Estate tax reform in 2010 was marked by significant disagreement from both the House and Senate on whether any changes should be temporary or permanent.

The Bush tax cuts finally proved too important to ignore, and on December 17, 2010, President Obama signed into law The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA). Despite left-wing criticism, liberals in Congress could not muster enough opposition to put the brakes on this groundbreaking legislation.  While there is a lot of time to figure out ways to implement the new estate tax rules, Wealth Managers have to be ready to answer the myriad questions that will be coming at them in 2011.

What the heck happened?

I will attempt to outline the basics of the estate tax reform portion of the tax bill that was signed into law in December.  Let’s try to take this one major subject at a time, although, as always, it isn’t quite that simple:

Estate Tax:  The new law allows for $5 million to pass estate tax free, per person.  This new exemption amount applies to persons who die in 2011, and may apply to persons who died in 2010.  Yes, this is a RETROACTIVE application of estate tax laws, and I’m sure we will hear more about the many lawsuits that will be forthcoming about the constitutionality of retroactive legislation. However, the new law does qualify this retroactive treatment.  Executors and estate settlement advisors are allowed to elect to apply the 2010 rules for estates of those who died in 2010.  Remember, those rules allow for no estate tax, but force carryover basis so the cost basis of assets of a decedent in 2010 would not be “stepped up” to date of death values and therefore those assets would incur potential capital gain treatment when sold. 

This essentially means that executors of 2010 estates with $5 million or less could opt to let the new exemption apply to them, get a step up in basis to date of death values, and avoid both estate and capital gain tax .   Executors of estates larger than $5 million have a decision to make:

1. Lose step up (beyond the rules of 2010 carryover basis which allows for basis increase up to $1.3 million for individual assets and $3 million for assets transferred to a surviving spouse) and don’t pay estate tax; or,

2. Get a step up to date of death values, but pay a 35% estate tax on assets over the $5 million exemption.  Clearly the George Steinbrenners of the world are not going to get a free ride here, and analysis of these types of estates will be interesting to witness.  Stay tuned – a lot of money, and a lot of lawyers, are in play!

Portability and the Rule of Unintended Consequences:  Wow, they actually did it.  They made estate tax exemption left over from a first to die spouse “portable” or transferrable, to a surviving spouse. Without the need for a credit shelter trust, a surviving spouse can utilize what is left of a $10 million married couple’s exemption to avoid estate tax.   For example, if the first spouse to die uses $2 million of their $5 million exemption, the surviving spouse can elect (actually the executor of the deceased elects, which also means some type of tax return needs to be filed for portability to happen) to transfer the remaining $3 million exemption to the surviving spouse.  This benefit is not available for transfers to friends, but rather only to spouses.  That surviving spouse ends up with $8 million of estate tax exemption. 

There are interesting ramifications to this. As the assets pass to the surviving spouse (with the exemption) the growth of those assets are not exempt from estate tax at the death of that surviving spouse.   Think about it.  Assets in a credit shelter trust grow in that trust free of further estate tax.  The new rules remove the need for the trust structure and therefore the assets would pass (assuming no other reason to fund an irrevocable trust with these assets) directly to the surviving spouse.  The growth derived from these assets would therefore be included in the surviving spouse’s estate when they die. 

As we think about this further, it leads to picturing other unintended consequences (some good, some bad) as well. These same assets would receive a step up in basis at the death of the surviving spouse (unlike assets in a credit shelter trust).  These assets passing directly to the surviving spouse (outside of a trust) are now fully controlled by that spouse, so they can be squandered, gifted, used to support a new spouse and new family, and lost to liability judgments. Clearly there will be renewed interest in using trusts for reasons other than estate tax planning.

Further, this transferred exemption (technically called the deceased spousal unused exclusion amount (or DSUEA), only comes from the most current deceased spouse.  If a surviving spouse remarries, they keep the deceased spouse’s DSUEA until their second spouse dies.  The second spouse to die becomes the latest deceased spouse and the once again surviving spouse gets their DSUEA instead.  How planners (and lovers) deal with the surviving spouse of someone with a large DSUEA falling for someone with a smaller DSUEA is going to be the butt of marital jokes, and the fodder for serious marital planning until further notice.  Needless to say, the future bar pick up line may change from “what’s your sign?” to “what’s your DSUEA?”

Although there is much to this reform law that is retroactive, portability only pertains to spouses who die in 2011 and beyond. 

Gift Tax:  This one is a little complicated, but the complication shouldn’t bog us down.  Essentially, the gift tax is being unified with the estate tax (remember the term “unified credit?”).  Going forward, the $1 million gift tax exemption is increased to $5 million.  Forgetting the complexities of retroactivity for gifts made in 2010 (still limited to $1 million), this, my fellow Wealth Managers, is a game changer.  I picture a surviving spouse with $10 million in assets who needed sophisticated planning to reduce their estate tax liability and transfer assets to kids and grandkids (GST discussion to follow).  Now they can gift a full $5 million tax free while alive and enjoy the largess they have bestowed on their offspring and still have $5 million to live on and die with estate tax free (even ignoring potential portability of the deceased spouse).  This is a truly amazing scenario for planners like me who worked really hard for these types of results under past tax regimes. 

GST Tax:  Generation Skipping Tax, or the tax on transfers that skip a generation is also impacted.  Going forward, transfers up to $5 million over a lifetime are exempt from GST tax.  Transfers made in 2010 are also exempt up to $5 million, although there is some complexity as to why that is the case, and how distributions to future generations from trusts that were funded with GST exempt assets in 2010 are to be taxed. This is beyond the scope of this summary, but worth keeping in mind when a wealthy client wants to gift large sums to irrevocable trusts for the benefit of grandchildren.  Advise them to seek counsel.

Minutiae

Answers to other quick questions from clients:

  • The top rate for both the estate tax and the gift tax rate is 35%.
  • Elections and tax returns generally need to be filed within 9 months after enactment (so those handling the estates of 2010 decedents have time to make some decisions).
  • Estate and gift tax exemptions will be indexed for inflation to the nearest $10,000 after 2011.
  • State estate tax just got very complex for states that have “decoupled” which will require state legislation to rectify.
  • There is no mention of the oft reported scrutiny and imminent changes to GRAT and FLP rules.
  • This law is an “extension” of EGTRRA, albeit with significant changes.  So we may have to do this all over again in two years. 

As we can see, there is good, bad and ugly in estate tax reform.  There are also unintended consequences and after some thought, there will be unprecedented opportunities to assist our clients in transferring more wealth to families and charities, and less to Uncle Sam.  STAY TUNED.

John Bock, JD, CTFA is a senior vice president and regional trust manager at Key Private Bank. He serves as a fiduciary expert on the relationship management team, and can be reached at john_bock@keybank.com.