Please Read This Important Disclaimer: The estate and gift tax provisions of the Act are complex, and this summary is not intended as a comprehensive summary of all of those estate and gift tax provisions. This summary of the estate and gift tax provisions of the new Act is not intended as and should not be construed by you to be legal advice. The application of the estate and gift tax provisions included in the Act will vary from individual to individual, and you should consult your tax advisor before applying those provisions to your personal situation. IRS regulations also require us to advise you that anything in this summary that might be construed as tax advice is not intended or written to be used, and cannot be used by you, to avoid penalties that the IRS might attempt to impose on you.
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As most of you have probably heard or read, on December 17, 2010 President Obama signed a new tax law passed by Congress which is entitled the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “Act”). The Act includes multiple provisions affecting the income taxation of individuals and entities, and it also includes important federal estate and gift tax provisions which may impact you. This letter includes a short summary of the major estate and gift tax changes included in the Act.
New Estate and Gift Tax Exemption. The individual estate and gift tax exemption for persons dying on or after January 1, 2011 and before January 1, 2013 is set at $5,000,000 per person (the “Basic Exclusion Amount”). The Basic Exclusion Amount is the amount that you can pass to any person or group of persons collectively without having to pay any federal estate or gift tax. Thus, under the new Act a single person can pass up to $5,000,000 to his or her beneficiaries free of federal estate and gift tax if he or she dies during the two years beginning on January 1, 2011, and a married couple can collectively pass up to $10,000,000 to their children or other beneficiaries with proper planning. Beginning January 1, 2012, the Basic Exclusion Amount is adjusted for inflation, but only in increments of $10,000.
This is a temporary extension. The Basic Exclusion Amount will return to $1,000,000 per person on January 1, 2013 unless Congress acts before then to extend or otherwise change the exemption.
New Maximum Estate Tax Rate. The federal estate tax rate is capped at 35% on assets that are subject to federal estate tax for individuals who die during the two-year period beginning January 1, 2011. For example, if you are a single person with a taxable estate of $6,000,000 and you die on September 1, 2011, leaving all of your assets to your children, the Basic Exclusion Amount will shelter the first $5,000,000 of assets from federal estate tax, assuming you have not used any of your Basic Exclusion Amount for gifts made during your life, and only $1,000,000 of your taxable estate will be subject to federal estate tax. The federal estate tax on the $1,000,000 of assets subject to estate tax would be $350,000 before taking into account any state death tax deduction.
Prior to the Act’s enactment, the maximum federal estate tax rate was scheduled to increase to 55% on January 1, 2011. However, like the new Basic Exclusion Amount, this new estate tax rate is temporary and will expire on December 31, 2012 unless Congress acts before then to extend or otherwise change the estate tax rate. Otherwise, on January 1, 2013 the estate tax rate will increase to 55%.
Return to Stepped-Up Basis Rules. Prior to January 1, 2010, the general rule was that upon a person’s death, his or her beneficiaries received a “stepped-up basis” with respect to most assets owned by the decedent. For example, if the decedent purchased a tract of land for $50,000 that was appraised at $300,000 on the date of the decedent’s death, then the income tax basis of the decedent’s beneficiaries in the land was $300,000. Thus, if the beneficiaries subsequently sold the land for $375,000 their gain on the sale would be $75,000.
The Act reinstates the stepped-up basis rules retroactive to January 1, 2010. Prior to the Act’s enactment, estate planners were working on the assumption that the stepped-up basis rules did not apply to estates of decedents dying on or after January 1, 2010 and before January 1, 2011, and that “carryover basis” rules applied, meaning the income tax basis of the decedent’s beneficiaries in the decedent’s assets is the same as that of the decedent in those assets. Under the Act, the executor of the estate of a person dying in 2010 must choose between stepped-up basis and carryover basis. We discuss this election in the Transition Rules section below.
