The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (HR 4853) (the “Act”) is now law. The estate and gift tax is one of the most dramatic aspects of this tax law change. President Obama was sharply criticized within his own party for these estate tax provisions.

Under the Act, estates will not be taxed on the first $5 million of value. Because any unused portion of a spouse’s $5 million exemption is portable to the second spouse’s estate, a husband and wife together can pass tax-free $10 million to non-spousal heirs. The executor of the first spouse to die must elect this option on his estate tax return, even if there is no liability owed. Above the $5 million (or $10 million) exempt amounts, estates will be subject to a 35% tax. The $5 million estate tax exemption will be indexed for inflation in 2012, with rounding to the nearest $10,000.

In 2010, there has been no estate tax. The Act allows representatives of those dying in 2010 to choose to apply 2010 or 2011 estate tax law for 2010. Since 2010 has had no estate tax, one might incorrectly think that this makes no difference. However, the Act eliminates the “carry over” basis in place in 2010. Carry over basis means that inherited assets are valued for the heirs’ subsequent income tax purposes based on the decedents’ original purchase price. In its place, the Act reinstates “step up” basis, which requires inherited assets to be re-priced at the inherited assets’ fair market value. Consequently, 2010 estates with less than $5 million can still pay no tax, yet receive the step-up in tax basis that could reduce heirs’ future income taxes. In 2010, certain limitations exist regarding the available step-up in basis.

The gift tax is now unified with the estate tax. This means that gifts up to $5 million during one’s lifetime are exempt from gift taxes. Prior to the Act, gifts had a $1 million total exemption. Any gift tax exemption used prior to 2010 reduces the $5 million exemption that would otherwise be available at death.

The estate tax change exists for only two years, at which point the law reverts back to a 55% rate after the first $1 million of taxable estate. This is the tax that would have otherwise occurred starting on January 1, 2011 absent this law change. Prior to the current compromise, President Obama proposed setting the tax at 45% with a $3.5 million exemption.

The Generation-Skipping Tax (GST) is zero for the remainder of 2010. This provides a short-term opportunity to gift amounts to a multigenerational generation-skipping trust through the end of the year. In 2011 and 2012, the GST is unified with estate and gift taxes, meaning the $5 million of gifts to grandchildren will be exempt from the GST.

Strategies in Light of these Changes

  1. For 2010 estates, if the value of a decedent’s estate is $5 million or less, the executor should not elect out of the estate tax. The estate will still pay no estate tax, yet the heirs will receive the step-up in basis. If the 2010 estate exceeds $5 million, the executor should probably opt out of the estate tax because the future tax effect of the step-up in tax basis is likely to be less than the estate taxes that would become owing. This analysis requires calculations that are best be done by a tax professional.
  2. Assuming you will have a taxable estate, gifting (perhaps to a trust) remains a cheaper way of passing assets to your heirs. This occurs because (i) the gift tax reduces the estate’s value (and hence is removed from the taxable estate), and (ii) future income and appreciation earned by the gift is removed from the taxable estate.
  3. If you anticipate having more than a $1 million estate, a typical A-B trust (aka credit shelter trust) remains useful. The $1 million amount occurs fairly commonly for those that own a home. The need for estate tax planning with a $1 million estate occurs because the current estate tax regimen lasts for only two years. As occurred in the last couple of weeks, a possible volatile political environment might exist both before and after the November 2012 elections, so it would be unwise to assume that the larger estate tax exemptions will remain. Even if estate taxes are not an issue because values are less than the exemption amounts, a trust may still be useful to avoid state probate and related costs.Additionally, the GST exemptions are not unified. If a GST issue exists, a credit shelter trust is needed for the estate of the first-to-die.

There are some provisions that are not in the bill that were part of the proposals and negotiations leading up to the Act. These include:

  1. In prior proposals, Grantor Retainer Annuity Trusts (GRATs) would have needed a minimum 10-year term. No such provision is included in the proposed legislation. Nevertheless, those interested in this vehicle should consider doing so now because the interest rates used under IRS requirements are at historic lows.
  2. Valuation discounts using family limited partnerships are used to reduce estate and gift tax exposure. Proposals to statutorily limit valuation discounts did not remain in the Act.

See our Summary of HR 4853 for major tax changes outside of the estate tax area.

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