Estate and Gift Tax Provisions and Planning Observations of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010
January 13, 2011
On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“the Act”).
Observation: The Act addressed estate, gift and generation skipping transfer taxes for 2010-2012. Therefore, while specific planning opportunities exist in 2011 and 2012, planning uncertainty exists for 2013 and future years.
1. Estate Tax
Under prior law, the Federal estate tax (the “estate tax”) was repealed in 2010. Accordingly, for an individual who died in 2010, regardless of the size of his or her estate, no estate taxes were due. Also under prior law, the estate tax was to be revived in 2011 but with rates and exemptions determined under 2002 law, meaning that the Federal estate tax exemption (“unified credit amount” or the “exemption amount”) was to be $1,000,000 with a tax rate of up to 55% on the excess balance. In 2010, contemplating the restoration of an increased estate and gift tax rate in 2011, many taxpayers implemented gifting strategies to take advantage of the 2010 gift tax rate of 35%. And, the effect of the perceived lower 2010 exemption and rates compared to expected 2011 higher rates and lower exemptions changed the focus of estate planning. For example, in 2009 a married couple could protect up to $7,000,000 ($3,500,000 per individual) of property from the estate tax, estate assets in excess of this amount taxed up to a top rate of 45%; in 2011, before the Act, that same couple would have only been able to protect $2,000,000 ($1,000,000 per individual) of property from the estate tax, with property in excess of $2,000,000 taxed up to a top estate tax rate of 55%.
Also under prior law, when a person died while the estate tax was in effect, the person’s estate received an income tax benefit in the form of a “cost basis adjustment” for the assets includible in the estate. The effect of this adjustment was to increase the tax basis of the estate assets to fair market value (which was commonly referred to as a “step-up in basis”). This step-up normally eliminated any inherent capital gain that may have existed at the time of death, avoiding the decedent’s assets from being taxed both for estate tax and again for income tax purposes.
Since there was no estate tax for 2010, the step-up provisions did not apply. Instead, prior law granted the estate of every decedent in 2010 a total of $1,300,000 in step-up adjustments, which the decedent’s executor could allocate to appreciated assets owned by the decedent at death. Such adjustments eliminated up to $1,300,000 of gain (otherwise taxable for income tax purposes) in the decedent’s assets. For married individuals, property passing to the surviving spouse (either outright or to a marital trust) was entitled to an additional $3,000,000 of basis adjustments for appreciated assets, which effectively eliminated $4,300,000 of taxable gain in the decedent’s assets.
New Law: $5,000,000 Exemption, 35% Tax Rate, and Available Election to Make the Estate Tax Applicable in 2010
Under the Act, the estate and gift tax exemption (per individual) is increased to $5,000,000 for 2011 and 2012, with a top tax rate of 35% also effective in these years.
Importantly also under the Act, is that the estate tax – and the pre-2010 general basis step-up rule – is applicable even to decedents who died in 2010. However, a special election is available for their estates whereby a decedent’s executor can opt out of the estate tax, so the estate will remain subject to the 2010 rules as if the Act had not been implemented.
Executors of estates that are well in excess of $5,000,000 may wish to opt out of the estate tax and forego the full basis step-up, because the overall income tax that would be due on the recognition of gain could be less than the estate tax that would be due on the decedent’s death.
On the other hand, the executor of the estate of a single individual who died in 2010 with an estate of $4,800,000 and which has $2,500,000 of built-in gains (which is in excess of the available $1,300,000 adjustment amount) may decide not to make the election to opt out of the estate tax. In this instance the total estate is less than the $5,000,000 exemption amount, so no estate taxes will be due. All estate assets will receive the basis step-up, thereby eliminating the $2,500,000 of built-in gains taxable for income tax purposes.
The timing of asset sales to which income taxes may apply, and the tax situations of beneficiaries who may otherwise have to pay such income taxes, need to be considered in this analysis. Thus, the decision to opt out of the estate tax for 2010 should be determined on a case-by-case basis.
Federal Tax Returns and Filings for 2010
The Treasury initially published a draft of the basis adjustment Form 8939 for deaths in 2010 under prior law, including the modified basis adjustment rules described above. The Internal Revenue Service (“IRS”) has subsequently rescinded the form without explanation. At the current time it is not known how the new opt-out election will be made; however, the IRS will eventually publish rules and forms guiding taxpayers on the election and filing procedures.
