Estate Tax Update

The law Congress and President Obama created near the end of 2010 gives clarity to the estate tax issue, but only for two years. The law the President signed on December 17, 2010 went into effect January 1, 2011 and sunsets on December 31, 2012. What this means is the new tax law will only affect the estates of those people who die between January 1, 2011 and December 31, 2012. How will an estate be taxed for someone who dies after December 31, 2012? At this point, it is anyone’s guess. The answer lies wherever the political and economic winds blow the Congress and the President.

As an estate planning attorney, the question I face every day is “How should a person plan their estate when such tax uncertainty prevails?” My short answer is to recommend that people create an estate plan that is flexible, and comprehensive enough to utilize all legal methods for protecting the estate from the estate tax, even if some of those methods are later never required. At a future time, I will be pleased to discuss the details of such an estate plan. However, for today, I thought a better starting point would be to discuss some key points in the tax law that was signed on December 17, 2010.

Higher Tax Exemption, But For How Long?
For the years 2011 and 2012, the estate tax exemption amount will be $5 million per person (in 2012, the $5 million will be indexed for inflation). As a result, only those people with estates over $5 million will have to pay Federal estate tax. The top estate and gift tax rate for 2011 and 2012 will be 35%. Thirty-five percent is the highest tax rate for gift, estate and generation skipping taxes, effective January 1, 2011. To put this into perspective, in 2001 the top rate was 55%, and was gradually reduced to 45% in 2009.

Reunification of Estate and Gift Taxes
Prior to 2001, the state and gift tax exemption amounts were the same. From 2001 to 2010, the two exemptions were “decoupled” in that the estate tax exemption gradually moved from $1 million in 2001 to $3.5 million in 2009, and then disappeared altogether in 2010, while the gift tax exemption remained at $1 million during all those years. The new law reunifies the two exemptions so that a person can give any amount and combination of lifetime gifts and estate bequests up to $5 million, and not be required to pay a transfer/estate tax.

Portability of Exclusion for Married Couples
Perhaps the most ground breaking change in the new law is the portability of the estate tax exclusion between married couples. Effective January 1, 2011, any estate and gift tax exclusion amount that is not required by an estate may be transferred over to the surviving spouse and added to the surviving spouse’s exclusion amount. The word “may” is an important word here because this portability is elective. In order to make this election, an estate tax return must be timely filed by the estate of the predeceased spouse. This filing must be completed even though the estate would otherwise not be large enough to require such a filing. If the filing is not completed in a timely manner, this exclusion portability option is lost.

To illustrate some of the practical applications for using the portability of the estate tax exclusion between spouses, the Joint Committee on Taxation gave the following examples:

Example 1:
Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1’s estate tax return to permit Wife to use Husband 1’s deceased spousal unused exclusion. As of Husband 1’s death, Wife has made no taxable gifts. Thereafter, Wife’s applicable exclusion is $7 million (her $5 million basic exclusion plus the $2 million deceased spousal unused exclusion from Husband 1), which she may use for lifetime gifts or for transfers at death.

Example 2:
Assume the same facts as in Example 1, except that Wife subsequently marries Husband 2. Husband 2 also predeceases Wife, having made $4 million in Taxable transfers and having no taxable estate. An election is made on Husband 2’s estate tax return to permit Wife to use Husband 2’s deceased spousal unused exclusion. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2’s $1 million unused exclusion is available for use by Wife. Thereafter Wife’s applicable exclusion is $6 million (her $5 million basic exclusion plus $1 million deceased spousal unused exclusion from Husband 2), which she may use for lifetime gifts or for transfers at death.

Example 3:
Assume the same facts as in Examples 1 and 2, except that Wife predeceases Husband 2. Following Husband 1’s death, Wife’s applicable exclusion is $7 million (her $5 million basic exclusion plus $2 million deceased spousal unused exclusion from Husband 1). Wife made no taxable transfers and has a taxable estate of $3 million. An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion, which is $4 million (Wife’s $7 million applicable exclusion less her $3 million taxable estate). Under the new law, Husband 2’s applicable exclusion is increased by $4 million, i.e., the amount of the deceased spousal unused exclusion of Wife.

The Future of Marital Tax Planning
In the past, a key component in marital tax planning involved the creation of an AB Trust. With this type of trust, an irrevocable “B” Trust would be created upon the 1st Spouses death. In a world without the “portability” of the deceased spouses tax exclusion, the AB Trust was essential in order to preserve the exclusion amount of the deceased spouse. Some people are questioning whether an AB Trust will continue to be a necessary part of tax planning for married couples. If “portability” of the deceased spouses tax exclusion continues, the answer is “no.” If “portability” of the deceased spouses tax exclusion ends, the answer is “yes.” It is important to remember that the new tax law ends December 31, 2012 and we do not know what the law will be on January 1, 2013 and thereafter.

Importance of Estate Tax Returns
It is critical to know that in order for the surviving spouse to take advantage of portability, the law requires an estate tax return to be filed in a timely manner for the deceased spouse’s estate. Without the estate tax return, the IRS has no effective paper trail to allow it to determine the correct amount of unused exemption that should be transferred to the surviving spouse. Many surviving spouses of moderate wealth will want to ensure that an estate tax return is filed for the deceased spouse, especially in the event that exemption amounts are reduced after the year 2012 and portability still remains the law.

Now is the time to review your estate plan to determine if your current estate planning documents are consistent with the new tax law changes. With this in mind, unless overriding factors exist, my general advice is for people to create an estate plan that is flexible and comprehensive enough to utilize all available legal methods for protecting their estate from the estate tax. This is very important even though it may later turn out that those tax saving methods were not required. For, as the old saying goes, “It is better to be safe than sorry.”