New Federal Estate Tax Laws

by Jackie Bedard on March 14, 2011

in Estate Planning,Estate Tax

The following is an update we recently shared with our clients regarding the new federal estate tax rules.

On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.  Some commentators have coined the acronym the TRAJC Act (pronounced “Tragic”)!

We have been waiting for the past 10 years for Congress and the President to pass some permanent legislation but instead we received more uncertainty, more confusion, and a new set of tax laws that will last for only two years – just in time for the issue to resurface again during the next Presidential election.   Despite the many questions that remain unanswered, here is what we do know:

1.     Two Year Law: The new law is only in effect for years 2011 and 2012.  After this time, the law expires and unless Congress and the President pass new legislation, the current law will expire on December 31, 2012.  This will result in the resurrection of the 1997 Tax Payer’s Relief Act with a reduced  $1,000,000 Federal Estate Tax Exemption (i.e. “Coupon”) and tax rates ranging from 37% to 55%.

2.     Increased Exemption: The TRAJC Act provides for an immediate increase in the Federal Estate Tax Exemption (“Coupon”) to $5,000,000 per person for individuals that die in 2011 and 2012.  The Coupon Amount is also indexed for inflation beginning in 2012.

3.     Change in Tax Rates: Federal Estate Tax rates were reduced to a flat rate of 35% on all transfers in excess of the Coupon amount.  When the TRAJC Act expires at the end of next year, the tax rates will return to the 37% to 55% range.

4.     Increased Lifetime Gift Tax Exemption: Gifts to non-spouses have traditionally been subject to Federal Gift Tax.  There are two primary ways to offset Gift Tax liabilities.  First, gifts to any individual that are less than $13,000 per beneficiary will be offset by the donor’s “Annual Gift Tax Exemption”.  This amount continues to be indexed for inflation and is not impacted by the new law.  Second, any gifts in excess of the Annual Gift Tax Exemption are then offset by the donor’s “Lifetime Gift Tax Exemption” which previously was at $1,000,000.  The new TRAJC Act increases the amount of the Lifetime Gift Tax Exemption to $5,000,000.  Note that any amount of the Lifetime Gift Tax Exemption that a donor utilizes is subsequently offset from their Estate Tax Coupon amount and thus reduces the amount the donor can pass on their death free of Federal Estate Tax.  The increase of the lifetime gift tax exemption has created significant planning opportunities for those that wish to engage in tax planning now to lock-in the current exemption.

5.     Time Machine Provisions: The TRAJC Act is retroactive in that it applies to not only those people that die in 2011 or 2012, but also to those individuals who died in 2010.  As you may recall, the Federal Estate Taxes were repealed in 2010.  The new law does provide some options for estates of those individuals that died in 2010.

The default provision of the new law provides for retroactive application to 2010 but it also gives the estate the option to opt out of the new law and have the former laws apply, which provided for a full repeal of the Federal Estate Tax.  So why would anyone that died in 2010 ever opt to have the new law apply?  Turn the page to find out!

6.     Restoration of the Step-up in Basis on Death: This issue deals with “capital gains taxes” which are a form of an income tax.  For some types of “special assets” (i.e. works of art, stock, real estate, business interests, etc.) tax payers do not receive a 1099 at the end of the calendar year showing how much their special asset appreciated.  Unlike a bank account where the growth on the principal is taxed each year, these special assets are subject to a capital gains tax when the asset is sold.  At the risk of oversimplifying, the difference between the sales price and the purchase price is generally the “gain amount” of the special asset.  The taxpayer is then responsible for paying a capital gains tax of 15% on the gain amount.  The long term capital gains tax rate was temporarily reduced from 20% to 15% in prior legislation.  The TRAJC Act extends the reduced capital gains tax rate of 15% through 2012.

Traditionally, when a person died owning a special asset the “original basis” (generally the purchase price) was adjusted to the value of the asset as of the date of death.  This is referred to as a “Step-up in Basis on Death” and resulted in significant capital gains tax savings when the heir later sold the special asset.  When the Bush Tax Act repealed the Federal Estate Tax for 2010, it also repealed the Step-up in Basis on Death and replaced it with a “Capital Gains Tax Exemption” of $1,300,000.  The new law restores the Step-up in Basis on Death provisions.

