ESTATE TAX UPDATE - 2011

A portion of the tax compromise that was signed into law by President Obama on December 17, 2010 impacts Federal estate and gift taxes for 2010, 2011 and 2012. The new law retroactively reinstates the Federal estate tax for 2010, but includes an opt-out provision. It also increases the Federal estate tax exemption and generation-skipping transfer tax exemption to $5,000,000 through December 31, 2012 and reunifies the Federal estate and gift taxes for 2011 and 2012.

What do these changes mean for those who lost a family member in 2010?

A. Option One—Accept the new law.

The new estate tax provisions are retroactive to January 1, 2010. Thus, estates of decedents who died in 2010 are subject to the Federal estate tax but are granted a $5,000,000 exemption. The Federal estate tax rate is capped at 35%.

With the imposition of the Federal estate tax provisions for 2010 comes an unlimited step-up in cost basis for income tax purposes on qualifying assets (the major exceptions being retirement plans, annuities and other income tax-deferred investments) to fair market value on date of death. Consequently, inherited property can be sold without incurring capital gain taxes. This step-up may provide beneficiaries with a much needed savings in capital gains tax.

B. Option Two—Elect out of Federal estate tax.

The estate of a 2010 decedent may opt out of the Federal estate tax—an affirmative election. If this election is made, no Federal estate tax will apply but the unlimited step-up in basis will be lost. For those estates that opt out of the Federal estate tax in 2010, the cost basis of inherited assets will be the lesser of fair market value and the cost basis in the hands of the decedent, subject to an upward adjustment that cannot exceed $1,300,000. An additional $3,000,000 in basis adjustment is available for property passing to a surviving spouse outright or in a marital trust. Capital gains taxes may be incurred if step-up in basis is not allocated to certain assets.

What about 2011 and 2012?

The Federal estate and gift taxes are reunified for 2011 and 2012 and the maximum rate of tax is 35% for both the estate tax and gift tax. Thus, the $5,000,000 exemption for Federal estate taxes may be used to shelter gifts during life. [The exemption for lifetime gifts had been capped at $1,000,000.] Further, the exemption amount will be indexed for inflation (in $10,000 increments) after 2011.

For estates of decedents dying in 2011 and 2012 with a surviving spouse, any unused estate tax exemption may be passed to that surviving spouse. This “portability” requires an election on the deceased spouse's Federal estate tax return (Form 706), which is due within 9 months of death.

How does the change in gift taxes impact on me?

Gifts that are not sheltered by the annual gift tax exclusion ($13,000), educational exemption or medical exemption may now total $5,000,000. This significant increase in the gift tax exemption provides new opportunities for gifts to family members.

While the recipients of gifts receive a cost basis equal to the lesser of (a) fair market value of the gift and (b) the cost basis of that gift in the hands of the donor, the possibility of removing assets from an estate may be valuable. The appreciation on the gifted assets will not be subject to estate tax on the donor’s death.

Uncertainty about estate and gift tax laws after 2012 should be factored into any decision regarding gifts. Donors may decide to make gifts in late 2012 when the future of gift and estate taxes for 2013 and thereafter is, perhaps, clearer. In light of the fact that the generation-skipping transfer tax exemption has also increased to $5,000,000, irrevocable trusts that benefit multiple generations will be particularly attractive.

What about the Maine estate tax?

The current threshold for Maine estate taxes is $1,000,000. On January 1, 2013, the threshold for Maine estate taxes is scheduled to increase to $2,000,000.

Discussion of the Maine estate tax relies on the term "threshold" rather than on the term "exemption" because of the method for calculating the Maine estate tax under the Federal "death tax credit" system. The Maine estate tax applies to all assets if the taxable estate exceeds $1,000,000 (or $2,000,000 in 2013 and thereafter) in contrast to the Federal estate tax that applies only to those assets over the applicable exemption (after any reduction for certain lifetime gifts). The resulting Maine estate tax reflects a much higher effective tax rate than is published in the Maine estate tax schedules.

In 2013, the Maine estate tax system for calculating the tax will change. For 2013 and thereafter, only those assets over the estate tax threshold will be taxed as follows: 8% on any amount between $2 million and $5 million; 10% on any amount between $5 million and $8 million; and 12% of the excess over $8 million.

While Maine does not currently have a gift tax, it does pull back taxable gifts made within one year of death. Thus, gifting history must be taken into account.

What is expected?

The federal compromise sunsets on December 31, 2012. Accordingly, Congress will soon need to address the future of the Federal estate and gift taxes. Failure to do so will result in a reversion to the provisions that would have returned on January 1, 2011 if the tax compromise law had not been adopted. These provisions include a Federal estate and gift tax unified exemption of $1,000,000 and a maximum rate of 55% (plus an additional 5% applied to portions of large estates).

What about my existing documents?

Married couples whose estate planning documents incorporate disclaimer plans should not have to update their plans. The control maintained by the surviving spouse will provide the flexibility to take advantage of the opportunities now afforded under the increased Federal estate tax exemption and the transfer of unused exemption to the surviving spouse.

For those married couples who have formula-based estate plans tied to the Federal estate tax exemption, changes to their documents may be warranted. Review of these plans will be necessary to determine whether the formulas that were written before enactment of the compromise law provide the intended results with respect to the level of support of the surviving spouse and other beneficiaries. Further, coordination of these new provisions with state estate tax laws is necessary to avoid possible adverse consequences.

What to do with 2010 estates?

Personal Representatives of estates of decedents who died in 2010 need to make a decision whether to accept the new Federal estate tax provisions or to elect no Federal estate tax with carryover cost basis rules applying. This decision will require consideration of the size of the taxable estate in relation to the available Federal estate tax exemption ($5,000,000 less certain lifetime taxable gifts) and the ramifications to beneficiaries with respect to the cost basis of the assets they receive.

Personal Representatives of estates of decedents who die in 2011 or 2012 and leave a surviving spouse will need to consider the timely filing of a Federal estate tax return (Form 706) to elect to pass any unused Federal estate tax exemption to the surviving spouse. That surviving spouse will then have the opportunity to take advantage of the larger exemption by making taxable gifts before the law sunsets.