New rules for Estate Taxes

Wednesday, August 3, 2011

On December 17, President Obama signed into law the

Tax Relief, Unemployment Insurance Reauthorization, and

Job Creation Act of 2010 (the “Act”), extending the Bush

tax cuts for two years. To the surprise of many, the Act

made substantial changes in the law governing estate, gift,

and generation skipping transfer taxes, although also on a

temporary basis

New Law Temporarily Extends Bush Tax Cuts and Provides New Rules for Estate, Gift, and Generation Skipping Transfer Taxes

For the first time, the estate tax exemption will be “portable”

between spouses. This means that the surviving spouse will

be able to use the predeceased spouse’s unused exemption

at the survivor’s death.

The gift tax exemption will also be portable between spouses.

This means that the surviving spouse will be able to use the

predeceased spouse’s unused gift tax exemption, as well as

the surviving spouse’s gift tax exemption, to make lifetime gifts

that will not bear gift taxes.

The absence of the GST tax in 2010 and reinstatement in

2011 will provide some clients with a limited time opportunity

to make highly tax-effective gifts to grandchildren, more

remote descendants, and other significantly younger beneficiaries.

However, the GST tax exemption taking effect in 2011

is not portable between spouses.

Provisions for 2010 decedents. The legislation also

provides clarification of the applicable law (or laws) for the

estates of 2010 decedents, although each such estate must

consider the ramifications of newly available tax elections

regarding the applicable law. During 2010, there has been

no estate tax, but only a very limited adjustment to the

income tax basis of the decedent’s assets. Many smaller

estates would not have paid any tax under the $3,500,000

exemption that was in effect in 2009, but as a result of

death in 2010, the decedent’s assets were deprived of

much of the tax basis increase they would have received

had the death occurred in 2009.

The personal representatives of 2010 decedents will now

have a choice to apply the original 2010 law of no estate tax

and limited basis adjustment or apply the new law and pay a

35% estate tax after a $5,000,000 exemption and receive a

full step up in tax basis (compared to a 45% estate tax and

$3,500,000 exemption for 2009 estates). The default position

is the new law, and the personal representative must make

an election to obtain the no estate tax, limited basis increase

result. The election must be made within nine months of the

enactment of the new law, but the form for making the election

has not yet been prescribed.

The new law did not, as anticipated, require that grantor

retained annuity trusts (GRATs) have a minimum 10-year

term. Therefore, short-term GRATs in this low interest rate

environment remain an attractive planning tool, particularly if

a client wants to make gifts in excess of the new, higher gift

tax exemption.

Estate, Gift and Generation Skipping Transfer Tax

Planning Ramifications

The Act creates a number of planning opportunities and

issues that should be addressed relative to the estate, gift

and GST taxes:

Many gifts should be deferred to 2011. Prior to the

introduction of this legislation, many taxpayers were making

or considering significant taxable gifts in 2010 to take

advantage of what was thought to be a one time opportunity

to have a 35% gift tax rate apply. Now, most gifts in excess

of the $13,000 annual gift tax exclusion amount should be

deferred to 2011 for taxpayers who have already used their

$1,000,000 lifetime exemption. On January 1, the exemption

will be $5,000,000, and significant additional tax-free gifts can

be made.

2010 Generation skipping gifts and transfers may still

be beneficial. It may still be beneficial to make generation

skipping gifts to grandchildren and non-family beneficiaries

more than 37½ years younger than the donor during 2010.

There is no GST tax in 2010, and some may still find it

advantageous to make generation skipping transfers in 2010

and pay the 35% gift tax (assuming the $1,000,000 exemption

has been used), in order to eliminate further transfer taxation

for one or more generations, while preserving the newly

enacted $5,000,000 GST tax exemption for future generation

skipping transfers. The $5,000,000 GST tax exemption will

automatically be allocated to any 2010 GST gift, unless you

make the election not to allocate such exemption, which you

must do in order to preserve the new $5,000,000 exemption

for future use.

Certain existing trusts that permit discretionary distributions

by the trustee may find it advantageous to make distributions

during 2010 that would otherwise be subject to GST tax, but

will not be if the distribution occurs during 2010.

Gifts in 2011 and 2012. There is no certainty that the lifetime

gift tax exemption will remain at $5,000,000 after 2012. Many

taxpayers who have already used their $1,000,000 lifetime

gift tax exemption will want to consider making another

$4,000,000 in gifts during 2011 and 2012. Even if the exemption

is reduced after 2012, it is unlikely that Congress would

try to impose a retroactive gift tax on those who used the full

exemption during 2011 and 2012. Using your full exemption

to make gifts will allow you to escape gift tax on the present

amount of the gift, and to avoid estate tax on any appreciation

in value after the gift that occurs before your death.

New York residents are presented with a unique opportunity

as a result of the $5,000,000 gift tax exemption.

