January 1, 2012   Estate Administration

What's Happening in Estate Planning


On December 17, 2010 President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

This legislation had some surprises for those who had been following the process. In addition to extending unemployment benefits, current income tax rates (the Bush tax cuts) were extended for all taxpayers for two years, and the estate tax was also extended for two years -- with a $5 million exemption and 35% tax rate.

Here are the highlights of this law and how these changes can affect your estate planning through 2012.

Estate Tax Exemption and Tax Rate

Your estate will have to pay federal estate taxes if its net value when you die is more than the exempt amount in effect at that time. For 2011 and 2012, the individual exemption is $5 million (adjusted for inflation in 2012) and the tax rate is 35%. So, if you die in 2012 and your net estate is less than $5,120,000 (the adjusted amount), no estate taxes will be due. If your net estate is more than this, the excess will be taxed at 35%. If you are married and plan ahead, you can use both your exemptions. (More on this later.)

It's important to remember that these changes are only effective through December 31, 2012. If Congress does not act again before the end of 2012, on January 1, 2013, the estate tax exemption will drop back to $1 million (adjusted for inflation) with a top tax rate of 55%. Also, some states have their own death/inheritance tax, so your estate could be exempt from having to pay federal estate tax but still have to pay state tax.

Portability of Estate Tax Exemptions Between Spouses

Many married couples are familiar with the unlimited marital deduction. Under this provision, the first spouse who dies can leave everything to the surviving spouse and no estate taxes will be due upon the first death. Most married couples have liked this arrangement because it's easy and all of the assets are available to the surviving spouse. But a big problem occurs when the surviving spouse dies.

For example, let's say Bob and Sue have a combined net estate of $10 million, and they both die in 2011 or 2012 when the individual exemption is $5 million. When Bob dies, he can leave the entire estate to Sue and no estate taxes will be due at that time. When Sue dies later, her estate uses her $5 million exemption. The taxes on the other $5 million, at 35%, are $1,750,000. By using the marital deduction, they wasted Bob's exemption.

Congress tried to fix this. As part of the new law, if one spouse dies in 2011 or 2012, the executor of the estate may transfer any unused federal exemption to the surviving spouse by filing an estate tax return in a timely manner. But only the most recent deceased spouse's unused exemption may be used by the surviving spouse. This could impact the surviving spouse's decision to remarry.

For example, let's say that after Bob dies, Sue marries Tom. If Tom dies before Sue does, Bob's unused exemption would no longer be available to Sue. And Tom may have little or no unused exemption that Sue could use.

Using the marital deduction can cause other problems. For example, by leaving everything to Sue, Bob has no control over how his share of their estate is managed or distributed. Sue can do whatever she wants with the assets, including disinheriting any children Bob may have from a previous marriage. Also, any growth on the assets will be included in Sue's estate when she dies and will be taxed at the rate in effect at that time. (Remember, the estate tax exemption could be just $1 million with a 55% tax rate in 2013.)

If Bob and Sue plan ahead, they can make sure they use both of their exemptions. Their will or living trust could include a provision that splits their $10 million estate into two trusts of $5 million each. When Bob dies, his trust uses his $5 million exemption and when Sue dies, her trust uses her $5 million exemption. This reduces their taxable estate to $0, letting them leave the full amount to their beneficiaries, saving $1,750,000. (This tax-planning provision is often called an A-B trust or credit shelter trust.)

There are other benefits to this planning. For example, Bob can keep control over how his share of their estate is managed. He can choose his own beneficiaries, which may or may not be the same as Sue's. The assets in his trust are valued and taxed only when he dies, so any growth on these assets will not be included in Sue's estate when she dies. And even though the assets remain in Bob's trust, they still can be available to provide for anything Sue needs.

While this planning can be done in either a will or living trust, if you use a living trust and properly fund it (transfer your assets to it), you will avoid probate which, depending on where you live, could save your family thousands more.

Note: This portability provision in the law was limited to 2011 and 2012. We do not know if it will be extended beyond 2012.

