Estate Tax Transition Years
new oppurtunities for planning, special concerns with state taxes
***With the passage of the American Taxpayer Relief Act on January 1, 2013, Congress made the estate and gift tax rules found in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 permanent. The only change from the rules for 2010, 2011 and 2012 (discussed in detail in this article) is that the new maximum tax rate is 40% rather than 35%. In addition, because of adjustments for inflation, the 2013 lifetime exemption has increased to 5.12 million dollars, and the annual exclusion for gifting has increased to $14,000. Otherwise, the tax principles and issues discussed below are the same for 2013 and going forward.***
On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, which put to rest any questions regarding the federal estate tax, at least through the end of 2012. The 2010 Act revives the estate tax for all deaths occurring on or after January 1, 2010, but is scheduled to sunset on December 31, 2012. The Act gives the estates of individuals who died in 2010 the option to apply either the reimplemented estate tax system, or the alternative carryover-basis capital gains system (which was the only option before the Act). In addition, the Act allows a surviving spouse to use their deceased spouse estate’s unused exemption amount under a “portability provision”, extends the state death tax deduction, reunifies the gift and estate taxes, and establishes tax rates for the generation skipping transfer tax for years 2010, 2011, and 2012.
Federal Estate Tax
Prior to the passing of the 2010 Act, the pre-EGTRRA (Economic Growth and Tax Relief and Reconciliation Act of 2001) estate tax was scheduled to return in 2011. This estate tax would have provided for a maximum tax rate of fifty-five percent (55%) and a one million dollar lifetime exemption amount. The 2010 Act instead revives the estate tax for all deaths occurring on or after January 1, 2010, but with a significantly increased exemption amount as well as a significantly decreased tax rate; allowing for a five million dollar exemption and a maximum tax rate of thirty-five percent (35%). In comparison, the 2009 estate tax provided for a three and one-half million dollar exemption, and a maximum tax rate of forty-five percent (45%).
For example, A, a successful businessman, dies in 2011 with an estate valued at eleven million dollars. Under the new law, A’s estate would be entitled to a five million dollar exemption, reducing the amount of his estate subject to the federal estate tax to six million dollars ($11,000,000 estate - $5,000,000 exemption amount). A’s estate would owe a total of two million one hundred thousand dollars in federal estate tax ($6,000,000 x 35% tax rate). Had the 2010 Act not been enacted, A’s estate would have been entitled to a one million dollar exemption, leaving ten million dollars subject to the federal estate tax at a rate of fifty-five percent (55%). This would have resulted in A having a tax liability of five and one half million dollars. In comparison, if A had died in 2009, the value of his estate subject to the federal estate tax would have been seven and one-half million dollars ($11,000,000 - $3,500,000). This would have resulted in A having a tax liability of two million, six hundred twenty five thousand dollars. Thus, the 2010 Act reduced the potential estate tax liability by a significant amount.
While the 2010 Act provides each individual’s estate a five million dollar exemption, the Act also provides for portability between spouses. Portability allows the surviving spouse to elect to use the unused portion of the deceased spouse’s five million dollar exemption. In practice, portability will provide the surviving spouse’s estate with an exemption in excess of five million dollars. If the surviving spouse wishes to use the remainder of the deceased spouse’s exemption amount, the election must be made on the deceased spouse’s timely filed estate tax return. For example, if Husband dies in January 2011, Husband’s estate must both timely file his estate tax return (nine months from the date of death), and elect on the return to allow his wife to use the remainder of his five million dollar exemption. Thus, if Husband’s estate only uses one and a half million dollars of his five million dollar exemption, and Husband’s estate both timely files the estate tax return and elects to allow Wife to use Husband’s unused exemption amount, when Wife dies, her estate has an eight and a half million dollar exemption.
Individuals who survive more than one spouse (those who were married, lost a spouse, remarried, and lost their second spouse) do not receive two (or more) deceased spousal unused exemption amounts; rather, they are entitled only to the lesser of five million dollars or the unused exemption amount of their last deceased spouse. Using the same example of Husband and Wife from above, if Wife remarries, and Second Husband dies in January 2012, Wife is entitled to a deceased spousal unused exemption amount of the lesser of five million dollars or Second Husband’s exemption amount. Thus, if Second Husband’s estate uses four million of the five million dollar exemption amount, Wife is entitled to a deceased spousal unused exemption amount of one million dollars, bringing her estate’s total exemption amount to six million dollars; the unused exemption amount from Husband’s estate (three and one half million dollars) is no longer available for Wife’s estate to use.
It should be noted that, like the estate tax imposed under the 2010 Act, the portability election will be available only to the estate of those individual’s passing away after December 31, 2010 and before January 1, 2013.