In addition, should an estate be subject to the estate tax, the tax returns for estates of decedents dying in 2010 will be due within nine months after the Act’s enactment date of December 17, 2010, i.e., by September 17, 2011 (rather than as normally due, which is nine months after the decedent’s date of death). However, we are of the view at the present time that, for a decedent dying in 2010 but after December 17, 2010, the estate tax return and any tax liability will be due by nine months from the date of death. We advise executors to confirm state inheritance or estate tax return due dates.
Generally, if the value of the estate in 2010 is $5,000,000 or less (including any prior taxable gifts that are generally added to the value of a decedent’s assets to compute estate tax), an executor should not elect out of the application of the estate tax. In this case, the $5,000,000 exemption will encompass the entire estate, resulting in no federal estate taxes. Additionally, the inherited assets of such an estate will receive a full step-up in basis to the value of such assets at the decedent’s death.
If the value of the estate in 2010 is over $5,000,000, an executor should consider electing out of the application of the estate tax. A critical consideration in this decision is whether the benefits of the additional basis step-up are outweighed by the estate tax that would otherwise be due, which is the lesser of (i) the present value of the ultimate capital gains tax on the non-stepped-up assets, and (ii) the estate taxes. If you are the executor of the estate of a decedent who died in 2010 with a value over $5,000,000, a careful analysis is needed to determine whether you should opt out of the estate tax. Care must be taken by the executor, in that incurring estate taxes may help certain beneficiaries at the expense of others.
2. Gift Tax
Under prior law, each individual had a lifetime exemption from the Federal gift tax (the “gift tax”) allowing aggregate gifts of up to $1,000,000 during his or her lifetime before having to pay any gift tax. In addition, an individual may gift assets with a value of up to $13,000 ($26,000 in the case of a married couple) per year to any other person, without incurring any gift tax – this is known as the “gift tax annual per donee exclusion.” Finally, individuals may 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 educational institution, respectively.
Increased Exemption Amount
Under the Act, a major change to the gift tax is that, for 2011 and 2012, the lifetime gift tax exemption amount is “unified” with the estate tax exemption. In addition, the Federal gift tax rate on amounts in excess of the exemption is 35%.
Therefore, the lifetime gift tax exemption for 2011 and 2012 increases from $1,000,000 to $5,000,000 which is also equal to the estate tax exemption. This $5,000,000 gift tax exemption is adjusted for inflation after 2011. The $5,000,000 gift tax exemption is reduced by any gift tax exemption used prior to 2011 – for example, if an individual utilized $1,000,000 of the gift tax exemption prior to 2011, the available gift tax exemption in 2011 and 2012 is only $4,000,000.
As of January 1, 2011, individuals who have already fully utilized their $1,000,000 Federal lifetime gift tax exemption have another $4,000,000 of gift tax exemption available to them. Thus, any asset transfer techniques that the individual may not have considered because it would have resulted in the payment of gift tax may now be reconsidered.
The Act creates opportunities to shift income to taxpayers (e.g., children) who may be in lower income tax brackets and not subject to the so-called "Kiddie” tax. For this reason, its provisions may be adjusted by future legislation.
3. Generation-Skipping Transfer (“GST”) Tax – Revived in 2010 But the Rate Is Zero!
The GST tax is complex and often misunderstood by both taxpayers and practitioners. Prior to the Act, it was unclear how the provisions of the GST tax were to apply during 2010 and many taxpayers postponed making GST gifts because of this uncertainty. The GST tax applies to a transfer by gift or bequest from an individual to his or her grandchild or any individual at least 37½ years younger than the individual making the transfer, and thus “skipping” a child or a generation. The GST tax was Congress’ attempt to prevent wealthy taxpayers from reducing estate taxes by skipping their children and transferring assets to grandchildren, thereby avoiding a transfer tax in their children’s estates. The GST tax forces a tax liability as if the assets passed through the skipped generation and is assessed at the highest applicable estate tax rate.
Under prior law, the GST tax, like the estate tax, was not applicable to transfers in 2010. As a result, many practitioners were uncertain as to the effect of making GST elections, allocations of GST exemption amounts, or GST treatment for transfers to a generation-skipping trust; this uncertainty resulted in a dearth of generation-skipping transfers to trusts in 2010. On the other hand, excluding the applicability of estate and/or gift taxes, in 2010 a grandparent could transfer (by gift or bequest) as much property as he or she desired directly to a grandchild without having to pay GST tax at the time of the transfer – but many grandparents opted out of handing over assets outright or to a so-called “direct skip” trust.
