Estate Planning after the Tax Relief Act of 2010
The President has signed into law the Tax Relief Act of 2010 on December 17, 2010. This law broadly changes the estate, gift, and generation-skipping transfer (GST) tax rules for 2010, 2011, and 2012, and then permits the pre-EGTRRA 2001 law to be resurrected on January 1, 2013.
The 2010 Tax Relief Act reinstates the estate tax, together with its estate-tax-value basis rules, effective January 1, 2010. The estate tax is retroactively reinstated with a full $5 million applicable exclusion amount (now referred to as the “basic exclusion amount”) and a 35% top tax rate. Therefore, the estate of any decedent dying in 2010 will be subject to the estate tax, but with a $5 million exemption (adjusted for certain lifetime gifts) and subject to a special election discussed below.
The 2010 Tax Relief Act gives the executor of a 2010 decedent’s estate the power to elect to apply either the estate tax regime (with a basis equal to estate tax value and a $5 million basic exclusion amount) or the carryover basis regime (with no estate tax) to the estate. If no election is made, the estate will be subject to the estate tax regime.
The decision whether or not a particular estate should be subject to the estate tax and estate-tax-value basis regime under Section 1014, with a $5 million exemption and 35% top rate, or the carryover basis regime with no estate tax, often will be difficult. Usually, calculating the estate taxes that will be due will be relatively easy, and the $5 million basic exclusion amount (even adjusted for lifetime gifts) and the unlimited estate tax marital deduction will result in most estates not being subject to estate taxes.
For estates that will not owe an estate tax, tax considerations often will favor accepting the estate tax regime, because it affords all of the decedent’s appreciated property a basis equal to the value of the assets on the date of death. Even for these estates, however, the executor should consider whether there may be a potential estate tax advantage at the surviving spouse’s death to elect out of the estate tax and have the decedent’s assets held in one or more trusts that will not be subject to estate taxes when the surviving spouse later dies.
Even estates that have substantial assets whose bases exceed their value will not benefit from the modified carryover basis regime, because that regime gives the estate and its beneficiaries a basis in the decedent’s assets that cannot exceed the lesser of the decedent’s adjusted basis or the fair market value of the asset as of the decedent’s death. Thus, both the estate tax regime and the carryover basis regime eliminate built-in losses.
The 2010 Tax Relief Act increases the basic exclusion amount to $5 million, indexed for inflation after 2011. The 2010 Tax Relief Act also reduces the top estate tax rate to 35%, creating a flat 35% estate tax on estates above the basic exclusion amount. These rules apply with respect to estates of decedents dying after 2009 and before 2013.
The 2010 Tax Relief Act reunifies the estate and gift tax exemptions after 2010. This means that, for gifts made in 2010, the gift tax lifetime exemption was $1 million, but for gifts made after 2010 and before 2013 it is $5 million.
This increased exemption will free some clients from the need to rely on annual exclusion gifts to make many of their lifetime nontaxable transfers.
One of the most important changes under the new law is the addition of the portability of the first deceased spouse’s unused basic exclusion amount, referred to now as the “deceased spousal unused exclusion amount.” The 2010 Tax Relief Act amends Section 2010(c)(4) to provide that an executor can elect to allow the decedent’s surviving spouse (but no other beneficiary) to take advantage of the deceased spousal unused exclusion amount, for the spouse’s estate and gift tax purposes. This rule applies with respect to estates of decedents dying after 2010.
This election must be made on a timely estate tax return that computes the amount of the unused basic exclusion amount and that affirmatively elects for the surviving spouse to receive this deceased spousal unused exclusion amount. The election, once made, is irrevocable.
The IRS can examine a deceased first spouse’s estate tax return to adjust the amount of the deceased spousal unused exclusion amount passing to the surviving spouse, without any limitations period on the examination. Therefore, if one spouse’s executor elects in 2011 to pass the deceased spousal unused exclusion amount to the surviving spouse, the Service can audit the first deceased spouse’s estate even if the surviving spouse dies decades later, but only in order to determine the deceased spousal unused exclusion amount and the correctness of the election.
The deceased spousal unused exclusion amount can be used by the surviving spouse to offset gift or estate taxes, but it does not increase the surviving spouse’s GST exemption. This means that anyone wanting to take full advantage of both spouses’ GST exemption must have the first spouse to die create a nonmarital trust or a reverse QTIP marital trust to take advantage of his or her GST exemption.
The increased basic exclusion amount also does not change the base amount on which the obligation to file an estate tax return is set. The estate of a surviving spouse who has a combined applicable exclusion amount of $10 million, including a deceased spousal unused exclusion amount of $5 million and a basic exclusion amount of $5 million, still would be required to file an estate tax return if the gross estate were over $5 million.
The deceased spousal unused exclusion amount received by the surviving spouse is not indexed for inflation. Only the surviving spouse’s basic exclusion amount benefits from future adjustments to the amount of the exemption to reflect inflation.
The surviving spouse cannot take advantage of a deceased spousal unused exclusion amount from more than one predeceasing spouse. Only the deceased spousal unused exclusion amount of “the last such deceased spouse of such surviving spouse” can be used.
