United States: Congress Enacts Two-Year Tax Relief Act

On December 17, 2010, President Obama signed an $858 billion tax relief package. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Relief Act) brings sweeping changes to many tax provisions and includes significant developments in estate planning tax law. This alert introduces and summarizes the estate, gift, GST, and charitable contribution tax laws that will be in effect for 2011 and 2012. Under the 2010 Tax Relief Act, each person will have a $5 million "portable" unified exclusion from estate and gift tax, with any excess taxed at a 35-percent maximum rate. Some of these provisions may be retroactively applicable to 2010 decedents if desired.

Tax Changes for Estate Planning

Estate Tax. The 2010 Tax Relief Act imposes an estate tax on decedents dying in 2011 and 2012, but the estate tax exclusion amount is increased to $5 million. This means that each person can transfer up to $5 million at death tax-free. A 35-percent tax is imposed on the amount of any transfers totaling more than $5 million. This is a dramatic change from the $1 million exclusion amount and the 55-percent tax rate previously scheduled for 2011. This new estate tax rate and exclusion amount is temporary, and is scheduled to expire at the end of 2012.

Gift Tax. The 2010 Tax Relief Act reunifies the gift and estate tax exclusion amount for 2011 and 2012. This means that each person can make lifetime gifts up to $5 million tax-free in the next two years. Until now, the gift tax exclusion amount has never exceeded $1 million (and remains $1 million for 2010). However, all lifetime taxable gifts will reduce the donor's remaining estate tax exclusion amount. For example, if a parent makes a $2 million lifetime taxable gift to a child, the parent's remaining estate tax exclusion amount is reduced to $3 million.

Since this new law is scheduled to expire at the end of 2012, clients considering lifetime gifts in excess of $1 million should delay such gifts until after 2010, when there will be a two-year window to make substantial gifts tax-free, beginning January 1, 2011.

The lifetime gift tax exclusion applies only to gifts in excess of the annual gift exemption, i.e., the annual amount a person may gift to any person tax-free. For 2011, the annual gift exemption remains $13,000 per person (or $26,000 per married couple).

Generation-Skipping Transfer (GST) Tax. The 2010 Tax Relief Act also reunifies the estate tax and GST tax exclusion amount for 2011 and 2012. This means that each person can make transfers to grandchildren (or a trust for their benefit) of up to $5 million tax-free in the next two years. GSTs in excess of the $5 million exclusion are subject to a 35-percent GST tax rate. GSTs made in 2010 are retroactively subject to a $5 million exclusion amount and zero-percent tax.

Charitable Rollover. Donors age 70½ and older can now give up to $100,000 from a traditional IRA directly to charity without incurring taxes. Under prior law, donors had to first include all IRA distributions to charity as income and then report a charitable-income-tax deduction for the gifts. This exclusion from income is retroactive to January 1, 2010.

Roth IRA Conversion. Clients considering a Roth IRA conversion in 2011 or 2012 will benefit from the extension of lower income tax rates in the 2010 Tax Relief Act. Due to the extension of 2010 income tax rates, clients who made Roth conversions in 2010 should consider deferring the income from those conversions over two years instead of reporting it all in 2010. Effective January 1, 2010, there is no income limit for Roth IRA conversions.

Estate and Gift Tax Exclusion Portability. The 2010 Tax Relief Act creates a new concept of estate and gift tax exclusion amount portability. Portability means that spouses, under certain circumstances, can share their unused $5 million estate and gift tax exclusion amount with each other. This portability allows spouses to effectively use a combined $10 million exemption. In prior years, a person's unused exclusion amount was not transferable to his or her surviving spouse. Starting in 2011, portability allows a surviving spouse to elect to use any exclusion unused by his or her deceased spouse in addition to his or her own $5 million exclusion. For example, if a husband dies in 2011, having made $2 million in lifetime gifts and leaving his entire $8 million estate to his wife, no tax is due at the husband's death, and an election is made on his estate tax return to allow his wife to use his $3 million unused estate tax exclusion. The wife's available exclusion amount is thereby increased to $8 million — her $5 million plus her husband's unused $3 million. Portability does not apply to the GST tax exemption.

Basis Rules. The 2010 Tax Relief Act grants a stepped-up basis to assets in a decedent's estate, replacing the modified carry-over basis rules in effect during 2010. Under stepped-up basis rules, a decedent's property receives a new basis, "stepped-up" to equal its fair market value as of the date of the decedent's death.

No GRAT Limits. The 2010 Tax Relief Act has no minimum term limit for Grantor Retained Annuity Trusts (GRATs), a provision that was included in many prior bills.

Optional Election for 2010 Decedents. Estates of decedents dying in 2010 may elect one of two estate tax schemes. They may use the prior 2010 law, which imposes no tax on a 2010 decedent's estate and allows a modified carry-over basis on estate assets, or they may elect to apply a $5 million exemption and 35-percent maximum tax rate to the entire estate and receive a basis step-up on all assets in the estate. This allows estates valued at less than $5 million to benefit from a basis step-up, while also allowing larger estates to benefit from an unlimited estate tax exclusion in 2010.

Estate Planning Document Review. The 2010 Tax Relief Act makes sweeping changes that will affect many estate plans. It is recommended that estate plans be reviewed to determine how the 2010 Tax Relief Act affects current plans.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.