In 2011, the GST tax was to be revived and, similarly to the estate and gift tax exemption amounts, individuals were to have a GST exemption amount equal to $1,000,000 (as indexed for inflation since 2001, or approximately $1,300,000).
The Act’s Clarification for 2010
Imagine a tax without a tax rate! Under the Act, the GST tax is revived for 2010-2012 -- however, for 2010 the GST tax rate is 0%. Thus, if a grandparent made a transfer (by gift or bequest) to a grandchild in 2010, that gift or bequest is subject to the GST tax, because it effectively “skips” the children’s generation, but no tax is due on the transfer because the GST tax rate is 0%.
Importantly, under the Act, for 2010 the GST exemption amount is increased to $5,000,000, and is indexed for inflation after 2011.
If an individual transferred property to a trust in 2010 for the benefit of both children and grandchildren, because a child has an interest in the trust, the gift was subject to gift tax but not GST tax. Unless a GST exemption amount is allocated to the transfer, distributions from the trust in 2011 and beyond will be subject to GST tax upon making distributions to skip persons. However, if the transfer is subject to GST tax, the transferor can allocate the full GST exemption amount to the trust, and future distributions from the trust up to the GST exemption amount of $5,000,000 will be subject to GST tax only on a pro rata basis, determined by the $5,000,000 exemption amount divided by the value at the transfer date of the asset receiving the allocation, if greater.
The Act's two-year life span creates continuing uncertainty as to the effect of the exemption after 2012, so generation-skipping gifts need to be carefully structured. Coordination between the accountant and the attorney is now more essential than ever!
The Act preserves the GST’s so-called "automatic allocation" rule, which means that many individuals may unknowingly waste their GST exemptions by making gifts to trusts that appear to be non-dynastic trusts. Revisiting your gifting and gift tax return history will allow you to plan for the most effective use of this increased exemption which can be extremely valuable.
4. Portability: A Surviving Spouse Can Utilize the Deceased Spouse’s Unused Exemption
Under prior law, if an individual died failing to utilize all of his or her estate tax exemption, this exemption was forever lost. As a result, professional advisors often recommended that each spouse should have sufficient assets in his or her individual ownership to take maximum advantage of the exemption amount in the estate of the first spouse to die. This also involved the use of a so-called “bypass” trust (see below) that added some measure of complexity.
As a result of the Act, the Executor of the estate of a spouse who dies in 2011 or 2012 can elect to transfer any unused exemption to the surviving spouse (i.e., $5,000,000 if no exemption was used during lifetime). This means that, with respect to a typical husband and wife, if in 2011 the husband dies and does not fully use his estate tax exemption, the deceased husband’s unused exemption can be attributed to the wife, so that when she dies, her estate plan can use both her unused estate tax exemption and her late husband’s unused exemption. Thus, a married couple can easily shelter $10 million of assets from the Federal estate tax.
Example: Suppose a husband dies in 2011, is survived by his wife, and he only utilized $2,000,000 of his $5,000,000 estate tax exemption. If the husband’s Executor makes the proper election, upon the wife’s subsequent death, if she has not used any of her own unified gift and estate tax exemption, her estate has an estate tax exemption comprised of her own $5,000,000 exemption as well as the deceased husband’s $3,000,000 of unused exemption, for a total estate tax exemption of $8,000,000.
Portability must be elected by the first deceased spouse’s executor on the deceased’s estate tax return, signifying that the surviving spouse may utilize the deceased spouse’s unused estate tax exemption. How the election is made will become part of future guidance from the Treasury.
The portability benefit is limited to the unused estate tax exemption of the “last” deceased spouse of the surviving spouse, apparently to avoid “serial marriages” to accumulate unused exemptions. However, one effect is that an individual may be reluctant to marry subsequently due to the loss of a prior spouse’s unused exemption amount.
Limitations on Portability
Planning remains necessary also because portability only applies to the unified gift and estate tax exemption amount and is inapplicable to any unused GST tax exemption.
Moreover, Federal portability does not apply to state death tax exemptions. Thus, for residents of New York, New Jersey, and other states that impose an estate tax, trusts may remain necessary to achieve full state death tax benefits.
