Publications > C & A News Alert - January 2011

Estate Tax Law Revisions for 2011-12

On December 17, 2010, President Obama signed into law the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010“. Tax laws are often referred to by their acronym, but since TRUIRJCA will be difficult to recall and defies pronunciation, we’ll simply call it the “2010 Act.” This law affects nearly all taxpayers as it contains provisions that affect both income tax and estate tax.

The scope of this outline is limited to the changes in the 2010 Act that impact estate and gift taxes, and the general implications of those changes on estate planning.

We have included below a short Executive Overview of the new legislation for your quick review, as well as a more detailed Explanation and Analysis, of the law and some planning thoughts for your consideration.

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Executive Overview

Changes in the Law:

• $5,000,000 Transfer Tax Exemption. The law provides each taxpayer with an exemption of $5,000,000 from estate tax, gift, and generation-skipping tax.
• 35% Tax Rate. The new legislation sets a flat tax rate of 35% to be applied to estates, gifts, and generation-skipping transfers in excess of the exemption amount.
• Unification. The gift tax and the estate tax have again been unified – each with the $5.0 million exemption.
• “Portability.” Married decedents have a new “portability” election. With this, deceased spouses can give to their surviving spouses any portion of their $5,000,000 exemption that they don’t use. To take advantage of this “portability,” a federal estate tax return has to be timely filed, even though one isn’t otherwise required.
• 2010 – The Transition Year. Executors of estates of decedents passing away in 2010 have the ability to choose between the new estate tax law with higher exemptions – or the law as it actually was last year (no estate tax at all, but with “carryover basis”).
• Return of the Illinois Estate Tax. Retroactive to January 1, 2011, Illinois will assess an estate tax on all estates in excess of $2,000,000, at progressive rates from 8% to 16%. Because the Illinois exemption amount is less than the federal tax free amount, many estates that are free of federal estate tax will still attract Illinois estate tax. Estate plans should be reviewed in order to fix this.
• Two-year Sunset. The provisions included in the new 2010 Act sunset at 12/31/12 absent further Congressional action. Stay tuned.

Your Takeaway:

Consider a review of your estate plan soon to make sure that your planning has you properly poised to take advantage of the new exemptions, and with the higher gift tax exemption consider whether implementing a gift program may be advisable.

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2010 Tax Act – Explanation and Analysis

1. Introduction & Historical Overview.

   In order to understand the significance of the changes wrought by the 2010 Act, we offer this brief (and simplistic) overview of the transfer tax system in the U.S., and its historical development.

   1. General Estate and Gift Tax Overview — Pre-2001.

      1. The estate tax applies to the value of a decedent’s “gross estate.” This generally includes all of the decedent’s assets, both financial (such as stocks, bonds, CDs and mutual funds – and closely held business interests) and real estate (homes, land, and other tangible property). It also includes the decedent’s share of jointly owned assets as well as life insurance proceeds, IRAs, annuities and other qualified plan assets.

      2. In computing the tax, estates are allowed to deduct from the value of the gross estate an unlimited amount for transfers to a surviving spouse and to charity. Estates may also deduct customary debts, funeral expenses, legal and administrative fees.

      3. Once that “net” estate is determined, the estate tax law also provides a credit against the tax due that effectively exempts a large portion of the estate from any tax.

      4. Congress enacted the companion gift tax in 1932 to prevent individuals from avoiding the estate tax simply by transferring their wealth to their heirs before they died.

         Small annual gift amounts were exempted from the gift tax. This exemption – currently set at $13,000 -- and indexed for inflation in $1,000 increments -- is granted separately for each recipient. For example, a married couple with three children could give their children a total of $78,000 each year ($13,000 from each parent to each child) without owing tax or having such gifts count against the lifetime or death time exemptions.

      5. The third piece of the “transfer tax” system – the generation-skipping tax -- was enacted in 1976 to prevent families from avoiding the estate tax for one or more generations by making gifts or bequests directly to grandchildren or great-grandchildren rather than passing them through each generation. The “GST” tax effectively imposes a second layer of tax (using the exemption and the top tax rate under the estate tax) on wealth transfers to recipients who are two or more generations younger than the donor.

