FEDERAL ESTATE AND GIFT TAX CHANGES FOR 2011 & 2012

Significant, albeit temporary, changes to federal estate and gift taxes were made in late 2010 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Relief Act), signed into law on Dec. 17, 2010. Before the new law, there was no estate tax for 2010, but some beneficiaries could have faced higher taxes because of less-favorable income tax basis rules. Also, under the prior law, estate and other transfer taxes were scheduled to rise substantially for post-2010 transfers.

Overview of the new law. The 2010 Tax Relief Act provides generous, temporary relief effective only for 2011 and 2012. The rules are temporary—much harsher rules are slated to return after 2012.

Among other changes, estate, gift and generation-skipping transfer taxes for 2011 and 2012 are reduced.

2010 Deaths. The estate tax repeal is maintained for deaths in 2010, but in a roundabout way: estates wanting zero estate tax for 2010 must elect the less-favorable modified “carryover basis” rules. Otherwise, by default, the estate tax is revived for 2010, with a $5 million exemption, a top tax rate of 35% and a step-up in basis.

Special tax-saving choice for 2010 Deaths. The 2010 Tax Relief Act allows estates of decedents who died in 2010 a choice between:

(1) Estate tax (based on a $5 million exemption and 35% top rate) and a basis “step-up” for assets transferred; or

(2) Zero estate tax, but a “modified carryover basis” for the assets transferred to heirs.

“Basis” is the yardstick measuring income tax gain or loss when an asset is sold. A “step-up” in basis means the basis in the heir's hands is increased – stepped up – to the date-of-death value of the asset. Thus, pre-death gain is eliminated.

On the other hand, with modified carryover basis, an heir takes the decedent's original basis, plus certain increases. Using modified carryover basis, if the decedent had low basis and large assets, some pre-death gain could be taxed when the heir sells the property.

These concerns factor into the special election for 2010. The goal is to make whichever choice producing the lowest combined estate and income taxes for the estate and its beneficiaries. The answer is depends on the decedent's basis in the assets immediately before death and how soon the estate beneficiaries plan to sell those assets.

2011-2012 Deaths. For individuals dying in 2009, the top estate tax rate was 45% and there was a $3.5 million exemption. Under prior law, the top rate was to rise to 55% for estates of individuals dying after 2010, and the exemption was to be $1 million.

For 2011 and 2012, the 2010 Tax Relief Act reduces the top rate to 35%. It also increases the exemption to $5 million for 2011 with a further increase for inflation in 2012.

But these changes are temporary. After 2012, the prior law returns: the top rate will be 55%, and the exemption will be $1 million.

Gift tax changes. The gift tax and the estate tax used to be “unified” — they shared a single exemption and were subject to the same rates.

This was not the case in recent years.

For example, in 2010, the top gift tax rate was 35% and the exemption was $1 million.

Now, for gifts made after Dec. 31, 2010, the gift tax and estate tax are reunified and an overall $5 million exemption applies. Remember, however, that using the exemption for lifetime transfers reduces the exemption available at death.

GST tax changes. The Generation Skipping Transfer Tax is an additional tax on gifts and bequests to grandchildren when their parents are still alive – where gifts “skip” a generation. The Act lowers GST taxes for 2011 and 2012 by increasing the exemption amount from $1 million to $5 million (and indexed after 2011) and reducing the rate from 55% to 35%.

New “portability” feature. For estates of decedents dying after Dec. 31, 2010, a deceased spouse's unused $5 million exemption may be shifted to the surviving spouse. This is known as “portability”.

Using portability, any unused exemption remaining after the death of a spouse is generally available for use by the surviving spouse in addition to the survivor’s own $5 million exemption. This applies to both lifetime transfers (gifts) and transfers on the surviving spouse’s death – whether by will or trust.

Before the Act, the first spouse’s exemption, if not fully used, would die with that spouse. This is why “Credit Shelter Trusts” and other techniques were employed to avoid this result.

Even with the new portability rule, good reasons remain to employ Credit Shelter Trusts and similar techniques. For example, a Credit Shelter Trust: (1) protects appreciation occurring between the death of the first and second spouse from being subject to estate tax; (2) protects against creditors; and (3) is useful in planning in “second marriage” situations to protect children from the first marriage of both spouses.

Remember: portability is only effective for two years: 2011 and 2012. After 2012, the 2009 rules return – unless Congress acts.

Conclusion. The Act’s estate tax relief is substantial, but temporary.

Don’t forget that state death taxes remain unaffected by the new Act. The Act only applies to federal estate taxes. We will work with you to do the planning necessary to deal with state death taxes, if applicable to your estate.

Remember: Estate planning to reduce taxes is important, but taxes are the tail, not the dog. Your goals and the interests of your beneficiaries are the most important issues to you, and to us.

Even if taxes are not a concern because your estate is below the exemption level – the Oregon exemption level remains at is only $1 million – a proper estate plan is crucial to ensure that your goals and the needs of your beneficiaries are met.

Give us a call to schedule an appointment to discuss how you and your family can make the best use of the new estate and gift tax rules.

For Additional Information Related to 2010 Estate Tax Options