Even with portability, we continue to recommend that married couples divide their assets approximately equally and structure their estate plans so that each spouse will fully utilize his or her exemptions at the time of death. There are several reasons for this, as follows:
As noted above, the GST tax exemption and applicable state tax exemptions are not covered by Federal portability.
Relying solely on the portability rule is risky because it is dependent upon the Executor of the first deceased spouse’s estate making an election to pass on the unused exemption to the surviving spouse.
Use of a bypass trust can shield future income and appreciation in assets, as described below.
By using a bypass trust and properly dividing their assets, both spouses can utilize their estate tax exemptions without the need for portability. A bypass trust is drafted in a manner that allows assets to “bypass” the estate tax that otherwise would be imposed when the second spouse dies. Aside from potential non-tax benefits (e.g., creditor protection) of holding assets in trust, funding a bypass trust on the first spouse’s death allows any appreciation in value of the trust assets that occurs between the first death and the second death to avoid estate tax. Asset value appreciation usually occurs where the marital trust is the primary support for the surviving spouse. Relying solely on the portability rule will fail to remove the increase in value between deaths to avoid estate tax.
Example 1: Assume that a husband dies in 2011 and his entire estate – $3,000,000 – is placed in a bypass trust for the benefit of his wife. This results in the husband having an unused estate tax exemption of $2,000,000 which the executor elects to pass to the wife. Assume further that upon the wife’s subsequent death in 2011, the assets in such trust have appreciated in value to $5,000,000 and the wife’s individual assets (exclusive of the trust) total $7,000,000. The $5,000,000 in trust will not be subject to estate tax on the wife’s death because it is held in a bypass trust. Further, no estate tax will be due on the wife’s death because the wife’s estate tax exemption is equal to $7,000,000 (i.e., $5,000,000 of her own estate tax exemption and $2,000,000 of the husband’s unused estate tax exemption).
Example 2: Conversely, assume the same facts as in Example 1, except that the husband’s $3,000,000 is left outright to the surviving spouse. On the husband’s death, no estate tax will be due because all of the property is left outright to his wife and therefore qualifies for the estate tax marital deduction. Further, because no estate tax exemption is needed to eliminate estate tax upon the husband’s death, the husband’s executor elects to allow the wife to use the husband’s full $5,000,000 of unused estate tax exemption. As in Example 1, by the time of the wife’s death, the $3,000,000 from the husband’s estate appreciates to $5,000,000, meaning that the wife’s estate totals $12,000,000 ($3,000,000 from the husband, $2,000,000 in appreciation and $7,000,000 of her own assets). The wife’s total assets exceed the total of her available estate tax exemption by $2,000,000 ($12,000,000 in assets less $10,000,000 available estate tax exemption), thus causing her estate to owe estate tax.
5. GRATs: Safe for the Near Term
A significant planning technique that many practitioners believed was in jeopardy – but is not precluded by the Act – is the use of grantor retained annuity trusts (“GRATs”).
Use of a GRAT is an estate planning technique that is provided for in the Internal Revenue Code and the subject of a taxpayer-friendly Court decision. An individual transfers property into a GRAT for a specified period of time, for example two years, and receives an annuity over the two year period. The annuity is determined, in part, based on an interest rate established by the IRS (the “Section 7520 Rate”). At the end of the trust term, if the assets have appreciated in value at a rate in excess of the Section 7520 Rate, the appreciation passes to the trust’s remainder beneficiaries with minimal or no current gift tax liability. This is referred to as “zeroing out” the GRAT because the value of the remainder interest in the GRAT for gift tax purposes is very close to zero. If the GRAT’s assets appreciate and/or produce income at a rate higher than the Section 7520 rate, then the GRAT will be successful because excess property value will pass to the remainder beneficiaries with little (or no) gift tax consequences.
If the individual dies during the term, then most or all of the value of the GRAT is included in the individual’s estate for estate tax purposes, similar to the result if the individual had done nothing. The key to the success of most GRATs is the ability to “zero-out” a GRAT using as many short annuity term GRATs as possible during a low Section 7520 Rate period.
Attempts to Increase the Annuity Term
President Obama has previously included in his budget proposals legislation that would require a ten-year minimum term for a GRAT (the “ten-year term”). While GRATs would still be a viable planning tool, the ten-year term would greatly reduce a GRAT’s effectiveness because the individual would then have to outlive the ten-year term. Throughout the past year, various bills were considered in both houses of Congress that would have mandated a ten-year term (and at least a minimal value for the remainder interest). This would have eliminated the short term “rolling GRAT” technique that many professional advisors recommend to clients (depending on asset appreciation/income potential and the Section 7520 rate).
