After a year of speculation as to how Congress would address the looming expiration of the 2001 and 2003 tax cuts, the answer ultimately came during the final week of the 2010 legislative session. The Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act of 2010 (the “Act”), which passed both houses of Congress and was then signed by the President on December 17, 2010, contains changes impacting both the 2010 tax year and the next two years. Below is a summary of the key estate, gift and generation-skipping transfer tax provisions of the Act.

The fluctuation in the transfer tax system over the last few years had created a complicated environment for estate planners and taxpayers alike. While longer-term questions on the future of the estate tax remain, the changes included in the Act provide some relief from transfer taxes for 2011 and 2012, until the Act provisions “sunset” on January 1, 2013.

Estate Tax Relief for 2011 and 2012

Estate Tax Exemption increases to $5 million and Estate Tax Rate Decreases to 35%

One of the most noteworthy changes under the Act is that the federal estate tax exemption will increase to $5 million, the largest amount to date, before reverting to $1 million (the rate in 2002) in 2013. In addition, the top tax rate for estates over this amount will be reduced to 35%. Both of these changes apply to 2010 through 2012 only. This means that a married couple can now shelter up to $10 million of property from the estate tax and have any excess property taxed at 35%. Under the present rules, beginning in 2013 rates would revert to those applicable in 2002, and that same couple would be able to shelter only $2 million of property from the estate tax with total property in excess of $2 million taxed at a top estate tax rate of 55%.

Portability – Surviving Spouses Can Utilize Deceased Spouse’s Unused Exemption

In addition, the estate tax exemption amount has been made portable, meaning any exemption amount not used at the death of one spouse may be added to the exemption amount for the surviving spouse. With respect to a typical husband and wife, if the husband dies in 2011 and does not fully use his estate tax exemption, the unused exemption is then attributed to the wife, so that when she dies, her estate can use both her estate tax exemption and her late husband’s unused exemption. For instance, if a husband dies in 2011, is survived by his wife, and he only makes use of $1 million of his $5 million estate tax exemption, then upon the wife’s subsequent death, her estate would have an estate tax exemption comprised of her own $5 million exemption as well as the predeceased husband’s $4 million of unused exemption, for a total estate tax exemption of $9 million.

Portability must be affirmatively elected on the predeceased spouse’s estate tax return, signifying that the surviving spouse may use the predeceased spouse’s unused estate tax exemption. This means that the predeceased spouse’s estate will be required to file an estate tax return irrespective of the value of the estate. The election, once made, is irrevocable. Further, this benefit is limited to the unused estate tax exemption of the “last” deceased spouse of the surviving spouse.

We do not recommend relying on exemption portability in your estate plan, as there are a number of downsides to using portability as compared to a traditional credit shelter trust. Furthermore, portability is scheduled to expire after 2012.

Gifting- The Estate and Gift Tax will be Re-unified

Another favorable change is that the estate and gift tax systems will be re-unified under the new rules beginning in 2011. Since 2002, the lifetime exemption had been limited to $1 million, while the estate tax exemption gradually rose to as high as $3.5 million in 2009. Under the new rules of the Act, individuals will now be able to use the full $5 million exemption to make lifetime gifts without incurring gift tax, and married couples will be able to make combined lifetime gifts of up to $10 million. The new 35% tax rate will apply to gifts above the exemption amount.1 In addition, portability applies for gift tax purposes, so that if a spouse dies without using his or her exemption, the surviving spouse could make gifts of up to $10 million without gift tax.

An individual may continue to utilize the gift tax annual exclusion, which allows an individual to gift up to $13,000 per year to any other person ($26,000 in the case of a married couple) free from any gift tax. Additionally, individuals may continue to make unlimited transfers for medical expenses and tuition for education without any gift tax consequences if the transfers are made directly to the health care provider and educational institutions, respectively.

2010 Estates

Special Election Available for 2010 Estates

Under prior law, the Federal estate tax was repealed in 2010 which means that no estate tax would be due on the estate of a person dying in 2010, regardless of the size of his or her estate. This law has been modified by the implementation of the Act, resulting in further flexibility. Under the Act, there is a special election available for estates of individuals dying in 2010. Executors of the estate of someone dying in 2010 may either: (1) allow the estate tax to apply, using the new $5 million estate tax exemption, with the basis of assets included in the decedent’s estate adjusted to the assets’ value on the date of death,2 or (2) elect to opt out of the estate tax3 (meaning no estate tax would be due), with adjustment to the basis of the decedent’s property limited as described below.

Cost Basis Adjustment

When a person dies while the estate tax is in effect, the person’s estate receives an income tax benefit in the form of a “cost basis adjustment.” An individual who sells an asset at a gain will typically pay income tax on the gain. When an individual dies, however, any gain that may exist at the time of death is eliminated by a provision under the income tax laws that increases the cost of the assets to the person, called the person’s “cost basis” in the asset, to the value at the time of the person’s death. This is called a “step-up” in the cost basis, and it prevents the person’s assets from being taxed both for estate tax and income tax purposes.

Under prior law, because there was no estate tax for 2010, the “step-up” provisions also did not apply. Instead, prior law granted every decedent a total of $1.3 million in basis adjustments which the decedent’s executor could allocate to appreciated assets owned by the decedent at death. Such adjustments eliminated up to $1.3 million of gain in the decedent’s assets. For married individuals, property passing to the spouse (either outright or to a marital trust) was entitled to an additional $3 million of basis adjustment for appreciated assets, which could have effectively eliminated $4.3 million of gain in the decedent’s assets.