   2. General Estate and Gift Tax Overview – the 2001 Tax Relief Act.

      1. Estate Tax. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, or simply, the “2001 Act”) introduced a dramatic change to the estate and gift tax regime. The 2001 Act eliminated the estate tax completely after a “phase-out” period. During this phase-out period, the amount of the exemption from estate tax was slowly, but irregularly, increased from 2001 to 2009, and the top estate tax rate was reduced over that same period:

         Year	Exempt Amount	Tax Rate
         2001	$675,000	55%
         2002	$1000,000	50%
         2003	$1,000,000	49%
         2004	$1,500,000	48%
         2005	$1,500,000	48%
         2006	$2,000,000	46%
         2007	$2,000,000	45%
         2008	$2,000,000	45%
         2009	$3,500,000	45%
         2010	N/A	0%

         As you can see – in 2010 the estate tax was scheduled to be repealed entirely.

      2. Gift tax. The amount of the exemption from gift taxes – which historically had tracked with the estate tax exemption - was set at $1.0 million in 2002 and remained there through 2009. The gift tax was not scheduled to be repealed in 2010.

      3. GST. The generation-skipping tax was also scheduled to be repealed in 2010 along with the estate tax.

      4. Back to the Past. The 2001 Act finally provided that if some future Congress did not act to make the estate and GST repeal permanent ... then the system would revert to the 2001/2002 rules, namely: the estate tax would be back, with a $1.0 million exemption for estate and GST tax purposes, and a 55% tax rate.

   3. General Estate and Gift Tax Overview - 2010 (REPEAL!)

      1. Estate tax. As stated, the estate tax was scheduled to be repealed in 2010. Tax practitioners across the country were convinced as 2009 ticked away that Congress would not actually allow the estate tax to be repealed. The uncertainty really centered on the shape and size of the estate tax when Congress finally got around to addressing it. However, despite much spirited debate about this issue in Congress, in fact the estate tax was allowed to lapse.

         So for decedents dying in 2010, there has been no federal estate tax.

      2. Supplanting the Lost Revenue. Because nothing is ever as simple as it seems when tax law is being discussed, there are a couple of issues to be aware of in 2010. Congress recognized that repeal of the estate and GST taxes would result in a loss of revenue, so two strategies were implemented to ameliorate that loss:

         1. Carryover Basis. We saw the reintroduction of “carryover basis” – an income tax concept - in 2010. Congress tried this once before in the ’80s and it was, simply stated, a failed experiment. Here’s how carryover basis works:

            Illustration: D owns 100 shares of XYZ Inc. that he bought for $10/share. His total cost basis is $1,000. XYZ Inc. is worth $500/share at D’s death, for a total value of $50,000.

            Under prior law, D’s heirs inherit the XYZ Inc. stock with the $50,000 dale-of-death FMV tax basis. This is called “stepped up” basis. If the heirs promptly sell the stock for $50,000 they will report a capital gain of $0.00.

            Under carryover basis, though, D’s heirs inherit the XYZ Inc. stock with D’s carried-over $1,000 basis. If the heirs promptly sell the stock for $50,000 they will report a capital gain of $49,000.

            With the implementation of carryover basis, Congress anticipated an increase in capital gain revenue to replace some lost estate tax revenue.

         2. Credit for State Death Taxes. Prior to the 2001 Act many states participated in the federal estate tax through the state death tax credit. That is, the federal government allowed a credit against the federal estate tax for death taxes paid to a State; naturally many States in turn levied a tax equal to that credit (sometimes called a “pick up” tax). Under the 2001 Act, the federal estate tax eliminated this state death tax credit. This left States without this source of revenue. When this happened, more than half the States “de-coupled” from the federal system and imposed their own death taxes.

            Illinois adopted its own estate tax – but it was tied to the federal exemption from an earlier point in time. When the estate tax was repealed in 2010, Illinois’s tax was effectively repealed as well.

            Note: Many States – including Illinois – have been fumbling with a revenue-replacement solution. Within the past two weeks Governor Quinn signed legislation that re-introduced the Illinois estate tax with a $2.0 million exemption. Note further that because of the disconnect in exemption amounts, there will be many estates that have no federal estate tax exposure, but will owe tax to the State.

