Understanding Federal Estate and Gift Tax

The version of this Article written in early 2010 had the subtitle "Estate Tax Repealed (for a while?)" Today an appropriate subtitle would be "Estate Tax Eliminated for Most (for a while).

In January 2010 the federal estate tax was repealed for one year, but it was scheduled to come back in January 2011 with a $1 million exclusion; in 2009 the exclusion was $3.5 million. For most of 2010 there was talk of a retroactive reinstatement of the $3.5 million exclusion. Finally, in mid-December the President and the Congress agreed to a new, two year law which included provisions for the estates of those who died in 2010.

The highlights of the new law are the following:

The federal estate tax was reinstated. As before, amounts going to charity or to a surviving spouse are not taxed, and the amount that can pass to others without tax (the "exclusion") was increased to $5 million.
The federal gift tax exclusion was increased from $1 million to $5 million
The estate and gift tax exclusions were unified (that is, a "Taxable Gift" using part of the gift tax exclusion also uses the same amount of estate tax exclusion.)
The rate for estate and gift tax is set at 35%.
A new concept of transfer between spouses was established. In the past, if estate tax exclusion was not used, it was lost. Now, any exclusion not used at the death of the first spouse can be added to the exclusion of the surviving spouse; that is a surviving spouse can have an exclusion which will protect $10 million of assets. This concept is called "portability."
The estate tax law with a $5 million exclusion was made retroactive for 2010, but estates of those dying in 2010 are allowed to elect the "no estate tax"/limited increase in tax basis provisions otherwise effective for 2010.

The question today is "how to proceed?" Unfortunately, as before there is uncertainty about the future. By historical standards, the new law is generous, but it lasts only through 2012. Unless a new law is enacted, the old 2001 estate tax law with its $1,000,000 exclusion will return at the beginning of January 2013.

There is now simplified estate planning for most clients. For the next two years, the new $5 million exclusion means that many of our clients don't need to be concerned about federal estate tax. If assets including insurance and retirement funds are less than $5 million, there should be no tax. For a couple, portability means that federal estate tax can be ignored if total assets are less than $10 million. Plans can be based upon what you want to do, not what you need to do to minimize tax. However, there remain concerns about your state's estate or inheritance tax and you will have to review your plan based on the federal estate tax in 2013.

State Estate Taxes - Virginia, like many other states, abolished its estate tax several years ago. If your state has no estate or inheritance tax, your estate planning must consider only the federal tax. Estate tax in Maryland and in the District of Columbia begins at $1 million, and Maryland also has an inheritance tax. Even though federal estate tax may be of little concern, any estate plan must take into consideration your state's estate and inheritance taxes.
Changes in Federal Estate Tax - The law providing for the $5 million exclusion and for portability terminates at the end of 2012. We believe it is likely it will continue beyond then, but that is only our best guess. The President's budget proposal assumed portability will continue beyond 2012, and as both political parties favor portability it appears very likely that it will continue. It is less certain that the exclusion will remain at $5 million. Most commentators assume that it will, and in our thirty odd years of practice the exclusion has never gone down.

Existing Plans containing estate tax planning need to be reviewed. Even though estate tax may be of little concern in the future, many existing estate plans should be reviewed and probably revised. The increase in the tax free amount to $5 million means that many plans not changed since the 1980's or 90's and plans prepared in the early 2000's will have unexpected results.

Married Couples. Most plans prepared before 2008 provide for a separate trust for each spouse and for division of assets between those two trusts. Before "portability," to avoid estate tax it was necessary at the first death to leave assets to someone other than the surviving spouse or to set up a "credit shelter" trust for the surviving spouse. If spouses left everything to one another, any exclusion not used after the first death was lost and only the credit of the survivor protected assets from estate tax at the second death. Now, the $5 million exclusion means that a plan which refers to the exclusion could result in the surviving spouse getting little while the credit shelter trust or children taking virtually all of the assets. Most older plans have a credit shelter trust which benefits the surviving spouse, but such a trust will result in unnecessary administrative burdens without any offsetting tax savings. Although there may be reasons other than tax reduction to put funds into trust for a spouse, such a trust, included in an estate plan only to minimize tax will result in the survivor having to deal with restrictions on access to funds and the requirement to file trust tax returns. These inconveniences made sense when they saved tax, but if there is no longer a tax reason for a credit shelter trust it will likely impose unnecessary administrative burdens and costs upon the survivor.

Individuals. Plans which based distributions on the estate tax exclusion may also have unintended consequences. Some plans provided that one or more charities were to receive any assets which exceed the maximum amount that can pass free of estate tax. The large increase in the exclusion may mean that charity will now receive nothing. That may or may not be what is intended.

The Gift tax lifetime exclusion was increased from $1 million to $5 million. That exclusion is reduced by certain gifts. Generally, the exclusion is not reduced by "annual exclusion" gifts or by payment of certain medical or education expenses benefitting someone else. Annual exclusion gifts are gifts made in a calendar year of up to $13,000 which are made directly to or for the benefit of another individual. There is no limit on such gifts, so a person with six grandchildren may give $13,000 to each grandchild (a total of $78,000) every year without reducing the $5 million exclusion.

Gifts that reduce the $5 million gift tax exclusion include gifts to any individual during any calendar year which exceed $13,000, certain gifts to trust, and gifts in which the recipient has no present interest. These gifts are referred to as "taxable gifts." Making a taxable gift, however, does not automatically trigger a gift tax. Taxable gifts are reported each year on a gift tax return (IRS Form 709), and that return reports that year's gifts, the amount of the cumulative gifts, and the cumulative reduction in the gifts and estate tax exclusions. Only after total taxable gifts are more than $5 million exclusion must gift tax be paid.

The maximum gift tax rate is 35% (it was 45% through 2009).