CLIENT UPDATE

Putney, Twombly, Hall & Hirson LLP
521 Fifth Avenue
New York, NY 10175
Tel: (212) 682-0020

 

March 23, 2011

Changes in U.S. Estate Tax Law

On December 17, 2010, the Federal Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act (the “2010 Tax Act”) became law. It makes major changes in current law relating to Federal transfer taxes. It also presents significant planning opportunities affecting clients’ current and prospective Wills and other transfer documents. This letter is an overview of these changes and a summary of planning suggestions and opportunities.

Old Law

As an aid to understanding the recent radical changes made in the Federal transfer tax system, the following brief review of the “old” law should be helpful.

Prior to 2001: Estate, gift and generation-skipping (GST) transfer taxes were limited to a $1,000,000 exemption and transfer tax rates reached 55%.

In 2001: Congress enacted a system of rates and exemptions for estate, gift and GST taxes to apply through December 31, 2010. Through that date, the exemptions would eventually rise to become $3,500,000 for each decedent’s estate and $3,500,000 for GST transfers. The maximum estate tax and GST tax rate was 45% through December 31, 2009. The gift tax exemption was fixed and remained at $1,000,000. In 2010 the estate tax and GST tax were to be repealed.

In 2010: The maximum gift tax rate was 45%.  Since the estate and GST tax had been repealed for that year, there was a zero rate for these taxes.

December 31, 2010: This state of the law was scheduled to end on December 31, 2010.  Effective January 1, 2011, the old 2001 law was due to come back into force. All exemptions would be limited to $1,000,000 subject to maximum rates that would reach 55%.

Changes in U.S. Estate Tax, Gift Tax and Generation-Skipping Transfer Tax Law

On December 17, 2010, the 2010 Tax Act became law. The Act transformed the Federal transfer tax system for 2011 and 2012 only, because the law will expire on December 31, 2012. The new law also applied to estates of persons who had died in 2010, during which the Federal estate tax had been repealed, by giving an election to legal representatives of estates of such persons to choose to report under the “old” law or under the provisions of the 2010 Tax Act.1

The new law left untouched the prior gift tax exclusion of $13,000 per donee per year (or $26,000 in the case of married couples) for gifts to as many donees per year as a donor chose.  It also left unchanged the use of tax reduction methods involving discounts for asset transfers to entities, such as LLCs, Limited Partnerships and by means of sales to Grantor Trusts. It preserved planning with dynasty trusts.

New Rates and Exemptions

Under the Act Federal estate, gift and GST rates are now capped at 35%, down from a maximum of 45% under 2001-2009 law, and 55% under the law prior to 2001. Each individual’s cumulative exemption from Federal estate taxes (the “applicable exclusion” amount) was increased to $5,000,000 from $3,500,000. The GST exemption was increased to $5,000,000 from $3,500,000. The gift tax exemption was increased to $5,000,000 from $1,000,000.

Estate and gift taxes are again unified, which means that to the extent the exemption is used during life, a corresponding reduction occurs at death. Spouses can elect to “split” gifts; thus married couples can combine their exemptions to pass up to $10,000,000 free of gift tax.

A novel feature of the new law is “portability.” If a decedent dies in 2011 or 2012, he or she can transfer his or her entire estate to the surviving spouse without “wasting” the estate tax exemption. Under old law, an estate passing to a surviving spouse outright or in qualifying trusts incurred no estate tax due to the marital deduction. But the first spouse’s estate would not have triggered any estate tax against which the exemption could have been applied, thus losing or “wasting” it. The unused exemption could not be used by the survivor. The new law changes that.

The survivor can now use the decedent’s unused remaining exemption against his or her own gifts or estate in 2011 and 2012.  This applies if both spouses die before 2013, but there is speculation that portability will be a component of the future legislation that will necessarily be enacted because the 2010 Act covers only 2011-2012.

Portability applies to the estate and gift tax exemption only, not to GST Tax. Any unused GST exemption will not be available to a surviving spouse, i.e., it is not “portable,” which behooves a spouse to “use it or lose it.”

The new law provides for inflation adjustments in 2012. We stress that the Act applies only for 2011 and 2012. Congress will have to revisit the legislation. Since the law merely extended the “sunset” provisions that were to have taken effect on December 31, 2010, under which the 2001 Tax law would have been resurrected (with a maximum transfer tax rate of 55% and a $1,000,000 exemption), if the 2010 Tax Act is not changed by the end of 2012, the 2001 law will come back.

