The Estate Tax Is Back, but with Some Twists—and Opportunitiesby Michael S. Kutzin Goldfarb Abrandt Salzman & Kutzin LLP
After nine years of speculation about what would happen to the federal estate tax once its one-year “repeal” disappeared at the end of 2010, on December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 Act”), which reinstated the estate tax for estates of decedents dying in 2010, expanded the exemption from estate and gift taxes, cut the maximum transfer tax rate and created significant planning opportunities to reduce or eliminate taxes during the two years while the new law is in effect.
I. Prior Law
In 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), which raised the federal estate tax exemption from $675,000 to $1 million in 2001 and up to $3.5 million in 2009. This meant, for example, that a husband and wife dying in 2009 could pass up to $7 million tax-free to their children, provided that each spouse had enough assets to take advantage of his or her $3.5 million exemption at death. If one spouse had less than $3.5 million in assets or left all assets to the surviving spouse, then the first spouse’s unused exemption would be lost.
Under EGTRRA, the maximum marginal rate of taxation on estates declined from 55% to 45% between 2001 and 2009. The federal estate tax was repealed for 2010, but EGTRRA was by its terms scheduled to sunset in 2011, with the result that for decedents dying in 2011 and beyond, the estate tax would return and the exemption would revert to $1 million (the amount to which it had been scheduled to increase under pre-EGTRRA law). Absent Congressional action, the maximum marginal tax rate was scheduled to revert to 55% in 2011, with the elimination of lower marginal tax rates for very large estates.
While the federal estate tax exemption rose to $3.5 million under EGTRRA, the federal gift tax exemption increased to only $1 million. (The amount of exemption that could be allocated for federal generation-skipping transfer (“GST”) tax purposes increased uniformly with the estate tax exemption.) Thus, someone who made $3.5 million in taxable gifts during his or her lifetime would incur gift taxes on the excess over $1 million, while the same amount left at death by a decedent who died in 2009 would pass free of any federal transfer taxes.
The temporary repeal of estate taxes for a decedent “lucky” enough to die in 2010 came at the price of a limitation in the step-up in basis for assets inherited by the decedent’s beneficiaries. Under EGTRRA’s modified step-up regime, the income tax basis of inherited assets for purposes of determining capital gain upon a subsequent sale would not be their fair market value at date of death. Instead, the decedent’s executor would have up to $1.3 million in basis step-up to allocate among assets inherited by non-spouse beneficiaries and up to an additional $3 million in step-up to allocate among assets inherited by a surviving spouse.
II. New Law
A. Decedents Dying in 2010
The estates of decedents who died in 2010 will have a choice between two tax regimes. The general rule under the 2010 Act is that estates of persons dying in 2010 will be subject to the federal estate tax under the same rules that are in effect in 2011 (see discussion below), unless the executor elects to pay no federal estate taxes and receive only the modified step-up in basis.
For the estates of decedents dying in 2010 with up to $5 million in assets, executors will not elect out of the federal estate tax (as none will be imposed) and will instead take advantage of the full step-up in basis to fair market value as of date of death. For estates in excess of $5 million, calculations will have to be made by the executor’s attorneys or accountants to determine whether avoiding federal estate taxes or obtaining a full step-up in basis is more advantageous. Some of the factors that will have a bearing on this determination include the amount of built-in gain in the assets passing to the beneficiaries and whether the beneficiaries intend to sell those assets in the near future or to hold them for the long term. Executors who elect into the modified step-up regime will have to decide how to allocate the $3 million and $1.3 million basis step-ups among the assets passing to spousal and non-spousal beneficiaries, taking similar factors into account.
As part of the 2010 Act, estates of decedents dying prior to the enactment date were given nine months from December 17, 2010 to file estate tax returns or basis allocation forms and to make qualified disclaimers.
B. Rules for 2011 and 2012
The 2010 Act is effective only through the end of 2012. In 2011, the federal estate, gift and GST tax exemption will be $5 million, and in 2012 it will be $5 million indexed for inflation. The maximum marginal tax rate will be 35% in both years. If the law is, in fact, permitted to sunset at the end of 2012, the exemption will return to $1 million and the marginal rate to 55%.
