Estate Tax Law Changes: 2011, 2012 and Beyond

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (“TRUIRJCA” or “TRA 2010″ for short) was signed into law on December 17, 2010. It was a compromise bill and, as such, it suffers from two major defects: it leaves many troubling issues uncertain, and it is temporary in duration: in effect only until December 31, 2012. Unless congress does something before then, it will pass out of existence. No one knows what the law is going to be thereafter. That has important implications for estate planning today.

Overview

The essential feature of TRA 2010 is that it creates the largest estate tax exemption ever – $5M, while reducing the estate tax rate to the lowest ever – 35%. This is to be contrasted with both the $3.5M and 55% regime in 2009, and the non-existent estate tax in 2010. Another aspect of the law is that it offered “portability” to the estate tax exemption. What this means is that, in a spousal trust, the exemption can be freely transferred (by filing IRS Form 706 upon the death of the first spouse) to the surviving spouse, so that the survivor may use all of the couple’s combined exemption no actually used by the decedent spouse. The law also “re-unified” the estate tax, gift tax and generation-skipping tax exemptions, which had become un-unified and at different levels during the decade of the 2000’s. However, despite this, the generation-skipping tax remains “un-portable” between spouses, and so might need to be treated differently than the estate tax exemption, where generation skipping tax is an issue.

Is Estate Planning Tax Obsolete?

One might think that these rules make estate tax planning unnecessary for all but the wealthiest people: (individuals with estates above $5M and couples with estates above $10M). However, bear in mind that the estate tax rules which apply to one’s estate are not those that exist when the estate plan is created, but those which will be in effect when the they happen to pass away.

During the decade of the 2000’s, I often explained to my clients that tax planning was needed on account of uncertainty. During that decade, the exemption amount changed almost annually until 2009, when it became $3.5M, after which the tax disappeared entirely in 2010. No one knew what would happen after that. It was assumed that a final fix would be created in 2010. Unfortunately, this did not happen; only a temporary system was put into place. So the uncertainty remains. No one knows what will happen when the 2010 law sunsets at the end of 2012.

Some of the scenarios of what the estate tax law might become in 2013 include: 1- Congress could extend the current system; 2- Congress could adopt the 2009 regime or a compromise version of it: $3.5M exemption, a tax rate of anything from $35% to 55%, and either portability or non-portability; 3- Congress could do nothing, in which case the law would revert to a $1M exemption and 55% tax rate. Of course, 4- Congress could repeal the estate tax entirely. It seems that while “death and taxes” are certain, death taxes are anything but.

There are several approaches to trust drafting that one can take in response to this uncertainty. A basic premise of trust drafting aimed at minimizing estate taxes is to create trust vehicles which permit use of the full amount of all possible exemptions, particularly the full estate tax exemption available to each spouse. Clearly, it would be nice to know beforehand what the amount of the exemption available would be and whether these would be portable, particularly as to estates which are somewhat less than the current exemption amounts.

Take, for example, a couple with an estate of $4.5M. If the tax law remains as it is, they will pay nothing in estate taxes, because each is entitled to a $5M.exemption. But what if the exemption amount is reduced to $3.5 with no portability (as proposed by President Obama during negotiations which led to TRA 2010)? There would be $1M at risk of taxation (at 55%, that could be as much as $550,000) unless planning is done. And, even if portability survives, will the survivor remember to file the tax election? What if the exemption amount is lowered to $2M? What if Congress fails to act at all (certainly not out of the question), and the exemption is reduced to $1M. How should one proceed in the face of uncertainty?

One can simply take the current numbers at face value and plan on re-drafting or amending after 2013 if the law changes significantly. But this may require many trusts to be redrafted. Or, one can plan every estate for the worst case scenario: that the exemption and tax amounts will revert to what they would be if no action is taken by congress ($1M and 55%). Well, while that would be a safe alternative, it would require many clients to pay for estate planning services they may not end up needing. My approach is to discuss the issue with the client, in the context of their particular financial situation and the probabilities of what might happen in the future, and find out what suits them best.

Most people with relatively small estates (less than $2M) opt for a basic trust which assumes there will be no estate tax issue, and which therefore does not include tax minimizing features. The likelihood of the “worst case scenario” is slight, since even the democrats appear to agree to a $3.5M exemption. This saves the client money in the short term, and, only in the unlikely event that the exemption is drastically reduced, would it be necessary to add an amendment to the trust, once the law becomes clear.

Those with middling amounts ($2-7M) usually want inclusion of tax minimizing devices which are optional and discretionary, so that they can be employed only if needed, depending upon the final shape of the law. They pay more in the present for the inclusion of these provisions, but can rest assured that their estate plan is prepared to handle eventualities without the need for amendment.

Those with large estates (above $7M) should assume that tax-minimizing provisions are required, in some cases fairly elaborate ones; these must be drafted in a manner which maintains maximum flexibility.

Additional consideration must be given to the gift tax and generation skipping tax. “Gift tax” is of concern where the estate owners have given beneficiaries lifetime gifts of more than the annual allowable gift tax exemption (currently now $13,000) in any one year. “Generation-skipping tax” is of concern whenever a lifetime or testamentary gift is given to a beneficiary who is more than a single generation removed forn the giver, (i.e. grandchildren, etc). Under the previous system, there were distinct exemptions for lifetime and generation skipping gifts, so that the total available exemption might be far greater than the estate tax exemption. Indeed, for large estates, it became a strategy to give assets away by lifetime gifts, and to spread the wealth around to many recipients, in order to reduce the size of the estate left at the time of death. However, under the 2010-2012 system these exemptions were unified, so that if each gift, no matter which type, would deplete the total amount of exemption available. Clearly, it is difficult to use these techniques where it is uncertain whether the exemption will remain unified. Accordingly, for the present they can only be made available as discretionary options, which can be used if available; but this is less than satisfactory, since they cannot be relied upon.

Conclusion

So, if you have heard that only the extremely wealthy need to be worried about estate tax planning, think again. The uncertainty makes it all the more necessary to consult an attorney and make an estate plan, if you haven’t, or to have your existing plan re-checked if it was not recently drafted, to make sure that your estate is ready for whatever happens. Learn more about our Estate Planning Services here.

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One Response to Estate Tax Law Changes: 2011, 2012 and Beyond

  1. site admin says:

    Thank you for the great insights.

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