Changes To The Federal Estate, Gift and Generation-Skipping Transfer Taxes For 2011 And 2012

Changes To The Federal Estate, Gift and Generation-Skipping Transfer Taxes For 2011 And 2012

By Trusts, Estates & Nonprofit Organizations Group, Morrison & Foerster LLP

On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Authorization Act (H.R. 4853, "the Act").  The Act affects a wide range of taxes, including income and capital gains taxes, the social security tax, the alternative minimum tax, and transfer taxes (i.e., the estate, gift and generation-skipping transfer taxes).  Despite its broad reach, it was the Act's changes to the estate tax that generated the most heated debate in Congress as H.R. 4853 approached its final vote. 

The passage of the Act brings some welcome certainty for estate planners with respect to transfer taxes, at least for the next two years.  In just the last 24 months we have helped our clients wrestle with the implications of EGTRRA's1 sunset in 2009, the repeal of the estate tax in 2010 and the modified carryover basis regime that took its place, the 2010 repeal of the generation-skipping transfer ("GST") tax, fluctuations in the gift tax rate, and the scheduled reimposition of 2001 tax rates and exemptions that was due to occur in 2011.  Now we have a markedly new transfer tax regime in place for this year and next year, and clearer choices for estates of decedents who died in 2010.  However, we face continued uncertainty over long-range planning, because the Act is scheduled to sunset on December 31, 2012.  Mark your calendars for December 2012, when we may see a repeat performance of year-end tax debates (and further tax changes?) in Congress.

Estate Tax Changes

Once again we have a federal estate tax in 2011 and 2012, but with a lower maximum rate than we expected:  35%.  In addition, the Act increased the applicable exclusion amount - often referred to as each person's "estate tax exemption" - to $5 million, the highest it has ever been. This will exempt an estimated 99.8% of US decedents' estates from federal estate tax.With the return of the estate tax comes a return of the step-up (or step-down) in income tax basis for all of a decedent's assets (not the $1.3 million increase in basis that was available under EGTRRA's modified carryover basis regime, with an additional $3 million increase in basis for appreciated assets received by surviving spouses).  The Act also introduced a new "portability" feature, which allows a surviving spouse to take advantage of the unused exemption of a predeceased spouse who died after December 31, 2010.  Normally an estate valued at less than the available exemption amount would not be required to file an estate tax return; however, a return will now be necessary for nontaxable estates in order to record the amount of a decedent's unused exemption for a surviving spouse who may want to use it later.  (Use will be limited to 2011 and 2012 unless the portability feature is extended by Congress.)

The Act applied the 35% maximum estate tax rate and the $5 million estate tax exemption retroactively to all of 2010, but allows the estates of decedents dying in 2010 to elect out of the estate tax system and into EGTRRA's carryover basis regime.  Executors of 2010 estates valued at less than $5 million presumably will choose the estate tax system in order to get an income tax-free basis step-up on appreciated assets, while executors of very large 2010 estates might calculate that the estate and its beneficiaries will pay less in capital gains taxes on the sale of inherited assets (whenever that occurs) than the estate tax that would otherwise be due in late 2011.  Executors will need to evaluate which system is more beneficial, given the facts of the particular estate. 

Because of these retroactive estate tax changes, the Act extended the estate tax return filing and the tax payment deadline until September 17, 20114 for the estates of decedents who died between January 1 and December 17 of 2010; this is also the deadline for filing the IRS Form 8939 if the decedent's estate elects out of the estate tax and accepts the modified carryover basis regime, and it is also the deadline for making qualified disclaimers from these estates.  Because the disclaimer deadline for the beneficiaries of these estates could be much longer than the usual nine months under IRC §2518, disclaimants will need to be especially careful not to accept the benefits of disclaimed property before making a disclaimer.  (The estates of decedents dying after December 17, 2010 follow the usual 9-month deadlines for filing tax returns and making tax payments and disclaimers.)  It will be important to check local law on applicable state deadlines for making a qualified disclaimer.

Gift Tax Changes

The 2010 gift tax exemption amount was $1 million, with a maximum gift tax rate of 35% on gifts in excess of that amount.  The 35% rate was a historically low gift tax rate that was scheduled to rise to 55% on January 1, 2011, which led to a spate of 2010 year-end gift planning to take advantage of the 20% rate differential.  The Act extended the maximum 35% gift tax rate, and increased the gift tax exemption amount to $5 million for 2011 and 2012, which made it more beneficial in many cases to postpone 2010 gifts into 2011 or 2012.  The Act also "unified" the estate and gift tax exemptions, meaning that every US citizen or resident taxpayer has a total exemption of $5 million that can be used on lifetime or testamentary gifts before the gift or estate tax will apply to their transfers. 

