the executor should calculate and select whichever choice would produce the lowest combined estate and income taxes for the estate and its beneficiaries, as shown in the following simplified illustrations.
Illustration 1: John, a single individual, dies in 2010 with an estate worth $6 million, and whose assets had a cost basis of $3.7 million. Under the 2010 Tax Relief Act, John’s heirs would face an estate tax of $350,000 ($2,080,800 tax on $6 million under the new rate schedule reduced by $1,730,800 tax offset by the applicable exclusion amount), and they would get a step-up in basis. On the other hand, if the executor chose to elect modified basis carryover treatment, the estate would owe no estate tax and John’s heirs would face capital gain tax on $1 million worth of assets when they sell them. The heirs calculate the $1 million gain by subtracting a basis of $5 million (John’s original $3.7 million basis as increased by $1.3 million under the modified carryover basis rules) from the $6 million inherited. Assuming the $1 million were taxed at 15%, the capital gain tax cost would be $150,000. Thus, the election should be made as it would result in lower combined estate and income tax ($150,000 as opposed to $350,000).
Illustration 2: Assume the same facts as in Illustration 1, except that John’s basis immediately before death was $700,000. If his executor were to elect to apply the modified carryover basis rules, there would be no estate tax but the beneficiaries would face a $600,000 capital gain tax on $4 million. Since this is more than the $350,000 in estate tax that would be owed without the election, the election should not be made.
Under the 2010 Tax Relief Act, the gift tax exemption for gifts made in 2010 is $1 million and the gift tax rate is 35%. For gifts made after December 31, 2010, the gift tax is reunified with the estate tax, with an applicable exclusion amount of $5 million and a top estate and gift tax rate of 35%. The “reunification” of the estate and gift tax allows individuals to give away up to $5 million during their lives without incurring any gift tax liability – a vast improvement over the previous $1 million exclusion amount.
Generation-Skipping Transfer Tax Changes
According to the 2010 Tax Relief Act, the GST tax exemption for decedents dying or gifts made after December 31, 2009 and before January 1, 2011 is equal to the applicable exclusion amount for estate tax purposes (i.e., $5 million). Therefore, up to $5 million in GST tax exemption may be allocated to a trust created or funded during 2010. Although the GST tax is applicable in 2010, the GST tax rate for transfers made during 2010 is 0%. The GST tax exemption for decedents dying or gifts made after December 31, 2010 is equal to the basic exclusion amount (a new concept arising under the portability feature, discussed below) for estate tax purposes (i.e., $5 million, as indexed). The GST tax rate for transfers made in 2011 and 2012 is 35%, which is the same for the estate and gift tax.
Pursuant to the 2010 Tax Relief Act, any estate or gift tax exemption that remains unused as of the death of a spouse who dies after December 31, 2010 (the “deceased spousal unused exclusion amount”) is generally available for use by the surviving spouse, as an addition to the surviving spouse’s exemption. Therefore, a surviving spouse may use the predeceased spousal carryover amount in addition to his or her own $5 million exemption for taxable transfers made during life or at death. However, the GST tax exemption cannot be transferred to a surviving spouse.
If a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion that is available for use by the surviving spouse is limited to the lesser of $5 million or the unused exclusion of the most recently deceased spouse. A deceased spousal unused exclusion amount is available to a surviving spouse only if an election is made on a timely filed estate tax return (including extensions), regardless of whether the estate of the predeceased spouse is otherwise required to file an estate tax return. In addition, notwithstanding the statute of limitations for assessing estate or gift tax with respect to a predeceased spouse (normally three years), the IRS may, at any time, examine the return of a predeceased spouse for purposes of determining the deceased spousal unused exclusion amount available for use by the surviving spouse.
Illustration 1: Husband dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made by Husband’s executor on his estate tax return to permit Wife to use Husband’s unused exclusion amount. As of his death, Wife has made no taxable gifts. Thereafter, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband), which she may use for lifetime gifts or for transfers at death.
Illustration 2: Assume the same facts as in Illustration 1, except that Wife subsequently marries Husband 2. He predeceases Wife, having made $4 million in taxable transfers and having no taxable estate. An election is made on his estate tax return to permit Wife to use his unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2’s $1 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse of the surviving spouse. Thereafter, if Husband 2’s executor makes an election on a timely filed federal estate tax return, Wife’s applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death. However, if Husband 2’s executor does not make a timely election, Wife’s exclusion amount is limited to her basic exclusion amount of $5 million.
Illustration 3: Assume the same facts as in Illustration 2, except that Wife dies before Husband 2. If Wife’s entire estate is valued at $3 million and all is left to a bypass trust, her deceased spousal unused exclusion amount is $4 million (see Illustration 1), and Husband 2’s exclusion amount is $9 million (his basic $5 million exclusion amount plus Wife’s $4 million unused exclusion).
Although the estate tax exemption is portable as between a husband and wife, which may marginalize the need for pure tax-based planning, the ability to transfer the deceased spouse’s remaining estate and gift tax exemption amount does not address the myriad of issues (such as probate fees and taxes, blended marriages, special needs and spendthrift beneficiaries, and caring for minor children) that many families face when planning their estates.
Planning for Continued Uncertainty
Title III of the 2010 Tax Relief Act is called the “Temporary Estate Tax Relief,” and the name says it all. While we can now plan for deaths occurring in the next two years, there will be much debate over what will happen when these laws sunset at the end of 2012. For example, we do not yet have regulations regarding continued portability – will a deceased spousal unused exclusion amount acquired in 2011-2012 disappear on December 31, 2012? If no further Congressional action is taken, the estate, gift, and GST taxes are scheduled to return to the 2001 amounts and rates, which is what would have happened on January 1, 2011, if the 2010 Tax Relief Act was not enacted. The 2013 possibilities include: a sunset to the 2001 $1 million exemption and graduated tax rates up to 55%; a permanent extension of the Tax Relief Act with a $5 million exemption and 35% tax rate; a permanent extension of EGTRRA 2009 with a $3.5 million exemption and 45% tax rate; or even a permanent repeal. Despite the current two-year “relief,” ongoing planning will be required in order to address these seemingly ever-changing tax and estate administration issues and to ensure that taxpayers’ estate plans remain flexible enough to meet their estate planning goals.