You have probably been reading in the newspapers, and hearing on radio and television news about The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (i.e. “2010 Tax Relief Act,” or “The Act” for purposes of this memo), which was signed into law by the President on Dec. 17, 2010. There are lots of new tax provisions in The Act. I am writing this memo to our clients to highlight some of the estate tax, gift tax, and generation-skipping transfer (“GST”) tax provisions of this new legislation relevant to common estate plans and planning structures.
ESTATE AND GIFT TAX “RELIEF” FOR 2011
Under the so-called “Bush Tax cuts” of 2001, the estate tax was “phased out” such that there was no estate tax for decedents dying in 2010. But, these cuts always had a 10-year lifespan, and were set to expire on December 31, 2010. The expiration of the Bush tax cuts would have resulted in substantial tax increases on January 1, 2011—back to pre-2001 levels.
The 2010 Tax Relief Act significantly reduced these looming tax increases (though The Act still represents an increase in the estate tax from 2010 levels). Nevertheless, don’t be mislead by news reports—the 2010 Tax Relief Act provides only temporary relief. The relief is only for wealth transfers in 2011 and 2012. Much harsher rules are slated to return, beginning in 2013—unless Congress again takes action.
INCREASED EXEMPTION AND REDUCED TAX RATE FOR 2011-2012
The 2010 Tax Relief Act “lowers” estate, gift, and GST taxes for 2011 and 2012 by increasing the exemption amount from $1 million to $5 million and by reducing the top tax rate from 55% to 35%. The $5 million exemption is per estate or per lifetime donor—not per recipient. But, due to the new portability provision described below, up to $10 million in total estate tax exemption is now available for a married couple.
The Act also brings back the estate tax retroactively for 2010 (in a semi-optional way), by allowing estates of decedents dying in 2010 to choose between being subject to (A) the new, 2011 law—estate tax based on a $5 million exemption and 35% tax rate, with a fair market value basis, or (B) the former, 2010 law—no estate tax and modified carryover basis in inherited assets. The executor, therefore, can choose whichever version of the law which would produce the lowest combined estate and income taxes for the estate and its beneficiaries.
The Act re-integrates the estate tax, gift tax and GST tax exemptions at $5 million. From a gift tax perspective, this reunification is a tremendous (although temporary) boon. Many of our clients have already used most if not all of their $1MM gift tax exemptions previously available. Now, (and for the next two years under the Act), there will exist an opportunity to leverage up to an additional $4 million of gift tax and GST tax exemption for each taxpayer. Using proper, tax-efficient wealth-transfer strategies, this additional amount of exemption will enable many of our clients to eliminate estate, gift, and GST tax costs completely from their estates. But, like the other key parts of the Act, this exemption increase, and tax rate decrease is scheduled to expire on December 31, 2012.
NEW EXEMPTION PORTABILITY FEATURE
Perhaps the most interesting structural change in the law made by The Act is the new “portability” feature available to married couples. Under this provision, the amount of any estate tax exemption that remains unused after the death of a spouse is generally available for use by the surviving spouse’s estate, as an addition to the surviving spouse's exemption available. A surviving spouse, therefore, may use the predeceased spousal carryover in addition to his or her own $5 million exclusion for taxable transfers made during life or at death.
This exemption “carryover” is available to a surviving spouse only if an election is made on a timely filed estate tax return for the predeceased spouse’s estate—regardless of whether the estate of the predeceased spouse otherwise would be required to file an estate tax return. So, this “carryover” opportunity increases the likelihood that one’s estate will have to file an estate tax return. Beware, however, that only the last spouse’s exclusion “carryover” is available to the spouse. So, one cannot re-marry in a serial fashion to accumulate exemption. There also, now exists a tax disincentive to get remarried to someone who has less exemption “carryover” available than one’s previous spouse had provided.
Illustration One: Husband 1 dies in 2011 with a $3 million estate. An election is made on his estate tax return to permit Wife to use his $2 million remaining unused exclusion. As of Husband 1’s death, Wife has made no taxable gifts. Thereafter, Wife's applicable exclusion amount available is $7 million (her $5 million basic exclusion amount plus $2 million “carryover” unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.
Illustration Two: Assume the same facts as in the prior illustration, except that Wife subsequently marries Husband 2. He also 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. Thereafter, Wife's estate & gift tax exclusion amount is $6 million (her $5 million basic exclusion plus the $1 million unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.
Bypass Trusts Still Viable. Prior to the existence of this portability, or “carryover” feature, the most common way to make sure the full exemption available to a married couple would be utilized was to cause a Bypass Trust to be created on the death of the first spouse. One might think, therefore, that this new portability feature could make a Bypass Trust obsolete. But, the portability feature merely helps the unprepared. There remain many reasons (both tax and non-tax related) for creating a Bypass Trust, including the following:
- A Bypass Trust removes from the surviving spouse’s taxable estate not only the current value of the Bypass Trust assets, but also any appreciation on those assets.
- The GST tax exemption is not portable; so, if there is a chance that grandchildren or similar beneficiaries will inherit any part of the estate, the Bypass Trust is likely the best vehicle for preserving the GST tax exemption.
- The Bypass Trust removes the tax disincentive to remarrying.
- The Bypass Trust protects the dispositive desires of the first spouse to die.
- The Bypass Trust can provide added creditor protections when compared to outright ownership by the survivor (and in some cases when compared to a Marital or QTIP trust).
- Perhaps most importantly, the portability provision, like most of the Act, is temporary—it is set to expire 12/31/2012.
“Optional” Bypass Trust Structure. For many of our Royse Law Firm estate planning clients, an “Optional Bypass Trust” has been built into the revocable trust structure, using a “qualified disclaimer” by the surviving spouse. This disclaimer provision allows the surviving spouse to use his or her power to cause the creation of a Bypass Trust by conscious choice after the death of the first spouse by executing the disclaimer within nine months after the death of the first spouse. For those of our clients for whom the Bypass Trust provisions in your revocable trust instrument are not “optional,” you should revisit whether or not you would like to make the Bypass Trust optional.
PLANNING OPPORTUNITIES FOR YEARS 2011-2012
The period beginning January 1, 2011 presents tremendous opportunities for estate, gift and GST tax planning. These opportunities are temporary, as this temporary tax law will likely change again prior to January 1, 2013—very possibly not for the better. Tax rates could go up (from 35% to 55%), exemptions could go down (from $5 million to $1 million), and certain other benefits could expire. In addition, although we are only lawyers, not economists, most of the economists we are hearing from today believe our current economic climate of low interest rates and low tax rates is also likely to be short lived. We are experiencing a “perfect storm” of opportunity for estate and gift tax planning and savings. Please contact us if we can be of assistance.