The return to the stepped-up basis rules is a permanent extension that will extend beyond December 31, 2012 unless Congress acts affirmatively to change the law.
As in the past, the stepped-up basis rules do not apply to certain assets such as those that would be treated as income to the decedent (“Income Assets”) had the decedent received distributions from such assets before death, like an IRA or 401(k) plan. Distributions from those Income Assets to a beneficiary will be taxed to the beneficiary in the same manner they would have been taxed to the decedent.
Portability. This is a new concept included in the Act and has significant impact for married couples. “Portability” means that after the death of the first spouse, if his or her Basic Exclusion Amount is not entirely used, then upon the surviving spouse’s death the unused Basic Exclusion Amount of the first spouse to die (the “Portability Amount”) can be used by the surviving spouse’s estate in part or whole to shelter from estate tax assets owned by the surviving spouse after applying the surviving spouse’s Basic Exclusion Amount.
For example, assume that Husband dies on June 1, 2011 with an estate of $4,000,000, half of which he leaves to Wife and the other half of which is left to the couple’s children. The half left to Wife qualifies for the federal estate tax marital deduction and therefore is not subject to estate tax, and the half left to the couple’s children is sheltered by using $2,000,000 of Husband’s Basic Exclusion Amount. Wife then dies on April 1, 2012, with an estate of $6,000,000 (including the $2,000,000 she received from Husband at his death in 2011), all of which she leaves to the couple’s children. The first $5,000,000 of Wife’s assets is sheltered from estate tax by using her 2012 Basic Exclusion Amount of $5,000,000 (possibly increased for inflation), assuming she has not used any of her Basic Exclusion Amount for gifts made during her life. The remaining $1,000,000 of assets passing to the children can be sheltered from estate tax by using $1,000,000 of Husband’s Portability Amount of $3,000,000 if Husband’s executor filed an estate tax return electing portability after Husband’s death. As discussed in the Unified Estate and Gift Tax section below, the Portability Amount can also be used by Wife to shelter transfers made during her life from gift tax.
The Portability Amount available to the surviving spouse is limited to the lesser of (i) the Basic Exclusion Amount in effect at the surviving spouse’s death, or (ii) the unused Basic Exclusion Amount of the last spouse of the surviving spouse. In other words, under the item (ii) limitation if Wife in the example above survived two spouses, each of whom died with a Portability Amount, the surviving spouse cannot use the Portability Amounts of both spouses to shelter assets from estate tax, but rather is limited to the Portability Amount of the last spouse who predeceased her, even if his Portability Amount is less than that of the first spouse who predeceased her.
Portability is for now a temporary provision of the estate tax law. Unless Congress extends the portability provisions of the Act prior to January 1, 2013, it will no longer be in effect after December 31, 2012. In addition, the Act appears to abolish the Portability Amount of the first spouse to die that is available to the surviving spouse if the surviving spouse dies after December 31, 2012, unless Congress extends portability before then.
Unified Estate and Gift Tax. The Act reunifies the federal estate tax, including the generation skipping transfer tax, and the federal gift tax effective January 1, 2011. This means that up to the entire amount of an individual’s Basic Exclusion Amount can be used to shelter gifts during the individual’s life. For example, assume Mr. Smith, a single person, has assets valued at $4,000,000. If he gives his son $2,000,000 of assets in 2011 (in addition to his annual exclusion amount of $13,000) and then dies in late 2012, Mr. Smith could apply $2,000,000 of his Basic Exclusion Amount by filing a gift tax return for the 2011 gift no later than April 15, 2012, and at Mr. Smith’s death his executor can apply the needed unused portion of his Basic Exclusion Amount against the remaining $2,000,000 of assets in his estate.
Assume Mr. Smith has $7,000,000 in assets and that at his wife’s death her executor filed an estate tax return electing portability. If her Portability Amount is $1,000,000, then Mr. Smith could give his son a total of $6,000,000 of assets in 2011 free of federal gift tax by using all of his Basic Exclusion Amount and his wife’s Portability Amount. Upon his death in 2012, the remaining $1,000,000 in assets will be subject to federal estate tax at the maximum 35% rate.