         3. Gift tax. Under the 2001 Act, the gift tax was maintained with a $1.0 million exemption, but with a 35% rate.

         4. GST. Under the 2001 Act, the GST tax was also eliminated in 2010– creating a window of opportunity for very wealthy families.

2. Explanation of 2010 Act

   With the passage of the 2010 Act, tax practitioners hoped that Congress would have provided some certainty and consistency to this area of the law. Instead, the 2010 Act – while including some thoughtful and helpful revisions – has deferred numerous problems and policy disagreements relating to the estate and gift taxes for two more years.

   Here’s what the new 2010 law now provides:

   1. Reinstatment of the Estate Tax. The 2010 Act reinstates the federal estate tax system in substantially the same form as it existed in 2009 - but with changed exemption amounts and rates. For decedents dying after 12/31/10, the estate tax exemption is $5.0 million and the estate tax rate is 35%. This exemption is indexed for inflation beginning in 2010; inasmuch as the 2010 Act has its own 2-year sunset provision, this means that the exemption will adjust just once.

   2. Gift Tax. For gifts made in 2010 the exemption is $1.0 million and the gift tax rate is 35%. For gifts made after 12/31/10, the gift tax is reunified with the estate tax with an applicable exemption of $5.0 million, with the top tax rate of 35%.

   3. Generation Skipping Changes. Under the 2010 Act, the generation skipping tax exemption for 2010 was set at $5.0 million; however, even though the GST was in place in 2010, the tax rate is 0% - so effectively, there was no GST last year. The GST tax exemption for decedents dying after 12/31/10 is equal to the estate tax exemption which is $5.0 in 2011 (indexed for inflation in 2012).

   4. Portability. The 2010 Act introduced a brand new concept to the estate tax regime – portability. Under prior law, an individual’s exemption from estate tax was a “use it or lose it” proposition. If a decedent died without using his or her exemption amount, then it was forever gone.

      Illustration: At D’s death, his estate is valued at $2.5 million and the federal estate tax exemption was $3.5. The $1.0 million in tax exemption that was not used is lost.

      Now under the 2010 Act, any unused exemption of a deceased spouse can be transferred to the decedent’s surviving spouse. In this way, a married couple effectively has a $10.0 million exemption from the federal estate tax.

   5. A Transitional Rule: Carryover Basis Election. Congress’s delay in dealing with the unresolved estate tax issues for so long made 2010 a troublesome year. Here’s the Congressional fix: for decedents dying in 2010 only, the executor of a decedent’s estate has the option to use the no-estate-tax but carryover basis system in effect in 2010 as a result of the 2001 Act OR to treat the decedent’s estate as though the 2010 Act applied – including the 2011 $5.0 exemption and a 35% rate, but without carryover basis. The latter is the default rule.

3. Planning Opportunities and Considerations Under the 2010 Act.

   There are numerous permutations and combinations that taxpayers face as they try to sort out appropriate courses of action under the new law. Here are some basic parameters that might help give shape to your thinking.

   1. Do I Have to Change Anything Now? The most frequent question our office has been fielding over the past month or so has been: “Do I really need to do anything right now?” It’s a fair question, and let’s consider it in light of one of the more common estate plan-ning scenarios. Here’s the basic structure of a typical estate planning strategy:

      Illustration: H and W have wills or revocable trusts that create, upon the death of the first spouse to die, two “pots.” One pot – a trust - is filled with an amount equal to the estate tax exemption (variously called the “Family Trust,” or the “B Trust,” or the “Credit Shelter Trust” – they all mean the same thing). The second pot goes to the surviving spouse or into a separate trust for the surviving spouse’s benefit.

      The amount in the Family Trust is exempt from estate tax at the death of the first spouse. It is also exempt from estate tax at the death of the surviving spouse as a result of the careful design of the Family Trust. On the second spouse’s death, he or she also has his or her own exemption from estate tax to use. In this way, both spouses’ exemptions are effectively used.

      Critical to this planning strategy is the core concept that both spouses must have significant value in each of their names in order to fund the Family Trust and take advantage of the estate tax exemption at the death of the first spouse to pass away.