State Death Tax Credit/Deduction
EGTRRA repealed the state death tax credit and replaced the credit with a deduction. The 2010 Act extends the deduction through the 2012 tax year. This has two practical effects. The first being that those states having a state death tax (known as a sponge tax) that is designed to collect an amount equal to the federal estate credit for state death taxes paid, will continue to no longer have a state death tax (perhaps, the most well known example of this is the state of Florida). The second practical effect is that the continuation of the deduction ultimately makes the amount of federal estate tax owed by a estate greater than if there was a credit. A deduction acts to reduce the value of the decedent’s estate, reducing the amount subject to estate tax, whereas a credit lowers the amount of tax owed dollar for dollar. For example, if an estate is provided with a one hundred thousand dollar deduction, under the 2010 Act, the deduction would result in a savings of thirty five thousand dollars ($100,000 x 35%) in federal estate tax. However, if the same estate was provided with a one hundred thousand dollar credit, the estate would save one hundred thousand dollars in federal estate taxes.
The 2010 Act provides that gifts made in excess of the annual exclusion amount in 2010 are subject to a thirty five percent (35%) gift tax, with a lifetime exemption amount of one million dollars. For gifts made in 2011 and 2012, the gift tax is reunified with the estate tax, meaning that the gift tax will be imposed at a top rate of thirty five percent (35%), with a lifetime exemption amount of five million dollars. This means that individual’s can make five million dollars worth of gifts, in addition to gifts valued at or less than the annual exclusion amount, before having to pay a gift tax.
The annual exclusion amount for an individual in 2011 and 2012 is $13,000 per donee. Married couples may continue to split their gifts, in essence allowing married couples to give gifts of up to $26,000 per donee per year. Under the 2010 Act, Grandmother and Grandfather can give each one of their grandchildren $26,000 per year, without ever touching their individual five million dollar lifetime exemptions. If Grandmother wishes to give each one of her grandchildren $20,000 a year, $7,000 more than the annual exclusion amount, Grandmother starts consuming her five million dollar exemption in the amount of $7,000 per grandchild. Only at the point when Grandmother exceeds the five million dollar lifetime exemption does the $7,000 per year over the annual exclusion amount become subject to gift tax. In 2011 and 2012, assuming that the five million dollar lifetime exemption amount has been used, each $7,000 gift would result in $2,450 worth of tax liability to Grandmother.
Generation Skipping Transfer Tax
The 2010 Act provides for a five million dollar exemption amount, and a 2010 generation skipping transfer tax rate of zero percent (0%). For generation skipping transfers made in 2011 and 2012, the applicable tax rate is equal to the highest possible estate tax rate for those years, thirty-five percent (35%).
For those persons who die between December 31, 2009 and January 1, 2011, the 2010 Act provides their estate with the option to select between two different tax treatments. The first option allows the estate to apply the reimplemented estate tax, with a maximum rate of thirty-five percent, a five million dollar applicable exclusion, and a stepped-up basis. If elected, a decedent’s estate would be subject to an estate tax of thirty-five percent only if their estate was valued at over five million dollars, with any property being received by children, family members, or others receiving a full step-up in basis; meaning that their basis in the property would be the value of the property on the date of the decedent’s death, and not the value of the property when the decedent came to own it. The second option allows the estate to elect the carry-over basis system and means that the estate will not have to pay any estate tax, but also requires using the carry-over basis rules established under EGTRRA, which does not allow for a full step-up in basis resulting in potential capital gains tax later when assets are sold. Once an election is made, the estate may change their election only with the approval of the IRS. The following discussion illustrates the major differences between the step-up in basis system and carry-over basis system.
Step-Up in Basis Option
First, under the pre-2010 system, the tax basis (or tax value) in property acquired from a decedent was adjusted (usually upward) to the fair market value of the property on the date of the decedent’s death without limitation. This is the “step-up in basis.” Depending upon the type of property in the estate, the tax savings from this rule can be tremendous, because a subsequent sale at date of death value results in no or limited capital gains tax.
To illustrate step-up in basis, suppose Dad bought a house for $50,000 several decades ago. At the time of his death, the property had increased in value to $400,000. If Son inherits the property from Dad, his basis in the property would be its value at the time of Dad’s death, or $400,000. If Son immediately sold the property for its present value, he would not realize any gain, and in turn, would not recognize or be taxed on any gain.
Carry-Over Basis Option
In comparison, under the carry-over basis system, inherited property is treated in the same way as if it were acquired by gift, that is, the beneficiary’s basis in the newly acquired property is the lesser of the decedent’s original basis (as may be adjusted for improvements or depreciation) or the fair market value of the property on the date of the decedent’s death.
This means that most beneficiaries will have a basis in inherited property equal to the decedent’s original basis (unless the property has decreased in value, a growing possibility given the current depressed housing market, and creates the unfortunate scenario of a property’s fair market value being less than its original purchase price). If the beneficiary immediately sells the property, the lower basis will result in a much higher gain, and in turn, a much higher capital gains tax.
Turning back to the original illustration, where Dad had purchased a house for $50,000 several decades ago that was worth $400,000 at the time of his death, applying the carry-over basis system, Son may only take as his basis the lesser of Dad’s original basis ($50,000) or the property’s current value ($400,000). Thus, Son’s basis will be $50,000. If Son then sells the property for its fair market value of $400,000, he will recognize a capital gain of $350,000.