Planning Techniques

The increased exemptions expand opportunities that existed under prior law. New concepts provide new opportunities, but again these have to be addressed within 2011 and 2012.

Gifts: The new law provides a significant opportunity for a client to make gifts with the increase in the gift tax exemption to $5,000,000. Gift property and its subsequent growth and income can be moved to later generations tax free. Since there is no New York State gift tax, gifts present an added benefit for New York residents.

Gift-giving techniques: The Tax Act did not reduce the annual gift tax exclusion ($13,000 or in case of spouses $26,000) available for outright gifts to as many persons as a donor chooses. (These gifts do not impair or reduce the exemption). Gifts by means of direct payment to the provider of educational or medical services and to “529 Plans” are unaffected.

Discounting: Gifts of property to trusts or partnerships to achieve discounts from market value are still possible. There had been concern that the benefits of transfers to “GRATS” and certain other Grantor Trusts would be diminished.

Generation-Skipping Transfers (“GST”): The GST exemption has also been increased to $5,000,000. Coupled with the gift tax exemption, there is enhanced opportunity to benefit “skip persons” (grandchildren and younger beneficiaries) without imposition of the separate, onerous GST Tax. Dynasty trusts will allow the passing of future growth and income as never before.

Problems:  Review needed

Existing Wills and Trust Instruments that contain “formula clauses” by which amounts passing into a “credit shelter” or “bypass trust” are to be calculated by reference to the maximum Federal exemption (now $5,000,000), should be reviewed. The trust may be overfunded beyond expectation at the expense of the residuary estate. In addition, the amount transferred into the credit shelter trust to avoid Federal transfer tax will trigger New York estate tax on the difference between the New York exemption ($1,000,000) and the Federal exemption ($5,000,000). This additional tax could be as much as $391,600.

In some instances, it may be wise to limit the credit shelter trust to the New York exemption amount, allowing the balance to pass outright to a surviving spouse, who can shelter it at his/her death by means of the unused remainder of the deceased spouse’s $5,000,000 exemption and his/her own exemption. This is the value of “portability.”

A credit shelter trust still has its place. While property valued in excess of $1,000,000 placed into such a trust will be taxed for State death tax purposes, at the death of the first spouse, that tax will be lower than would be imposed on the property if held at the survivor’s death outside the trust. If held in trust, the growth in value of the trust property would not be taxed at the survivor’s death. Further, the usual benefits of a trust to provide investment management, beneficiary protection against creditors and insulation from inheritance by others, divorcing spouses and claims by right of election, are among these.

Consideration should also be given to GST transfers and possible use of long term dynasty trusts to avoid future transfer taxes at the death of descendants.

Conclusion

The new legislation provides an occasion to review Wills, Trust Agreements and other documents, such as powers of attorney and health care directives.

New York substantially modified its power of attorney statute in September 2009 and further amended the statute in September 2010, affecting powers of attorney executed after September 1, 2009. (Powers of attorney executed before then remain valid.)

The current short form statutory power of attorney provides information for the agent regarding legal obligations and responsibilities that continue until the agent resigns or the power of attorney is terminated or revoked. It requires the agent to signify his/her understanding and acknowledgment of these duties. Significantly, the statutory short form power of attorney no longer permits the agent to make gifts to anyone, including himself or herself, unless a supplemental document, called a statutory gift rider, is also executed by the principal. This change better protects the principal by requiring the document to delegate specific gift making authority to any agent.

Clients should also be sure that health care directives allow one’s health care agent to obtain confidential medical information, access to which is restricted by the Health Insurance Portability and Accountability Act (HIPAA) of 1996.

We invite you to consult us regarding your estate planning needs and this new legislation.

PUTNEY, TWOMBLY, HALL & HIRSON, LLP
I

RS CIRCULAR 230 DISCLOSURE: To comply with IRS Regulations, we inform you that any discussion of U.S. federal tax issues in this correspondence (including any enclosures) is not intended or written to be used, and cannot be used, (i) to avoid any penalties imposed under the Internal Revenue Code, or (ii) to promote, market, or recommend to another party any transaction or matter addressed herein.


1The option to pay no estate tax in 2010 estates or to use the new law permits 2010 estates to compare the new estate taxes to possible capital gains taxes that might be payable since a 2010 estate that filed no estate tax return got only a limited step-up in capital gains tax cost bases. This is not relevant to our discussion.