Bypass trusts will still be advantageous. Under the law

in effect through 2009, the “bypass” trust was often created

in order to take full advantage of both spouses’ estate tax

exemptions. At the death of the first spouse, if the decedent

left everything to the survivor, the predeceased spouse’s

estate tax exemption would not be used, and the surviving

spouse’s taxable estate would include the full amount of

the assets inherited from the predeceased spouse. In that

situation, only the surviving spouse’s estate tax exemption

amount could be applied to reduce estate taxes. To avoid

this result, a bypass trust was often created after the first

spouse’s death under the terms of the estate plan and

funded with the amount that the decedent could pass free of

estate tax to beneficiaries other than the surviving spouse

and charities (e.g., children and other individuals). Properly

structured, the assets in the bypass trust, regardless of

value at the time of the surviving spouse’s death, were not

subject to estate tax in the surviving spouse’s estate. The

bypass trust could also effectively preserve the predeceased

spouse’s GST tax exemption.

With the Act’s introduction of portability of the estate tax

exemption, bypass trusts are not necessarily required to

utilize both spouses’ estate tax exemptions. However, such

trusts may still be beneficial for other reasons. Beginning

in 2012 (and assuming no further changes in the law), the

$5,000,000 exemption is indexed for inflation. When the

first spouse dies, that spouse’s unused exemption is not

further indexed for inflation after his or her death. It will be

frozen at its level at the time of the first death. The survivor’s

exemption will continue to be indexed until the survivor

dies. This means that it may still be advantageous to fund

a bypass trust at the first death in order to protect future

appreciation in the assets in the bypass trust from estate

taxes in the surviving spouse’s estate, while preserving

use of the survivor’s full exemption (which continues to

be indexed for inflation). Moreover, a properly structured

bypass trust can provide significant protection against the

surviving spouse’s creditors, and can protect the rights of

the remainder beneficiaries (e.g., the predeceased spouse’s

children) from actions taken by the surviving spouse that

would alter or eliminate their inheritance rights.

Keeping a bypass trust as part of your estate plan will also

be useful if the portability feature does not remain in the law

after 2012. Hopefully it is now a permanent feature of the law,

but each year the legislative process becomes increasingly

difficult to predict.

The portability provision in the new law was written in a way

that prevents one from accumulating exemptions through

multiple marriages. Only the unused credit of the spouse

to whom you were last married may be carried over to your

estate. In contrast, a bypass trust will also protect against the

loss of the predeceased spouse’s exemption by reason of

the surviving spouse’s marriage to a new spouse. Also, the

unused estate tax exemption of the first spouse will be available

to the second spouse only if the predeceased spouse’s

estate files an estate tax return and elects on the return to

pass the unused exemption to the surviving spouse. The

statute of limitations will remain open for the estate tax return

of the predeceased spouse for the limited purpose of determining

the amount of exemption available to the estate of the

surviving spouse.

Taxpayers should focus on amount that will go to the

bypass trust. Taxpayers who have estate plans that fund a

bypass trust at the first death with the full estate tax exemption

amount must be aware that for at least 2011 and 2012,

this will mean that up to $5,000,000 (but no more than onehalf

of all community property in community property states)

will go into that trust. In estates of more modest size, this may

be far more assets than the couple desired to put into this kind

of irrevocable trust. We previously warned of this problem in

2009, when the exemption increased to $3,500,000.

Window to make qualified disclaimers with respect to

2010 decedents may have been extended. In a number

of cases, when someone died in 2010, the surviving spouse

disclaimed a portion of the predeceased spouse’s property

in order to reduce his or her eventual estate tax. In some

families, the children who benefited from the disclaimer also

disclaimed in favor of their children to take advantage of

the absence of the GST tax in 2010. Some families were

reluctant to use disclaimers due to concern that the estate,

gift and GST taxes might be restored retroactively to apply in

2010. Under Internal Revenue Code (“IRC”) Section 2518, a

qualified disclaimer must be made within nine months after

the decedent’s death so the window had closed for decedents

who passed away early in 2010.

The Act extends the period to make a qualified disclaimer so

that the period will close not sooner than nine months after

the date of enactment of the Act. This will extend the period

to September 17, 2011, which becomes September 19

because the 17th is a Saturday. Waiting so long may be

problematic because a disclaimer cannot be made if the

beneficiary has accepted the benefit of the property, and

certain state disclaimer statutes may also impose nine month

limitations. A disclaimer may still be possible but the state’s

law will have to be studied. It should be noted that there is

some uncertainty about the validity of disclaimers made

under the new federal tax law that do not comply with state

law requirements.

Evaluating options for 2010 decedents. As noted in the

Executive Summary above, the Act provides a choice for

estates of 2010 decedents. The default rule is that estate tax

will apply with a maximum rate of 35%, a $5,000,000 exemption,

and full fair market value basis accorded the assets. This

will likely be advantageous for estates of less than the new

$5,000,000 estate tax exemption, or in which the decedent’s

estate plan deferred estate taxes until the surviving spouse’s

death, both of which would have no estate tax due but would

benefit from the full basis increase. The personal representative

may elect to apply the previous 2010 rules and have no

estate tax and only the limited basis increase. The election

to apply these rules must be filed in a time and manner to be

prescribed by the Secretary of the Treasury.

If the personal representative determines that a 2010 estate

should be subject to estate tax, the earliest date that the

estate tax return and payment of tax will be due is September

19, 2011 (nine months from date of enactment, then to the

next business day). If the personal representative elects the

no tax and carryover basis regime, the basis allocation report