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Temporary Guidance Provided under the Tax Relief Act of 2010
January 11, 2011

The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “Act”) was signed into law on December 17, 2010. Albeit temporary, the Act provides some clarity regarding the federal estate, gift and generation-skipping transfer tax systems for the next two years. This Client Alert will summarize the key provisions of the new Act most likely to impact you.

Estate Tax Exemption Increased to $5 Million

  • For 2011 and 2012, the federal estate tax exemption has been increased to $5 million per person from the previous 2009 exemption of $3.5 million (see special discussion regarding deaths occurring in 2010 below). With proper planning, a married couple can pass up to $10 million at their deaths free of federal estate tax.
  • The federal gift and estate tax exemptions have been reunified as of January 1, 2011. This means that the $5 million exemption is an aggregate limit that applies to transfers both during lifetime and at death.
  • The $5 million exemption will be indexed for inflation beginning on January 1, 2012.
  • The value of any assets of a decedent in excess of $5 million which are subject to estate tax will be taxed at a flat 35 percent rate for deaths occurring in 2011 or 2012 (see special discussion regarding deaths occurring in 2010 below). This rate is down from the flat 45 percent estate tax rate applicable for deaths occurring in 2009 and is far below the anticipated 55 percent (and even 60 percent in some circumstances) maximum estate tax rate that would have applied had the Act not been passed.
  • Portability

The Act introduces the new concept of “portability” into the federal estate tax system for married couples. Beginning on January 1, 2011, portability allows a surviving spouse to use any unused portion of the predeceased spouse’s federal estate tax exemption at the time of the second death.

The personal representative of the predeceased spouse must file a timely federal estate tax return to make an election to preserve the unused portion of the predeceased spouse’s federal estate tax exemption. Thus, a federal estate tax return will need to be filed for even small estates that fall below the $5 million estate tax exemption if the surviving spouse wants to preserve any portion of the predeceased spouse’s unused estate tax exemption.

Portability is only beneficial if both spouses die in either 2011 or 2012, as the Act will expire on December 31, 2012, without further Congressional action.

  • Planning Strategy: While portability certainly increases the chance that the federal estate tax exemption of both spouses will be utilized, the use of credit shelter trusts designed to shelter some or all of the assets of the first spouse to die from estate tax at the time of the second death is still an important strategy. Credit shelter trusts still work if the new portability rules do not survive beyond December 31, 2012. Moreover, credit shelter trusts shelter any appreciation on the credit shelter trust assets between the death of the first and second spouse and may provide some asset protection for the surviving spouse.

Special Rules for Deaths Occurring in 2010

  • The Act retroactively applies the federal estate tax system to deaths occurring in 2010 as the default rule. The federal estate tax exemption for deaths occurring in 2010 is $5 million. The value of any assets of a decedent in excess of $5 million which are subject to estate tax will be taxed at a flat 35 percent rate for deaths occurring in 2010. The Act extends the deadline for filing a federal estate tax return for any decedent dying in 2010 to September 17, 2011.
  • Income Tax Basis Adjustment Rules

For many years other than 2010, the general rule has been that all assets included in a decedent’s estate receive an adjustment in their income tax basis equal to the fair market value of such assets as of the decedent’s date of death. For example, if one purchased a share of stock for $5/share, but it was valued at $10/share at the purchaser’s date of the death, the new income tax basis of the share would be $10/share in the hands of the decedent’s beneficiaries. In prior years, there has been no limit to the amount of assets that could be “stepped-up” at one’s death, which had the tremendous benefit of eliminating or minimizing capital gains tax on the assets when later sold.

Under the Act, the unlimited “stepped-up” basis rule returns retroactively to January 1, 2010.

The personal representative of the estate of a decedent dying in 2010 has the option to opt-out of the federal estate tax completely by making a special election. This would likely be beneficial for an estate in excess of $5 million. The consequence of this election, however, is that a modified carry-over basis rule then applies to the assets included in the decedent’s estate.

  • In general, the income tax basis of the decedent’s assets would simply carry over to the decedent’s beneficiaries with a few exceptions:

Up to $1.3 million of the decedent’s assets may be “stepped-up.” Note that any assets held in a retirement account are not eligible to be “stepped-up.”

An additional $3 million of the decedent’s assets may be “stepped-up” if passing to a surviving spouse or qualified marital trust.

The amount that may be “stepped-up” may be increased if the decedent has certain unused carry-over losses on his or her final federal income tax return.

  • The personal representative of a decedent dying in 2010 must file a special tax return (Form 8939) indicating which of the assets of the decedent will be “stepped-up” within the limits described above. This return must be filed with the decedent’s final income tax return for 2010. While the IRS released a draft Form 8939 last month, instructions are yet to be provided.
  • Planning Strategy: While the Act provides a personal representative with the flexibility to opt-out of the federal estate tax system for deaths occurring in 2010, it will be important for personal representatives to seek guidance in determining whether to opt-out for larger estates, as the analysis is not as simple as it seems. In such cases, personal representatives must also allocate the estate’s available basis increase among the decedent’s assets, which can be controversial if beneficiaries are not all receiving the same assets.

