posted by: William J. Grinde
Followed is a summary of (1) the federal estate and gift tax changes in the recently enacted 2010 Tax Relief Act, (2) the reinstatement of the Illinois estate tax, and (3) an expansion of the Illinois rules pertaining to asset protection and tenancy by the entirety property.
Before the new federal law, there was no estate tax for persons who died in 2010, but some beneficiaries could have faced higher income taxes because there were less favorable income tax basis rules under the “carryover basis” provisions that applied for 2010. Also, under the prior law, estate and other transfer taxes were scheduled to rise substantially for post-2010 transfers.
Overview of the new law. The 2010 Tax Relief Act (the “Act”) provides temporary relief for the years 2011 and 2012. It reduces estate, gift and generation-skipping transfer (GST) taxes for those years. It preserves the zero estate tax for those who died in 2010, but in a roundabout way. Estates desiring a zero estate tax for 2010 must elect that option, which carries with it the less favorable modified carryover basis rules that were set to apply for 2010. If no election is made, the estate tax is revived for 2010, with a $5 million exemption, a top tax rate of 35%, and a step-up in basis. For estates of decedents dying after December 31, 2010, a deceased spouse’s unused exemption may be shifted to the surviving spouse. However, these generous rules are temporary – much harsher rules are slated to return after 2012.
Lower rate and higher exemption for 2011 and 2012. For estates of persons dying in 2009, the top estate tax rate was 45% and there was a $3.5 million exemption. The top rate was to rise to 55% for estates of persons dying after 2010, and the exemption was to be $1 million. For 2011 and 2012, the Act reduces the top rate to 35%. It also increases the exemption to $5 million for 2011 with a further increase for inflation in 2012. After 2012, unless changed again, the top rate will be 55%, and the exemption will be $1 million.
Special tax saving choice for 2010. The Act allows estates of decedents who died in 2010 to choose between (1) estate tax (based on a $5 million exemption and 35% top rate) and a step-up in basis, or (2) no estate tax and modified carryover basis. Basis is the yardstick for measuring income tax gain or loss when an asset is sold. With a step-up in basis, pre-death gain or loss is eliminated because the basis in the heir’s hands is set at the date of death value of the asset. On the other hand, with a modified carryover basis, an heir gets the decedent’s original basis, plus certain increases in basis, which can be substantial. Even so, if the decedent had a relatively low basis and significant assets, some pre-death gain may be taxed when the heir sells the property. These concerns factor into the special choice for 2010. The executor should make whichever choice would produce the lowest combined estate and income taxes for the estate and its beneficiaries. This would depend, among other factors, on the decedent’s basis in the assets immediately before death and how soon the estate beneficiaries may sell the assets.
Gift tax changes. Years ago, the gift tax and the estate tax were unified – they shared a single exemption and were subject to the same rates. This was not the case in recent years. For example, in 2010, the top gift tax rate was 35% and the exemption was $1 million, even though there was no estate tax (for 2009, the top estate tax rate was 45% and the exemption was $3.5 million). For gifts made after December 31, 2010, the gift tax and estate tax are reunified and an overall $5 million exemption applies.
GST tax changes. The generation-skipping transfer (“GST”) tax is an additional tax on gifts and bequests to grandchildren when their parents are still alive. The 2010 Tax Relief Act lowers GST taxes for 2011 and 2012 by increasing the exemption amount from $1 million to $5 million (as indexed after 2011) and reducing the rate from 55% to 35%.
New portability feature. Under the 2010 Tax Relief Act, any exemption that remains unused as of the death of a spouse who dies after December 31, 2010 and before January 1, 2013 (the Deceased Spousal Unused Exclusion Amount, or “DSUEA”) is generally available for use by the surviving spouse in addition to his or her own $5 million exemption for taxable transfers made during life or at death. Under prior law, the exemption of the first spouse to die would be lost if not used. This could happen where the spouse with resources below the exemption amount died before the spouse with more resources. One way to address that was to set up a trust for the spouse with the lesser resources. Now, the portability rule may make setting up a trust unnecessary in some cases. But there still may be other reasons to employ credit shelter trusts. For example, a credit shelter trust may protect appreciation occurring between the death of the first spouse and the death of the second spouse from being subject to estate tax. Such a trust also can protect against creditors. Plus, the DSUEA may be lost if the surviving spouse remarries and his or her new spouse dies. Also, the DSUEA is not indexed for inflation, which favors credit shelter trust planning.
Reinstatement of the Illinois Estate Tax. The Illinois Estate and Generation-Skipping Transfer Tax Act, which lapsed at the end of 2009 (the “Illinois Act”), has been reinstated for deaths occurring after December 31, 2010. The tax under the Illinois Act is based on the amount of the old state tax credit that would have been allowed under the Internal Revenue Code in effect on December 31, 2001, with a top rate of 16%. The amount exempt from tax under the Illinois Act is limited to $2 million. Because of this, a decedent with a $5 million estate would not be subject to any federal tax due to the increased exempt amount, but would have an Illinois estate tax of approximately $350,000. Married persons are allowed to provide for a state-only marital deduction trust to cover the difference in the exempt amounts in order to eliminate any state tax at the first death, but the property in the state-only marital deduction trust will be included in the survivor’s taxable estate for Illinois purposes at the second death.
Tenancy By the Entirety Property. For purposes of creditor protection, married couples in Illinois have for years been allowed to hold title to their primary residence as “tenants by the entirety.” Prior to 2011, couples holding homestead property as tenants by the entirety could not transfer their interests into any type of trust for estate planning purposes. However, pursuant to the Illinois Act effective January 1, 2011, spouses in Illinois can hold title to their primary residence as trustees of their respective revocable living trusts.
Conclusion. The federal estate tax relief under the Act is temporary, but substantial. Estate planning to reduce taxes remains an important consideration. Even if taxes are not a concern because an estate is below the exemption level, it is important to have a proper estate plan to ensure that the needs of intended beneficiaries are met.
At the very least, taxpayers should consider the following:
- Make lifetime gifts in excess of the annual gift tax exclusion (currently $13,000 per donee, per donor) to take advantage of the increase in the lifetime exemption from $1 million to $5 million.
- Re-evaluate the use of credit shelter trusts vs. relying on the portability features of any DSUEA at the first death.
-Formula for allocating between the marital trust and the credit shelter trust.
-Beneficiaries and distribution standards to be designated for the credit shelter trust.
-Allocation of assets between spouses.
- Make provision for state-only marital deduction trust at the first death to eliminate any Illinois estate tax at the first death and defer it to the second.
- Transfer tenancy by the entirety property to revocable living trusts so that the disposition of a married couple’s residence is better incorporated into their overall estate plan.