Gifting in 2011 and 2012

For 2011 and 2012, the gift tax exemption is $5 million per person ($10 million for a married couple), with the amount adjusted for inflation in 2012. The tax rate is 35%. This exemption is unified with the estate tax exemption, so any unused amount can be transferred to the surviving spouse under the portability provision explained above.

You can still make annual tax-free gifts of $13,000 ($26,000 if married) to as many individuals as you wish each year. (This is amount is tied to inflation and is adjusted from time to time.) You can also make unlimited gifts for tuition and medical expenses if you give directly to the institution. Charitable gifts are also unlimited.

If you give more than this, the excess is considered a taxable gift. You can either pay the gift tax now (and remove more from your taxable estate) or apply it to your $5 million unified gift/estate tax exemption. (If you use your unified exemption while you are living, it's considered a gift tax; if you use it after you die, it's considered an estate tax.)

Generation Skipping Transfers in 2011 and 2012

A generation skipping transfer occurs when some or all of your estate goes directly to a grandchild, bypassing your child (their parent). This can happen intentionally: for example, if you skip the living parent (your child) and leave an inheritance directly to your grandchild, that is a generation skipping transfer. It can also happen unintentionally: for example, if an inheritance is in a trust for your child, he or she dies after you but before receiving the full amount and, under the terms of the trust, your grandchildren will receive their parent's remaining inheritance, that is a generation skipping transfer. It can also happen if you leave assets to a non-relative who is more than 37.5 years younger than you.

Skipping a generation can cause the inheritance to be subject to the "generation skipping transfer (GST) tax." It is equal to the highest federal estate tax rate in effect at the time of the transfer and is in addition to the federal estate tax. This tax exists because Uncle Sam wants the estate tax when assets are transferred to every generation. So, if you skip a generation, you don't skip the taxes that would have been paid.

For 2010, the GST tax exemption was $1 million with a 0% tax rate, because there was no estate tax. In 2011 and 2012, the GST exemption is $5 million, adjusted for inflation in 2012, with a 35% tax rate. If you are married and plan ahead, you can double this amount.

Remember, there is a possibility that Congress will not act before the end of 2012, and this exemption will decrease in 2013 to $1 million with a 55% tax rate. With this in mind, if you have a large estate, you may want to use a good portion (or all) of your $5 million exemption (twice that, if married) in 2011 and 2012.

Planning Opportunities Abound

Being able to give up to $5 million ($10 million, if married) will allow many individuals to transfer as much as they would want to family members without having to worry about gift taxes.

For those with larger estates, planning opportunities abound during this two-year period and, when combined with leveraging strategies, allow for huge amounts of wealth to be transferred. Quite often, the value of transferred assets can be discounted due to a lack of control and marketability. For example, if you transfer assets to a family limited partnership or limited liability company that you still control, an outside buyer would pay substantially less than market value for shares he/she cannot sell without your approval. Discounting values through planning strategies like this can leverage your $5 million exemption and further increase its value.

Also, a very large amount of life insurance can be purchased with a $5 million or $10 million exemption. If structured properly, the insurance proceeds can pass free of probate, income and estate taxes to younger generations.

Income and Capital Gains Tax Rates

Individual income tax rates remained at current levels for 2011 and 2012. If no action had been taken in 2010, the top income tax rate would have increased from 35% to 39.6%. Also, the tax rate on long-term capital gains and qualified dividends remains at 15% for 2011 and 2012. If no action had been taken, capital gains would have been taxed at 20% and dividends would have been subject to the individual ordinary tax rates.

After so much time of uncertainty about the federal estate tax, now is the perfect time to move forward with your estate, retirement and disability planning. This law provides tremendous planning opportunities for families with estates of all sizes to transfer vast amounts of wealth through 2012.

What Will Happen in 2013

This is definitely a political issue, and it is one that the House Democrats have targeted. Much will depend on who controls the House, Senate and Presidency after the November elections. Possibilities include:

  • $5 million exemption and 35% tax rate;
  • $3.5 million exemption and 45% tax rate;
  • $1 million exemption with graduated rates up to 55% (if Congress does nothing)
  • Permanent repeal

At this point, no one knows what the laws will be in 2013. We will just have to wait and see what Congress does.

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