Gift Tax Provisions

  • The $1 million lifetime gift tax exemption remained intact for 2010. The flat 35 percent gift tax rate also remained intact for 2010 gifts in excess of the $1 million lifetime gift tax exemption.
  • Due to reunification with the federal estate tax exemption, the federal lifetime gift tax exemption will be $5 million for 2011 and 2012. The gift tax rate for lifetime gifts in excess of the $5 million gift tax exemption will be a flat 35 percent in 2011 and 2012.
  • The “portability” rules discussed above also apply to the federal lifetime gift tax exemption for married couples.
  • In addition to the lifetime gift tax exemption, gift tax-free annual exclusion gifts ($13,000 per person for 2011), qualified educational expense gifts and qualified medical expense gifts all remain intact.
  • Planning Strategy: With the large jump in the lifetime gift tax exemption to $5 million, 2011 and 2012 present wonderful opportunities for wealthy individuals to make gifts on a gift-tax free basis, especially those wealthy individuals who previously used their $1 million lifetime gift tax exemption. Based upon the controversy that surrounded the passage of the Act, there is no guarantee that the lifetime gift tax exemption will remain at such a high level after December 31, 2012.
  • Additional Planning Strategy: While threats have been made to do away with valuation discounts and short-term grantor retained annuity trusts (“GRATs”), these more advanced wealth transfer strategies remain intact for now under the Act. The transfer of assets, such as interests in closely-held businesses, which can be transferred at a discount, as well as the use of GRATs, sales to intentionally defective grantor trusts and other techniques, allow wealthy individuals to further leverage the use of their $5 million lifetime gift tax exemption. Moreover, those willing to actually pay federal gift tax will be paying at the relatively low rate of 35 percent compared to rates in prior years.

Generation-Skipping Transfer Tax (“GST”) Provisions

  • A generation-skipping transfer is one made to a person that is more than one generation below the generation of the transferor (i.e, a gift to a grandchild). The GST tax is a penalty tax applied to transfers in excess of the GST exemption in addition to any estate or gift tax that may be imposed.
  • The Act retroactively reinstated the GST tax system as of January 1, 2010, but increased the GST exemption to $5 million. While the GST tax rate was zero percent in 2010 (essentially eliminating the GST tax in 2010 for direct skip transfers), the GST tax rate for generation-skipping transfers made during lifetime and/or at death in excess of the $5 million GST exemption will be a flat 35 percent in 2011 and 2012.
  • The “portability” rules discussed above do not apply to the GST exemption.
  • Planning Strategy: The increase in the GST exemption provides an opportunity to pass additional assets down to future generations without the middle generation (i.e., the children) incurring estate tax. Keep in mind that children need not be completely skipped in order to have an effective GST transfer for GST tax purposes.

New Sunset Provisions

  • The prior law that temporarily repealed the federal estate, gift and GST tax systems was scheduled to “sunset” or expire on December 31, 2010. The original “sunset” would have reinstated the $1 million federal estate tax exemption and 55 percent maximum estate tax rate.
  • The Act now extends the new “sunset” until December 31, 2012.
  • Stay tuned, as all of the new provisions described in this Client Alert will expire on December 31, 2012, without further Congressional action. Reinstatement of the $1 million federal estate tax exemption and 55 percent maximum estate tax rate still looms, as the Act only provides temporary relief. Further extension of the relief provided under the Act will likely be a hot topic as the 2012 presidential election approaches.
  • Planning Strategy: To ensure the opportunities provided under the Act are available, it is prudent to act now because of the Act’s looming December 31, 2012, expiration date.

Wisconsin Estate Tax Implications

  • As with many states, Wisconsin’s prior estate tax system was based upon the federal estate tax state death tax credit. This revenue-sharing credit was phased out under a prior federal law in 2005. While Wisconsin passed a temporary estate tax system several years ago, that system expired on December 31, 2007.
  • Since the expiration of the Wisconsin estate tax system in 2007, the Wisconsin state legislature has taken no action to reinstate it. Had the prior federal estate tax law expired on December 31, 2010, as originally scheduled, the Wisconsin estate tax system would have automatically sprung back into effect on January 1, 2011, with a $1 million Wisconsin estate tax exemption.
  • Rather, the Act now extends the “sunset” of the federal estate tax system to December 31, 2012, which, in turn, extends the automatic reinstatement of the Wisconsin estate tax system to January 1, 2013, without further Congressional and/or Wisconsin state legislative action. Again, stay tuned.
  • Planning Strategy: While there currently is no Wisconsin estate tax in effect, it is important that estate planning documents are flexible enough to anticipate that the Wisconsin estate tax may automatically revive on January 1, 2013, with only a $1 million Wisconsin estate tax exemption.

Conclusion

A good estate plan remains flexible due to the constantly changing estate, gift and GST tax landscape. Estate plans should be reviewed, especially those containing formulas tied to the federal estate tax law or those drafted five (5) or more years ago. Despite the significantly increased exemptions, thoughtful planning to take advantage of the new portability rules or more traditional estate and gift tax exemption shelters is still very important.

Moreover, estate planning goes beyond tax planning to include probate avoidance, marital property classification, disability and asset management planning, advance health care directives, as well as asset protection planning for beneficiaries and business succession planning.

Please contact a member of our Trusts, Estates & Succession Planning Practice Group if you would like to have your estate plan reviewed and/or if you have any questions regarding the topics covered in this Client Alert.

 

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