Estate and Gift Tax: Favorable (but Temporary)
Provisions of the 2010 Tax Relief Act

The time may be right to move forward with the planning that, due to uncertainty
in the tax laws, you have been considering but putting off

John K. Hanson

Although the primary feature of the 2010 Tax Relief Act, which was enacted in December 2010, was a two-year extension of the Bush-era income tax cuts, the Act also addressed the repeal of the estate tax for 2010 and reinstatement in 2011. The estate tax was reinstated for 2010 (but grants an option to elect repeal), and there are generous estate and gift tax exemptions and rates for 2011 and 2012.

Unfortunately, the Act is only a temporary measure; in 2013, the pre-2001 estate and gift tax provisions will return, with a much higher tax burden on estates and gifts.

Below is a summary of the provisions of the new Act, with a discussion of the opportunities and pitfalls that it presents for your personal estate planning.

Estate and Gift Taxes in 2011 and 2012

For persons who die in 2011 and 2012, the Act greatly reduces the impact of the estate tax by granting estates a $5 million exemption for property subject to the tax. This is a significant increase over the $3.5 million exemption in 2009, the last year in which there was an estate tax. The Act also adds "portability" of the exemption between spouses: If one spouse does not use all of his or her $5 million exemption, the remaining exemption may be used by the estate of the surviving spouse. Effectively, this creates a $10 million exemption for married couples. The few estates that exceed this $5/$10 million threshold will be subject to a new 35% tax rate, rather than the 45% rate in effect before 2010.

Gift taxes are also lower. Since 2001, taxpayers have had only a $1 million lifetime gift tax exemption. That exemption is increased to $5 million for gifts made in 2011 and 2012. The tax rate on 2011 and 2012 gifts in excess of $5 million is 35%.

Generation-Skipping Transfer Tax

The generation-skipping transfer (GST) tax is an additional tax on transfers to grandchildren and great-grandchildren. Legislation passed in 2001 repealed the GST tax for 2010 only, but the effect of repeal was not clear. The Act eliminates that uncertainty; it provides that the GST tax was in effect in 2010 but with a 0% tax rate. This means that any generation-skipping transfers in 2010 were tax-free, but in future years taxpayers may still use the various GST tax exemptions to reduce or eliminate the tax.

After 2010, the Act aligns the GST tax with the new estate and gift taxes. In 2011 and 2012, the GST exemption is increased to $5 million, and the tax rate is 35%. In 2013, the GST tax, like the estate and gift taxes, will revert to a $1 million exemption and a 55% tax rate.

Estates of Persons Dying in 2010

Prior to passage of the Act, the estates of persons who died in 2010 faced considerable uncertainty. The 2001 legislation repealed the estate tax for 2010 but also required that heirs use the decedent's tax basis for inherited property. Before 2010, that property had received a basis step-up at death. This is known as "carryover" basis. For some heirs, this 2010 requirement was a greater tax burden than would have been imposed by the estate tax. In addition, there was a risk that the estate tax would be retroactively reinstated for 2010; as a consequence, many executors (known in Arizona as “personal representatives”) did not know what to do.

The Act eliminates that uncertainty for 2010 estates. Carryover basis is repealed and the estate tax is reinstated for 2010, but with the $5 million exemption and 35% tax rate that are available in 2011 and 2012. The new law also provides that estates of persons who died in 2010 can elect out of the estate tax, if they accept the carryover basis.

The estate tax return is normally due nine months after the date of death. Due to the special circumstances in 2010, the Act extends to September 17, 2011, the date for filing the return and paying the tax for 2010 decedents.

Planning Opportunities

Estates of persons who died in 2010 now have certainty as to the tax law but still must decide between (a) the $5 million exemption and 35% tax rate or (b) no estate tax but carryover basis. If the estate is less than $5 million, in most cases it will be best to accept the estate tax and thereby acquire an income tax basis at the date-of-death fair market values. (This is known as "stepped-up" basis or a "step-up" in basis.) But an analysis should still be done to determine whether the heirs are better off with a stepped-up basis or the carryover.

Also, if the estate of a married decedent accepts the application of the estate tax in 2010, the new portability provisions do not apply to the unused portion of the $5 million exemption. Portability applies only to persons who die in 2011 and 2012.

The estate plan of any individual likely to die in 2011 or 2012 must be reviewed to determine if it takes full advantage of the $5 million exemption and, if applicable, the portability of that exemption. However, for most persons, the temporary nature of the estate and gift tax changes means that they cannot be relied upon for planning purposes.

Congress should revisit the estate, gift and GST taxes by late 2012, but we cannot predict what action it will take at that time. Nevertheless, if you have been reluctant to do any estate planning, in light of the legislative uncertainty and the possibility of estate tax repeal, now that we know that the estate tax will be with us for at least another two years, the time is ripe to do the planning that you have been putting off. ■