The Act does not include any references to GRATs, so short term GRATs appear to remain viable for the near future. However, their long term viability is open to question.
Optimal GRAT results are achieved through combining (a) the shortest annuity term possible, with (b) with a low Section 7520 rate. This is because the lower the Section 7520 rate, the lower the threshold for the GRAT’s assets to appreciate/produce income in excess of that rate. The Section 7520 rate is currently very low; the January 2011 rate is 2.4%. Thus, depending upon the appreciation/income potential of the asset transferred to a GRAT, the current interest rate environment could provide an ideal time in which to create a GRAT.
6. State Taxes
State inheritance and estate taxes remain deductible for Federal estate tax purposes, but the new lower 35% Federal estate tax rate effectively increases the after-tax cost of state taxes on a domiciliary of a state that imposes such a death tax because, with a reduced Federal estate tax rate, there is less of a Federal estate tax benefit arising from the Federal deduction for a state death tax
Consider the impact of a state inheritance or estate tax for individuals that reside in jurisdictions that are decoupled from the Federal estate tax. In 2010, 13 states plus the District of Columbia had an inheritance or estate tax for deaths occurring in 2010, and most are former pick-up states that decoupled from the Federal estate tax. Ten of these states (including Maryland, Massachusetts, New Jersey, and New York) apply some or all of the older Federal exemptions, tax rates, definitions and deductions. Certain other states have enacted their own tax rules that are not linked to Federal estate tax calculations; e.g., Pennsylvania, where inheritance tax rates range from 0% for legally married spouses, to 4.5% for children and grandchildren, and up to 15% for non-family members. Recently, certain states repealed their inheritance or estate taxes; Wisconsin allowed theirs to expire; and other states never had a tax.
Consider severing domicile from any state that imposes an inheritance or estate tax, assuming your lifestyle and other factors would not outweigh the benefit of avoiding such state tax.
7. Nonresident Aliens: Still Subject to U.S. Estate Tax on Property in Excess of $60,000
The gross estate of a nonresident alien (“NRA”) generally includes only property that is situated in the U.S. at the time of the decedent's death (including certain debt obligations issued by U.S. persons and stock issued by a domestic company). Unless property is excluded from a U.S. estate under a treaty between the U.S. and applicable foreign country, generally the NRA is entitled to a $13,000 unified (estate) tax credit (i.e., a $60,000 estate tax exemption equivalent). The Act extended the estate tax look-through rule for stock of a U.S. regulated investment company (“RIC”) or mutual fund owned by an NRA. Under this provision, the RIC or mutual fund is not deemed to be property situs within the U.S. in proportion to those assets held by the RIC that would be treated as situated outside of the U.S. This proportion is measured at the end of the quarter of the RIC’s tax year before the decedent’s date of death.
This special provision allows an NRA to invest in stock issued by a domestic RIC and not be completely exposed to U.S. estate tax if the underlying investments are situated outside the U.S. The estate of an NRA holding U.S. property in excess of $60,000 will be subject to Federal estate tax up to a maximum rate of 35% through 2012.
While the Act does not modify the statutory unified credit equivalent for NRAs, nor adjust the credit equivalent for inflation, certain U.S. treaties with foreign countries may provide partial relief by a credit which is equivalent to the exemption available to the estate of a U.S. citizen or resident, multiplied by that proportion of the worldwide estate which is situated in the U.S.; therefore, the increased credit equivalent, due to the Act’s increased estate tax exemption, will benefit an NRA entitled to the benefits of such a treaty.
8. Remaining Planning Observations
The Act is scheduled to "sunset" after 2012. Thus, unless Congress acts again within the next two years, the provisions of pre-2001 estate, gift, and GST tax law will return.
Therefore, our best recommendation is to act expeditiously to take advantage of opportunities present in the current two year window.
We also recommend maintaining and – as needed in the future -- modifying flexible Federal and state estate planning documents that will carry out your intentions considering both current law and expected legislative changes.
For further information on these provisions, please contact EisnerAmper LLP partners Jack Meola, the principal author of this Alert, or Timothy Speiss.
This publication is intended to provide general information to our friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.