Given continued depressed asset values, the increased gift tax exemption, the continued low 35% maximum gift tax rate, and the fact that it is possible to leverage the value of gifts of fractional interests in property through discounts (supported by appraisals), many of our wealthy clients are making substantial gifts early in 2011 and opting to pay a 35% gift tax on the value of the gifted property in order to transfer assets (and future appreciation) to their children and grandchildren.  This window may close after 2012, if Congress increases the gift tax rate or reduces the exemption amount, or if the Act is allowed to sunset with no replacement.  Note too that a surviving spouse who "inherits" a predeceased spouse's unused estate tax exemption amount  (through the portability feature) may be able to make large lifetime gifts using that exemption.  This opportunity may only be available in 2011 and 2012, but will present some unique gift planning opportunities.

Generation-Skipping Transfer Tax Changes

From 1986 through 2009 the GST tax existed as an additional transfer tax at a flat 55% rate.  The tax was imposed on transfers (including distributions from trusts) in excess of a GST exemption amount5 to persons two or more generations below the transferor.  Under EGTRRA, the GST tax was repealed in 2010, along with the estate tax, and would have been reinstated in 2011 at a 55% rate for GST transfers in excess of $1.36 million.  The Act imposed the GST tax retroactively for 2010 (eliminating many technical problems that had surfaced with repeal), and increased the GST exemption amount to $5 million.  The Act also lowered the GST tax rate to 35% for 2011 and 2012 (but not for 2010, as described below).  The combination of a lower GST tax rate and a higher GST exemption creates planning opportunities this year and next year that may disappear if the tax rate rises, or the exemption shrinks, after 2012.

The Act also provided an unexpected opportunity for transfers during 2010.  As mentioned above, the GST tax was imposed retroactively for 2010 with a $5 million exemption, but with an applicable rate of "zero" for transfers subject to GST tax.  This allowed many of our wealthier clients to make very significant generation-skipping gifts in the last two weeks of 2010:  they were able to give property to grandchildren or more remote descendants, outright or in "skip person" trusts, and will only pay gift tax (at a 35% rate) and no GST tax, on the value of the transferred property.  They will elect out of the automatic allocation of GST exemption when they file their 2010 gift tax returns later this year, thereby technically subjecting these "non-GST-exempt" transfers to a GST tax, but no tax will be due because of the zero applicable rate.  In this way our clients will have removed from their estates not only the value of the gifted property (leveraged in some cases by appropriate discounts), but also the funds used to pay the gift tax,6 as well as any post-2010 net income from, and appreciation on the value of, the gifted property.  Some clients no doubt feel that this planning opportunity in the waning days of 2010 was a welcome reward for the aggravation they faced all year over the federal tax law uncertainty.

Additional Thoughts

  • The estate, gift, and GST exemption amounts are indexed for inflation starting in 2012 (which may be of little utility if they are allowed to sunset on December 31, 2012).
  • The GST exemption is not portable between spouses.
  • As of this writing, we are still digesting the Act and looking forward to further clarification on certain points that will need to be addressed by regulations.  One such point is whether the $5 million GST exemption is available for estates of 2010 decedents that elected the modified carryover basis regime instead of the estate tax system.  This is certainly just a technical issue and will be confirmed by regulations.
  • Despite the increased estate tax exemption amount (to $5 million per person and $10 million per married couple), it will continue to be prudent from a tax perspective for married couples to consider establishing credit shelter trusts in their estate plans.  The trusts will capture the exemption amount of the first spouse to die, as well as any net income and appreciation, and shield it from estate taxation on the death of the surviving spouse, which could occur if portability disappears or if the exemption amounts are reduced by future Congressional action (or inaction). 
  • By extending the estate tax provisions of EGTRRA, the Act did not reinstitute the state death tax credit for 2011 and 2012, leaving those states whose state estate tax is framed as a "pick-up" tax (based on the federal credit) continuing to impose no state estate tax. 

Conclusion

December 2010 was a memorable month for estate planners.  The Act was a welcome development both for providing some certainty, as well as for providing some significant gifting opportunities in 2010.  The Act will continue to provide opportunities for interesting tax planning in 2010 and 2011.  Stay tuned for changes after that.           


[1] The Economic Growth and Tax Relief Reconciliation Act of 2001.

[2] Special rules and/or lower exemptions will continue to apply to nonresident aliens, and to property that is given to a spouse who is not a US citizen.

[3] Based on nonpartisan Tax Policy Center analysis; if the exemption were reduced to $3.5 million, 99.7% of estates would be exempt.

[4] This is a Saturday, so the actual deadline is Monday, September 19.

[5] In recent years the GST exemption amount tracked the estate tax exemption amount.

[6] Assuming they live for three or more years following the date of the gift.

Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.

© Copyright 2011 Morrison & Foerster LLP.  This article is published with permission of Morrison & Foerster LLP.  Further duplication without the permission of Morrison & Foerster LLP is prohibited.  All rights reserved.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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