This rule creates several interesting tax and social issues. The Staff of the Joint Committee on Taxation has included in its Technical Explanation an example that strongly suggests that, when a surviving spouse dies, he or she first uses up any deceased spousal unused exclusion amount, before using his or her own basic exclusion amount. This often will mean that there is more basic exclusion amount remaining to pass to a subsequent surviving spouse.
The determination of the last predeceased spouse of a surviving spouse can be made only when the second (or later) spouse has died. Therefore, it seems likely that the surviving spouse can make gifts using the basic exclusion amount received from the first deceased spouse, if they are made while the second spouse is still alive. The language is not absolutely clear, but it does not appear to require that the surviving spouse surrender the first deceased’s spouse’s unused basic exclusion amount until it is determined whether or not the surviving spouse survives his or her next spouse, so the use of this exclusion for lifetime gifts should be permissible.
The statute does not address the issue of death of spouses in a common disaster. Regulations will have to clarify how portability will work in this context.
Thus, pending clarification, you should include a common disaster clause in your estate planning documents that conclusively presumes that your spouse survives you, in any situation in which it cannot be established which of you actually survived. Under current law, such presumption would be respected.
Relying on portability could result in a reduction of the aggregate available shelter from tax, if the exclusion amounts are subsequently reduced. This is specifically contemplated in the statute, which creates a ceiling on portability equal to the basic exclusion amount available at the second death.
Portability will convince a large number of clients that they do not need significant estate tax planning and, for some clients, this will be true. Clients whose total estates are between $5 million and $10 million can avoid all estate taxes on both estates, but using simple wills and trusts will have several important deficiencies in comparison with an arrangement that creates a nonmarital trust at the first spouse’s death.
The deceased spousal unused exclusion amount is not adjusted to reflect the appreciation of, or income generated by, specific assets. Coupled with the lack of indexing for the deceased spousal unused exclusion amount, the ability of a nonmarital trust to shelter future growth strongly favors its use.
A couple whose total estate is only slightly over $5 million may find this point immaterial, but a couple whose total estate is close enough to $10 million (two basic exemption amounts) that it may exceed that figure before the surviving spouse dies, should very seriously consider using a nonmarital trust at the first spouse’s death to protect a greater sum from ultimate estate taxes.
Second, any married couple wanting to take advantage of both $5 million GST exemptions will need to create a nonmarital GST-exempt trust at the first spouse’s death. Portability does not apply with respect to the GST exemption. Couples with estates of $8 to $10 million often appreciate the value of avoiding estate taxes for several successive generations, and portability will not really do much to simplify the estate planning for these clients.
Unlike a nonmarital trust, merely leaving one’s estate outright to the surviving spouse or to the surviving spouse’s revocable trust will not provide many of the other nontax benefits associated with good estate planning, including protection from the claims of creditors of the surviving spouse, protection from the claims of a new spouse, diversion of the assets from the first spouse’s family to a new family created on remarriage of the surviving spouse, and professional asset management. Some of these benefits can be achieved with an estate plan that leaves the entire estate in trust for the surviving spouse, but they cannot all be achieved through an outright marital gift or a gift to a surviving spouse’s revocable trust.
Unlike a nonmarital trust, the portable annual exclusion would give the surviving spouse a full step-up in basis at death.
This is a distinct advantage of the portable basic exclusion amount over a nonmarital trust, because the nonmarital trust does not receive such a second step-up in basis. On the other hand, the nonmarital trust takes a full basis increase on the first $5 million of assets passing at the first spouse’s death, and avoids estate taxes on the balance. For taxable estates, this should almost always be a superior tax result to that produced by an outright gift to the surviving spouse coupled with use of the deceased spousal unused exclusion amount. For estates that are under the $10 million tax-free level, the basis adjustment strongly favors use of the deceased spousal unused exemption amount.
A nonmarital trust will be important in any state that still has a state estate tax with an exemption different from the federal basic exclusion amount, if it is anticipated that the estate of the surviving spouse also will be subject to that state’s death tax. Illinois presently has a $2 million exemption after which a 16% tax is imposed. In such states, a nonmarital trust is important to take full advantage of both spouses’ exemptions and minimize state estate taxes on the surviving spouse’s estate. These taxes are often imposed at rates of up to 16%, and avoiding them is not immaterial.
You must consider carefully the amount of nonmarital trust that should be used in a state that has a state estate tax exemption lower than the federal exemption amount. Creating a nonmarital trust in the amount of the lower state exemption figure will avoid all state estate taxes at the first spouse’s death, but it will waste part of the federal exemption amount. Creating a $5 million nonmarital trust in the amount of the federal exemption amount will make the fullest use of the federal exemption, but it will generate a state estate tax.
Under the law as it is written, portability disappears after 2012. Hence, either both spouses must die before 2013 or at least one must die and the other make a significant taxable gift by the end of 2012 in order for portability to be effective. Practical estate planners likely will be hesitant to recommend that their married clients base their estate plans on portability unless and until Congress makes portability permanent.