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The New Estate Tax Law

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act was signed into law by President Obama on December 17, 2010. This new law provides broad changes to the rules governing federal estate taxes, gift taxes and generation-skipping transfer taxes for the 2010, 2011 and 2012 tax years.

For 2011 and 2012, the federal estate tax exemption will now be $5 million and the estate tax rate for anything over this amount will be 35%. This means that a person who dies in 2011 or 2012 can leave an estate valued at up to $5.0 million tax free to their heirs. If the estate has a value over $5.0 million, the first $5.0 million is tax free and the remainder is taxed at 35%.

Also, the estate tax has now become unified with federal gift and generation-skipping transfer taxes so that now the lifetime gift tax exemption and generation-skipping transfer tax exemption will also be $5 million each with any amount over $5 million taxed at 35%. The annual gift tax exemption remains at $13,000 per year per person or $26,000 for a married couple.

Background

In 2001, as part of the tax legislation enacted during the Bush Administration, Congress passed an estate tax act that scheduled the estate tax exemption to gradually increase from $1.0 million (with a 50% tax rate for any excess) in 2001 to $3.5 million (with a 45% tax rate for any excess) in 2009. The 2001 legislation provided that the estate tax would be repealed entirely in 2010 and then automatically revert to the 2002 exemption of $1.0 million, (with a tax rate of 55% on the excess) on January 1, 2011. In 2010, while the estate tax was repealed, any person who died that year could leave his entire estate, regardless of value, to his/her heirs tax free. Had Congress not enacted this new law for 2011 and 2012, the estate tax exemption would have reverted and been a great disadvantage to anyone who dies with an estate over $1 million. The new law that was passed is a significant improvement over what would have occurred without Congressional intervention and is also more favorable than the 2009 law.

OTHER IMPORTANT PROVISIONS

The new law also contains several other important provisions which may impact your estate plan:

  1. Choice of Law. The new law provides an option for the heirs of a person who died in 2010 to either have the estate governed by the 2009 law or the 2010 law. If the estate would be non-taxable under 2009 law, because is less than $3.5 million (or because of the unlimited marital deduction), it will be beneficial to elect to have the estate governed by the 2009 law. However, if the estate would be taxable under the 2009 law, then it will make sense to have is governed under the 2010 law.
  2. The law restores the "stepped up" cost basis upon death. Under the new law, all of the estate assets (except for a few exceptions such as IRAs and other retirement accounts) get revalued as of the date of death and the new value becomes the beneficiary's cost basis for capital gains forward. For 2010 decedents, there is only a limited stepped up cost basis ($3.0 million for a spouse and $1.3 million for other beneficiaries.
  3. The law retains the unlimited marital deduction. Therefore you can have your entire estate tax free to your spouse regardless of value, (although special rules continue to apply if your spouse in not a US citizen).
  4. The law introduces a new concept of "portability" of the $5.0 million exemption. Under prior law, if one spouse died and lift his estate entirely to his wife she would inherit the estate without tax due to the unlimited marital deduction. However, when the wife died and left the estate to their children, the children would get the benefit of their mother's $5.0 million exemption but would have lost the benefit of their father's $5.0 million exemption. Under prior law, the only way to preserve the exemption of the first spouse to die was to establish a Credit Shelter Trust (a.k.a. B Trust, Bypass Trust, and Exemption Trust). Under the new law, providing certain requirements are met, the children will be able to inherit up to $10 million estate tax free even though no estate tax planning was done when the first spouse died.
  5. The law restores the Generation Skipping Tax (GST) which applies to certain trusts and gifts to grandchildren. The GST exemption is also increased t0 $5.0 million. The law confirms that transfers to GST Trusts which occurred in 2010 are protected from the GST.
  6. The law reunifies the Gift Tax and the Estate Tax. The annual gift tax exemption remains at $13,000 per year per person ($26,000 for a married couple) but the lifetime gift tax exemption is increased to $5.0 million per donor ($10.0 million for a married couple).
  7. 7. The law indexes the $5.0 million exemption for inflation beginning 2012.

FREQUENTLY ASKED QUESTIONS

Here are some of the most frequent questions and answers:

Q. If my estate is less than $5.0 million, do I still need a living trust?

A. Yes, your living trust serves other purposes in addition to potentially reducing or eliminating estate taxes. For example, your living trust avoids probate (along with the associated costs and time delays), avoids the necessity of a conservatorship if you are incapacitated, provides a management vehicle for your estate after your death if your children are minors, poor money managers, or have special needs, and can protect your children's inherited assets from divorces, lawsuits, bankruptcies and other creditors' claims.

Q. Does my living trust need to be revised as a result of the new law?

A. Probably not, but it is always a good idea to revisit your estate plan every 3 to 5 years. Your financial and family situation is constantly changing and you should periodically review your estate documents to make sure that decisions you made when the documents were first drafted are still appropriate based on the current value of your estate, the ages and maturity of your beneficiaries, and a variety of other factors.

Q. Should I be reviewing other parts of my estate plan such as my life insurance planning, annual gifting and other tax mitigation strategies given the increased estate tax exemption?

A. Yes, you should review any estate tax reduction strategies you are currently utilizing, particularly if you are single and your estate is less than $5.0 million or you are married and your estate is less than $10.0 million.

Q. If I am the beneficiary of a trust established by someone who died in 2010, are there any special tax forms I need to file documenting my inheritance?

A. The IRS has yet to issue a form or other guidance for 2010 decedents. Undoubtedly, something will need to be filed with the decedent's 2010 income tax return (due April 15, 2011) in order to elect and allocate the limited stepped up cost basis ($3.0 million to a spouse and $1.3 million to other beneficiaries) or alternatively to elect to have the estate governed by the 2009 law.