Aside from the highly advantageous exemption amount and reduced marginal tax rate, there are two other provisions of the 2010 Act that greatly benefit taxpayers: portability of the exemption between spouses and the ability to make taxable gifts up to $5 million in 2011 and 2012 free of gift taxes even if the $5 million exemption amount sunsets at the end of 2012.
If a decedent who dies in 2011 or 2012 has unused exemption (referred to in the new statute as the “deceased spousal unused exclusion amount”), the surviving spouse may take advantage of the unused exemption as long as the executor makes an election on the decedent’s federal estate tax return allowing the surviving spouse to do so. For example, suppose that husband dies with $2 million of assets in 2011, having never made any taxable gifts, and that he leaves his estate to his children instead of to his wife. If his executor makes the appropriate election on the federal estate tax return, the deceased spousal unused exclusion amount of $3 million ($5 million minus $2 million) will be available to the surviving spouse, either to make taxable gifts during her lifetime or to shelter assets from estate tax at death. (Portability does not apply to the exemption from the federal GST tax.) If wife then dies in 2012 without having made any taxable gifts during her lifetime, she could pass up to $8 million ($5 million plus the deceased spousal unused exclusion amount of $3 million, ignoring any potential indexing for inflation) free from federal estate tax. If husband instead left his entire $2 million estate to his wife, his deceased spousal unused exclusion amount would be the entire $5 million, and wife would have $10 million that she could transfer free of federal estate or gift tax before December 31, 2012.
What if the surviving spouse remarries and also survives the new spouse? Under the 2010 Act, the deceased spousal unused exclusion amount is limited to the lesser of $5 million and the unused exemption of the last deceased spouse, regardless of whether or not an election was made on an estate tax return to allow a (twice unlucky) surviving spouse to use a prior spouse’s exemption. For example, suppose that wife dies in 2011 and an election allows husband the use of her $4 million unused exemption. She leaves all her assets to husband, confident that he will pass those assets on to their children at his death. Husband remarries, signing a valid prenuptial agreement with his new wife under which neither will leave property to the other. New wife then dies in 2012, leaving her $4.5 million estate to her children from a prior marriage. Assuming no indexing for inflation, the most that husband can transfer to his children free of federal estate and gift tax is only $5.5 million—his $5 million exemption, plus new wife’s unused exclusion amount of $500,000.
Needless to say, for well-advised, wealthier individuals, this could complicate the decision to remarry.
The IRS can examine the estate of the first spouse to die for the purpose of determining the deceased spousal unused exclusion amount claimed by the estate of the surviving spouse.
Like the expanded exemptions and lower tax rate, portability is set to expire on December 31, 2012.
Prior to the enactment of the 2010 Act, good estate planning often focused on ensuring that each spouse had at least enough assets in his or her name to take full advantage of the exemption amount then in existence and to pass that amount to children, either outright or in trust. In order to build in flexibility to estate plans as the exemption amount grew over the past nine years, some couples wrote wills with “disclaimer trusts,” leaving most or all of an estate to the surviving spouse but providing that the surviving spouse could disclaim some or all of the residue in order to take advantage of the then applicable exemption. The disclaimed property would pass to a trust that would benefit the surviving spouse during his or her lifetime but would not be included in his or her estate for tax purposes, and upon the surviving spouse’s death any remaining assets would pass to children. Other clients whose assets far exceeded the maximum $3.5 million exemption left the full exemption amount to a similar “credit shelter” trust for spouse and children and the residue to spouse.
Is there any role for disclaimer and credit shelter trust planning, or ensuring that each spouse has assets solely in his or her name, now that we have portability? The answer is yes. First of all, as discussed above, portability is scheduled to expire at the end of 2012. So unless both spouses die before 2012, no one can count on being able to take advantage of portability. Secondly, leaving assets to a disclaimer or credit shelter trust keeps future appreciation on the assets from being taxed in the surviving spouse’s estate. In addition, state estate taxes must also be considered. For example, the New York State estate tax exemption remains at $1 million, and there is no concept of portability under New York law. Even if portability is made permanent, New York residents will still be well advised to try to pass at least $1 million in the estate of each spouse to the children of their marriage in order to minimize New York State estate tax.