Executors or personal representatives faced with this election should consult with their tax advisor before making a decision, as this should be determined on a case-by-case basis.

Generation-Skipping Transfer Tax

GST Exemption Increased from $1 million to $5 million

In general, the generation-skipping transfer (“GST”) tax applies to a transfer (whether by gift or bequest) from an individual to his/her grandchildren or more remote descendants, thus “skipping” one or more generations. The IRS would prefer that there be an estate or gift tax imposed upon the passing of property between each generation; however, because a GST “skips” a generation, there is no transfer tax at the skipped level. Therefore, the GST tax was enacted as a tax at the skipped generation. Under the Act, for 2010 and beyond, the GST exemption amount is increased from $1 million to $5 million, and is indexed for inflation after 2011. This means that an individual is able to transfer an additional $4 million to his/her grandchildren or more remote descendants without paying any GST tax or to a trust that is permanently exempt from GST tax. Any GST above the exempted $5 million will be taxed at a rate of 35%. It is important to note that portability does not apply for GST tax purposes.

Unique Opportunity for GST in 2010

Under the Act, the GST tax rate through the end of 2010 is 0% and the gift tax rate is 35%. As a result, you will be able to make transfers to grandchildren and more remote descendants through the end of December 2010 at a cost of only 35% (sheltered to the extent of your and your spouse’s remaining $1 million gift tax exemptions), as opposed to the combined 110% rate that would have been payable on a similar transfer in 2009 or the combined 82% rate that will exist in 2011 and 2012 (sheltered to the extent of your and your spouse’s $5 million gift and GST tax exemptions). In addition, property currently in trust for the primary benefit of your children may be transferable at no tax cost to grandchildren and more remote descendants, or to a trust for their benefit.

To take advantage of this unique moment in the law, transfers must be made before the end of this year either directly to grandchildren (and/or more remote descendants) or to a trust for their sole benefit. (It is not necessary for you actually to have living grandchildren at this time to fund such a trust, although the trust may require different terms in that situation.) Due to the limited time available before the end of the year, we suggest anyone interested in making such transfers to a trust review our recently distributed Gifting Bulletin regarding generation-skipping transfers in 2010 and contact Hume R. Steyer or David E. Stutzman for additional information.

Planning Points and Considerations

Estate Tax Relief for 2011 and 2012

• State Estate Tax Planning. While increases have been made to the federal estate tax exemption and the top tax rate for estates over the exemption has decreased, it is important to remember that estate tax laws may not have changed in your respective state. Trusts will be important in any state that still has a state estate tax with an exemption different from the Federal exemption. Notably, New Jersey’s exemption remains at $675,000, New York’s remains at $1 million and Connecticut’s remains at $3.5 million.

Portability

• No Protection from Growth of Assets. The portable exemption from a predeceased spouse is not adjusted to reflect the appreciation or income generated by specific assets.
• Portability does not provide other trust benefits. Unlike a credit shelter trust, simply leaving one’s estate outright to the surviving spouse or to the surviving spouse’s revocable trust would not provide other non-tax benefits including protection from the claims of creditors and protection from the claims of a new spouse or new family created upon remarriage.

Gifting

• Increased gift tax exemption amount. As of January 1, 2011, individuals who have already fully utilized their $1 million Federal lifetime gift tax exemption will have another $4 million of gift tax exemption available to use. Such an individual may now wish to utilize this exemption and make additional gifts during his/her lifetime.

2010 Estates

• Value of the estate in 2010 is $5 million or less. In such a circumstance, an executor should not elect out of the application of the estate tax because the $5 million exemption will shelter the entire estate, resulting in no estate tax. Additionally, the inherited assets of such an estate will receive a full “step-up” in cost basis to the value of such assets at the decedent’s death.
• Value of the estate in 2010 is over $5 million. In such a circumstance, an executor should consider electing out of the application of the estate tax. An important element of this decision is whether the benefits of the additional basis “step-up” are outweighed by the estate tax that would otherwise be due, i.e., which is less – the ultimate capital gains tax on the non-“stepped-up” assets or the estate tax.

GST Planning in 2010

Please see the recently distributed Gifting Bulletin which discusses GST considerations in great detail. If you are interested in making gifts to grandchildren at some point in the future, please contact us immediately to determine whether it is more tax efficient to make those gifts this year or in the next two years.

Below is a summary of the federal estate tax provisions under the Act.

Effective Dates for Tax Provisions

Federal Tax Act Summary Chart

Many provisions of the Act are scheduled to expire or “sunset” once more in 2013, and Congress will again be tasked with the responsibility of re-evaluating and implementing changes to the transfer tax system. If Congress does not make any further changes in the law, on January 1, 2013, the estate tax exemption, gift tax exemption and the GST tax exemption will return to $1 million, and the top estate tax rate, gift tax rate and GST tax rate will return to 55%.

If you have any questions regarding this Bulletin or would like to express your interest in making year-end transfers to grandchildren or more remote descendants, please contact Hume Steyer (212-574-1555) or David Stutzman (212-574-1219) of our Trusts and Estates practice group.