from MARTIN ZELNER
Cox Padmore Skolnik & Shakarchy LLP
IMPORTANT CHANGES ENACTED IN THE FEDERAL ESTATE, GIFT AND GENERATION-SKIPPING TAX RATES AND EXCLUSIONS
On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ( the "2010 Tax Act"). Although The 2010 Tax Act has significant income tax, business incentive and unemployment relief provisions, the purpose of this advisory is to summarize the estate, gift and generation-skipping transfer tax provisions and planning issues.
The federal estate, gift and generation-skipping transfer ("GST") taxes that have been in force since 2002 are the product of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"). Pursuant to EGTRRA, the highest marginal transfer tax rate ( i.e., estate, gift and GST) decreased from 55% in 2001 to 50% in 2002, and then dropped one percent a year until reaching 45% in 2007, which remained the rate through 2009. The estate and GST exclusions (formerly known as "exemptions") increased in stages from $1 million in 2002 to $3.5 million in 2009. However, the gift tax exclusion remained constant at $1 million.
For reasons not germane to this advisory, EGTRRA provided that there would be no estate or GST tax in 2010 but that in 2011, the law would revert to a $1 million exclusion, a maximum estate tax rate of 55% and a flat GST tax rate of 55%. However, the gift tax would remain in force in 2010.
Faced with the possibility of a return in 2011 to significantly lower levels of exclusions and higher rates, the transfer-tax issues were included in the recent tax compromise between the Obama administration and Congress. The administration's position during and since the 2008 presidential election has been a $3.5 million exclusion and a 45% maximum rate, which was the structure in place in 2009. However, Senators Kyl and Lincoln had long since proposed a $5 million/35% rate structure.
The compromise resulted in the adoption of the Kyl/Lincoln proposal and, in substance, going forward (although with some caveats, as explained below) there will be -
• A $5 million exclusion from a unified gift and estate tax;
• A maximum estate and gift tax rate of 35%;
• A $5 million exclusion from the GST tax; and
• A flat 35% GST tax rate.
The principal provisions will play out as follows:
Decedents Dying in 2010
It has been well-publicized that several billionaires died in 2010, including New York Yankees owner, George Steinbrenner. There has also been speculation about the retroactivity of any end-of-year estate tax legislation. The 2010 Tax Act addresses this issue by providing that the estate tax (at a $5 million exclusion and maximum 35% tax rate) will apply to estates of decedents dying on or after January 1, 2010, unless the estate elects not to pay estate tax but, instead, to use the decedent's tax basis when recognizing capital gain - known as "carryover basis". Using carryover basis will be in lieu of acquiring the stepped-up basis that accompanies participation in the estate tax system. Given that the current capital gains rate is 15% and the new estate tax rate is 35%, it is unlikely that many substantial estates will opt to pay the estate tax.
The GST exclusion for 2010 is also $5 million.
The Rules for 2011 and 2012
Effective January 1, 2011, there is no election between the estate tax and carryover basis; rather, the estate of a decedent dying in 2011 or 2012 will have a $5 million exclusion and be subject to a maximum estate tax rate of 35%. In addition, testamentary gifts constituting transfers subject to the GST tax will also be subject to a $5 million exclusion and a flat 35% tax rate.
Estates after 2012
At the end of 2012, we are likely to go through the same legislative drama we have just witnessed. Unless changed by Congress, effective January 1, 2013 we will revert to an exclusion from estate tax of $1 million and a top estate tax rate of 55%. The exclusion from the GST tax will also be $1 million and the GST tax rate will be a flat 55%.
The Gift Tax
The exclusion from the gift tax in 2010 has been $1 million and will continue at that level through December 31, 2010. However, effective January 1, 2011, the gift tax exclusion will be the same as the estate tax exclusion and will be $5 million.
Transfer Tax on Lifetime Gifts
As indicated above, the exclusion and rate of the GST tax for testamentary transfers is the same as the estate tax. For transfers after December 31, 2009, the same is true for lifetime gifts which are subject to the GST tax. That is to say, each taxpayer has a $5 million exclusion from the GST tax; gifts above that amount are subject to a flat 35% tax rate.
Estate Tax Exclusion Portability
The 2010 Tax Act introduces the concept of "portability" of the estate tax exclusion. This is a significant change and will help to avoid "waste" of all or a portion of a deceased spouse's estate tax exclusion.
In substance, under the 2010 Tax Act, a surviving spouse may utilize the estate tax exclusion of his or her deceased spouse upon the surviving spouse's death. So, for example, if the first spouse to die does not have sufficient assets to utilize his or her entire $5 million exclusion, the estate of a surviving spouse may add the unused portion of the deceased spouse's exclusion to his or her exclusion. It is possible, then, than a surviving spouse may be able to exclude up to $10 million in assets from the estate tax.
Portability also applies to a decedent's unused gift tax exclusion; however, it does not apply to the GST exclusion.
There are many complexities in the portability provisions and close examination will be required from a planning standpoint before going that route.* Furthermore, under current law, the portability election is limited to situations where both spouses die within the two-year period of 2011 to 2012.
Effects on Planning
The changes described in this advisory require that you consider the following:
• In many cases, the exemption for state estate tax purposes does not conform to the federal exclusion amount. For example, the New York State estate tax exemption is $1 million while, as noted above, the federal exclusion is now $5 million. Your Will may contain a formula clause which was designed to make maximum use of the federal exclusion. Such Wills assumed substantial conformity between the federal and state exclusions. In 2011 and 2012, however, with the gap between the federal and state exclusions having increased in some states (such as New York) to $4 million, the cost to the estate of a married decedent of using the full federal exclusion upon the first death could be as high as $390,000 in state estate taxes.
• Another result of the use of formula clauses tied to the federal exclusion may be the transfer upon death to a spouse in trust (rather than outright) and/or to children of a greater amount than anticipated when the Will was drawn. For example, a person who signed a Will in 2005 with a formula clause tied to the federal exclusion may have anticipated that $1.5 million ( i.e. the exclusion in 2005) would pass to the spouse in trust and/or to the children. However, if that Will becomes operative in 2011 or 2012, approximately $5 million (and not just $1.5 million) would be transferred pursuant to that clause.
• The $5 million gift tax exclusion provides substantial opportunities for lifetime planning. The gift tax exclusion is even more significant when coupled with the $5 million exclusion from the GST. In both cases, the exclusion is $10 million for a married couple. Furthermore, under current law there is only a two-year window ( i.e. 2011 and 2012) to use the larger exclusions and lower rates.
• The ability to leverage the gift tax exclusion is enhanced through the use of short-term grantor-retained annuity trusts ("GRATS") and significant discounting for lack of marketability and minority interests in closely-held entities. During the past several years, federal legislation to curtail the use of these devices has been proposed but not enacted.
This may be an appropriate time to review your Will and estate planning, particularly from the standpoint of the change in the federal estate tax exclusion, the widening of the gap of such exclusion from state exemptions and the enhanced opportunities for lifetime planning.
If you have any questions regarding this Client Advisory or wish to discuss any of the matters covered, please be in touch with Martin Zelner at (646) 355-1648 or at [email protected].
The purpose of this Client Advisory is to inform clients and other interested parties of changes in the tax laws which may affect their personal planning. This Client Advisory does not constitute legal advice or an opinion. This document was neither written nor intended by Martin Zelner, Martin Zelner, P.C., or Cox Padmore Skolnik & Shakarchy LLP to be used, and cannot be used, by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.
Except that GST gifts during 2010 are subject to a $5 million exclusion and a zero GST tax rate.
It should also be noted that New York tax law does not provide for portability of the exclusion.