It’s time to pull out your estate plan, make an appointment with your planner, and begin a thorough review. Congress finally pass-ed a new estate tax last December, and each of us should revise our wills and other documents to reflect the changes. The changes are only for 2011 and 2012, but you need to update your documents, because the law is very different from what it’s been the last few years. Besides, the odds are Congress will extend this law in 2012 or before.
As you know, the estate tax expired at the end of 2009, and the 2001 estate and gift tax was scheduled to be reinstated on Jan. 1, 2011. Instead, Congress extended the 2009 estate and gift tax law for 2011 and 2012 with some modifications.
The lifetime estate tax credit is raised so it is worth up to $5 million per person. That amount will be indexed for inflation after 2011. The maximum estate tax rate is 35%. The generation skipping transfer tax also is extended for 2011 and 2012 with the same exemption and tax rate as the estate tax. The GSTT is the tax for gifts made directly to grandchildren and subsequent generations.
There are two wrinkles in the new estate tax.
l Congress didn’t try to retroactively reinstate the estate tax for 2010. Instead, it gave estates of those who died in 2010 an option. Executors of those estates can choose to be taxed under either the 2010 rules or the 2011 rules. Even if the estate tax return already is filed, an executor who wants to choose the 2011 rules can file an amended return taking the election, after the IRS issues rules explaining how to do that, within nine months after the new law was enacted.
Here’s why an estate could favor prefer the 2011 estate tax to the tax-free 2010 rules.
The estate of someone who died in 2010 would avoid all estate taxes, but heirs are subject to the “carryover basis” on all the assets they inherit above the exempt amounts. They take the same tax basis the decedent had. When they sell an asset, they’ll pay capital gains taxes on all the appreciation that occurred while the decedent owned the property. If the property appreciated a lot, the capital gains tax could be substantial. There are some exemptions, so heirs of small and some medium-size estates don’t worry about the carryover basis.
Under the 2011 (and 2012) rules, however, heirs take a stepped up basis. Their tax basis in property they inherit is its fair market value on the date the decedent died (or six months later if that option is elected). They can sell it immediately and not owe any capital gains taxes. Or they can hold the property and, when they sell, owe capital gains taxes only on appreciation that occurred during their ownership.
When the estate was worth $5 million or less, it probably makes sense to choose the 2011 regime. There won’t be any estate tax, and the heirs receive the stepped up basis on all the assets they inherit. Larger estates need to calculate the estate taxes they would owe under the 2011 rules and compare them to the capital gains taxes heirs would be liable for under the 2010 rules. Then, in most cases they should opt for the lower of the two taxes.
l The other wrinkle is that in married couples the surviving spouse now can inherit the other’s unused lifetime estate and gift tax credit. Estate planners have started calling this portability or portable credits.
Previously, the lifetime estate tax exemption was available only to the individual. It had a use-it-or-lose-it feature. Any exemption amount not used by your estate and your lifetime gifts was lost. To maximize tax savings and avoid losing a credit, it was important for married couples with substantial assets to split title to their assets and limit use of the marital deduction.
Under the new law, in 2011 and 2012 a surviving spouse may take the unused exemption amount of the first spouse that passed away and add it to his or her own. When the surviving spouse had more than one deceased spouse over his or her lifetime, only the exemption of the last deceased spouse can be used. This rule means a couple jointly has a $10 million estate and gift tax exclusion, regardless of how ownership of the assets is split. Here’s how portability works.
Example. Rosie Profits dies, leaving her husband, Max. Rosie had a previous husband who passed away and his estate used only $3 million of his exemption. So, Rosie’s estate can exempt $7 million (her $5 million exclusion amount plus the unused $2 million exclusion amount from her first husband). Rosie didn’t make any taxable gifts during her lifetime and has a taxable estate of $3 million. Rosie’s estate elects to let Max use Rosie’s unused exclusion amount, which is $4 million (Rosie’s $7 million exemption less her $3 million taxable estate). So, Max’s exclusion is increased by $4 million and is $9 million if none of his exclusion was used by taxable gifts.
For the exclusion to be portable, the estate of the first spouse to die must file an estate tax return and must elect to transfer the unused election to the surviving spouse. A price for this is the estate of the first spouse to pass away is subject to audit until the audit period for the second spouse to pass away has closed. Also, the carried over exempt amount from the first spouse to pass away is not indexed for inflation. It’s a fixed dollar amount, regardless of how long the surviving spouse lives.
It’s a good idea for most estates to take the election, even when the surviving spouse’s exemption seems more than sufficient, because the surviving spouse could receive a windfall at some point.
The estate and gift tax are unified again. That means any amount of the lifetime gift tax exclusion you use reduces the amount of the estate tax exclusion available to your estate. You have a $5 million lifetime gift tax exemption to match the estate tax exemption, which is used any time gifts to a person exceed the annual exclusion amount currently at $13,000. Gifts above the lifetime exclusion are taxed at a maximum rate of 35%, the same as the estate tax rate. Of course, if you use the lifetime gift tax exemption, you’ve also used your estate tax exemption.
Currently, these provisions are scheduled to expire after 2012 and the 2001 law would be restored. My guess is the provisions will be extended again or made permanent. You shouldn’t let the two-year time frame on this law keep you from updating your estate plan. Every two years is a good pattern for revising estate plans anyway, so the expiration of the law works out well.
Here are some specific actions to consider for your plan.
l Wills with bypass trusts need to be reconsidered. Fewer families will need them now, because of the higher estate tax exemption. There still are cases when a bypass trust should be considered as part of an estate plan, and we’ll discuss them in next month’s visit. But in many cases, the bypass trust could produce results you don’t want under the new law.
l Formulas in wills need to be rewritten when they determine the amount of an estate transferred to a bypass trust or when for any reason they refer to the estate tax exemption amount. We’ve been encouraging this step for several years, but many people still haven’t done it. Under traditional formulas, the $5 million exemption will use all or the bulk of most estates. Many surviving spouses will be impoverished under current wills. If your estate plan has a bypass trust or formula clause, you need to visit an estate planner soon.
l Don’t forget state levies. The District of Columbia and at least 14 states have some form of estate or inheritance tax or both. Often these have much lower exemptions than federal law and will be a more significant burden on your heirs. You might want to revise your will primarily to avoid these taxes.
l Make tax-free gifts. The wealthy or near-wealthy who have enough assets to pay for retirement should consider removing appreciating assets from their estates. You want to remove future appreciation from your estate, especially when the assets are appreciating faster than the Consumer Price Index. Otherwise you take the risk your future estate will be taxable. You transfer more wealth tax free to heirs when you give property before it appreciates, especially when you can make those transfers free of gift taxes.
Even those with modest estates might want to make gifts when they live in states with high estate or inheritance taxes and they have enough to maintain their standard of living.
l Income shifting is back. With the higher gift-tax exemption, you can transfer a lot of income-generating assets or property with large capital gains to family members free of gift taxes. When they family members are in a lower tax bracket than you, this keeps more after-tax wealth in the family.
l Focus on non-tax issues. For most of us, Estate Planning is about a lot more than tax planning. For many, taxes aren’t even a significant consideration. Your plan needs powers of attorney for financial and medical decisions when you’re unable to act, and perhaps a living will. Determine if you have too much or too little life insurance. Consider how your will should be worded to minimize family conflicts and prevent assets from being wasted. We’ve covered these and other non-tax issues in detail in past visits, and those discussions are in the Archive on the members’ web site.
The new estate and gift tax is good until the end of 2012. You should have your estate plan revised now. The tax part will be good for two years, which is about the right schedule for a plan to be reviewed.
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