Under the unified estate and gift tax scheme, (i) the gifts made during a decedent’s life above the annual exclusion amount (currently $13,000 per person) are added to the assets owned by the decedent at his or her death, (ii) the Basic Exclusion Amount, including portions already applied to lifetime gifts, is applied to the total amount of the decedent’s gifts and assets owned at death, and (iii) the balance above the Basic Exclusion Amount (and any available Portability amount) is subject to estate tax.
The temporary nature of the Act and the substantial increase in the Basic Exclusion Amount might create a trap for some gifts. Suppose Mr. Smith dies in 2013 instead of 2012, Congress has not extended or changed the estate tax law before January 1, 2013, and the Basic Exclusion Amount reverts to $1,000,000 on January 1, 2013. If Mr. Smith has $6,000,000 in assets, $5,000,000 of which he gave to his son in 2011, and then Mr. Smith dies in 2013 with $1,000,000 in assets, does his estate in 2013 only get the benefit of a $1,000,000 Basic Exclusion Amount, and of the $6,000,000 grossed up estate (which includes the $5,000,000 of gifts he made to his son in 2011) is $5,000,000 subject to estate tax? The answer to this question, unfortunately, is not clear at this time, although some commentators have stated that it was not the intent of Congress to “take away” in later years the Basic Exclusion Amount available and applied to gifts made during 2011 and 2012. The IRS is expected to provide an answer to this question through regulations, forms or otherwise. Thus, until we receive a definitive answer from the IRS or until Congress permanently fixes the Basic Exclusion Amount, a taxpayer might want to carefully consider whether or not to make lifetime gifts in excess of $1,000,000 if he or she is not willing to pay possible estate tax later on these earlier gifts.
Taxpayers should also remember that the Act does not change the tax law provisions mandating carryover-basis for gifted assets. Thus, if in the above example Mr. Smith, who has $6,000,000 in assets, gave to his son in 2011 assets valued at $5,000,000 but having an income tax basis of $2,000,000, his son’s income tax basis in those assets will also be $2,000,000. If Mr. Smith dies in 2012, his remaining $1,000,000 in assets will be subject to estate tax at the 35% rate and his son will only get a stepped-up basis in the $1,000,000 of assets, assuming they are not Income Assets. If Mr. Smith makes no gifts in 2011 and dies in 2012 leaving all $6,000,000 of his assets to his son, the estate tax consequences are the same as in the previous example, but his son gets a stepped-up basis in all of Mr. Smith’s assets equal to $6,000,000, assuming none of the assets are Income Assets.
Transition Rules. The Act provides that the new Basic Exclusion Amount is retroactive to January 1, 2010 with respect to the estate tax (but not the gift tax, for which the lifetime exclusion amount was $1,000,000 in 2010) and that the maximum estate tax rate in 2010, as well as the maximum gift tax rate, is 35%. However, the executor of the estate of a person who died in 2010 can elect to apply the estate tax law in effect for 2010 prior to the enactment of the Act. If the executor makes such an election, the estate tax will not apply to the decedent but the carryover-basis rules will apply to assets passing to the decedent’s beneficiaries with limited step-up amounts for a surviving spouse and other beneficiaries. For decedents who died in 2010 before the enactment of the Act, the executor will have at least nine months from the date of enactment of the Act to file an estate tax return. The IRS will also determine the time and manner for opting-out of the Act and applying the prior estate tax law to estates of decedents who died in 2010, including the allocation of the limited basis step-ups provided under the prior estate tax law.
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We hope this summary of the estate and gift tax provisions of the new tax law will be helpful to you, and we will happy to discuss with you the application of the Act to your particular situation. Please call us at your convenience to schedule an appointment.