   2. The Real Impact of the Changes. So the real inquiry becomes: is this common estate planning structure – with the administrative requirements of changing title to assets, funding revocable trusts and so forth -- still needed with the increase in the estate exemption to $5.0 million per person and the benefit of tax exemption portability?

      For now, we believe that the answer is yes – in most circumstances. With the increase of the estate tax exemption to $5.0 million per person, and with portability, a married couple has $10 million exemption that can be used – regardless of prior planning strategies. Let’s look at two:

      Illustration 1: Assume that H and W have a collective estate of $10 million but have done no prior planning, and all of their assets are held in joint tenancy. At the death of the first spouse, the survivor owns all of the collective $10 million estate by virtue of the joint tenancy.

      Because of estate tax exemption portability, the first spouse’s exemption can be transferred to the survivor, and all of the survivor’s estate can be shielded from estate tax as well.

      Illustration 2: Assume that the same H and W have executed so-called simple wills (“I leave everything to my spouse and if he or she predeceases, then everything to my children equally”). At H’s death, everything goes to W. Because of estate tax exemption portability, H’s unused estate tax exemption can be transferred to W, and all of their collective estate can be shielded from estate tax at W’s later death.

      At first blush, it certainly seems like many taxpayers with sophisticated estate tax planning in their wills and trusts can scrap all that planning, get rid of complicated trust structures, and return to a much simpler structure for disposing of their estates. But let’s consider that postulate carefully.

   3. Too Good to Be True? Like anything else that seems just a bit too good to be true, we believe that this A-B trust planning continues to have vitality, and in support we offer you a few items to consider before you dismantle your carefully thought out estate plan.

      1. Multiple Marriages (Part 1). Clients frequently create trusts upon the death of the first spouse to die because it protects against the possibility that assets acquired during the course of a joint marriage could be left to a second (or third) spouse instead of to the children (or other beneficiaries) of the original decedent. Outright gifts to the surviving spouse (or the use of joint tenancies) leave open the possibility that a surviving spouse could easily effect changes later to a couple’s thoughtful planning.

      2. Asset Protection. Leaving assets in trust for a surviving spouse and children frequently gives an estate owner the opportunity -- through proper trust design -- to protect those assets from most creditors of the spouse and/or children (such as tort creditors, a divorced ex-spouse, and so forth). This asset protection feature is not possible through outright gifts to those beneficiaries.

      3. Professional Asset Management. Often surviving spouses and children are not adept at sophisticated money management. Continued use of the trust structures can allow for professional management of trust assets by professional trustees for their benefit. Clearly, asset management services can be purchased by the survivor after the death of the first spouse to pass away, but many of our clients enjoy the comfort of knowing that the structure is in place prior to death.

      4. Asset Appreciation. Unlike outright gifts or joint tenancies, the continued use of the trust strategy described above will allow the appreciation in value of the assets in the Family Trust to escape future estate taxation. That is, a decedent’s unused exemption, while portable, is not inflation adjusted.

         Illustration: H and W each have $5.0 million estates. H dies leaving all his property outright to W (no use of H’s exemption). W dies 5 years later when H’s bequest has grown to $6.0 million. H’s unused estate tax exemption of $5.0 million that was transferred to her shields only $5.0 million of that $6.0 million bequest ... $1.0 million is subjected to tax.

         Had H’s $5.0 million been instead transferred into the Family Trust for W’s benefit (conventional planning), that extra $1.0 million in future appreciation also would have escaped tax at W’s death, a savings of at least $350,000.

      5. No GST Portability. Under the 2010 Act, the generation-skipping tax exemption was set at $5.0 million, but was not made portable. The use of trusts to take ad-vantage of the first decedent’s GST exemption is critical.

      6. Other Problems with Portability.

         1. Multiple Marriages (Part 2). Portability applies only to the unused exemption amount from the last predeceased spouse.

            Illustration: H and W1 are married, and W1 dies with $4.0 million of unused exemption, which is expected to be available to H’s estate at his death.

            H remarries W2, who also predeceases H. If W2 only has $1.0 million available exemption, that $1.0 million is portable to H (and not the $4.0 million from W1).