Income tax considerations may also weigh in favor of funding a trust in the estate of the first spouse to die. A disclaimer or credit shelter trust under the will of a New York decedent may escape New York State income taxation of its income and gains if it satisfies the requirements of N.Y. Tax Law § 605(b)(3)(D), whereas the same income and gains would be subject to New York State income tax if the assets were held by a surviving New York-resident spouse.
Non-tax considerations—such as creditor protection and control over the disposition of assets after a surviving spouse’s death—may also favor the creation of a disclaimer or credit shelter trust, just as they would have before the new tax law.
Between the impermanence of portability, the potential estate and income tax savings and non-tax considerations, it will still make sense for many couples to ensure that each spouse has assets in his or her own name and to continue to provide for disclaimer or credit shelter trusts in their wills.
2. Taxability of Gifts Made if 2010 Tax Act Sunsets and Opportunities Presented
One of the critical changes made by the 2010 Act was in reunifying the federal estate and gift tax systems and providing both higher exemptions from the taxes and a lower maximum rate. This will permit wealthier individuals to more fully take advantage of lifetime gifting without incurring current taxes. Estate planning techniques such as gifts of interests in family limited partnerships, gifts to GRATs and QPRTs and installment sales to intentionally defective grantor trusts can now be used to transfer much larger amounts because individuals can gift up to $5 million ($10 million for married couples) free of gift tax in the next two years.
If the 2010 Act is allowed to sunset, and the 55% rate and $1 million exemption amount return, taxable gifts made in 2011 or 2012 that were exempt from gift tax could become subject to federal estate tax in the estate of the donor at the 55% rate. Even if there is such a “claw back” or recapture of tax on lifetime gifts, the tax will be deferred until death, and any appreciation of the assets gifted will escape taxation in the donor’s estate. In addition, through the use of estate planning techniques such as family limited partnerships, which are designed to pass assets at discounted values for estate and gift tax purposes, more assets can be transferred during life and reduce the ultimate tax bill.
One potential drawback to making larger lifetime gifts is that assets that are gifted during lifetime will not receive a step-up in basis at the donor’s death. A taxpayer considering major taxable gifts may therefore wish to consider making cash gifts or gifts of assets whose tax bases are close to fair market value.
The 2010 Act provides significant opportunities, especially for wealthy individuals and couples, to reduce or eliminate federal estate and gift taxes with appropriate planning. Because most of the substantive provisions of the 2010 Act are scheduled to sunset at the end of 2012, however, and because of state estate tax systems that do not reflect changes to the federal tax laws and other considerations, good estate planning still requires substantial flexibility and regular review.
Michael S. Kutzin is a partner in the New York City and White Plains law firm of Goldfarb Abrandt Salzman & Kutzin LLP, a firm concentrating in trusts and estates and elder law. He is a Vice Chair of the Legislation and Governmental Relations Committee of the Trusts and Estates Law Section of the New York State Bar Association and a former Vice Chair of the Estate Litigation Committee of this Section. He is also a member of the Estate Planning Council of Westchester and an adjunct faculty member of the George H. Heyman, Jr. Center for Philanthropy and Fundraising at New York University, where he teaches the Law of Nonprofit Management.
The author gratefully acknowledges the contributions of Louise Ding Yang, an associate at Debevoise & Plimpton LLP, in the preparation of this article.
 This could be the result under the calculations required to take into account post-1976 gifts, and the gift tax previously paid or deemed to have been paid on such gifts, when computing the estate tax on the Federal Estate and Generation-Skipping Transfer Tax Return (Form 706). New IRC § 2001(g) provides that in computing the gift tax deemed previously paid, the tax rates in effect at the date of the decedent’s death are used instead of the rates in effect at the date of the gift. 2010 Act § 302(d). Under this method of computation, no additional tax would be imposed on gifts made in 2011 and 2012 to take advantage of the $5 million exemption even if tax rates later increase. Section 2001(g), however, is scheduled to sunset at the end of 2012 along with the rest of the 2010 Act. Some practitioners believe this was an oversight in the legislation and that it will be resolved through a technical legislative correction or a clarification on the Form 706.