Thus, for people who died in 2010 with estates around $5,000,000 in value, the estate representative should carefully consider whether less tax would be paid using the 2010 laws that provided for a repeal of the Federal Estate Tax and the Step-up in Basis on Death provisions or the new TRAJC Law, which provides for an Estate Tax Coupon of $5,000,000 with a fully restored Step-up in Basis on Death.  It will all come down to number crunching!

7.     Portability: The prior law provided for a “use it or lose it” approach regarding the Federal Estate Tax Coupon amount.  This issue was limited to married couples.  If the first spouse to die left all of their assets to the surviving spouse there was no Federal Estate Tax on the transfer because of the Unlimited Marital Deduction.  Thus on the death of the second spouse, he or she only had their Coupon amount to offset the transfer to the heirs.  We traditionally recommended (and still do!) the first spouse leaves their assets to a Family Trust thus resulting in the first spouse fully utilizing their Coupon amount.  This strategy enabled both spouses to fully utilize both Coupon amounts to offset the greatest amount of Federal Estate Tax possible.

The new law allows the first spouse to pass their unused Coupon amount to the surviving spouse to use on their death.  We refer to this new option as “Portability”.  It works like a gift card to a department store.  Whatever the balance is on the first spouse’s gift card can be used by the surviving spouse.  Note that Portability is not automatic.  The first spouse’s estate must file a Federal Estate Tax Return (i.e. form 706) in order to make the Portability election even if their estate is less than the Coupon amount.

Additionally, the second spouse must cooperate and die before 2013 in order to have the benefit of the first spouse’s unused Coupon amount.  Like many department store gift cards, the TRAJC Law Portability provisions must be used before the TRAJC law expires on December 31, 2012.

8.     Tax Free Distributions from IRA’s to Charities: The TRAJC Act also provided that a tax payer can make a gift from an IRA to a qualified charitable organization without any income tax consequence.  This provision is in effect only for 2011 and requires; the tax payer must be at least age 70.5; the amount of the gift is $100,000 or less; and, the transfer must occur directly from the IRA to the charity.  Note the amount of any direct distributions to a charity would be included in calculating the tax payers Required Minimum Distribution amount from the retirement plan for that year.

So what does all this mean to you and me?  For starters, we know that we have some short term tax relief in a number of areas.  The reality is that we continue to face uncertainty as we move forward in planning our estates.  The new law certainly provides some great planning opportunities but we also have to plan for a “worst case scenario” – namely the current law is not extended and we revert back to the old 1997 Tax Payer’s Relief Act with much lower Coupon amounts.

Final Thoughts

As we observe the landscape of estate planning after these changes, one of the questions people ask is “should you still plan if you don’t have a taxable estate?” The answer to that question is a resounding YES!    We’ve seen over the last few years that our government is facing a very real revenue problem.  Even in a good economy, the debt and deficit will continue to grow without significant cuts and/or additional sources of revenue.  The growing entitlements and the aging population will likely force the government to collect more taxes from people who have money.  We continue to advice our clients and planning partners to plan their estates regarding taxes as if $1 million will be the estate tax exemption.  If you do, your assets will be protected.  If you plan for $5 million and die at the wrong time, you could lose anywhere from  37 to 60% of your estate.  It’s just not worth it.

In addition to tax consideration, planning always comes down to goals.  Tax reduction or elimination may be an important goal for some, but it is almost never the most important goal.  Almost universally, people want to take care of their families first, including their spouse and children.  Here are some of the goals regularly cited by our clients:

  • Reducing the amount of hassle
  • Avoiding probate
  • Protecting privacy
  • Reducing legal fees
  • Protecting the assets in the hands of my spouse and then my children from things such as divorce, remarriage, alimony, child support, creditors, predators, additive behavior or disability
  • Preventing beneficiaries from inheriting too much, too soon
  • Paying for post-secondary education for grandchildren or other individuals

If you’d like to learn more about how these laws impact your family, I encourage you to call our office at (919)443-3035 to schedule a complimentary Peace of Mind Planning Session.

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