The carry-over basis system does have an exception that allows an electing estate a basis adjustment equal to $1,300,000 plus the rest of the decedent’s unused section 172 net operating loss carryover, unused section 1212(b) capital loss carryover, and section 165 losses that would have been otherwise allowable had the decedent sold the property immediately before his or her death. One important point worth mentioning is that, understandably, under section 1022(d)(2), these upward basis adjustments are allowed only to the extent of the fair market value of the property. In other words, if the estate’s only property has a basis of $50,000 and fair market value of $400,000, a $350,000 allocation can be made, increasing the property’s basis to $400,000 (however a $1,300,000 allocation, increasing the basis to $1,350,000, is not permitted).
Building once more upon the original illustration, assume Dad owned three properties, the house with a basis of $50,000 and fair market value of $400,000 and also two rental properties, each with a basis of $100,000 and fair market value of $500,000. If Son inherited all three of these properties, he would have a total basis of $250,000 while the total value of the properties on the date of Dad’s death was $1,400,000. If Son wishes to sell all three properties at their present value, he will not realize any gain on the sale because Dad’s estate has the $1,300,000 basis allocation to be applied. Of the total $1,300,000 allocation available, $350,000 will be applied to the house (increasing the basis from $50,000 to $400,000) and $400,000 will be applied to each of the two rental properties (increasing the basis in those two properties from $100,000 up to $500,000 each). The remaining $150,000 allocation is unused. Next, if Son immediately sells all three properties at the value each had on the date of Dad’s death, he will not recognize any gain from the sales.
Finally, one more note, while the $1,300,000 basis allocation is the general rule, non-resident aliens are limited to only a $60,000 basis allocation. In addition, non-resident aliens are unable to take advantage of the additional adjustments for unused net operating loss and capital loss carryovers and section 165 losses.
In addition to the General Basis Allocation, under the carry-over basis system, a second basis allocation of $3,000,000 is allowed for property left outright to a spouse or in a trust from which a spouse is entitled to all of the income from the property and no other person can appoint the property to anyone other than the surviving spouse. This allows for a much greater adjustment for property left to a spouse.
Furthermore, although under the step-up in basis system, life estates and property subject to a general power of appointment are includable in a decedent’s estate and can receive a step-up in basis. Under the carry-over basis system, such property is not given the benefit of a basis adjustment. In addition, the basis adjustment is also inapplicable to property acquired by a decedent within three years of death for less than adequate consideration, unless the property was received from a spouse, and that spouse did not receive the property for less than adequate consideration, him-or-herself. The purpose of this section was to avoid possible death bed planning, in which property is transferred to a dying person, in order to be able to include the property in that person’s estate and receive a basis allocation, and then give the property, with a now increased basis, back to the original owner.
The Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010, in addition to extending the Bush Era income tax rates, reinstated the federal estate gift tax which had sunsetted on December 31, 2009. Under the 2010 Act, the estate tax is reinstated, for at least 2011 and 2012, at a maximum rate of 35% with a five million dollar exemption amount. For those deaths occurring in 2010, the decedent’s estate has two options: apply the estate tax based on the 2011 and 2012 rate and exemption, and receive a full step-up in basis; or pay no estate tax, but receive a modified carry-over basis. Surviving spouses may use their deceased spouse’s unused exemption amount, allowing the surviving spouse’s estate to have an exemption amount greater than five million dollars. The 2010 Act continues the state death tax deduction, rather than returning to a state death tax credit. The gift tax has been reunified with the estate, meaning that the gift tax also has a five million dollar lifetime exemption amount, and a gift tax rate of thirty-five percent. Also, the annual exclusion amount for gifts in 2011 and 2012 is $13,000. Generation skipping transfers occurring in 2010 are subject to tax at zero percent (0%), meaning that there is no generation skipping transfer tax for 2010. In 2011 and 2012, the generation skipping transfer tax will be imposed at a rate of 35%.
In general, the 2010 Act leaves taxpayers in a better position than they would have been if the Act was not passed and signed into law. The Act provides for a tax rate of twenty percent (20%) below what the estate tax rate would have been in 2011 if Congress had taken no action; likewise, the Act provides an exemption amount five times larger than the exemption amount that would have been in place in 2011. The portability of the unused deceased spousal exemption amount provides surviving spouses who recognize a significant change in economic status between their spouse’s death and their own, or whose spouse had significantly less assets than they did, to reduce the amount of their estate subject to tax, ultimately reducing their tax liability, but has a trap for the unwary client who does not properly file a return on the first death. In states imposing a sponge-tax death tax, the Act continues to ensure that no state death tax will be due, reducing the amount of state death tax owed by a decedent’s estate. Finally, the 2010 Act increases the lifetime exemption amount for the federal gift tax from one million dollars to five million dollars, further reducing the amount of taxes individuals and their estate’s have to pay to the federal government for tax years 2011 and 2012.