The Estate Tax is Back Under the 2010 Tax Relief Act

by Michael P. Cannady

The long-awaited changes to the federal estate tax have finally happened. Under the recently enacted “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010,” the federal estate tax, which disappeared for 2010, springs back to life.

Background. In 2001, Congress passed a law which gradually lowered the maximum estate tax rate and substantially raised the estate tax exemption amount over the years 2002 through 2009. The maximum tax rate fell to 45% and the estate tax exemption rose to $3.5 million. Then in 2010, the estate tax was completely repealed, but only for decedents dying in 2010. On January 1, 2011, the estate tax was scheduled to come back with a maximum tax rate of 55% and an estate tax exemption of $1 million.

New law. Under the new law, each person is entitled to a credit against the federal estate tax (commonly referred to as the estate tax exemption) which allows each person to pass $5 million free of estate tax. This means that a husband and wife together can pass $10 million on to their children (or anyone else) without paying any estate tax. If your combined estate is in excess of $10 million, you can delay the payment of any tax until the death of the survivor with the use of the unlimited marital deduction. The new law also reinstates the step-up in basis rules that we had prior to 2010. This means that the cost basis of an asset, which is used to determine capital gain at the time an asset is sold, will now be stepped-up to the date of death value (i.e. it is as if the heirs purchased the assets of the estate on the date of the decedent’s death for a purchase price equal to their fair market value on that date). This is very important for estates which hold assets which have increased in value a great deal since they were purchased.

Gifts and Gift Taxes. Gifts that you make during your lifetime can have an effect on the amount you can pass tax-free at the time of your death. As you make significant gifts during your lifetime, you will be using up part of your estate tax exemption amount, but only if you make gifts of more than $13,000 per person per year. Under the previous law, you could only use up $1 million of your estate tax exemption before you were required to start paying gift taxes. Under the new law, the estate tax exemption and the gift tax exemption are unified. Therefore, during your lifetime you can now give away $5 million (in addition to the $13,000 per person per year annual exclusion gifts) without paying any gift tax. If you do this, however, keep in mind that you will have no estate tax exemption left at the time of your death, and any assets left in your estate will be subject to federal estate tax.

Generation-Skipping Transfer Tax (GST Tax). There is also a special tax on transfers you make (whether during your life, or upon your death) to generations below the generation of your children (e.g. grandchildren and great-grandchildren). The exemption from the GST Tax under the new law also increases to $5 million and the GST tax rate drops to 35%.

Portability. Under the prior law, if the first spouse to die left everything to the surviving spouse, due to the unlimited marital deduction there would be no estate tax owed at the first death. However, the entire value of the combined estates would have ended up being taxed in the estate of the survivor, and only the estate tax exemption of the survivor would have been available to reduce the amount of the tax. The estate tax exemption of the first spouse to die, therefore, would have been wasted. Under the new law, the estate tax exemption will be “portable.” When the first spouse dies, if he or she does not use his or her entire estate tax exemption, it can be transferred to the surviving spouse. In order to allow the surviving spouse to use the unused estate tax exemption, the personal representative of the first spouse to die must make an election on the estate tax return of the decedent. This means that if there is any chance the additional estate tax exemption will be needed by the surviving spouse, you will need to file an estate tax return for the first spouse to die, even though such a return might not otherwise be required.

Decedents Dying in 2010. The new law also gives heirs of decedents dying in 2010 a choice of which estate tax rules to apply - 2010's or 2011's. This is important because although there is no estate tax in 2010, there is also no step-up in basis under the 2010 rules. Therefore, if the estate of a person dying in 2010 includes a lot of low-basis assets, the executor of the estate may want to be taxed under the 2011 rules because the step-up in basis may save more in capital gains taxes than would be saved in estate taxes under the 2010 rules. Actually, the 2011 rules will automatically apply, unless an election is made to be taxed under the 2010 rules.

New Law is Temporary. The most disappointing aspect of the new law is that it is, once again, only temporary. It is applicable for 2011 and 2012, and after that, if no action is taken by Congress and the President, the previous law automatically comes back into effect, bringing with it a $1 million estate tax exemption and a maximum tax rate of 55%. With the way things seem to be going in Washington right now, it certainly seems possible that this could happen.

Conclusion. The estate tax relief in the new law is substantial, and provides some significant opportunities for reducing estate taxes. Even if taxes are not a concern because an estate is below the exemption level, it is still important to have a proper estate plan to ensure that the needs of intended beneficiaries are met. With all of the changes that have taken place, now is the time to review your estate plan to make sure you have taken advantage of every opportunity available to provide maximum benefits to your heirs at the time of your death.

(Article appeared in Adams Jones March 2011 Newsletter)