         2. Tax Return Filing Requirement: The 2010 Act requires that the executor of the deceased spouse’s estate must file a federal estate tax return in order to claim portability. The preparation of the federal estate tax return can be costly and time consuming, and requires that appraisals of estate assets be performed to justify the valuations and hence the calculation of the unused exemption amount.

         3. Executor’s Dilemma. What does an executor do? Arguably the executor of an estate is always under an obligation to file a return and claim the transfer of the deceased spouse’s credit “just in case.”

            Illustration: H and W have a relatively modest estate – say, $500,000. H dies and all assets are left to W. No estate tax return is filed and no unused exemption is transferred to W.

            Later W wins $12 million in the lottery. Her then $12.5 million estate is subject to estate tax on all amounts in excess of her $5.0 million (not $10.0 million) exemption.

      7. Don’t Forget Probate Avoidance! For many of our clients, creating and funding revocable trusts is not driven by estate tax avoidance or minimization – but by the desire to have their estate administered and settled outside of the Probate Court process. With clients for whom this consideration remains vibrant, maintaining their trust structure is sound.

      8. Yet ANOTHER Sunset Provision: In our view, the biggest factor in making planning decisions right now is the fact that the 2010 Act has another two-year timeline. Its provisions only extend through the end of 2012. What happens after 2012 is – again – anyone’s guess.

         It is unlikely that the law will be repealed (although we’ve said that before), and it is unlikely that we’ll see a return to $1.0 million exemptions and 55% rates. Unfortunately Congress has saddled us with yet another deadline, and has chosen to make us live with another two years of planning uncertainty.

   4. Current Gifting Strategies.

      With the gift tax and GST exemption set at $5.0 million, high net worth individuals have unique opportunities right now to implement business succession and wealth transfer strategies before Congress acts to take them away.

      1. Early drafts of estate tax reform proposals (mostly introduced in 2009) included special provisions to eliminate the use of “discounting techniques” due to their perceived abuse. Very simply put, with these techniques, stock in closely held businesses could be valued at less than 100% of an appraisal by using so-called “minority interest” discounts and “lack of marketability” discounts. This allows for transfers of significant amounts of value at a reduced gift tax cost.

         The 2010 Act did not curtail the use of these discounts at all – leaving the door open to these planning techniques for now. If this type of transaction has been on your horizon for a while, the time is now to act on it.

      2. The low interest rate environment that we now experience continues to present opportunities for GRATs, charitable trust planning, and other split-interest trust techniques, the discussion of which are beyond the scope of this outline.

4. Conclusion.

   The 2010 Act is disappointing in that it does not provide certainty and finality to this area of the law. That this new “temporary patch” must again be revisited in two years is as frustrating for our clients as it is for us.

   For now though, we offer these takeaways:

   1. For clients who do have estate plans in place, a review of your planning structure to confirm that with higher exemption limits and the new portability you are properly poised to defer and minimize any potential estate tax liability for your family.

   2. Frequently clients’ estate plans employ formulas to fund the “A-B Trust” (or “Family Trust – Marital Trust”) structure discussed above. For them, a review is warranted to assure that the current large tax exemption does not result in a trust funding that was not foreseen back when the exemption was only $1.0 million.

   3. Many estate plans were written when the Illinois estate tax was a “pick-up” tax, i.e., wholly depend on the federal estate tax. Since Illinois now has its own, separate, tax regime, many plans may adequately defer and minimize federal taxes, but still leave the estate exposed to significant Illinois tax, so a review is suggested.

   4. For clients who have been on the sidelines, waiting for some tax resolution before electing to begin the estate planning process, you are unfortunately no closer to having any clarity. However, since we expect that any changes in two years will likely be revisions to the 2010 Act rather than a complete overhaul, we believe that planning your estates now under current law should require no major revamping in two years.

   5. For clients with significant net worth who have been contemplating substantial gifts to family members or charities, there are unique planning opportunities available to you right now that you should consider.

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Feel free to contact any of the members of Coman & Anderson, P.C.’s Estate Planning and Wealth Transfer Group -- Daniel G. Coman, Mark D. Anderson, William J. Cotter or Lynn Cagney.

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