The new year brought several major changes to the federal transfer tax laws. Three important transfer tax benefits were increased: the estate tax exemption, the gift tax annual exclusion and the generation skipping transfer (GST) tax exemption. In addition, 2008 saw the enactment of several favorable income tax laws. In this alert, we will discuss recent updates in the transfer and income tax laws, and how these changes create opportunities to minimize taxes in 2009 and beyond.

Transfer Tax Laws for 2009

Federal Estate Tax Exemption Increased to $3.5 Million

As of January 1, 2009, the exemption from the federal estate tax for a U.S. citizen or resident increased from $2 million to $3.5 million. The federal estate tax is scheduled to be repealed in 2010, but only for individuals who die in that year. Thereafter, the estate tax exemption is scheduled to return to $1 million. Congress is expected to revise the estate and gift tax laws before the end of the year, however, and several bills have already been introduced this year that would freeze the federal estate tax exemption at $3.5 million.

Married residents of jurisdictions that have an estate tax (such as Illinois, New Jersey, New York and Washington, D.C.) must be mindful of the disparity that may exist between the federal and state exemption amounts. Residents of these states who make full use of their federal estate tax exemptions will incur a state estate tax, even if they are survived by spouses. Alternatively, a will can be designed to maximize the state estate tax exemption amount, eliminating the state estate tax but sacrificing the advantages of the larger federal exemption amount. Through careful estate planning, clients can provide their surviving spouses with the flexibility to select the most advantageous method upon the death of the first spouse, so that the decision can be made at a time when more information is available regarding the size of the estate and applicable tax exemption amounts.

Gift Tax Exemption Remains at $1 Million

The lifetime gift tax exemption remains at $1 million per person for 2009 and is not scheduled to increase. Gifts may be made with either cash or property. The gift (and any associated appreciation or future earnings) is removed from the donor’s estate, and the donor’s exemption from the gift tax, as well as the donor’s $3.5 million exemption from the estate tax, is reduced by the value of the gift. Proper estate planning can maximize the tax savings opportunities provided by this limited resource.

Gift Tax Annual Exclusion Increased to $13,000

The amount that a person may transfer to any number of individuals in a single year increased from $12,000 to $13,000 for 2009. Such “annual exclusion” gifts are excluded from gift tax and do not count against the otherwise available $1 million lifetime gift tax exemption. By making annual exclusion gifts over a period of time, individuals can transfer considerable sums entirely free of all transfer taxes. For example, suppose a family consists of two parents, two children, and four grandchildren. By giving $26,000 per year to each of their six descendants, the parents can transfer $1.56 million over a 10-year period entirely free of transfer taxes and without using up any gift or estate tax exemption. Annual exclusion gifts are often made to life insurance trusts that contain “Crummey powers” (named after a taxpayer who was successful in a dispute with the IRS). Individuals with life insurance trusts should have their trust documents reviewed. Those trusts may have self-adjusted to allow full use of the increased annual exclusion amount.

GST Tax Exemption Increased to $3.5 Million

In addition to gift and estate taxes, a GST tax may be imposed when property passes to or in trust for the benefit of a person who is more than one generation younger than the transferor (such as a grandchild). The GST tax exemption increased to $3.5 million (the same amount as the estate tax exemption) as of January 1, 2009. A well-constructed estate plan can transfer assets (during life or at death) to or in trust for grandchildren or more remote descendants without any GST tax consequences.

Income Tax Planning Opportunities for 2009

Enhanced Deductions for Qualified Conservation Contributions

The Heartland, Habitat, Harvest, and Horticulture Act of 2008 (part of the Food, Conservation, and Energy Act of 2008) extended the favorable tax treatment for real property donated for qualified conservation through December 31, 2009. The enhanced deduction provision will allow taxpayers making “qualified conservation contributions” to deduct up to 50 percent (rather than 30 percent as under prior law) of their adjusted gross income and carry forward any excess deduction for up to 15 years (rather than 5 years). A qualified conservation contribution is a contribution of a qualified real property interest to certain governmental or charitable organizations exclusively for conservation purposes. Qualified conservation contributions may take many forms, including outright donations of real estate, a bargain sale of real estate, a donation of a remainder interest in real estate or the grant of a qualified conservation easement.

IRA Charitable Rollover Extended

The Emergency Economic Stabilization Act of 2008 extended the legislation permitting the tax free rollover of IRAs to charities through the end of 2009. The charitable rollover allows a taxpayer 70-1/2 years of age or older (at the time of distribution) to transfer up to $100,000 (in the aggregate) tax free from one or more traditional IRAs directly to one or more public charities. While these transfers will not be eligible for a charitable deduction for income tax purposes, the amounts passing to charity are excluded from taxable income, essentially acting as an indirect charitable deduction. Such transfers will also count toward the taxpayer’s required minimum distribution.

No Required Minimum Distributions

The Worker, Retiree, and Employer Recovery Act of 2008 provides a one-year moratorium on required minimum distributions from IRAs and defined contribution plans. Owners and beneficiaries of IRAs and other defined contribution plans who are 70-1/2 years old or older and otherwise required to take required minimum distributions from their plans in tax year 2009 will generally be able to leave their money in their plans without suffering any penalty for failure to withdraw. The relief applies to participants in and beneficiaries of IRAs, SEP-IRAs, SIMPLE IRAs, 401(k) plans, money-purchase plans, profit-sharing plans and any other defined contribution retirement plan. The relief does not apply to defined benefit plans. For beneficiaries using the 5-year rule for complying with the required minimum distribution rules and 2009 falls within the 5-year period, the period is automatically extended by one year.