On December 17, 2010, the 2010 Tax Relief Act was signed into law.  It included many important estate, gift and generation-skipping tax provisions including those generally summarized below.

A transfer tax is generally imposed on the transfer of property to others: upon death (estate tax), during life (gift tax) and during life or upon death where the transfer of property skips a generation such as from a grandparent to a grandchild (generation skipping tax). There are exemptions allowed against the imposition of transfer taxes which have changed over the years.  Any gift tax exemption used during a person's life reduces the available estate tax exemption for transfers upon that person's death.  The same is true for the generation skipping tax exemption used during life. 

For income tax purposes, property inherited from a decedent would generally receive a step-up in basis to fair market value as of the date of death.  Property received as a gift during life would not receive a step-up in basis; the recipient of the gift would assume the donor's basis in the property.

Under the prior transfer tax law passed in 2001:

• the exemption from federal estate tax and generation-skipping tax was increased over the years from $1,000,000 in 2002 to $3,500,000 in 2009;
• in 2010 the estate and generation skipping taxes were completely eliminated but the step-up in basis was also eliminated and replaced with a modified carry-over basis step-up allowance of $1,300,000 plus $3,000,000 for certain transfers to a surviving spouse; and
• during this period, the gift tax exemption remained at $1,000,000 and the gift tax was not eliminated in 2010.

The provisions of the 2001 Act automatically expired (sunset) on January 1, 2011, and the estate and generation-skipping taxes were restored as if the 2001 Act were not passed, including the exemption reverting back to $1,000,000 and the top rate for transfer taxes increasing to 55%. 

The new 2010 Tax Relief Act postpones, for two years only, the expiration of the old 2001Act and makes certain additional changes during this two-year period through 12-31-2012.  After 12-31-2012, unless Congress takes further action, the 2010 Tax Relief Act will also expire, and the law prior to the 2001 Act will once again apply (i.e., the exemption would revert back to $1,000,000 and the top rate for transfer taxes increases to 55%).

The 2010 Tax Relief Act lowers estate, gift and generation-skipping taxes for 2011 and 2012 by increasing the exemption amount from $1,000,000 to $5,000,000 and by reducing the top tax rate from 55% to 35%.  The $5,000,000 exemption is per person so that a married couple has $10,000,000 of total exemption available.  The generation-skipping tax is retroactively imposed during 2010 but the tax rate is 0%. This has been done for technical planning purposes to allow for certain elections and options under the generation skipping tax rules for 2010.

Under the 2010 Tax Relief Act, for deaths occurring in 2010, these estates have been given an option to be retroactively subject to the 2010 Tax Relief Act (which imposes an estate tax with the exemption at $5,000,000 but with a full step-up in basis) or to elect to remain under the 2001 Act which was otherwise in effect during 2010 (i.e., no federal estate or generation-skipping taxes but only receive a modified step-up in basis).  An examination of the particular facts and circumstances in each case will dictate which option is preferable. Filing deadlines for these actions have been extended to nine months after the date of enactment of the 2010 Tax Relief Act.

A key change in the 2010 Tax Relief Act was the increase of the gift tax exemption from $1,000,000 to $5,000,000 with a top rate of 35%.  There are a number of advanced estate planning techniques, such as grantor retained annuity trusts ("GRAT") and qualified personal residence trusts ("QPRT") that can take advantage of this increase in the lifetime exemption. Since the new 2010 Tax Relief Act is scheduled to expire at the end of 2012, there is a limited opportunity to take advantage of this change and make increased gifts without the current payment of gift tax.  If Congress does nothing over the next two years and the 2010 Tax Relief Act is allowed to expire, then the estate and gift tax exemption will thereafter be reduced to $1,000,000.

Another very favorable provision of the new 2010 Tax Relief Act is the portability of unused estate tax exemptions between spouses. The new portability rules do not apply to unused generation-skipping tax exemption. Under the 2010 Act, any estate tax exemption that remains unused at the death of a spouse who died after December 31, 2010, is generally available for use by the surviving spouse as an addition to the surviving spouse's exemption.  This would eliminate the need of transferring assets to a spouse who has less than the available exemption in assets in order to take advantage of the full exemption.

For example, assume a spouse dies in 2011 with no assets and the surviving spouse dies in 2012 with $10,000,000 in net assets.  The first to die spouse's unused $5,000,000 exemption can be used by the surviving spouse under the portability provisions to eliminate the federal estate tax on the surviving spouse's $10,000,000 estate.  Without the new portability provisions, the first to die spouse's exemption would have been wasted and the surviving spouse's estate would be responsible for federal estate tax on $5,000,000. 

In the alternative, assume the first spouse dies in 2013 with minimal assets when the applicable estate tax exemption is $1,000,000 and the portability provisions have expired. The surviving spouse dies shortly thereafter with $2,000,000 in assets. The surviving spouse can only exclude $1,000,000 of assets and will owe an estate tax on the remaining $1,000,000.  If instead assets were previously transferred so that each spouse owned $1,000,000 of the family assets at death, there would be no estate tax regardless of the expiration of the portability provisions. In addition to transferring assets during life, the wasted exemption problem between spouses could also be corrected by a technique that grants the other spouse a formula general power of appointment over the wealthier spouse's estate.  Since the portability provisions are scheduled to expire at the end of 2012, estate plans should be reviewed to determine the extent that these corrective measures should still be implemented on a contingent curative basis so as to avoid wasting an available exemption. 

It is very common for estate planning documents to have formulas creating separate trusts designed to fully utilize the available exemption and minimize estate and generation-skipping taxes.  Since the amount of the exemption has changed (and will change in 2013 unless Congress takes further action), the effect of these formulas on a client's general estate plan should be reviewed to make sure it still fits within the intended objectives.

For example, assume the following facts about a married couple:
• the wealthier spouse with children from a prior marriage has $5,000,000 in net assets;
• the other spouse (with no children) has a minimal amount of assets; and
• revocable trusts were prepared years ago when the exemption was $1,000,000 and contain a formula provision in which the amount of the available estate tax exemption  would be allocated to a bypass trust solely for the benefit of the children of the first marriage and the remainder of the estate would be given outright to the surviving spouse.

If the wealthier spouse in this example dies first in 2011, the entire estate will be placed in the bypass trust for the children and nothing will pass to the surviving spouse. If the wealthier spouse dies first in 2013 (assuming the new law expires), then only $1,000,000 of the estate will be placed in the bypass trust for the children and $4,000,000 will pass to the surviving spouse outright. Even if the surviving spouse is also a beneficiary of the bypass trust while alive, the change in exemption shifts how much will be inherited outright by the surviving spouse versus what is inherited in trust by the surviving spouse.  It is very important that will and trust documents be periodically reviewed to keep place with these changes in the law as well as changes in a person's estate.

With respect to residents of the State of Illinois, the state estate tax provisions have been recently changed to create a tax trap. Married couples with estates that are larger than $2,000,000 may need changes to their current estate plan documents to avoid paying Illinois estate tax even though the will and trust documents have been properly set up to completely avoid federal estate taxes at the death of the first spouse.  Although the federal estate tax exemption is currently $5,000,000, the Illinois estate tax exemption is limited to $2,000,000 (with a maximum Illinois estate tax rate of 16%).  If you fully utilize your federal exemption by creating a bypass trust to minimize federal estate taxes, Illinois will impose an estate tax on such excess over $2,000,000.  This Illinois tax can be avoided by adding certain provisions to your estate plan documents to create a formula supplemental marital trust to be used in conjunction with the recently enacted Illinois QTIP election. 

Please contact us to discuss this further or to arrange for a review of your estate plan documents.