Strategic Estate Planning under the New Tax Rules

Our firm just posted a great article on estate planning under the new tax rules. Here is a reposting of the content.

The new tax cut extension package, which was signed into law on December 17, 2010, establishes a new (but temporary) estate and gift tax regime for 2011 and 2012. It also clarifies the situation for the estates of individuals who died in 2010. 

Here is a brief summary of the relevant estate and gift tax provisions in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. 

Exemption and Tax Rate  

For estates of individuals who die in 2011 or 2012, the federal estate tax exemption is $5 million and the tax rate is 35 percent. In 2012, the exemption amount may be increased by an inflation adjustment. 

Deceased Spouse's Unused Exemption Is Portable 

Under the new law, unused federal estate tax exemptions of individuals who die in 2011 or 2012 are "portable" which means they can be passed along to surviving spouses. 

The Impact for Married Couples 

Thanks to the portable estate tax exemption in conjunction with the unlimited marital deduction, the first spouse to die can leave everything to the surviving spouse without any federal estate tax bill (assuming the surviving spouse is a U.S. citizen and is therefore eligible for the unlimited marital deduction). The surviving spouse will then have two $5 million exemptions to work with, for a total of $10 million (assuming the surviving spouse dies in 2011 or 2012). 

Therefore, the surviving spouse can leave up to $10 million to his or her heirs (typically the couple's children) without any federal estate tax bill (assuming the surviving spouse dies in 2011 or 2012). 

In effect, the new portable estate tax exemption in conjunction with the longstanding unlimited marital deduction allows the first spouse to die to simply leave everything to the surviving spouse without losing the benefit of his or her $5 million federal estate tax exemption. Because the deceased spouse's unused exemption can be passed along to the surviving spouse, he or she effectively is given a $10 million federal estate tax shelter. 

Example 1: Let's say a married man dies in 2011 with a $3.5 million estate. Thanks to the new $5 million federal estate tax exemption, he can leave the $3.5 million to his children without any federal estate tax hit. The executor of his estate can then elect to pass along his $1.5 million unused exemption to the man's wife, who is a U.S. citizen. If the wife dies in 2011 or 2012, she can leave up to $6.5 million to the children without any federal estate tax hit (thanks to her $5 million exemption plus her husband's unused $1.5 million exemption). 

Example 2: Same basic facts as in the preceding example except this time the husband takes the easy way out and simply leaves his entire $3.5 million estate to his wife without any federal estate tax bill and without using up any of his $5 million exemption. The executor of the husband's estate then elects to pass along his unused $5 million exemption to the wife. If she dies in 2011 or 2012, her estate will have a whopping $10 million exemption available (her $5 million exemption plus her spouse's unused $5 million exemption). So the wife could leave up to $10 million to the children without any federal estate tax bill. 

Key Point. Before the new law, it was necessary to take tax planning steps like: 

-        Transferring assets between the spouses while they were both still alive in order to equalize their respective estates or to make sure each spouse's estate was worth at least the estate tax exemption amount. 

-       Setting up credit shelter trusts to make sure the estate tax exemptions of both spouses were taken advantage of without shortchanging what the surviving spouse inherited from the deceased spouse. 

Such tax planning steps may no longer be necessary if both spouses die in 2011 or 2012. But such steps might be necessary again in 2013 and beyond -- because we don't know what the rules will be then. 

Inherited Capital-Gain Assets  

For heirs of decedents who die in 2011 and beyond, the familiar rule that allows the federal income tax basis of inherited capital-gain assets (such as real estate and stock) to be stepped up to reflect the date-of-death fair market value is reinstated. For decedents who died in 2010, the simple-and-easy unlimited basis step-up rule was replaced by a complicated modified carryover basis rule that limited basis step-ups to a maximum of $1.3 million plus up to another $3 million for assets inherited by a surviving spouse. 

What this means for heirs: Thanks to the reinstated unlimited basis step-up rule, heirs won't owe any federal capital gains taxes on asset appreciation that occurs through the date of death--as long as that date is after 2010. 

Estate and Gift Tax Rules Are Equalized  

For 2011 and 2012, the new law sets the lifetime federal gift tax exemption at $5 million (the 2012 amount will be indexed for inflation). So the gift tax exemption is now equal to the estate tax exemption, which is a big improvement from the relatively paltry $1 million gift tax exemption that was available previously. Therefore, an unmarried person can give away up to $5 million in 2011 and 2012 while still alive without owing any gift tax, and a married couple can give away up to $10 million while still alive. Those amounts are in addition to gifts that are already sheltered by the annual federal gift tax exclusion ($13,000 per gift recipient for 2011). To the extent you make gifts that utilize part of your $5 million federal gift tax exemption, your $5 million federal estate tax exemption is reduced dollar-for-dollar. 

The tax rate on 2011 and 2012 gifts in excess of the $5 million exemption is 35 percent, same as the estate tax rate. 

Estate Taxes in Your State 

It is not just Uncle Sam that charges estate taxes. So if you decide to update your estate plan, factor in your exposure to any taxes in your state. 

Stay Tuned 

The new estate and gift tax rules are as taxpayer-friendly as we could have reasonably hoped for, but they are only in place for two years. It is likely these rules will become a major campaign issue during the lead-up to the 2012 election. What happens in 2013 and beyond will probably depend on how the 2012 election turns out. If nothing gets done on the estate tax front, we will once again be facing a confiscatory estate tax for 2013 and beyond -- with only a $1 million exemption and a maximum tax rate of 55 percent. Similarly, the gift tax exemption would fall back to only $1 million, and the maximum gift tax rate would jump to 55 percent.

Continued long-term uncertainty will make estate planning challenging. Please contact us to ensure your documents are up to date and your wishes are carried out.

This blog

by Scott Heintzelman - Scott is a CPA, CMA and CFE living in Pennsylvania. Scott is a partner serving on the executive team at McKonly & Asbury LLP, a regional accounting firm with multiple offices in the Mid-Atlantic. The firm has been an IPA ALL-STAR as well as winning Best Places to Work in Pennsylvania for numerous years.

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