As we previously reported, The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 Act”) made significant changes to the estate, gift and generation-skipping transfer (“GST”) tax regimes.
Under the 2010 Act, each of the federal estate tax, GST tax and lifetime gift tax exemptions has been increased to $5 million as follows:
- In 2011 and 2012, there is a $5 million federal estate tax exemption (increased from $3.5 million in 2009) and a 35% top estate tax rate (decreased from 45% in 2009).
- In 2011 and 2012, there is a $5 million GST tax exemption (increased from $3.5 million in 2009) and a 35% top GST tax rate (decreased from 45% in 2009).
- In 2011 and 2012, the lifetime gift tax exemption is $5 million (increased from $1 million) and a 35% top GST tax rate (decreased from 45% in 2009).
Of paramount importance is the “reunification” of the gift and estate tax exemptions. Previously, in 2009, and in prior years, the gift tax exemption was capped at $1 million, while the estate tax exemption was as high as $3.5 million in 2009. Now the exemption has been “reunified” at $5 million so every individual can gift up to $5 million during life without paying gift tax.
The increased gift tax exemption of $5 million creates opportunities to make larger lifetime gifts, to leverage more assets through a variety of estate planning techniques (such as a sale to a grantor trust) and to shift income producing assets to individuals such as children or grandchildren who may be in lower income tax brackets and/or reside in states with a low income tax rate or no state income tax.
In order for married couples to take full advantage of the increased exemption amounts, each spouse should have at least $5 million of assets (other than retirement assets) in his or her own name. To accomplish this, some married couples may need to re-title certain assets so that ownership is held by only one spouse. In the case of a spouse or spouses who have significant retirement plan assets, special planning, including customized beneficiary designation forms, may continue to be necessary.
Another important change under the 2010 Act is the newly enacted system of portability. Under the 2010 Act, for the first time in history, a deceased spouse’s unused estate and gift tax exemption is portable and can be used by the surviving spouse. Portability is intended to prevent families from incurring gift and estate tax that could have been avoided through proper estate planning. The following is an example of portability:
Assume Husband and Wife each has $5 million of his or her own assets. Husband dies in 2011 leaving his entire $5 million to his Wife. There would be no federal estate tax imposed on the Husband’s estate since the federal estate tax exclusion is $5 million.
Assume upon Wife’s later death, the $5 million she inherited from Husband has appreciated to $8 million, so that Wife’s total estate is worth $13 million.
Portability allows Wife to use her $5 million estate tax exemption as well as Husband’s $5 million estate tax exemption for a total estate tax exemption of $10 million. In this example, the Wife’s total estate is worth $13 million. With portability, Wife has a $10 million estate tax exemption (her $5 million exemption and Husband’s $5 million exemption) which results in only $3 million being subject to estate tax. Assuming a 35% estate tax rate, the federal estate tax due is $1,050,000.
Similar to portability, a bypass trust can be used to allow assets to “bypass” the federal estate tax that otherwise would be imposed when the second spouse dies. While portability may simplify estate planning and be useful to married couples who do not engage in proper estate planning, there are several advantages to using a bypass trust including protecting assets from creditors, sheltering the appreciation of assets from estate tax and ensuring that the assets are ultimately distributed to the first dying spouse’s intended beneficiaries. For example:
Assume the same facts as above, except that Husband leaves his $5 million to Wife in a bypass trust rather than outright. The assets in the bypass trust are protected from Wife’s creditors and will ultimately pass to Husband’s children. On Husband’s death, no federal estate tax is due because of Husband’s $5 million estate tax exemption.
Assume upon Wife’s death, the $5 million in the bypass trust has appreciated and is worth $8 million. Since the assets are held in a bypass trust, the $8 million in the bypass trust is not subject to estate tax in Wife’s estate. Wife’s total assets for estate tax purposes is $5 million which means that the federal estate tax on her estate would be $0 since she can use her $5 million estate tax exemption. By using a bypass trust, Husband and Wife pay no federal estate tax obtain creditor protection for the assets held in trust and the assets remain in the bloodline.
How do these changes affect your existing Proskauer estate-planning documents?
The good news is that our estate-planning documents are drafted to be flexible and, in general, their overall structure remains unaffected by the increased exemption amounts.
Typically, our Wills and Revocable Trusts for a married couple are structured to include a bypass trust for the surviving spouse (discussed above) and GST tax-exempt trusts for their descendants upon the death of the surviving spouse so that both spouses can utilize their maximum federal estate tax and GST tax exemptions.
A GST tax-exempt trust is drafted so that an individual can pass the maximum amount of property that is exempt from the GST tax in trust tax-free from generation to generation. Generally speaking, the GST tax applies when a person transfers property to someone who is at least two generations younger than the transferor (or to a trust which eventually benefits such individual). The GST tax is designed to tax the transfer of property which effectively “skips” one or more intervening generations.
Our typical documents are drafted with formulas which allow the bypass and GST tax- exempt trusts to be funded with assets equal to the maximum tax exemptions applicable at the time of an individual’s death. These formulas adjust automatically if the amount of the tax exemption changes.
Accordingly, a typical Will or Revocable Trust which was signed before the 2010 Act would still be effective and the bypass trust and GST exempt trusts would be funded with the maximum exemptions now allowable. For example, suppose Husband and Wife had signed a typical Will in 2009 when the estate tax and GST tax exemptions were $3.5 million. If Husband died in 2009, the bypass trust for Wife would be funded with $3.5 million and would be exempt from GST tax. If Husband dies in 2011, the bypass trust would be funded with $5 million and would be exempt from GST tax.
Overall, the increased exemption amounts under the 2010 Act mean that trusts created under your Will or Revocable Trust may be funded with significantly more assets than was previously possible. In general, this is good news and allows you to protect more assets from estate and GST taxes.
There may be instances where you will want to update your documents because the new larger exemption amounts result in too much money passing to particular individuals. For instance, if your bypass trust was left directly to your children instead of your spouse, you may want to make sure that there are enough assets available to your spouse at your death. Additionally, if you are a married couple and live in a state with a state estate tax (mostly states in the northeast) and we drafted your documents before 2004, there may be provisions that should be added to your documents which could save state estate taxes at the death of the first spouse.