Respectfully Submitted by Patricia D. Henderson
On December 17, 2010, the President signed into law the "Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010" (the "2010 Tax Act"). This new law included sweeping tax law changes that will likely affect your estate planning.
News sources have been reporting that the new exemption from estate taxes has increased to $5,000,000 for individuals and $10,000,000 for married couples, and that the rate of tax has dropped to 35%, down from 45% in 2009. Those numbers are accurate. However, tax law changes were not quite that simple, and there are a number of components of the new law that are worth noting.
1. Portability.
First, the 2010 Tax Act introduced "portability" as a way for married taxpayers to save estate taxes, effective January 1, 2011. Before that date, if a spouse with a taxable estate died without proper estate planning, and left his or her estate outright to the surviving spouse, that deceased spouse's ability to shelter property from estate taxes after both spouses died was lost (absent a disclaimer of the inheritance by the surviving spouse, something most surviving spouses are never interested in doing). Even though the bequest to the surviving spouse did not generate any estate taxes due to the "unlimited marital deduction," it meant the surviving spouse was left with all the property, but with only one person's exemption from estate taxes. The exemption of the first spouse to die was therefore lost if no "bypass" trust was created. Now, when a spouse leaves property directly to the surviving spouse, that surviving spouse can add the unused portion of the deceased spouse's $5,000,000 exemption to his or her own $5,000,000 exemption, thereby potentially doubling the amount that can be given away or left tax-free at death.
These new estate tax provisions may make planning less complicated for some clients, but there are still good reasons to create a bypass trust at the first spouse's death.
First, if an estate is left to a trust, any appreciation that accrues between the two spouses' deaths will be removed from the surviving spouse's estate. The "deceased spousal unused exclusion amount" is a fixed number, and it does not get adjusted for inflation. For example, for a couple with a $10,000,000 combined estate where the husband dies first, if the wife's estate grows to $15,000,000 prior to her death, she would still get to add only $5,000,000 to her exemption even though her husband's half had grown to $7,500,000. This clear disadvantage is mitigated though, because property owned outright by a surviving spouse receives a stepped-up cost basis upon the surviving spouse's death, whereas assets in the trust will not. Even so, estate tax rates have historically been at least double that of capital gains tax rates, so in most cases, it will be best to use a trust rather than rely on portability.
Second, trusts are creditor-protected and divorce-protected, two benefits that can be very important to many surviving spouses. Not only that, but if the surviving spouse in the above example remarries a wealthy man who dies shortly thereafter leaving his large estate to his own children, he will not have an unused exclusion amount since he will have used all of his exemption. The new law says you can only claim the unused exemption from your last deceased spouse! So, for some widows without a bypass trust, there's the very real possibility that extra unplanned taxes might be owed if they remarry and the new spouse dies first. Furthermore, because a surviving spouse is usually not permitted to pass trust property to a new spouse or other beneficiaries, a trust has the added benefit of preserving the trust property for the children or other beneficiaries of the spouse who dies first.
Third, since the new tax laws are set to expire in only two years, as discussed later in this letter, there is no guarantee that portability will be continued in 2013 and thereafter. In addition, in order to take advantage of portability, the estate of the first spouse to die will need to file a Federal Estate Tax Return and make a special election on that return. Estate tax returns are very complicated and expensive to prepare, as they must also list and accurately value every investment owned by the decedent. For many estates, costly appraisals must be obtained. If the return is not filed on time, the ability to add the deceased spouse's exemption to the surviving spouse's exemption will be lost for good. Lawyers and accountants will, more often than not, advise their clients to file a return even when the client's estate is less than the filing threshold.
2. Gift and GST Taxes.
Another major change made by the 2010 Tax Act involves gift taxes and generation skipping transfer ("GST") taxes. Gift taxes apply when people make transfers in excess of any available exclusions and exemptions while they are alive. GST taxes apply to transfers made to grandchildren, great-grandchildren and certain other persons and trusts. The annual exclusion from the gift tax, which is the amount that any person can give to any other person each year without using up any part of the lifetime exemption from gift taxes was not changed. The annual exclusion was $13,000 per recipient last year, and although it has been indexed for inflation for years, it remains at $13,000 for gifts made in 2011.
Starting in 2011, the available lifetime exemption from both the gift and GST tax has been increased to $5,000,000 per taxpayer. The gift tax exemption had previously been only $1,000,000, and in 2009 the GST exemption was $3,500,000, so a jump to $5,000,000 for both exemptions is a significant change that received almost no attention in the press. Not only that, but if a surviving spouse has unused exemption from a spouse who died, then that carry-over amount can be added to the $5,000,000 gift tax exemption, thus increasing the amount that can be given away gift-tax free during his or her lifetime. With such large exemptions now available, there are far more planning options available to people who want to make gifts while they are alive, whether in trust or outright to their children or others.
3. Indexing For Inflation.
One additional change is that the $5,000,000 exemption is now indexed for inflation starting in 2012. And since the exemption is such a large number, even small percentage increases will result in large additional amounts that can be given away tax free. Over the past few decades, the typical annual adjustment made to other exemptions has been about 4%, and if that rate of change continues, the $5,000,000 exemption would grow by about $200,000 per year.
4. Two Year Window.
Most importantly, the new estate, gift, and generation-skipping transfer taxes are in effect for only two years. In 2013, unless Congress addresses these same tax issues again in 2012, which will be right in the middle of a Presidential election year, the tax rates and exemptions will revert to the way they were before the 2001 Bush-era tax cuts. In that event, the exemption from estate taxes would drop to $1,000,000, and the highest marginal estate tax rate would rise to 55%. There will also be no portability of the estate tax exemption between spouses. Therefore, as good as the recent changes seem, there is no guarantee these new laws will be in place for more than two years.
So, where does this leave us today? For most married couples, it is now crucial to have documents that maximize flexibility. Estate planning documents now need to account for the possibility that (i) the new laws may remain effective after 2012, (ii) that the old pre-2001 tax laws could once again be in place, or (iii) that other, unknown tax laws may be enacted. Many married couples have already done their planning, but the documents they have may contain significant over-planning (because the exemptions were much lower in the past than they are today), or the documents may lack the flexibility needed to address future uncertainties. As things are now, it is best for your estate plan to be as flexible as possible so that estate taxes will be saved no matter what tax laws are in effect when death occurs.
Therefore, in light of the 2010 Tax Act, it is my recommendation that we meet to review your estate plan to determine if changes are needed. If you are interested in such a consultation, please call my office to schedule a time that is convenient for you.
