On December 17, 2010, the President signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Relief Act), a bipartisan measure that, temporarily, extends or otherwise modifies a variety of Bush era tax measures that were scheduled to expire at the end of 2010. While the focus in the mainstream media has been on the income tax provisions of this legislation, the most surprising modifications made by this legislation fall within the ambit of the gift and estate tax arena.
Increase to $5 Million of Estate and Gift Tax Exemption
Prior to passage of the 2010 Tax Relief Act, the gift and estate tax regime was scheduled to revert on January 1, 2011 to the regime in place prior to 2001. In essence, the pre-2001 regime allowed each U.S. citizen to give away, either during lifetime or at death, a total of $1 million without paying any gift or estate taxes; and, for each dollar in excess of such amount, there was a transfer tax assessed at rates ranging from 45-55%. However, with the passage of the 2010 Tax Relief Act, the amount each U.S. citizen is now able to give away has been increased to $5 million, and the transfer tax rate paid on each dollar given away in excess of the $5 million has been capped at 35%.
Such changes to the transfer tax regime are short-lived, however, as the modifications made by way of the 2010 Tax Relief Act are scheduled to expire in just two years. So, the time is now to take advantage of these unprecedented changes to the transfer tax regime, as there is no guarantee that Congress will be able to extend the changes at the end of 2012, especially because 2012 is a presidential election year.
Benefits of Lifetime Gifts
One way to take advantage of the current increase in transfer tax exemption so is to revisit any gifting programs you currently have in place or to otherwise consider implementing new gifting programs. While it is true that the $5 million gift tax exemption may be a thing of the past on January 1, 2013, any gifts made while the $5 million exemption is in effect will not be subject to gift taxes, even if we end up reverting to the $1 million exemption regime in 2013. And, while an estate tax may be assessed against any such gifts if we do revert to the pre-2001 transfer tax regime, the estate tax need not be paid until your death (in effect, an interest-free loan from the government). Further, even though Illinois just reinstated the Illinois estate tax (with a $2 million exemption), Illinois still does not assess a tax on lifetime gifts. So, any gifts made now will significantly reduce the amount of Illinois transfer taxes that may be due at death.
Effect of Increased Exemption on Current Estate Plans
Furthermore, the 2010 Tax Relief Act calls for an immediate review of your existing estate plan, as your plan may be drafted in a manner that exacts gifts to certain beneficiaries utilizing mathematical formulas tied to the transfer tax exemption amount. For example, Barb, a married resident of Illinois with 3 daughters, executed an estate plan in 1990 when the estate tax exemption was $600,000. Under her estate plan, Barb employed what was then a somewhat common disposition scheme where at Barb's passing an amount equal to the federal estate tax exemption is to be distributed outright equally to her daughters with the balance of her estate to be held in trust for her spouse, Art, until his death, at which time the balance of the trust for Art is to be distributed to Barb’s daughters. If Barb had died in 1990 with an estate worth $4 million, under such a disposition scheme, Barb’s daughters would have received $600,000 while the trust for Art would have received the remaining $3.4 million. If, however, Barb were to die with the same sized estate in 2011, her daughters would receive $3.75 million while Art's trust would receive nothing (there is a $250,000 tax at the Illinois level).
Carryover Basis Selection for 2010 Estates
The 2010 Tax Relief Act also contains many provisions which impact the administration of estates of decedents dying in 2010 and beyond. First, prior to passage of the 2010 Tax Relief Act, estates of decedents dying in 2010 were not subject to estate taxes, but were, rather, subject to a modified carryover income tax basis regime. Under an estate tax regime, the income tax basis of assets compromising the estate is, generally, adjusted to the value of the assets as of the decedent’s death thereby eliminating taxation of any unrealized capital gains as of the decedent’s death, whereas under the modified carryover basis regime, there are significant limitations to the adjustments that can be made to the income tax basis of the decedent’s assets thereby requiring the beneficiaries of the estate to, for the most part, pay taxes on the unrealized gains when the assets are eventually sold. However, under the 2010 Tax Relief Act, estates of decedents dying in 2010 are now given an option, either be subject to estate taxes with the $5 million exemption amount or continue to be exempt from estate taxes and, instead, be subject to the modified carryover income tax basis regime.
Ability of Surviving Spouse to Use First Spouse’s Unused Exemption
Second, the 2010 Tax Relief Act allows the surviving spouse of a decedent in the next two years to use the pre-deceased spouse’s unused transfer tax exemption. So, in other words, if a decedent does not fully utilize his or her entire $5 million exemption at death, the decedent’s surviving spouse is now able to utilize the unused portion as part of his or her own estate planning.
Assume, for example, a husband dies this year leaving his entire $3 million estate to his wife, outright and free of trust. Because transfers between spouses are not, under current tax laws, counted in determining how much of a decedent’s transfer tax exemption has been used, the husband in this example has not used any of his $5 million transfer tax exemption. Under the transfer tax laws in place prior to the 2010 Tax Relief Act, the husband’s unused transfer tax exemption would have been forever lost, as his surviving spouse only had the right to give away tax-free whatever the transfer tax exemption amount was in effect as of her subsequent passing. However, under the 2010 Tax Relief Act, the wife can now, with the permission of the executor of the husband’s estate, tack the unused portion of the husband’s transfer tax exemption to her own exemption, thereby increasing the amount the wife can give away, whether during lifetime or at death, from $5 million to $10 million. But note, this provision only applies if one of the spouses dies in the next two years. So, while the benefits of this provision have been touted in the press, it will likely be of limited benefit for many individuals, as it only comes into effect if one of the spouses dies in the next two years. (Note that special rules apply if the surviving spouse is not a U.S. citizen.)