JANUARY 2011 NEWSLETTER

Federal Estate Tax Changes

After a long year of watching and waiting what would be done with the Federal Gift and Estate Taxes, Congress finally decided what to do, well sort of…. We did not receive the long‐term permanent solution expected to bring more certainty to clients planning their estates and for estate planning practitioners, but we received the next best thing. Congress has optionally kept the 2010 Estate Tax repeal alive and has prolonged an even more generous version of the Economic Growth Tax Relief Reconciliation Act (“EGTRRA”) rules that we have become familiar with over the past 10 years. The following will discuss the major Federal Gift, Estate, and *Generation Skipping Transfer (“GST”) Tax consequences of the recent Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“the Act”) passed on December 17, 2010.

*The GST Tax is a tax in addition to the Estate or Gift Tax imposed if the transfer is to two generations down or to an unrelated person 37 ½ years younger. This is to inhibit taxpayers from avoiding wealth transfer taxes by transferring assets directly to grandchildren essentially avoiding the second layer of tax that would apply if the assets went to the decedent’s children (being taxed once) and then to the grandchildren at the children’s deaths (being taxed twice).

Background:
In 2001, President George W. Bush passed EGTRRA, of which one of many consequences was to provide lower Federal Estate, Gift, and GST Tax consequences for estates. EGTRRA left a $1 million dollar Gift Tax Exemption for lifetime transfers as provided under the prior rules, but provided that the amount exempt from Estate and GST taxes increased gradually from $1 million in 2002 to $3.5 million in 2009 less any Gift Tax Exemption used. EGTRRA also lowered the highest marginal tax rate for wealth transfers from 55% in 2001 to 45% in 2009.

The shining star of this was the 2010 repeal of the Federal Estate and GST Tax and a maximum gift tax rate of 35% as opposed to the pre‐EGTRRA 55%. However, this came at the cost of a modified step up in basis rule. Traditionally, beneficiaries received an income tax basis increase (called a “step up in basis”) equal to the fair market value of property at the time it is inherited. **This meant lower income
taxes to the beneficiaries. In 2010, this rule was modified where a decedent could only allocate $1.3 million of step up and an additional $3 million for property passed to a spouse. Prior to the recently passed Act, after 2011, the Federal Wealth Transfer Tax rules were to revert back to pre‐EGTRRA rules with a $1 million dollar exemption, a maximum marginal tax rate of 55%, and a full step up in basis of the property to the fair market value at the death of the decedent.

**This is lower income tax because when the beneficiaries try to sell the property, their gain is measured by the amount received less basis, thus a higher basis means a lower future taxable gain.

2010:
After nearly 11 ½ months into 2010, Congress finally acted to solidify the 2010 rules for Estates of people who passed away in 2010 and those that gifted in 2010. In effect, Congress has retroactively imposed new rules for 2010, but the taxpayer or Estate has the option to revert back to the pre‐Act 2010 rules of no Federal Estate Tax and a modified step up in basis if properly elected. If no election is made, then the rules revert back to a 2009 type scheme except with (i) Estate/GST Exclusions of $5 million instead of $3.5 million; (ii) the maximum marginal tax rate of 35% instead of 45%; and (iii) the GST effectively does not apply for specific transactions. The main benefit on 2010 is that taxpayers and
tax practitioners can now rest easy for two (2) years with certainty to the 2010 Federal Wealth Transfer Rules.

2011 and 2012:
The real benefit of the Act is that the 2011 and 2012 rules do not revert back to the restrictive pre‐EGTRRA rules of a $1 million Exemption across the board and a maximum marginal tax rate of 55%. Similar to 2010, the Estate and GST Exclusions are $5 million per individual however there are a couple extra sweeteners. First, the Gift Tax Exemption is raised to $5 million to finally become unified with the Estate and
GST Tax Exemptions after a decade allowing one the freedom to use his/her full Exemption in his/her lifetime. Second, there is a portability of the exemptions between spouses. A surviving spouse is permitted to use any unused exemption of a predeceased spouse if the predeceasing spouse’s executor makes the proper election through an estate tax return. Last, in 2012, the exemption amounts are inflation indexed to increase in increments of $10,000 to compensate for inflation. 2011 and 2012 also receive special treatment with a lowered maximum marginal tax rate of 35% instead of the 55% as provided under pre‐Act law. Further, the traditional step up in basis rule applies so beneficiaries receive property with a basis at the fair market value as of the date of death reducing future income tax consequences to beneficiaries.

While the 2011 and 2012 rules do not provide the permanent certainty desired, they do provide significantly advantageous rules compared to the EGTRRA rules and the rules that were to be in place for 2011 on prior to the passing of the Act.

Sunset in 2013:
As in 2011 under the pre‐Act rules, the above rules sunset in 2013. This means the Exemption are reduced back down to $1 million, the maximum marginal tax rate goes back up to 55%, and a loss of the spousal portability, but the step up in basis rules remains. However, the 2013 rules face uncertainty as 2011 did prior to December 17, so the above rules may be made permanent, modified or allowed to expire. This will create uncertainty as 2013 approaches.